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Chief Executive Officers (CEOs)' compensations have grown rapidly over the past several decades. Executive compensations play significant role in a reward strategy for the top level of managers and subsequently development and profitability of the company (Hijazi & Bhatti, 2007). Executives engage in vital roles in which their decisions and actions would influence the company's capabilities and eventually performance. Thus, compensate to top level of management is more efficient rather than to entire workforce of the company (Bartov & Mohanram, 2004). For that reason, executive compensation is useful method in motivating executives to strive for the company's directions and activities (O'Connor et al. 2006).
Typically, a company with higher ability to pay for executive compensation will attract and retain the right employees to do the right job for the company (Chaudhri, 2003). Currently, there is shortage of executive talent, thus the company with higher of executive compensations paid will able to retain existence executives. Meanwhile, it will minimize employee costs such as recruitment and training costs (Hijazi & Bhatti, 2007).
In reality, executive compensations are aimed to combat the agency problem. The agency problem stems from the shareholders' desire for the executives to maximize their value of returns. Nevertheless, the shareholders are unable to observe or evaluate the executives' actions sufficiently (Lilling, 2006). Moreover, fixed salaries mitigate the motivation of Chief Executive Officers (CEOs) to maximize shareholder value (Chaudhri, 2003). Thus, there is an existence of executive compensation to align interests of management and shareholders. It implies that executives should be offered with compensation to enhance shareholders' value (Marjorie, 2008).
However, in the wake of recent corporate scandals such as Enron, these have drawn attentions that excessive compensations paid can induce executives to act fraudulently to manipulate earnings with the intention to increase their personal wealth (Goldman & Slezak, 2006). Such scandals lead to issue that the structure of executive compensation package is deficient and improper benchmarks are being used. Consequently, it gives executives' incentives to use their company's strategic benefit to pursue their self interests instead of the shareholders' interest (Hill & Yablon, 2002).
Generally, executive compensations comprise of four main components which are fixed salary, restricted stock, bonuses, long term incentives payouts and stock options (Efendi et.al 2007). Fixed salaries for executives are determined by benchmarking within the same industries. Sometimes, the companies might grant restricted stocks that are forfeited under certain condition. Bonuses paid annually based on the companies' particular year performance and long term incentives payoff according to cumulative three or five year performance (Matsumura & Yong Shin, 2005).
Stock options, is the firms grant executives' rights to purchase the company's shares at a pre-specified exercise price for pre-specified term. Stock options awards are the best way to motivate executives as the stock based compensations received by them are sensitive to the company's stock prices. It is able to encourage executives to be careful in making value added operation, financing and investment decisions to maximize firm value and subsequently shareholders' value (Cheng & Farber, 2008).
Nonetheless, there are arguments that stock options are ineffective means to compensate executives as they will use it for personal interest (Erickson et.al 2006). Furthermore, executives who are entitled to sizable amount of stock options will be more likely to be induced by strong temptation to artificially inflate stock prices (Harris & Bromiley, 2007). This is because stock options will exacerbate executives' unethical behaviors to act in their own interest particularly unprincipled agents (CEOs) (O'Connor et.al, 2006).
Advantages of Executive Compensation
Previously, there were several incentive contracting studies which indicated that reliance on executives' compensations will improve executives' performance. Meanwhile, it will be able to align the interests between agent and principal. Thus, organizations use executive compensations as method to motivate their top level of managers as it will make sure them to exert their efforts and strive to achieve the organizational goals (Vincent & Eggleton, 2007).
Furthermore, according to tournament theory, it proposes that executive compensation schemes are designed to motivate executives to strive towards the highest organizational ranks. Such higher rank will be awarded with higher pay. Thus, with more compensation paid, there will be more competent and aggressive executives involved in the tournament. Subsequently, it enables the organization to attract expertise and skillful executives (Shen et al. 2009).
Performance based incentives
According to agent principal theory, there are two means to mitigate the conflicts of interest between agents and principals. Firstly, it is through monitoring of the executives' actions by boards of directors or its shareholders. Nonetheless, such monitoring mechanisms hard to implement due to high costs and they might not observe the executives' actions at all the time (XiaoMeng et al. 2008). Thus, there is an existence of performance based incentives such as stock options which directly linking to executives' personal wealth. Thus, it would able to motivate the executives to act with the interests of the shareholders. As a result, many organizations use the performance based incentives as an important mechanism to align the interest between executives and shareholders (Marjorie, 2008).
Hence, well designed executive compensation scheme plays essential role to organizations. With the optimal executive compensation packages, the company will able to attract and retain higher quality of executives. By linking pay and performance, executives will strive for the company and serve for the shareholders' value. Meanwhile, it helps to minimize the overall costs.
Since 2002, there has been a number of high profile corporate collapses which have occurred globally. There is an emerging relationship between the escalation of Chief Executive Officers (CEOs)' compensations paid and current corporate collapses. Such scandals lead to questions on whether the design of executive compensation scheme, rather than used to combat principle-agent problem, or used by executives to pursue their own interest (Hill, 2006). It implies that executive compensation schemes are inherently flawed. For instance, in Enron's case, it paid excessive amount of incentives to its Chief Executive Officers (CEOs). According to the United State (US) Senate report on The Role of the Board of Directors regarding to Enron's collapse, the total compensation of its executive who is Kenneth Lay more than US$ 140 million in year 2000.This significant amount include US$ 123 million in exercising stock options. Furthermore, after Enron's collapse, the company still paid its executives with massive performance based bonuses in year 2001 as they had successfully achieve certain stock price target. However, it was discovered that such target was achieved through fraudulent account manipulation (Hill, 2006).
One of the performance based incentives such as stock options where link the executives' awards directly to the company's stock price and firm performance. Hence, it will motivate executives to strive for the shareholders' interests (XiaoMeng et.al 2008). Even though performance based incentives aimed at align Chief Executive Officers (CEOs)' interests with shareholders' interests. Nonetheless, it also imposes risks on executives (Craighead et.al 2005). For instances, in Enron's case, it highlights that substantial amount of stock based incentives will create compensation risk for executives and induce unfavorable behavior (XiaoMeng et.al 2008). As a result, Enron's executive fraudulently improved reporting information via illicit means in order to gain higher compensations payouts. With strong incentives of stock options award, it leads to strong temptation on unprincipled executives to raise stock price deceptively (Harris & Bromiley, 2007). Here, Enron's unprincipled executives act intentionally for their self interest which may harmful to the shareholders value maximization and ultimately lead to corporate collapse (O'Connor et.al 2006).
Hence, by tying executive compensation to the company's stock prices will not generate the desired outcome for better aligning the interests between executives and shareholders (Ryan & Wiggins, 2001). Stock based incentives will induce executives fraudulently manipulate earning information to increase their own wealth. Executives attempt to affect stock prices by engaging in unobservable earning manipulation and increasingly biases disclosed information (Goldman & Slezak, 2006). For example, In Enron's case, executives with considerably amount of equity based incentives, particularly stock options and unrestricted stocks, they inclined to abuse earning managements by manipulating reporting to enhance their wealth (Crocker & Slemrod, 2007). After the collapses of Enron had changed the public's perception that accounting and financial disclosures provided by the corporate on stock price performance cannot be relied. Obviously, the lack of disclosure in executive compensation scheme cause severe loss of investors' confidences (Goldman & Slezak, 2006). At this point, stock options proved to be a problematic reward mechanism and could lead to incentives misalignments. It may actually cause executives to pursue their self interest in the form of earnings manipulation.
Executive Compensations, Firm Performance and Earnings Manipulation
Chief Executive Officers (CEOs)' compensations and poor firm performance will increase the likelihood of earning manipulation by the executives (Harris & Bromiley, 2007; Nourayi & Daroca, 2008). Therefore, executive very concern about company's performance as it will directly reflect of their management capabilities and effectiveness. Moreover, firm performance in favorable position also related closely to executives' personal wealth.
High performance of the company in favorable condition will increase the executives' wealth. In contrast, poor firm performance in unfavorable condition will most probably cause executives loss their personal wealth. As a result, executives will attempt to maintain the company's performance in favorable position to make sure that their stock option value was enhanced. The firm performance related with stock option incentives will influence Chief Executive Officers (CEOs) to act fraudulently in earning manipulation. Therefore, when the firm in poor performance, it will more likely induce undesirable behaviors of the executives.
Under such unfavorable conditions, executives will be tempted to artificially manipulate earnings in order to improve the company's performance. It is not only reflects executives' abilities in running the company, but meanwhile also increase their own wealth (XiaoMeng et.al 2008). For instances, in year 2001, National Australia Bank (NAB) wrote down approximately A$ 4 billion as a result failed with the HomeSide venture. Nonetheless, in such poor performance position, its Chief Executive Officers (CEOs), Frank Cicutto was still regarded as the second highest executive paid in Australia. He was entitled to the increment in compensation paid by approximately A$ 1 million from year 2000 to 2001. Additionally, a number of (NAB)'s Chief Executive Officers (CEOs) in the United State associated with the HomeSide had received considerable amount of performance bonuses (Hill & Yablon, 2002).
In the National Australia Bank (NAB)'s case, illustrates the difference between executive pay and firm performance (Hill & Yablon, 2002). It shows that even though the bank achieved poor performance, but its' executives still obtained massive amount of compensation paid. There was fraudulent earning manipulation by the executives aimed at improving the company's reported earning to reach expected level.
Managerial Power Approach
Chief Executive Officers (CEOs) with the managerial power in setting their own executives' compensation paid would permit them to enhance their own interests by engaging in rent extraction. Usually, firms with weak board of directors and few institutional shareholders would raise executives' managerial power to enhance their executive compensation, and directors will cooperate at least to some extent (Shen et.a 2009). In addition, the separation of ownership and control in organization will entitle executives with absolute power to enhance their self interest. As a result, it will induce executives to manipulate artificially disclosures in financial performance from their desire to pursue higher paid of compensations (Bebchuk et.al 2002).
For example, in the events of corporate collapse in Sunbeam Corporation which was a beleaguered small-appliance maker, its Chief Executive Officers (CEOs), Dunlap had the power in setting of his executives compensations. In the beginning, Dunlap entered into a three years contract with Sunbeam, but after only eighteen months, he negotiated a new contract with the board of directors. In the new contract, his base fixed salary was increased with considerably amount and became entitled to one of ten largest options grant in the company. This was due to Dunlap using his power and control over the board of directors by influencing the directors' nomination process and subsequently over the financial reporting and disclosures (Hill & Yablon, 2002).
Lack of Disclosures in Executive Compensations
The current regulatory framework fails to capture all forms of compensation such as deferred compensation scheme, long term incentive payout and pension scheme. All of these compensations not subject to any specific disclosure. For instances, executives' retirement compensations are not required to disclose in the companies' publicly filed compensation table. Ultimately, these compensation values might be disclosed by the managers artificially. Since, stealth compensation such as deferred compensation scheme, long term incentive payout and pension scheme are not required any specific disclosures.
Executives might fraudulently use such stealth compensation to camouflage excess compensation paid (Marjorie, 2008).
Moreover, there is insufficient disclosure with regard to stock options incentives. The financial reporting only requires disclosure of the year where options are to be granted, its strike price and duration of options. Other than that, there is no need to disclose with detailed information such as type of options to be granted. Apart from that, the companies only required to disclose total compensations paid which comprise from all the top level of managers. There is not necessity to disclose the compensations paid according to executives individually. As a result, the deficiency of disclosure in term of executive compensations scheme are not able to provide useful information to shareholders in the long term prospect (Hill & Yablon, 2002).
For instances, there are corporate scandals which related to option backdating without disclosure in financial reporting. Before board of directors decide date to be grant date, executives inclined to design the date with the low stock prices to be a grant date. Subsequently, it will enhance their stock options incentives. Such option backdating leads to misstatement of financial reporting which hurt to the shareholders' value (Marjorie, 2008).
The Impact of Lack of Disclosures of Executive Compensations payouts
With excessive Chief Executive Officers (CEOs)' compensations paid, executives tend to enhance their personal interest by misstating the financial information. The artificial figures which are disclosed in financial reporting tend to be harmful to the organization involved, shareholders, employees and even the economic system (Harris & Bromiley, 2007). As shareholders are providers of risk capital to the entity, they need information to assist them determine whether they should buy, hold or sell. Meanwhile, they are also interested in financial information which enables them to assess the ability of the entity to pay dividends. Moreover, employees are interested in information about the stability and profitability of their companies. Hence, the misleading financial information would not provide useful information for them whose depend on accurate financial statement to support the debt and stock market. Ultimately, the organizations will become the main victim when filing for bankruptcy and collapse. Subsequently, all employees, investors, and other users will suffer (O'Connor et.al, 2006).
Reform of Executive Compensations
Since there is severe dilemma in manipulating and abusing in executive compensations scheme by executives. Securities and Exchange Commission has undertaken reform efforts to increase the quality and quantity of executive compensation disclosures (Matsumura & Yong Shin, 2005).
Under new regulations of Securities and Exchange Commission, there should be discussion of the compensation and analysis section where certified by Chief Executive Officers (CEOs). There are new rules on options disclosure. The company is required to disclose of the grant date and the grant date fair value of stock option incentives. Moreover, if the option grant date differs from the board of directors' decision date, the information should be disclosed in order to curb the problem of option backdating. Performance pay incentives and restricted stock are restricted in term of disclosures. There should be narrative descriptions when disclosing deferred compensation scheme, long term incentive payout and pension scheme (Marjorie, 2008).
Consequently, shareholders will be able to notice the company's practices and policies which are related to its executive compensation scheme. They will be able to detect whether the Chief Executive Officers (CEOs)' compensation packages are reasonable (Matsumura & Yong Shin, 2005). If there is excessive compensation paid, it will raise the public anger and outcry or even lead to shareholders' lawsuit. Therefore, board of directors should put more effort in to building up optimal executive compensation scheme in order to avoid such undesirable events to be occurred (Marjorie, 2008).
Hence, it is essential for the organization to provide full, understandable, precise and appropriate disclosure for shareholders to concern all vital components of executive compensation and practices. This is due to the lack of disclosure of information regarding the executive compensation will provide opportunistic for executives to form compensations packages according to preference with the intention to enhance their personal wealth (Craighead, 2004).
Corporate governance is aimed at eliminating and controlling conflict of interest which related to executive compensation through the use of independent directors, compensation committees. It revolves around erecting structures that may encourage the executives to be consistent with the objective of maximization the shareholders value (Chaudhri, 2003).
Nevertheless, in the case of Enron, even though it existed to operate in accordance with corporate governance best practice with an experienced board of directors, audit committees and compensation committees, severe conflict of interests was still observed by its board of directors' actions.
Thus, there should be mandated compensation disclosure to reinforce corporate governance. According to Securities and Exchange Commission, there are specific compensation disclosure rule which aimed at improving the organization's corporate governance structure in order to achieve higher governance transparency through disclose the way of executives be compensated. It permits shareholders to direct the board of directors to compensate executives meanwhile enhance the shareholders' value. It enables shareholders to exercise pressure on the board members in case of needed. The shareholders should impose pressure on board of directors to increase disclosure of information in executive compensation scheme (Craighead, 2005).
In point of fact, the company's compensation committees play significant role in assessing the performance of the executives and decide optimal executive compensation scheme (Matsumura & Yong Shin, 2005). Nevertheless, in Enron, its compensation committees only check on compensation paid structure but without ensure that the paid should match with its competitors (Hill & Yablon, 2002). As a result, there is an existence of corporate governance reforms by New York Stock Exchange (NYSE). Executive compensations paid should be strictly decided by the compensations committees, which are comprised of independent directors, in order to combat the excessive executive compensation paid. This is because executives who engage in nominating process may tend to appoint less independent directors aiming to design higher compensation packages. Thus, there should remove executives from nominating committee to reinforce the more independent committee and board of directors (Matsumura & Yong Shin, 2005).
Executive compensations, particularly stock options awards are aimed at offsetting the principal and agent objectives. According to the previous studies, it is effective due to the positive relationship between CEO compensation and market value of the company. A well designed executive compensation scheme will reinforce the incentive of the executives to run for the better corporate performance and enhance shareholders' interest.
Nevertheless, most of the time, Chief Executive Officers (CEOs) prefer executive compensation scheme which maximize their personal wealth. In contrast, shareholders prefer the compensation scheme motivate executives to strive for shareholder value maximization. There is the rash misstated financial statement by the unprincipled executives who with substantial compensation paid with the intention to increase their personal wealth. Moreover, insufficient disclosure of executive compensation in financial reporting has led to severe loss of the public's trust.
As a result, there are regulatory bodies that put effort in reforming of executive compensations schemes with the goal to increase the quality and quantity of executive compensation disclosures. Meanwhile, there is mandated compensation disclosure with the goal to enhance corporate governance transparency. It is to ensure that the corporate governance revolve around erecting structures that may encourage the executives to be consistent with the objective of maximization the shareholders value. Moreover, according to Sarbanes-Oxley Act (SOX) provision, the organization's Chief Executive Officers (CEOs) are required to assert that all information provided in the financial statements is accurate. Otherwise, they need to repay back bonuses and profits received in the event of proven fraud or even organization collapse.
These organizations should also wisely design and determine the appropriate compensation schemes to motivate the Chief Executive Officers (CEOs). For example, restrict the executives' stocks award based on specific requirements. Since the power of shareholders to determine the executive compensation scheme are relatively small. Hence, there should be institutional shareholders to take part in the nomination process and election of the directors. Thus, shareholders will be able to monitor the procedures of evaluating and rewarding Chief Executive Officers (CEOs). This will make sure that board of directors concern on shareholders' value through expansion power of the shareholders.
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