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In the aftermath of the collapse of several well known organisations such as Northern Rock Bank in United Kingdom (UK), the structure of executive compensation systems has become a controversial issue in corporate finance. It stemmed from the fact that investment banks had paid large bonuses to their employees, particularly to managerial level executives. Nevertheless, the executives end up with poor corporate performance and ultimately led to business collapse.
In reality, an executive compensation scheme functions as a mechanism to provide an incentive to Chief Executive Officers (CEOs) to act in the best interests of the shareholders. Meanwhile, it plays a role to encourage the managers to take risky investment which would increase the firm's value. (Chaudhri, V., 2003)
According to March and Simon (1993, p. 82), “the greater the dependence of monetary reward on performance, the more favorable are the consequences perceived as resulting from a decision to increase production.” Moreover, they agree that an inducement will increase the managers' effort work toward the goals and objectives of the corporate.
Typically, there are two kinds of executive compensations which are bonuses and stock option grants tied to performance. They are usually offer very clear connections between firm performance and individual compensation. Therefore, a well-defined executive compensation scheme would reinforce the manager incentives and lead to better corporate performance. (Harris, J. and Bromiley, P., 2007)
In fact, the directors of the company use executive compensation to combat the principal agent problem. The principal agent problem stems from the shareholders (principal) desire the executive (agent) to maximize their value. Nevertheless, the shareholders are unable to observe or evaluate the executive directors sufficiently. (Lilling,M.S., 2006)
In addition, fixed salaries mitigate the executives' incentives to maximize shareholder value. (Chaudhri, V., 2003) Hence, in order to combat this problem, there is an existence of pay for performance incentives in executive compensation contract to compensate Chief Executive Officers (CEOs). It aims to encourage the executives to perform well by aligning the interest of Chief Executive Officers (CEOs) and shareholders. (Lilling,M.S., 2006)
In retrospect to the previous twenty years, there has been a tremendous development in empirical economic testing which successfully prove that executive incentive compensation was effective. The level of managerial effort to combat the principle agent problem is relatively high with the pay of executive incentive compensation. It impressed that Chief Executive Compensation is an effective way to solve the principal agent problem. Moreover, it also indicates that Chief Executive Compensation and performance are both heavily linked during the initial years of an executive's career. (Lilling,M.S., 2006)
Nowadays, however it does not motivate the manager effectively to strive for the sake neither of the company nor the shareholders. Instead, the executive director perks are set with shareholders' interest in mind.
Currently, Chief Executive Officers (CEOs) with large amounts of stock options tend to be provided with an incentive to misstate the financial statement. They attempt to improve real financial performance via illicit means. Illicit means include direct misrepresentation of the firm's financial outcomes or improperly misrepresent the financial statement to avoid exposure. Subsequently, by improving reported performance, it would elevate stock prices and executive compensation of the Chief Executive Officer (CEO). (Harris, J. and Bromiley, P., 2007)
According to Varian (2002, p.10), Chief Executive Officers (CEOs) 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, J. and Bromiley, P., 2007) This was evidenced by the spectacular failures in corporate history, such as One.Tel which is an Australian telecommunications. Its Chief Executive Officers (CEOs) compensation was not properly thought through and implemented. As a result, its market share yielded negative corporate outcome. Eventually, it resulted in severe loss of the shareholder value. (Chaudhri, V., 2003)
As a result, a few experts call for total change in executive incentive compensation system. For instances, the former Federal Reserve Board chairman, Paul Volcker, concludes that all stock option compensation should be scrapped, due to the almost the way of stock options are subject to abuse and tempted.
Due to the current management ethical is deteriorated, Chief Executive Officers (CEOs) tend to adversely misstate the financial statement. Even if that manager generally yields towards ethical actions, nevertheless the likelihood of managerial impropriety would be arisen with the inducements higher paid of compensation schemes.
The misstatement of the financial statement by Chief Executive Officers (CEOs) will have significant impact on firms and its stakeholders. Moreover, the revelations of misstatement will often result in ruinous corporate economic outcomes. Subsequently, the confidence of its stakeholders such as employees, customers, suppliers, and investors who depend on its financial reporting will be severely damaged. (Harris, J. and Bromiley, P., 2007)
Indeed, an incentive executive compensation is in principle aimed at offsetting the principal and agent objectives. It is effective due to the positive relationship between CEO compensation and market value of a firm. (Lilling, M.S., 2006) Moreover, a well-defined executive compensation scheme will reinforce the incentive of the managers and lead to better corporate performance. (Harris, J. and Bromiley, P., 2007)
Currently, however, there is a considerable controversy around the relative merits of financial and non pecuniary benefits within organisations. (Chaudhri, V., 2003) It stems from an occurrence of the rash misstated financial statement by the unethical CEO who with substantial compensation paid. As a result, there is a severe loss of the public's trust. (Harris, J. and Bromiley, P., 2007)
Hence, there should be exchange between the culture, transparency and openness of information across an organisation which is more focus on maximising shareholder value across time rather than tout executive compensation schemes. Furthermore, the corporate governance should revolve around erecting structures that may encourage the agent who is the manager to be consistent with the objective of maximisation the shareholders value. (Chaudhri, V., 2003)
Finally, the firm also should play the crucial role to be wisely in designing and determining the appropriate compensation schemes to motivate the independent directors. For example, restrict the CEO stocks award based on specific requirements. Meanwhile, they should be imposed to act for the best interest of the shareholders but not perks are set with shareholders' interest in mind. (Harris, J. and Bromiley, P., 2007)