Finance and Accounting, Analyzing Remuneration Packages - Literature review Example

?Finance and Accounting, Literature review For quite some time, the issue of remunerations has been a thorn in the flesh of many companies. Managers have been accused of getting much more than they deserve while the employees are sweating more to help them achieve a fat check at the end of the month (Fama and French 2001:16). Many companies have become victims of these accusations with many more suffering price losses and even closures as a result of having their executives drawing more from the bank than the company would handle. Others have been accused of being involved in scandalous activities that have led to the collapse of company shares. Controversies such as those linked to the former GE CEO, Jack Welch and the NYSE CEO Richard Grasso have made many companies to create a guideline that will be used to limit how much company executives can earn. It is important to note that even in the cases of the above CEOs, their work and performance on the job was impeccable and many would believe that they earned what they had worked hard for (Jensen and Murphyn 2004:15). However, there is a perception that there was a lot of inadequate disclosure and that they received a little ‘too much’ despite their performance. According to the general conference convened by the International Labor Organization in 1951; the term remuneration was defined as (Yang 2008:654): “the ordinary, basic or minimum salary and any additional benefits that are payable whatsoever directly or indirectly, whether in cash or in kind, by the employer to the worker and arising out of the worker’s employment.” Success on the other hand is mainly defined by the amount of output acquired as a result of one’s ability to utilize the opportunity given to them to lead, supervise, mentor and motivate others effectively. Though many believe that performance is imperative, others postulate that traits and effective practices determine who one becomes and how much they achieve while at the executive position (Yang 2008:654). Others believe that the successful ones are not necessarily the most effective and the debate may go on for a long time. However, the main aim of this report is to look into the issue of remunerations and how they are determined based on performance, success and commitment rather than astuteness to ascend to higher positions quickly. Analyzing Remuneration Packages The past history, if anything to go by, teaches the corporate world that managers, however effective, require having a maximum for the company to remain afloat even when they leave. Attention is mainly given to those who draw so much that the divide between them and the employees widens every other day. People are entitled to get the maximum they can from their hard work. However, placing a cap on how much one can draw is also important for effective running of the company. Many however argue that the lack of proper and adequate disclosure on how much each of these executives earns has placed a barrier between them and other employees (Jensen and Murphyn 2004:13). Many believe that they are receiving record salaries and bonuses. As a result of this, the 1951 convention sought to bring all the remunerations at par within the companies without watering down the motivation of all the employees. For instance, GE’s CEO had planned for some lavish retirement benefits that were kept secret to the board and the shareholders (Fama and French 2001:23). The reputation of one of the world’s greatest entrepreneurs was questioned. This incident led many to believe that this is what all the other CEOs were receiving. The case of the NYSE CEO was no different. He was accused that he was bound to receive a retirement benefit of close to $190 million in 2003 which was also not disclosed to the board (Jensen and Murphyn 2004:15). These cases bring about a lot of questions that the report will try to answer. The issue of disclosure is very vital in any organization based on the sensitivity of the remunerations issue. However hardworking these executives are, the importance of transparency cannot be overlooked by all means. The company must first be ready to create a corporate objective that plays a critical role in defining the productivity and efficiency of its executives to avoid confusion and misunderstandings. This may be achieved through value maximization which allows both the employees and the managers to think about comprehensive tradeoffs among any competing interests (Erickson, Hanlon and Maydew 2003:56). Remuneration, however much or little, must be guided by what the workers do and whether it maximizes the values of the company as stated in their mission and objectives. Managers and Remunerations Given the scorecard, are the effective and hard working managers paid the most remuneration? This is quite a difficult question given the fact that many companies have spread out the remuneration packages to include amongst other benefits medical insurance, house allowance, commuter allowances, bonuses and incentives, fringe benefits and compensation methods, whether differed or executive amongst others (Erickson, Hanlon and Maydew 2003:58). By creating an enlightened value maximization theorem that works on the structures of the stakeholder theory will help in understanding who deserves the pay increase and how those who are active, committed and successful according to the scorecard used can be and should be remunerated (Jensen and Murphyn 2004:17). Though they receive many benefits from their current assignments and positions in the management team, there is a need to level the playing ground to ensure that the rest of the workforce does not feel left out. There must be a policy that seeks to limit the expected total benefits associated with each job description and position. This will determine how one gets compensated for their skills. This will take into account the risks and the costs of switching employers (Bertrand and Mullainathan. 2001:902). Actually, any company that has put in place a well-designed remuneration package for executives has the ability to attract the very best at lower costs, retain the best executives at lower costs and motive the rest to take actions that create higher shareholder values. In the long-run, the philosophy that they put in place will be useful in understanding why and how remunerations are awarded (Bebchuk and Fried 2003:72). The most successful managers need to be recognized by their companies. However, certain rules must be followed to ensure that the total cost accrued by the company benefits the employee maximally. Following the equity theory, the employees with the least prospect of redressing payment inequities should have the greatest incentives so that they can respond to salary inequalities by cognitive adjustments. This means that the topmost paid managers will require lesser incentives because of their large payments (suleman and Paul 2007:2). However, the human capital theory tells of a different opinion. Attributes emphasized by this theory such as experience and education play a vital role in determining the position that one is at. If this is so, they should be compensated more for their value of skills. However, there is a sharp division on the same based on the diversity of human skills and their usage within a company (Bettis, Coles and Lemmon 2000:192). As such, competence related pay may not be confined to the acquisition of competence but on the effective use of the competences to generate more value for the company one is in. This means that even if the manager is hard working and successful (quick rise to higher positions), they may not be adding value to the company (Jim and Rolf van der 2000:64). If this is so, they are not expected to get higher remunerations. But the reverse is true; if their competences are adding value to the company, they require an addition to their package to reflect their skills and their values as gauged by the remuneration committee and in line with the corporate agenda. If this is true, then from inference, it is clear that remunerations are based on competences, which is misleading. Remunerations should be related to pay rather than based on it because measuring and quantifying competences are quite difficult. Other factors such as the economic trends, the market dynamics and company position are also known to affect the remuneration packages (suleman and Paul 2007:4). Psychological factors such as extrinsic motivation also play a large role in enticing the workers to actively engage in company activities. Conclusion From an analytical point of view, those who work the hardest and are more successful only need a good pay rise. Those with lower standards need to be uplifted through incentives and packages. Since skills only relate to the pay based on how much value they present to the company, the importance of a philosophy to guide the remuneration committee on how to award its bonuses is imperative. They may not earn the most remuneration but they get enough to show that the company appreciates their presence and output in the company. 2: From far and wide, researchers have endorsed performance-based remuneration as the best way of rewarding and aligning shareholder and executive interests within a company. Given the past histories of CEOs awarding themselves hefty allowances in the name of conducting company business, aligning the interests of the shareholders with those of the company is imperative at one point or the other (Yang 2008:655). It should be noted that businesses have grown from small entities to large corporations that are not owned by one but by many shareholders and executive directors who have different roles. Creating an appropriate design that recognizes these roles would lead to better performance as well as options in meeting the goals of the company (Yang 2008:657). Many believe that the best way of showing appreciation for this unity between the shareholders and the managers is by using share-based options. Though many do not object to higher pay, they believe that there must be a connection created between pay and performance as well as stock price. Importance of Aligning Interests Corporations, as stated above, were first an individual or personal entity. However, with time, the amount need to steady operations could not be raised by a single entity and thus required the input of others to make it grow. This led to public cooperation that was aimed at meeting two main virtues. First, they aimed at allowing shareholders and other investors to reduce the risk of their investments through the limitation of their liability to the said value of their investment in the company. Secondly, they sought to allow the same stakeholders to purchase and sell their investments and share interests easily. Even if these are seen as straightforward and easy-to-achieve, a problem exists (Hall and Murphy 2002:5). The separation of ownership and the control of various operations within the company have really strained the relationship and this has made it difficult for their interests to be aligned. Managers run the company on a day-to-day basis while the shareholders have been relegated to a limited set of decision rights as opposed to any physical ownership of the company. There is a need to bring this to a common level so as to ensure that the shareholders also hold a say in the financial success of the company as a whole. They also have to feel the pro-rata share of the company has not been taken from them if the debts have not wiped out the company’s prospects (Hong and Kubik 2003:315). The principle-agent relationship comes about as a result of the separation of powers and control in the company. The principal here being the shareholders, directs the activities of the agents and thus implies that the agent has to act on behalf of the principal and based on the principal’s directions. The expectation is that the shareholders, being the principals, will steer the company to success by offering invaluable advice to the agents, the managers (Martin 2003:20). However, the managers have placed a barrier between them and the shareholders by awarding themselves with incentives that give them the powers to act in ways that are contrary to the interests of their principals. But some scholars are of the opinion that the increasing changes within the shareholders’ portfolio in various times become problematic (Jensen and Fuller 2002:45). They advice that a certain number of shareholders should be chosen to monitor the firm’s managers and thus ensure that things run smoothly has been put forth. This will also lessen the costs through which managers will be monitored since it has been noted that the costs make it difficult to effectively monitor these managers. With fewer shareholders monitoring the managers, it becomes easier for them to work and effectively attain their goals (Kocabiyikoglu & Popescu 2007:835). How Managers and Shareholders Break Off In cases where monitoring is too much or a little below the optimum, agency problems occur. Managers thus create incentives that allow them to benefit themselves at the behest of the shareholders and the rest of the stakeholders. This is through too compensation, mergers, over-diversification in the line of duty and bonuses amongst others. Some have even been said to have an average compensation package that is 364 times that of the average worker. This has been seen as a direct result of the 163% rise in the CEO pay in a span of 20 years compared to 10% over the same period of time (Zhang et al. 2008: 245). Shareholders are also getting worried that there are continued discrepancies between executive compensation and firm competence which brings the question of why the payment plans are skewed as such. Further, these compensation plans are seen to weigh heavily on stock compensations and were more related to incidents of accounting frauds. This is so because of the notion that the top managers have too much say when it comes to setting their pay and the boards are not able to place a cap on how the remunerations will be awarded (Eriksson & Villeval 2008:412). Further, they are not in charge of the running of the company and this forces them to employ directors to hire the managers to do so. They however have little control over those elected or nominated as the board of directors and this jeopardizes their chances of controlling those elected as managers. These places a barrier since the board may feel as part and parcel of the CEO and the management team as compared to the shareholders who are not included in the whole appointment issue (Zhang et al. 2008: 248). They stop acting on behalf of the shareholders and also lose focus on evaluating the organization’s performance. This strains their relationship with the shareholders and the stakeholders alike since the performance, both strategically and financially, form the basis of the company’s growth (Laux 2008:627). Realigning the Interests Several mechanisms have been proposed on how to re-align the interests of the two parties and ensure that remunerations reflect the performance and market dominance of the company. Monitoring is one of the attributes that have been noted as serving to align the interests between the two parties. The roles of the shareholders here will be to place a cap on the value that the managers can be compensated and this allows them to monitor their performance (Ofek and Yermack. 2000:1367). The incentives will be awarded based on the performance as well as how well the manager sets high yet achievable results at the end of the day. Another option that has been recommended by many is the use of stock options and other equity-linked compensation components. This is meant to limit the risk-taking behavior that some of the managers are known for. By having the larger shares in the company, they are able to limit any hostile takeovers that may place them in jeopardy. They will also use their shares as a way of maintaining the best talent in the company implying success and good performance (Davidson, Jiraporn, Kim & Nemec 2004:268). The only problem is that this will be a reward for success but not used as a penalty for failure. But if they have a way of ensuring that these agents perform their tasks, then the use of shares is an option that should be sought. In a study by Rajgopal and Shelvin (2002:147), share options were seen as an opportunity to align the interests of the risk neutral shareholders and the risk-prone managers by offering a middle ground through which CEOs approve risky projects. But these share options must be well thought of. Many CEOs find themselves in a fix when the options given to them are higher than their performance levels, leading to the setting of higher targets that are unachievable. The CEOs end up manipulating the financial results to exhibit an effective company whereas the opposite is true (Ofek and Yermack. 2000:1369). Another way that interests can be realigned is through the use of well-designed corporate governance policies which allow the mitigation of agency problems that have to deal with creation of rules, checks and balances and processes that will be used to ensure the fiduciary duties are fulfilled by the directors to the shareholders (Gordon 2005:677). This will also place a hold on the way the remunerations are awarded for all the parties have a say in the running of the company. Conclusion Shareholders are an important lot in the corporate world. Realigning their interests with those of the managers means that the company will run effectively with all the parties playing their part as expected. It is imperative though that each party works towards the inclusion of the other in decision-making. This way, they will meet their obligations and improve on performance and business prospects as a way of increasing shareholder wealth and value through stringent corporate governance strategies. Shareholders should work on ensuring that the remunerations are offered based on performance and in relation to better prospects for the company as a whole. Monitoring and evaluating the way managers operate is one effective way of meeting company goals and aligning the interests of all parties. References Bebchuk, L.A. & Fried, J.M. 2003 "Executive Compensation as an Agency Problem." Journal of Economic Perspectives, vol. 17, no. 3, pp. 71-76. Bertrand, M. & Mullainathan, S. 2001 "Are CEOs Rewarded for Luck? The Ones Without Principals Are." Quarterly Journal of Economics, vol. 116, no. 3, pp. 901-932. Bettis, J., Carr, Coles, J.L. & Lemmon, M.L. 2000 "Corporate Policies Restricting Trading by Insiders." Journal of Financial Economics, vol. 57, no. 2, pp. 191-220. 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Zhang, X., Bartol, K.M., Smith, K.G., Pfarrer, M.D. & Khanin, D.M. 2008 ‘CEOs on the edge: earnings manipulation and stock based incentive misalignment’, Academy of Management Journal, vol.5 1, no. 2, pp.2 43–258. Read More