The authors conduct an event study to analyze the effect of greater earnings transparency on the link between CEO share bonuses and firm performance. The authors examine the 1999–2004 period in Taiwan, when large stock bonuses were given to top executives but never disclosed on the income statement. In 2002, a new accounting rule went into effect that required footnote disclosure of what reported earnings would have been if stock bonuses had been treated as a firm expense (i.e., pro forma earnings). The authors analyze more than 6,500 executive-level observations from 986 listed nonfinancial firms in Taiwan from 1999 to 2004 and observe a significant reduction in bonus shares after the disclosure rule became effective in 2002. The change in compensation structure for top executives suggests that pro forma earnings disclosure can improve board choices and create a better alignment of manager and stockholder interests.

Compensation for top executives in the United States has attracted significant criticism and controversy. This criticism has primarily been focused on salary, severance pay, options, and restricted stock. But share bonuses for top executives have received less attention and regulation. The authors examine whether CEO and top executive share bonuses could constitute value extraction detrimental to shareholders. Their findings support the idea that pro forma earnings disclosure can change CEO pay structure and produce a closer link between executive share bonuses and firm financial performance.

The authors examine three research questions relating to pro forma earnings disclosure and CEO compensation arrangements. They estimate various regressions using a dataset of 6,583 observations from 986 listed nonfinancial firms in Taiwan between 1999 and 2004.

The first question relates to the extent that pro forma earnings disclosure influences the structure of CEO compensation. The authors’ findings suggest that after the 2002 disclosure rule went into effect, there was a significant reduction in executive share bonuses. The second question relates to whether CEO compensation arrangements are more congruent with the optimal contracting theory or the rent extraction theory. The authors find that after the new disclosure rule went into effect, the estimated inverse relationship between excess share bonuses and subsequent accounting performance became significantly less negative, which is in line with the optimal contracting theory.

The third question relates to the extent that share bonuses and total compensation became sensitive to stock returns after implementation of the 2002 disclosure requirement. The authors’ findings suggest that for many firms with an elevated ratio of market value of share bonuses to market value of total compensation, the relationship between pay and performance became closer after the disclosure rule came into effect. The results indicate that stock bonus reductions have a greater positive impact on the relationship between pay and performance in such firms compared with the sample average.

The authors’ research successfully provides insight into a controversial topic that has garnered relatively minimal attention. They make a compelling argument that greater transparency through pro forma earnings disclosure will improve board choices and create a better alignment of manager and stockholder interests. Ultimately, this closer link between CEO compensation and firm performance should enhance firm value and be beneficial for shareholders.