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The separation of the owners and the management of the company have introduced the agency theory in an organization. The managers (the agent) of the company are acting on behalf of the shareholders (the owner) in the daily operation in the organization, and they are compensated with an agreed amount of remuneration. However, the collapse of several well-known organizations such as Enron in United States has created doubt on the issue of executive compensation by the society particularly the investors and stakeholders of an organization.
Recently, the news regarding the failure of several well-established financial institutions around the world has further increase the popularity of topic regarding executive compensation. Although facing the possibility of bankruptcy, media reported that these financial institutions are still paying high executive pay for unproductive executives. This situation caused the public to lost confidence on the trustworthiness of the compensation schemes especially to the investors.
Executive compensation is the remuneration received by the executives for their service in the corporation. Generally, executive compensation is given in several forms such as base salary, annual bonus, stock options, restricted stock grant and long term incentive plan. Level of executive pay may vary from firm to another depending on several factors.
The research revealed that the main factor that influences the executive pay is the size of the firm which directly affect the firm's ability to pay and job complexity. Other than stated above, the availability of the human capital of executives also plays a vital role in the determination of the compensation packages provided by the corporation. Primary purpose of the reward of remuneration to the executives is to increase motivation of the executives who responsible in establishing the direction of company development and profitability (Matsumura and Jae, 2005). Correctly allocated remuneration also useful to attract and retain the right person into the organization.
However, recent occasion shows that the existing executive compensation packages in corporations are unable to demonstrate the intended purpose. The compensation packages are designed for the purpose of interest alignment between the managers and the shareholders. Yet, these packages designed have not able to accomplish the intended purpose. Various circumstances have arisen that essentially alter this objective into condition that is totally against to the shareholders.
This can be illustrated by the role of stock options granted by the executives is initially mean to align interest of managers and the shareholders by motivating the managers to act on behalf of the shareholders by maximizing the firm value. Nevertheless, some executives serve on their own interest rather than shareholder. Highly compensated executives are not exhibit the expected performance (Perel, 2003). Furthermore, provision of such compensation has caused the executives to extract rent from the company and transfer the wealth from the shareholders to the executives themselves.
This issue has attracted the attention of the investors as well as the regulators in dealing such matter. The viability of the executive compensation disclosure to the third parties is questionable. Investors and other parties are concern to the extent of disclosure on whether sufficient and appropriate information has been disclosed as the information will affect their economic decision making. Disclosure requirements relating to executives compensation has becoming more crucial in the society in order to protect the public interest.
Executive compensation is acting as an instrument to align the interest of the shareholders and the managers of an organization. Agency theorists believe that the compensation designed to be long-term oriented is associate to the future performance of the company. When the executives are compensated with long-term incentives, they will be motivated to increase the value of the firm in order to ensure they obtain the incentives as promised. However, assumption made by the agency theorists is not fully practiced by the executives in the reality.
The compensation provided to the executive often has no relation to the performance of the company. Moreover, the remuneration to the executives is not affected even the firm is performing poorly. This can be proven in the case of Washington Mutual Bank. Media reported that the new chief executive officer of the bank was paid 18 million US dollar for three weeks of office hour. However, the truth is the bank is facing illiquidity position and being charged into bankruptcy. Yet, the executive is still compensated with high remuneration.
Furthermore, executives have managerial power to control on their compensation in some organization (Efendi, et.al., 2007). This can be shown in the case of American Insurance Group (A.I.G.). The compensation of the group executives are overseen and control by A.I.G.'s former chief executives, Maurice R. Greenberg. The ability of the executives to control over their own compensation schemes allows them to extract wealth of the company's owners to themselves. This clearly exhibit that the shareholders' interest is leave unprotected.
The objective of pay for performance is to compensate the individuals in the organization in accordance to their performance contributed to the company. Individuals with higher performance are likely to be compensated with higher compensation and thus motivate them to achieve better performance. Better performance by the employees in the organization has direct influence on the performance of the company which can increase the satisfaction of the customers, better reputation of the company, higher sales generation and thus increase the value of the company as well as the wealth of the shareholders.
On the contrary, the pay for performance incentive has later become inconsistent with the initial intention that aims to motivate the managers or executives to act in the interest of the shareholders (Crocker and Slemrod, 2007). For the purpose of showing better performance, the executives tend to manipulate and conceal the true performance of the company from the public especially the owners in order to obtain high remuneration and other incentives from the company. They attempt to maximize the short term benefits available to them in expense of the shareholders. Due to the absence of a monitoring mechanism on the executives' behaviour in the organization, this has caused the wealth of the shareholders channelled to the executive themselves.
In addition, the executives also alter the timing of the company's information disclosure to achieve the target requirement for entitlement of the bonus or incentives. For example, when the shareholders promised the executive for a certain amount of bonus when the share price of the company achieve a given target, the executive will release insider information or news regarding the company to third parties.
The timing of the information released to the public can directly increase the share price of the company thus indirectly fulfils the requirements requested. Besides that, the executives also may collude with the forecasting analyst on the future earnings of the company to provide a lower forecast on the company's financial performance (Matsumura and Jae, 2005). Lower future earnings forecast provided by the analyst enables the executives to achieve the target requested by the shareholders effortlessly.
Share option is the shares of a company offer to the employees of a company at a price lower than the market price or at no cost imposed on them. Share option to the executives is also mean to align their interest to the shareholders and motivate them to increase the firm value and thus benefits the shareholders. Moreover, the number of share options hold by the executives has effect on the fraudulent financial reporting by the executives. Higher value of the share options hold by the executives tends to reduce the falsified reporting on the financial status of the company when the chief executive officer is also the board's chairman and compensated with share options and vice versa.
The executive ownership of the company's share implied that the executive become part of the owners of the company. For example, in the event of liquidation, voluntary liquidation is likely to protect the interest of the shareholders compared to compulsory liquidation. Percentage of share options hold by the executives positively influences the decision on the type of winding up of the company (Mehran et.al., 1998). When company's executive posses higher percentage of shareholdings in a company, voluntary winding up is more desirable compared to compulsory winding up as voluntary winding up is more favourable to interest protection of the shareholders.
However, granting share options to the executive may not necessary achieve the objective as expected. The role of share option in reducing fraudulent reporting has opposed by Harris and Bromiley (2007) where the proportion of the share option can also have negative influence on the misrepresentation on the financial statements. Executives with higher amount of shares options will likely to provide a falsified report of the financial statements.
In order to please the shareholders with the favourable company's performance and financial position, executives may use fictitious financial statements for this purpose. In fact, the company's financial performance might be totally different from what was reported by the executives. Meanwhile, the executives may have already sold all the shares on their hand before the information about the actual financial position of the company being released to the public. The failure of corporate governance in company may cause such matter to occur more easily and erode the interest of the owners.
Furthermore, managers with share options tend to use insider information to gain profit (Matsumura and Jae, 2005). The managers that act as the agent for the shareholders in the daily management of the company have caused the shareholders to have limited information about the company's operation. This has give advantage to the executives to have more information compared to the shareholders, and thus, occurrence of the information asymmetry. The executives are likely to know the details about the event happening in the company that may cause the movement in the company's share price in advance. Their ability to know the news in advance compared to the shareholders has enabled them to enjoy maximized profit while the investors may not be able to gain from the news.
Difference between the pay of the executive and the top management team has the motivational effect to encourage competition among them (Carpenter and Sanders, 2002). The managers of the firm are likely to improve their skills and expertise in order to compete with each other. Better equipped knowledge management is able to increase the efficiency and effectiveness if the company's operation and hence increase the performance of the company. This can also reduce the cost of monitoring on the performance of the executive and the management team. Furthermore, if the executive and the management team are better compensated via long term compensation, this can promote cooperation among them. This is due to the executive and the management team are sharing similar challenges to achieve their goal in order to obtain the compensation promised.
However, unbalanced incentives given to the executives and the management team may create dissatisfaction among them (Devers et.al., 2007). If the executive is better compensated compared to the management team, this will cause the management team to be envious and feel uneasy because their role in an organization is equally important in order to achieve high performance for the firm. This effect can further enlarge the problem face by the firm if the executive of the firm required the knowledge of the management team in the operation of the company such as in a high-technology firm. The wealth of the shareholders will be greatly affected when the performance of the firm is reducing by the performance of the employees.
In the United States of America, the Securities and Exchange Commission (SEC) has encouraged the disclosure of the executive compensation of the listed companies to be more transparent (Kin, 2003). This is due to increased disclosure of the compensation schemes granted by the executives can reduce the information asymmetry. Disclosure of the compensation information can increase the confidence of the investors towards the company's policy and hence increase the creditability of the company.
Importance of executive compensation schemes disclosure has become greater in order to protect the interest of the shareholders and other stakeholders. In the corporate world, disclosure of executive compensation schemes acts as an instrument to increase the creditability of the executives (Gordon, 2006). By disclosing the executives' pay, this has enabled the governance of the executives to be easier and effectively executed. This can enhance the knowledge of the shareholders about their management pay and to take action in the event of inappropriate compensated granted by the executives.
The extent of disclosure of the executives' remuneration has increased dramatically since the regulatory bodies make changes on the disclosure requirements (Liu and Taylor, 2008). However, the disclosure of the compensation is mainly focused in the remuneration received by the executives when they are still servicing in the company. Benefits that received by the executives post-employment such as pension and termination payments to the executives are still disclosed with the minimal information. The true compensation may reside in the final compensation received by the executives. Large amount of the compensation paid to the executives when they are retired or terminated may become a burden to the financial position of a company.
Furthermore, some components in the executive compensation are not fully disclosed in the reporting of the company's financial position (Rashind, 2005). Example is the perquisites consumed by the executives. Some managers tend to use the company's resources for own benefits in expense of the company. Due to the nature of the fact that value of perks consumed by the executives unable to value accurately, the executives have a propensity to abuse the value to be disclosed (Gordon, 2006). In addition, they may presume that the expenses incurred to be part of the professional costs to hide away from the eyes of public. The failure of a company to disclose such expenses may not able to provide true view on the compensation given to the executives and may affect the economical decision with regard to the company true performance.
Governance mechanism in an organization plays an important role to ensure that reasonable compensation is offered to the executives. Good practice of corporate governance can become an effective tool to monitor the composition of the compensation scheme rewarded to the executives. The existence of independent remuneration committee in the board of directors is likely to ensure the appropriateness of the compensation scheme designed (Liu and Taylor, 2008). The remuneration committee has the role to design the compensation packages provided to the executives. In addition, the committee also has the responsible to keep the shareholders always informed about the policies with regards to the design of compensation.
Yet, the information disclosed to the shareholders may not accurate when the composition of the remuneration committee has the influence of the executives (Matsumura and Jae, 2005). For instance, the committee may be elected or nominated by the executives. The independence of the committee is questionable as well as the appropriateness of executive compensation disclosure. The situation becomes worse when the board of directors also become supporters of the executives (Perel, 2003). The board may not able to challenge the position of the executives and influenced by the executives on the disclosure requirement. This has significantly influence the shareholders when the information provided regarding the compensation is not represent the actual amount expense in the compensation.
The collapse of many well-known organizations around the world has increased the concern of society especially among the investors and regulatory environment about the causes of the corporate failures. Executive compensation has been argued to be one of the potential causes in the collapse of the organizations. The inappropriate design of the executive compensation has caused the shareholders to bear a cost on the wealth extracted by the executives.
Although the intended purpose of the executive compensation components such as the stock options and the performance related pay is to align the interest of the shareholders to the managers, negative effects have take place eventually. The fraudulent reporting in the financial position of the company by the executives has caused further losses to the principals of the company. Self-centred executives are likely to produce falsified financial performance and trading the options grant by the use of the insider information in order to obtain maximized profit. In a nut shell, the executives will still have the intention to provide dishonest reporting of the financial position to the public even they are well compensated.
Disclosure requirements of the executive compensation are important to the executives to provide information regarding the design and rewards offered to the executives. The information provided has influence on the decision making process by the shareholders, potential investors and other stakeholders. However, the disclosure of the information may not always in favour of the interested parties. Some organizations may not disclose full information regarding the compensation granted by the executives. Compensation to the executives may has hidden expenses that is not reflected in the disclosure such as the perquisites consumed. This may not able to provide useful information to the shareholders and the investors during decision making.
Therefore, appropriate actions should be taken to improve the feasibility of the executive compensation and its disclosure to the public. To facilitate better interest alignment of the owners and the managers of an organization, institutional investors should be encouraged to involve in the shareholdings of an organization (Hartzell and Starks, 2003). In order to attract institutional investors with large pool of fund to invest into a firm, the firm may adapt the compensation schemes that are preferred by most investors. This has indirectly influence the design of the executive compensation as well as the disclosure of the information associate with the executive compensation provided. These disclosures can provide advantages such as reducing information asymmetry between the managers and other investors and the shareholders.
Furthermore, the role of independent remuneration committee should be emphasized in the design of the remuneration package. The independency of the committee members should always examine in order to ensure the remuneration designed is not opposing the interest of the shareholders. The disclosure requirement of the executive compensation also needs to be more stringent by covering more details of the composition of the compensation. More information regarding the compensation is disclosed can assist the investors and shareholders in making economic decision.
Finally, in order to protect the interest of the owners, shareholders are urged to participate more in the decision making process in the company particularly in the annual general meeting. This can ensure the interest of the owners is well protected and the voice of the shareholders can be taken into consideration by the management of the company in direction and policies adoption by the management.