Discuss the Case Study of Pepper & Gore (2015).
The company is an artificial person thus its owners, and managerial authorities are different. Shareholders are owners, but operational activities and business decisions are managed by managers and directors (Hitz & Müller-Bloch, 2015). Due to this aspect, it has to be ensured that managers are paid fairly so that interest of shareholders is not affected. The present study is focused on the description of factors to be considered for determination of executive compensation. For this aspect, the theoretical framework provided by various research scholars will be considered. Collected information will be applied for evaluation of given case of Commonwealth Bank of Australia regarding remuneration policy of Ian Narev for the financial year 2015.
Determinants of executive compensation
In the study of Pepper & Gore (2015), it is clarified that bonus should be awarded to executives only if they are capable of accomplishing goals and objectives of business. In the case where the bonus was granted despite worst performance than their conflict in the interest of shareholders and top management. In research of Martin and et.al. (2013), this aspect was considered in bonus and salaries of executives of various top companies. By considering this fact, business performance plays a significant role in the determination of compensation of executives. In a situation where business is growing and developing, it is only because of viable decisions and effective strategic plans of top management thus they must be paid off for their hard work.
In accordance with the viewpoint of Cremers & Grinstein (2014) in perfectly competitive conditions of the managerial labour market, the executives earn on the basis of a marginal revenue product. However, at a minimum, he must earn that he could earn in their next-best employment opportunity. In research of the marginal revenue, product has been stated as incremental profit that they earn for the company with their management skills and capabilities. Further, the size of business, market conditions, their qualifications also needed to be considered in their compensation. In the case of large firms, a minor increase in profits per unit sold will results in a huge hike in profitability due to a sheer number of units sold. Consequently, in large firms compensation of executives, is higher in comparison to small firms. As per the study of Peters, & Wagner (2014), the structural complexity of large firms also indicates for higher compensation for the executives.
Political and regulatory factors
Remuneration policy of executives must be designed in accordance with the legislative norms developed by current political parties and regulatory norms. As per the study of Gomez-Mejia and et. al. (2014), non-compliance of these norms can lead to severe penalty and non-qualification of directors. This approach has been developed due to the concept of duality. Bennett and et. al. (2017) had stated that duality escalates the power of the single individual, and reduces the ability of the board and restricts its decision-making power. As a consequence, there must be standard guidelines for a compensation policy of executives which is mandatory to be followed by corporate entities.
Study of Chan (2008) shows that higher the stake of the executive in a business entity will result in an increase in incentive for effective management of business resources in order to obtain profitable opportunities. It is because; executives have to bear direct consequences of their decisions. Nevertheless, by considering the overall aspects of human endeavour, it can be said that there are huge differences in managerial skill over broad ranges of both type and quality. Further, these managerial traits are predictable to fluctuate on the cross-sectional basis as a consequence of a number of firms, industry, and manager-specific factors. In accordance with the viewpoint of Lin and Lu (2009), there is a negative association of executive ownership and their compensation. Thus, at the point of higher ownership concentration level controlling shareholders will shorten managerial power and in contrary to this in a low level of ownership concentration, there will be an increase in CEO compensation by associating it firm’s performance.
Theoretical explanation for the increase in executive compensation
Marginal productive theory
As per the study of Peng and et. al. (2015), this theory is concerned with the determination of pay level of executives of corporate entities. In accordance with this theory, compensation paid to executive must in proportion to the profits and productive output of the company. Thus, growth in these factors should be considered as a significant parameter for an increase in the compensation of executives. According to the viewpoint of executive pay, package reflects the net profit of the firm.
Frydman & Jenter (2010) stated that this theory is a theoretical extension of managerialism. According to this theory, owners of the firms are principals and executives are agents. Thus, agents should work in benefit of owners instead of their own interest. This theory states that agency cost for the owners of the firm is the difference the profit that could be earned by owners and profits earned under the stewardship of the agents. Thus, improvement in overall value and performance should be the base for an increase in compensation of the executives.
Human capital theory
As per this theory, individual characteristics of individuals must be considered for the prediction of their pay levels. Study of Bettis et. al. 2010 (2010) shows that amount of human capital attained by executives shows their value to firm on the basis of that prediction can be made that how much should it pay for their services. Thus increasing the value of human capital should be the base of increase in compensation of executives.
Association between compensation and performance of business entity
Various scholar agree with the direct connection between executive compensation and performance of business entity. Study of Franken (2010) shows that these two aspects are directly connected in the commercial era as executives will be motivated to work in the interest of the company as their pay is directly connected to the performance of the business and it will fluctuate accordingly. Performance criteria have been introduced for determination of compensation of executives to ensure that they will provide priority of interest of the company instead of their interest. According to research of Bettis et. al. (2010), this assoication develops executives with proven track records of constructing shareholder value with their management capabilities and skills. These individuals demand and receive outsized compensation levels in comparison to others doing the similar job as they have better potential to impact a future profitability and value of the firm.
Discussion and Analysis
Ethical issues associated with the compensation package of Ian
By considering annual report of the company, it can be noticed that there are various issues associated with the compensation package of Ian. Primarily compensation provided to Ian Narev is excessive in comparison to the provision of services by applying the model of a deontological model (Annual report of Common Wealth Bank, 2015). It is because Ian Narev is a director since 2011 and only for the duration of five years there is a significant increase in pay. Moreover, annual increment in comparison to 2014 is high by considering growth and annual performance of the bank. It is because; there is consistency in share price which shows there is not a significant increase in stockholder value. This fact raises issues that on what basis Ian Narev is provided with the bonus and reward rights of worth 248,068 and increment of AUD75000. Another issue with a compensation package of Ian Narev is that he is receiving a significantly higher amount in comparison to other directors. He is managing director so it is justified that he must attain higher pay but twice of other directors is the viable amount.
Benefits and drawback of considering social performance criteria in compensation package of Ian
It has been argued by various research scholars that viable combination of short and long-term incentives structure around social performance will provide various benefits to the company. As per the study of Gopalan and et. al. (2014), top managers are primarily responsible for resource allocation regarding social initiatives. As a consequence, if Ian Narev will be rewarded on the basis of then he will be motivated to promote a consistent social strategy for the company. This will increase the firm value and company will received market-based incentives. In addition to this, the company will be able to develop goodwill and strengthen their brand image to attain competitive advantages. The major drawback of considering social performance criteria in compensation package of Ian is a contradiction of interest of stakeholders as they will not be in favour of this fact. Drawback of considering social performance criteria in compensation package drawback of considering social performance criteria in compensation package. It is because; all stakeholders are assumed to be have favourable responsible way and for the same they must be treated in a similar way. However, this is not viable in all cases as some constituencies may have general preference for social initiative but presumption cannot be made that social friendly policies will not contradict interest of shareholders. For example, employees and their families would not agree for environmental policies if it will put their employment at risk. As a consequence, rewarding actions that can benefit Ian can cause discontent among other stakeholders. Henceforth, it will be a partial policy which will not be justified in employment practices. Study of Pepper & Gore (2017) shows that recognising and supporting social efforts through monetary pay will undermine the built in incentive which can have unintended consequences for business.
Critical analysis of compensation package of Ian in solving agency conflicts
With reference to accounting theory, compensation package of Ian is not solving agency conflicts it is because the package is not justified and it is needed to be modified. Accounting theory suggests that compensation package of executives should be increased if there is (1) reduced tax payments, (2) complimentary regulations, (3) reduction in political costs, (4) reduced in production costs, and (5) increase in reported earnings considered for evaluation of incentive bonus plans but none of these occurs in annual report of company. In accordance with the data of last financial year it can be noticed that total pay of Ian Nare (Commonwealth Bank chief) was $12.3 million, after he get ownership of multimillion-dollar share bonuses for the performance of bank in previous years. CBA's annual report shows that the total remuneration for Mr Narev has been enhanced by 50 per cent, from $8 million a year earlier. Reason of this hike is long term association. There were no changes in fixed remuneration and there was slight reduction in the cash component of his short-term bonus. Nonetheless, the total value of his pay packet had a significant boost from share awards of worth $6.6 million. Long-term incentives of CBA have been linked to shareholder returns and customer satisfaction in ratio of 75.25 However, this proportion proposed to be changed in 50:50 near future. Further, management compensation plans encourage managers for the inflation of earnings, but the size of firm encourages managers for the deflation of earnings (Hitz & Müller-Bloch, 2015). In the present case, sales have been improved, but there are not significant changes in shareholder value which is not justified as per accounting theories given on compensation of executives. It shows the need of change in compensation policies to motivate executives to showcase their skills and capabilities for the betterment of the business.
In accordance with the present study, it can be concluded that there should fair remuneration system for company executives in order prevent conflicts of interest between shareholders and top management. For effective payment system, business performance, size as well as duality should be considered so that executives can be motivated to work for the betterment of the company. By considering the situation of given case study; compensation package of Ian Narev is not justified which is required to be modified to prevent company conflicts due to agency theory.
Books and Journals
Bennett, B., Bettis, J. C., Gopalan, R., & Milbourn, T. (2017). Compensation goals and firm performance. Journal of Financial Economics.
Bettis et.al. (2010). Stock and performance grants with performance-based vesting provisions. Review of financial studies. 23. 3849-932
Cremers, K. M., & Grinstein, Y. (2014). Does the market for CEO talent explain controversial CEO pay practices?. Review of Finance, 18(3), 921-960.
Gomez-Mejia, L. R., Berrone, P., & Franco-Santos, M. (2014). Compensation and organisational performance: Theory, research, and practice. Routledge.
Gopalan, R., Milbourn, T., Song, F., & Thakor, A. V. (2014). Duration of executive compensation. The Journal of Finance, 69(6), 2777-2817.
Hitz, J. M., & Müller-Bloch, S. (2015). Market reactions to the regulation of executive compensation. European Accounting Review, 24(4), 659-684.
Martin, G. P., Gomez-Mejia, L. R., & Wiseman, R. M. (2013). Executive stock options as mixed gambles: Revisiting the behavioural agency model. Academy of Management Journal, 56(2), 451-472.
Peng, M. W., Sun, S. L., & Markóczy, L. (2015). Human capital and CEO compensation during institutional transitions. Journal of Management Studies, 52(1), 117-147.
Pepper, A., & Gore, J. (2015). Behavioural agency theory: New foundations for theorising about executive compensation. Journal of management, 41(4), 1045-1068.
Peters, F. S., & Wagner, A. F. (2014). The executive turnover risk premium. The Journal of Finance, 69(4), 1529-1563.
Chan, M. (2008). Executive Compensation. Business and Society Review, 1.
Lin, B. X., & Lu, R. (2009). Managerial Power, Compensation Gap and Firm Performance: Evidence from Chinese Public Listed companies. Global Finance Journal, 20(2), 153–164.
Annual report of Common Wealth Bank. 2015. [Pdf]. Available through < https://www.commbank.com.au/content/dam/commbank/about-us/shareholders/pdfs/annual-reports/cba-annual-report-30%20June-2015.pdf>. [Accessed on 26th April 2017].
Franken, M. R., (2010). The determinants of executive compensation. Available through < https://arno.uvt.nl/show.cgi?fid=107308>. [Accessed on 26th April 2017].
Frydman, C. & Jenter, D., (2010). CEO Compensation. [Pdf]. Available through < https://web.mit.edu/frydman/www/COMP%20SURVEY%2008-02-10.pdf>. [Accessed on 26th April 2017].