1.0 Introduction
Executive compensation is an incentive payment to the executive who acts as an agent to operate the company on behalf of the shareholder. (Vivek, 2003) [Online] The remuneration package includes short-term and long-term incentives. The example of short term incentive is like cash compensation which includes salary and bonus. The long term incentive is like share payment which includes the stock grants or stock options. (John 2005) [Online]
According to Nourayi the compensation scheme is to determine level of the reward and to motivate the agent with correlated to their performance to the company. (Nourayi and Daroca, 2008) [Online] The compensation practices should align management’s interests with those of shareholders. Furthermore, the executive compensation scheme also important to reduce the conflict of interest between agent and principle (the Agency Problem).
Recently, arguments had occured whether to disclose the executive schemes in the Annual Reports and Accounts of listed companies. The disclosure of the executive schemes may help to create greater transparency in the company and it is fair for the shareholder and the executive to understand the performance of the company and whether they are paid according to the level of performance. (Bahar, 2005) [Online] But anyway, some parties have disagree and stated that this information does not provide shareholders with useful information about the companies’ long-term prospect. Such information may mislead the decision making of the investor if they use it as a fundamental support when making decision in the investment.
2.0 Body of the report
2.1 Pay of performance
Previously, the executive compensation was dependent on the accounting performance of the firm.(Canarella and Gasparyan, 2008; Nourayi and Daroca, 2008) [Online] If the overall accounting performance of the company is good, the compensation or rewards would also will be higher. However, research by to Nourayi (2008) show different result, he found out a declining link of the compensation with the performance of the company.
Pay for performance compensation scheme may help to induce future profitability of the company as the executives will work hard and look forward for best compensation or rewards at the end of the financial year.(Nourayi and Daroca, 2008) [Online] Through this mechanism also, it can make sure the CEO focused on the current year operation and the current value of the company to enable for them to achieve the executive bonus.(clieaf, 2005) [Online] The executive compensation also may have own incentive package from the stewardship role.
Anyway, there is inherently flawed in this type of method. First, the executive compensation pay according to performance of the company may cause the Chief Executive Officer (CEO) to manipulate the earning to show the exceeding to the financial analysts earning from expectation, to receive the bonus or to entitle the stock rewards for the performance measurement.
Second, the magnitude of the observed pay and performance relationship is too small to provide an effective measurement of performance. The accounting based measurement about the company past performance may show the usefulness of the measurement in the compensation scheme.
2.2 Pay for performance – value creation (agency theory)
The basic pay for performance compensation scheme is too simple, the time frames are too short, and the goals are easily achieved. (Hewitt, 2007) [Online] By the way, the sales, operating income, earnings per share may not be necessarily correlated with the companies’ actual value. This is also proved by Nourayi (2008) who stated that the sensitivity of company performance is no longer tenure and not perfectly aligned with the CEO compensation objectives.(Vivek, 2003) [Online] As a result, a lot of top performance companies nowadays, have moved to evaluate the executive compensation by using value creation (agency theory) scheme.
The corporation may consider using cash flow, economic profit and Return on Investment (ROI) as variable to measure the level of compensation. They should avoid using the easy measurement like earning per share (EPS) to manipulating the result. (clieaf, 2005) [Online] The goal of the scheme is to link executive decisions and performance outcomes to the production of long term cash flow which over time, drives stock prices and the ability of company to exceed investors’ expectation.
Through this scheme, to enable for the executives to get paid on the compensation, the executives have to value not only to their personal goals but the company’s overall financial performance and their contribution to the company’s strategic goals. This performance paid incentive mechanism may increase corporate value by the manager, and the certain key management. (Hewitt, 2007) [Online]
The challenge of this mechanism is that the compensation committees need to design the scheme by considering multiple-year pursuits. They must make sure the incentive payouts are balanced between the achievement of interim goals and long-term success (Hewitt, 2007) [Online].
2.3 Pay for performance – maximizing shareholder return
Another measurement for executive compensation is through maximization of shareholder return or earning per share (EPS). The shareholder value include revenue, operating margin, cash tax rate, incremental capital expenditure, investment in working capital, cost of capital and competitive advantage period. Using of the total shareholder returns or earning per share as a measurement of the total executive compensation can be more managerial and indeed is an ultimate measurement of total executive compensation. This is because the top executive needs to consider the interests of shareholders foremost in business decision. This avoids the CEO or management taking actions to enrich themselves at the expense of shareholders.
Anyway, short period based compensation on the total shareholder return and a stock price or the sale of assets in pay, may take risk to destroy long-term value return of management, while long-term shareholders will have significant economic losses.(clieaf, 2005) [Online] This have happen to Enron and WorldCom. Before Enron and WorldCom declare bankruptcy, they have positive EPS growth for 20-plus consecutive quarters.(clieaf, 2005) [Online]
2.4 Stock option
According Meek, Rao and Skousen (2007) believes that executive compensation should be closely tied to company and stock performance. As so, another executive compensation scheme is through the non cash compensation (stock option grant). (Nourayi, 2008) [Online] There is different opinion from different researchers on the stock option mechanism. From the research of Meek, Rao and Skousen (2007), he found out that stock option executive compensation has the positive relationship with the earning management. But according to the empirical research of Nourayi (2008), the growth of the sales or shareholder return are not much related to the executive compensation, but are correlated to the earning, book value and per share dividend.
Anyway, through this type of compensation scheme, it may create conflicts of interest between the management and the shareholders. This conflict arises when the management has motives to pursue their own interest at the expense of the shareholder. The stock option executive compensation scheme may let the CEO to manipulate the earning in the firm to led the share price increase and get more return on the selling stock.(Anon 1. 2003; Meek, Rao and Skousen 2007) [Online] This may cause the executive to mislead the investor about the true condition of their company especially when the executive want to increase the value of the company’s shares. This may incur the fraudulent activity in the company. As a result, it may create asymmetric information problems. (Vivek, 2003) [Online]
2.5 Executive taking the advantage of the stock price movement
A well designed compensation scheme may help the company to reduce the agency costs. The advantage of compensation scheme by stock option is that it may help the company to reduce the tax rate to be paid. This is because according to the statue, the compensation are deductibility when excess a certain amount (Anon1. 2003) [Online]. Another advantage is the stock option may less expense than the salaries base this is because the stock option may have links to the performance of the company and the return will be based on the investment from Extenal Company. (Dorata and Petra 20008) [Online]
Another major concern for the stock option scheme is probably because the shareholders do not know the level of the compensation to be paid to the executive. They do not know the target that should be achieved by the executive. (Vivek, 2003) [Online] If the executive compensation using stock price as measurement of executive compensation, it may create problem to the company especially harm the long term benefit of business. The fraudulent activity in the company may increase. The CEO may reduce the expense to boost up the year-end earnings in the financial statement. They may do some adjustment by cutting down the cost like reducing the expense incurred for training, marketing, advertising and R&D investments in the year end to increase the earnings. (clieaf, 2005) [Online] This may contribute to collapse of the organization in the future like what happen with Enron. (Nourayi and Mintz 2008) [Online]
2.6 Executive Loan
Another common executive compensation scheme includes executive loan program. Executive loan programs include relocation loans, sign-on loans, loans to purchase restricted stock, loans for cashless exercise of stock options, salary advances, split dollar life insurance policies and personal use of corporate credit card (Insight, 2009) [Online]. Prior to Sarbanes-Oxley Act 2002, more than half of the large organization lent money to the executive (Bebchuk and Fried, 2003) [Online]. The benefit of this scheme is this loan has favorable interest rate compare the market rate from bank. By the way, it is believe that by doing so it will benefit the company by the salience of manager’s compensation. (Bebchuk and Fried, 2003) [Online]
Unfortunately, there are a lot of abusive cases in the executive loan scheme. It is believed that there is abusive lending to insiders for items of conspicuous personal consumption (Insight, 2009) [Online]. As a result, the Sarbanes-Oxley Act 2002 has prohibited public companies to lending funds to their directors and executive officers.
3.0 Disclosure
There are a lot of cases where the large corporate firms had collapse after high incentive paid to the top level executive (Enron). (Nourayi and Mintz 2008) [Online] As a result, there is argument whether to disclose the executive compensation in the business report.
The disclosure of the executive compensation mean the company has to write in the detail report for the element make up the compensation package for executive. This includes the explanation of compensation philosophy, the objective of compensation program, the reward and performance payments.
Disclosure in financial report may be beneficial to the constituencies and shareholder, the corporate governance provide more power to shareholder to give pressure to the board when there is necessary. (Canarella and Gasparyan, 2008) [Online] When the executive compensation packages are not subject to shareholder scrutiny, then they are under pressure in setting the level of incentive to executive. (Belfield and Marsden 2003) [Online] The level of compensation may also influence by the number of member in the board of director and the compensation committee. (Bahar, 2005) [Online] The size of the board may affect the decision of the shareholder, and control the level of compensation scheme paid to the top executive level. The corporate governance system also plays a role in protecting shareholder from abuse by management. (Bahar, 2005) [Online]
Anyway, the corporate governance does not force every large company to disclose the detail of the stock option compensation in the financial statement. (Bahar, 2005) [Online] But, they need to disclose the part of the compensation scheme such as the time of grants and the strike price of the stock option. However, the company does not have to disclose the executive compensation grant by stock option, publicity option value what is prevailing market conditions, is granted or, if they are in compliance with the waiting period.(Bahar, 2005)[Online]
Anyway, in the principle and agent relationship, the disclosure is not important to the board of director, this is because they are employed by the shareholder to monitor and run the company on their behalf. However, if directors found that their welfare more closely to the firm than shareholders within enterprises, and then this disclosure may become important. (Weber 2006) [Online]
Compensation disclosure provides transparency in the operation. The transparency of the executive compensation may help the shareholders to know that whether they are sharing the same goal with all executive. (Bahar, 2005) [Online] Compensation disclosure can help inactive shareholder to analyze result of the implementation plan and discover inappropriate react by the top level executive.(Bahar, 2005) [Online] The transparency of executive compensation also may prevent atrocities and make the management more constraints.(Bahar, 2005) [Online] Furthermore, the transparency of the executive compensation scheme may reduce the protection of the private sphere of the corporate executive.(Bahar, 2005) [Online] The disclosure in financial statement can reduce the uncertainty of shareholder and the incentive systems are set to promote the management accountability.(Bhattacharyya, Mawani and Morrill, 2008) [Online]
On the other hand, the compensation scheme base on the stock option may cause the conflict on the value of the compensation when disclose it. (Verbeeten, 2008) [Online] The executive compensation using the stock option may led to inaccuracies of the accounting, this is because of the difficulties to discern the value in term of monetary which show in the financial statements. In the stock option, only the economic cost occurred for the outside investors. But it does not provide accounting cost or cash expenditure in the statement. (Nourayi and Mintz, 2008) [Online]
To prevent the misconduct of executive loan, the Sarbanes-Oxley Act 2002 have prohibits the remuneration by loan. At first, the compensation’s below market interest rate often does not appear in the compensation tables in the annual company filling. But under the Security Exchange Commissions (SEC) rule, it is stated that firms must disclose such interest in the classification of other annual compensation by stating the difference between the interests actually paid on executive loans and the market rate.(Bebchuk and Fried, 2003) [Online] However, the SEC does not define "market value" and the company has explained that they can be excluded from compensation table big interest rate subsidy of the value of the term. (Chun-Keung and Ashok Robin) In the case of Ebbers’s, despite the large financial benefit provided by the extremely low interest rate on his loan, the loan does make the attention in disclosure in company filling until WordCom involve in an accounting scandal. (Bebchuk and Fried, 2003) [Online]
4.0 Recommendation
Getting executive compensation right is a challenge for every corporate. Mr William H. Donaldson, Chairman of U.S. SEC commented that executive compensation as “one of the great as-yet-unsolved problems” in most of corporate America. Committees are actively evaluating the existing programs to figure out the right way of compensation scheme.
One of the ways to improve the executive compensation scheme is to create independence, diversity and expertise in Compensation Committees. Committee members should be independent directors or third-party counsel. (Yao and Appelbaum 2007) These people can have different background and finance knowledge. Since they are independent directors, their judgment will be free of interest conflicts between agent and principle. They are given authority to give approval in the process of executive compensation at the board level. Independent compensation committee will lead to more independent executive compensation plan proposal.
One of the indicators for executive compensation may be through peer comparison. In this remuneration scheme, the executive compensation is tied closely not only to the overall performance of company itself but the performance relative to its peers. Executives will be paid in line with company’s relative performance.
Peer groups are selected for the compensation purposes. The factors of evaluation include size (revenues, market capitalization, assets and number of employees); performance (total shareholder return, cash-flow measures, return on investment, and growth); competitors for customers, suppliers and investors) and peer executive talent. The performance is being weighted based on one-, two- or three year data. By doing this, the committee will ensure that the executives only get paid when they deliver outstanding performance compare to their peer.
The compensation committee may also design Balanced Performance-Based Long-Term Equity Compensation. The executive compensation should design a system to link pay with corporate performance. It should be aligned with corporate goals and strategies and the long-term interests of stockholders by including significant performance-based criteria related to long-term stockholder value. (Nourayi and Mintz, 2008) [Online] This includes sales growth, profit gains, improved efficiency and market share. (Verbeeten, 2008) [Online] By the way, the executive incentives should be tied not only business accomplishments, but also include individual accomplishments. The individual accomplishment can also be measure by non-financial indicator like customer satisfaction, innovation and product quality. The compensation committees should encourage or require executives to build and maintain more prevalent long-term equity investment in the corporation. (Bahar, 2005) [Online]
By using the above indicators, it will enhance the independence of corporate boards in making decision. It also may shift power away from a group of people (top executive). This may prevent the fraudulent activities done by the top executive.
With non-finance indicator, it may force the company to concern about the needs of customer to enable for the company to fulfill customers’ satisfaction. Continue innovation and value creation to the customer may help in company positioning. Product with better quality and value added may boost the sales of the company in the long-term and as a result may increase the market value of the company in the long run. (Clieaf, 2005) [Online] It create win-win situation among all the stakeholders.
5.0 Conclusion
In conclusion, the Sarbanes-Oxley Act has given the corporate governance an important role to ensure the accountability of certain individuals in an organization and reduce or eliminate the principal-agent problem. The statue required Executive Compensation to be disclosed to prevent executive from manipulate the purpose of executive compensation by receiving record-breaking compensation packages regardless of company performance. The executive compensation planned should not only indicate by the performance of the company, but must also involve the balance blending of performance-based and long-term approach to executive and equity compensation. However, every company has to tailor the executive compensation package plan with its own unique corporation culture.