The Effect of Directors Remuneration on the Fair Presentation - Essay Example

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The Effect of Directors’ Remuneration on the Fair Presentation of Financial ments and overall Organization’s Performance ID Module Name Module Code Table of Contents Table of Contents 2 Introduction 3 Structure of the Report 3 Directors’ Remuneration 4 The Rationale behind Directors’ Remuneration 4 The Structure of Directors’ Remuneration 5 Literature Review 6 The Effect of Directors’ Remuneration on the Fair Presentation of Financial Statements 6 The Effect of Directors’ Remuneration on the Overall Organizational Performance 7 Research Methods Used 8 Case Study Research 9 Research Question 2: Does directors’ remuneration or either of its components (fixed or variable) have an effect on fair presentation of financial statements? 9 Findings of the Study 10 Research Question 2: Does directors’ remuneration either of its components (fixed or variable) have an effect on overall organizational performance? 10 Findings of the Study 11 Discussion and Conclusion 11 Recommendations 11 List of References 13 The Effect of Directors’ Remuneration on the Fair Presentation of Financial Statements and overall Organization’s Performance Introduction The concept of directors has been existent for a many years prior to the introduction of management sciences as a field of study. Due to the recent plethora of cases pertaining to fraudulent activities, negligence and mismanagement, we now witness the practice of corporate governance as a means to control the activities of management and directorial boards. Contemporary models of corporate governance are efficient in succinctly outlining the tasks and restrictions placed on directors (Hahn & Lasfer, 2011). The purpose of this paper is to examine the concept of directors’ remuneration and whether directors’ pay has an impact on the fair presentation of financial statements and the performance of the organization. Structure of the Report The paper commences with an overview of directors’ pay and uses agency theory as a justification. The structure of directors’ remuneration is explained, along with the various components. We then present a review of the existing literature concerning directors’ remuneration and some of its components and whether there are any studies that support or negate a cause and effect relationship between directors’ remuneration and fair presentation of financial statements and with overall organizational performance. The review is supplemented with a case study approach of research in which multiple cases are analyzed and discussed to try and establish the relationship (or lack thereof) between directors’ remuneration, financial statement presentation and performance. The paper concludes with a brief discussion which encompasses the findings of the literature review and the case study approach and provides recommendations for strategy and policy devisors. Directors’ Remuneration The issue of directors’ remuneration has been hotly debated and is a cause of concern for the shareholders of any company. Since the major accounting scandals of the late nineties and early 2000’s, there has been a higher amount of scrutiny on corporations, especially the management and board of directors. This examination of the actions of the boards is defined under several forms of legislation, such as the Sarbanes-Oxley Act (SOX) of 2002 (Gordon et al., 2006) in the United States and the Cadbury Report (1992) in the United Kingdom. For instance, the Cadbury Report has established rules regarding the formation and layout of the board and recommended that the compensation received by directors should be handled by a separate committee and it would decide the suitable package to be provided to members of the board and other top level managers (Conyon, 1997). The reason for such intense scrutiny can at least partially be attributed to the sums of money involved. Take for instance the accounting firm KPMG’s Guide to Directors’ Remuneration 2012, where the data collected on Directors from FTSE100 companies shows the mean and median salaries for CEO’s, Finance Directors and Other Executive Directors. The data shows that for FTSE 100 Companies, the average basic salaries for finance directors and other executive directors were ?492,000 and ?500,000 respectively. This figure is non-inclusive of bonuses, share option plans and other performance based incentives, the sum of which when taken into account results in total annual earnings of over ?1.6 million for finance directors and almost ?1.7 million for other executive directors respectively (Johnson, 2012). The Rationale behind Directors’ Remuneration Agency theory has been applied to this research for the determination of the reasoning behind directors’ pay. It is widely recognized and used in research pertaining to management in corporations and by academics in clarification of the reasons that cause owners to give legal rights of business to external sources (Lafontaine & Slade, 1997). Agency theory is a deal between the owner (referred to as the principal) and the agent (the board of directors in this case). The owner delegates the responsibility of management to the agent for performance of certain agreed upon duties (Seifert & Weinhardt, 2006). According to Jensen and Meckling (1976), there are conflicting interests between the board of directors and the shareholders. Their hypothesis is that the board of directors (who are the agents) do not have sufficient motivation to render their efforts towards increasing the productivity and profits of the organization which clashes with the aim of shareholders to maximize their wealth. Furthermore, due to the intricacy and convoluted nature of the directors’ work, it is not possible for the investors to control and review the performance of the directors on a regular basis (Jensen & Meckling, 1976). The Structure of Directors’ Remuneration The concept of structuring directors’ remuneration designed in a way to nullify, or at the very least reduce as much as possible the chances of fraud has been the subject of various researches. According to Mallin (2004), the pay that directors receive can include six vital areas which are base salary, bonus, stock options, grants, pension and other benefits. The majority of research has been conducted on the first four components, namely base salary, bonus, options and grants. Base Salary is the fixed portion of the directors’ salary irrespective of performance. Bonuses are directly related to directorial and organizational performance. Options provide rights for buying a specified amount of stock in the company at an agreed upon price within a pre-decided time frame. Finally, grants or restricted stocks plans are designed to award directors after a continued period of service and can be tied to performance (Mallin, 2004). Literature Review The Effect of Directors’ Remuneration on the Fair Presentation of Financial Statements Since the Enron scandal, there has been greater scrutiny on the executives and non executive directors across most organizations. According to a study by ACFE (2008), fraudulent activities in organizations in the USA sets its economy back by almost nine ninety four billion dollars each year on average. A study conducted by Healy (1985), executive directors with ulterior motives can easily manoeuvre the presentation of the financials of a company by delaying expense payment for later accounting periods to inflate current period income for personal gain. However, other studies suggest that executives will have to face the consequences for these fraudulent actions in the period when these actions are realized or they might have to commit fraud yet again to further manipulate the accounts to hide their earlier misdemeanours (Beneish, 1999). A survey conducted by accounting firm Price Waterhouse Coopers shows a positive relationship between accounting fraud and incentives based executive compensation (PWC, 2007). This relationship was earlier examined in research undertaken using the twenty five biggest fraud cases in the latter part of the nineties till the first two years of the new millennium. The results of the study favoured the conclusion that there a phenomenon known as the ‘dilemma of the successful CEO’ where the person in question is entitled to receive incentives such as performance bonuses and in order to realize material gain and build on previous success, the executive hard to achieve targets in every subsequent bonus scheme. There comes a time when the target becomes impossible and the executive has to resort to financial manipulation (Cools, 2005). This study further identified that the organizations that were blamed for fraud provided significantly larger share option plans to directors. The link between incentive based pay for directors and financial fair play is summarized in a report by the European Corporate Governance Forum: “...variable pay could help to align the interests of executive directors with the interests of shareholders of listed companies. Meanwhile, experience has shown that variable pay schemes have become increasingly complex and that in certain instances this has lead to excessive remuneration and manipulation” (EUCGF, 2009). On the other hand, there have been studies where options help in reducing the risk of directors, especially in industries of high uncertainty (Rajgopal & Shevlin, 2002). A few years back, a study showed that provision of effective option plans helped in retaining directors, who can be highly valuable to a firm, and significantly reduce the probability of loses that valuable resource in the foreseeable future (Balsam & Miharjo, 2007). Fixed pay for directors is not sufficient as there is no motivation for directors to exert extra efforts in order to increase performance as they will not receive anything in return for their work. The fixed component of directors’ pay is explained by the agency relationship where an employee is not as motivated to work extra as he will not receive anything except for the guaranteed base salary (Krueger A, 1991). Furthermore, Cullinan et al. (2008), found that 90.5% of the companies that provide options to directors as a part of their pay are involved in fraudulent manipulation of accounting statements. To summarize, variable pay is shown through the review of existing literature as having a positive relationship with manipulation of financial statements. Fixed pay, on the other hand does not exhibit any kind of relationship with fair financial statement presentation. There are some limitations though in establishing a link between fixed pay for directors and fair presentation of financial statements. The Effect of Directors’ Remuneration on the Overall Organizational Performance A study conducted in Australia on a possible relationship between directors’ remuneration and organizational performance reiterated results of studies conducted in the United States, the United Kingdom and Canada. The findings showed a positive relationship between directors’ pay and performance of the organization (Merhebi et al., 2006). Berle & Means (1932) were one of the initiators of the concepts entrenched within the infamous Agency Theory and explained that directorial compensation is a means to solve the problems associated with agency costs. These views were echoed by Jensen & Meckling (1976) who supported the concept of payment to directors for their time rendered. However, there are conflicting opinions here as the following researches portray. For example, take Bebchuk & Fried (2003), who see executive compensation for directors as a component of the agency problem and the behaviour of directors seeking compensation as opportunistic. Similarly, another research found that in United States companies, while director pay was found to have positive impact on the overall performance of an organization, the effect was too minimal to be considered (Jensen & Murphy, 1990). In a research conducted in Australia, it was found that there existed an association between directorial pay and organizational performance. This was a unique research for the Australian continent as all previous studies had resulted in supporting the alternate hypothesis of no existing relation between the two. The existing literature on the relationship between directors’ remuneration and overall organizational performance is limited in establishment of a relationship or in negating the existence of such. While empirical evidence has been gathered, it has been mostly for larger organizations. Research Methods Used We use the case study method for our research in which is defined as “an empirical inquiry that investigates a contemporary phenomenon within its real life context; when the boundaries between phenomenon and context are not clearly evident; and in which multiple sources of evidence are used” (Yin, 1984). We have devised the following research questions for our hypothesis that “directors’ remuneration has an impact on the fairness of financial statements, but no relation with overall performance”: 1. Does directors’ remuneration or either of its components (fixed or variable) have an effect on fair presentation of financial statements? 2. Does directors’ remuneration either of its components (fixed or variable) have an effect on overall organizational performance? Case Study Research Research Question 2: Does directors’ remuneration or either of its components (fixed or variable) have an effect on fair presentation of financial statements? Enron Viewing the Enron case in detail such as explained in Eichenwalt (2002), we discover that the company had given massive compensation packages to directors that included basic pay and variable components such as bonus schemes and options which were connected to the fulfilment of certain objectives related to price and earnings, etc. Since that time, as is now widely known, the company went bankrupt and it was disclosed to the public that the directors and senior managers at Enron had achieved their objectives by completely misrepresenting the facts in the financial statements of the company. WorldCom Similarly, in WorldCom, there were fraudulent activities involving huge sums of money, amounting to billions of dollars, that were actually expenses but had been wrongly treated in the financial statements as capital expenditure in order to inflate the value of the stock of the company and consequently, the worth of the stock options that were possessed by the directors of the company (USA Bankruptcy Court, 2002). Satyam Computers Services Ltd. Another popular case is from India, pertaining to the famous (or infamous) Satyam Computers Services Ltd where the founding director and Chairman of the company, Mr. Ramalinga Raju admitted in 2009 to committing fraud that involved misstatement of financial assets that totalled slightly over $1.5 billion according to the current prevailing exchange rates (Kumar, 2009). AIG Similarly, AIG was fined over one hundred and thirty million dollars for fraudulent activities on the parts of their directors related to accounting manipulations due to the financial benefits received by the directors in committing those fraudulent activities (Langley & Francis, 2004). Findings of the Study Our findings show that there is support for a cause and effect relationship between directors’ remuneration and the fair presentation of financial statements. These results show that specifically, bonuses and options, i.e. the variable part of directors’ pay is positively correlated to fraudulent activities through ‘cooking the books.’ Research Question 2: Does directors’ remuneration either of its components (fixed or variable) have an effect on overall organizational performance? Enron Enron was a growing company in terms of overall performance towards the end of the twentieth century. In the last 5 years of the century ending in 2000, the company’s profits grew by 16% and this was in line with the growth in the director compensation, which included variable pay measures such as options and restricted stock that grew by around 166% during the same period. In the year 2000, the 5 highest ranked directors were receiving wages amounting to more than two eighty million dollars. To base directorial pay primarily on profit measures such as EPS and profits can be foolhardy as the Enron case shows. While the share prices were increasing, Enron raised its debt portfolio and the value per share deteriorated (Ackman, 2002). The Royal Bank of Scotland (RBS) Another interesting case pertains to the UK bank, RBS where the company reported a massive loss of around ?5.2 billion in 2012 and yet the company managed to fork over ?600 million in terms of bonuses to directors and other employees. A significant portion of this bonus went in the directors’ pockets (Salmon & Shipman, 2013). This case shows that director compensation does not necessarily affect organizational performance. Findings of the Study Our study provided two cases where in the former case, there is an effect of the variable portion of directors’ compensation on performance. While performance improved in terms of profits and earnings, the overall performance did not improve as we consider the impact of remuneration on the chances of committing fraud. In the latter case, we cannot find any link between pay and performance. Discussion and Conclusion Our research agrees with the existing literature that director’s remuneration has an impact on fair presentation of financial statements and it is found to have an inverse relationship. Furthermore, neither the literature nor the research show support to the idea that directors’ remuneration has any effect on overall financial performance. Therefore we accept the null hypothesis. Recommendations We believe that companies should take the following actions to avoid cases of misstatement and fraud and to increase the relationship between directors’ pay and overall organizational performance: Increasing directors’ independence to avoid chances of fraud Employment of remuneration committees to monitor and effectively control director compensation Linking directors’ pay with suitable and multiple performance measures that give a truer picture of ‘overall’ organizational performance (Frederic W. Cook & Co., Inc., 2012). Profits and earnings are not sufficient to estimate directors’ performance as seen in the Enron case. List of References ACFE , 2008. Report to the nation on occupational fraud and abuse. Austin: Association of Certi?ed Fraud Examiners ACFE. Ackman, D., 2002. Pay Madness At Enron. [Online] Available at: [Accessed 8 May 2013]. Balsam, S. & Miharjo, S., 2007. 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Is there an association between director option compensation and the likelihood of misstatement? Advances in Accounting, incorporating Advances in International Accounting, 24, pp.16-23. Eichenwalt, K., 2002. Enron’s many strands executive compensation. New York Times, 1 March. EUCGF, 2009. Statement of the European Corporate Governance Forum on Directors' Remuneration. [Online] European Corporate Governance Forum: EUCGF Available at: [Accessed 8 May 2013]. Frederic W. Cook & Co., Inc., 2012. 2012 Director Compensation Report. Frederic W. Cook & Co., Inc. Gordon, L.A., Loeb, M.P., Lucyshyn, W. & Sohail, T., 2006. The impact of the Sarbanes-Oxley Act on the corporate disclosures of information security activities. Journal of Accounting and Public Policy, 25(5), pp.503-30. Hahn, P.D. & Lasfer, M., 2011. The compensation of non-executive directors: rationale, form, and findings. Journal of Management & Governance, 15(4), pp.589-601. Healy, P., 1985. 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