A study of executive compensation schemes

Category: Accounting

A business corporation is organized and carried on primarily for the profit of the stockholders' [Bebchuk L et.al, MA: Harvard University]. Lucian Bebchuk state that, executive compensation has spiraled up in the last couple of decade, many observer believe that top corporate managers are benefiting themselves at the expenses of the shareholder.

Executive compensation grouped into three basis categories, (1) salary and benefit that do not depend on the firm performance, (2) option and other incentive compensation that are based on the performance of the firm's stock price, and (3) bonuses and other incentive compensation that are based on the firm's performance according to specified accounting metrics. [Bebchuk L et.al, MA: Harvard University].

Main Body

Jeffrey Kerr says that, evaluating and rewarding executive performance is responsible by board of directors, and other have argued that the purpose of both a corporation's management and its board is to maximize the economics value of shareholder 's investment. [Kerr J et.al , Southern Methodist University].Lucian Bebchuk says that, even though manager are under a fiduciary duty to maximize shareholder wealth, executive compensation arrangement often fail to provide executive with proper incentive so to do and may even cause executive and shareholder interest to diverge.

Compensation schemes are claimed to be the product of arm's-length bargaining between managers attempting to get the best possible deal for themselves and board seeking to get the best possible deal for shareholders. Arm's-length bargaining model assume compensation schemes are generally efficient. [Bebchuk L et.al, MA: Harvard University]. Jeffrey Kerr states that, performance are measure based on raw rates of return. This indicated a positive relationship between various components of compensation and performance. In study of 29 conglomerates, Jeffrey Kerr indentify firms with greater than 30 percent or less than -30 percent shareholder return, the executive typically gained or lost about five times their annual compensation in stock value. In study of 249 corporations, Jeffrey Kerr used abnormal return based on comparison between performance in current and previous measurement period. They found a statistically significant relation between stock performance and executive compensation. [Kerr J et.al, southern University].

In June 2002, a new listing standard has been approved by the New York Stock Exchange's board that among other thing significantly enlarged the role and power of independent member of listed companies' board of directors. In month of July of the same year President Bush signed into law the 'Public company Accounting Reform and Investor Protection Act of 2002(The Sarbanes Oxley Act)' which he praised for making 'the most far-reaching reform of American business practice since the time of Franking Delano Roosevelt'. Bebchuk and Fried indentified a number of those reform speak directly to the sources of management power. Compensation committee must be created by listed company under the new listing standard of New York Stock Exchange, it comprised solely of CEO's. [Bebchuk L et.al, MA: Harvard University].

The compensation committee that created by listed company under New York Stock Exchange new listing standard, is now charged with hiring compensation consultants, a task previously left to management. To address the longstanding problem of directors interlock, in which CEO's of two companies would sit on each other's compensation committee and presumably scratch each other's back, the new listing standard provide that a directors may not be deemed independent if he is employed or has been employed in the last three years by a company in which an executive officer of the listed company serves as a member of the compensation committee. [Bebchuk L et.al, MA: Harvard University]. Lucian Bebchuk state that, New York Stock Exchange standard also address a cornerstone element of managerial power model, the CEO's has influence over the selection, reappointment, and compensation of directors.

To motivate the agent to select the action that are in the best interest of the principal, the owner design a compensation contract that makes the agent pay contingent upon observed measures of performance.[J. Conyon et.al]. Martin J.Conyon state that the measures of total executive compensation include cash remuneration plus stock based compensation.

Jeffrey Kerr says that, the purpose of salary and bonuses is to provide income security to executive. The relationship between compensation and performance is therefore unlikely and

also unnecessary because stock awards to executive has provide the connection between compensation and stock performance.

According to Lucian Bebchuk, salary and other non-performance based compensation schemes lack incentives that align manager and shareholder interest. In theory, manager compensation with fixed cleins on the corporations' assets will want to reduce risk, because they will value preservation of assets more than creating new wealth. Likewise, they will favor retention of earnings within the firm, rather than disbursement to shareholder. Lucian Bebchuck state that managers cash compensation has been at most tied to performance.

Accounting metrics disaggregated to reflect the performance of particular division within a firm bonuses and other accounting based compensation are an important tools for incentivizing mid-level managers, whose contribution are limited to a particular areas of the firm. Bonus paid compensation affects the choice of accounting techniques, with managers favoring these that shift income to current period. [Bebchuk L et.al, MA: Harvard University].

According to Jeffrey Kerr, the relationship between CEO's salary and bonus and the percentage change in shareholder return has described in pronounced monotonic relationship. If firm returning less than -30 percent to shareholder, the CEO's salary and bonuses dropped by only 1.2 percent, it is an insignificant penalty for obviously poor performance. In firm returning more than +30 percent to shareholder, the CEO's salary and bonus increased by only 8.7 percent, it is not insignificant but hardly a dramatic reward.[Kerr J et.al, Southern Methodist University]

Jeffrey Kerr says that, each CEO's total pay, consisting of salary, bonus, deferred compensation, stock option and fringe benefit, actually has increased regardless of return to shareholders. Jeffrey Kerr state that, in a firm the returning is less than -30 percent, the total pay for CEO's increased by 6.8 percent. In other hand in a firm returning is more than +30 percent, total paying for CEO's increased by 22 percentages.

Conclusion

Executive compensation is a classic agency-cost problem. Although CEO's and other executive is agent of the corporation and its shareholders, they have incentives to shirk. Executive officers maximize their own wealth and perks at the expense of their shareholder principal. Executive compensation schemes should strive to align executive's interest with those of the shareholder [Bebchuk L et.al, MA: Harvard University].

Back references :

Bebchuk L. and Fried J. 'Executive Compensation: Who decide?' MA: Harvard University, Book Review Essay 2004. [Online] Vol.88:1615, pp 1615-1662. Abstract from business Source Premier.

[http://web.ebscohost.com/ehost/pdf?vid=1&hid=102&sid=6f939fed-212f-4ea1-b770-299604adff86%40sessionmgr110]

[Accessed: 26th July 2009]

Conyon J.M, Peck I.S and Sadler V.G 'Corporate Tournament and Executive Compensation: Evidence from U.K.' Strategic Management Journal 2000. [Online] Vol.22, No.8, pp 805-815. Abstract from JSOR: Business Collection.

[http://www.jstor.org/stable/pdfplus/3094387.pdf]

[Accessed: 29th July 2009]

Kerr J. and Bettis A.R 'Board of Directors, Top Management Compensation, and Shareholders Return' The Academy of Management Journal 2004 [Online] Vol.30, No.4, pp. 645-664. Abstract from JSOR: Business Collection.

[http://www.jstor.org/stable/pdfplus/256153.pdf]

[Accessed: 30th July 2009]