Managerial Pay, Bonus Plans, Agency Problems, And Risk Management Essay.

Balance between Managerial Pay and Performance Measures

1. Making managerial pay contingent on measures of managerial and/or firm performance motivates them to deliver good performance for shareholders. However, it also burdens them with greater risks than they may like. How do organisations balance these two considerations when choosing managerial pay and performance measures?

2. Obtain the remuneration report for a publicly listed company. Examine the compensation contract for the chief executive officer (CEO). Prepare a report which summarises your findings relating to the following issues:

• What amount is short-term in nature (salary and cash bonus) and what is based on long-term firm or managerial performance?
• What proportion of the CEO’s pay is performance based, and what proportion is not?
• What measures of accounting performance are used to determine the CEO’s bonus?
• Given the accounting firm performance measures in the contract, what accounting decisions could the CEO might make in order to maximise their bonus?
• Can agency theory provide an explanation for the various remuneration components? Justify your answer.

3. Bonus plans are used to reduce agency problems that exist between managers and shareholders. Discuss two (2) of these problems specific to the relationship between shareholders and managers and identify how bonus plans can be used to reduce the agency problems you have identified. In your answer you should provide examples of specific components that should be added to a bonus contract to address the issues identified.

4. You have recently been appointed as a lending officer in the commercial division of a major bank. The bank is concerned about lending in the current economic environment, where there has been an economic downturn. You have been asked by your supervisor to provide a report indicating how you can safeguard the bank against the risks of lending. In your report you should outline how covenants in debt agreements can be used to reduce the risks, what agency problems the bank should be concerned with, and how accounting information can be used to assist in this process.

It can be observed that most of the business organizations develop their managerial pay contingent based on the performance of the managers or performance of the firms. This aspect provides major motivation to senior managers to perform better in order to get high pay. At the same time, they feel the pressure for not-performing as there is risk of termination. In order to maintain a balance between the managerial pay and performance measures, business organizations use the technique of bonus system or incentive system. Under this scheme, the business organizations provide the compensation of the senior managers based on two aspects. They are fixed salary and performance based bonus or incentives. Under the fixed salary, the senior managers are entitled to receive a certain amount of salary on fixed basis irrespective of their performance (Geiler and Renneboog 2016). It implies that this portion of the managerial pay does not depend on the performance of the senior managers and the company provides the guarantee for the payment of the amount of the fixed salary.

CEO Compensation of Woolworths

On the other hand, the other part of the salary is considered as the variable salary and it is also considered as performance bonus or performance incentive. It needs to be mentioned that the performance of the senior managers determine the payment of this portion of compensation. Under this process, the senior managers receive bonus on incentive in case they are able to achieve the targeted performance of the company. Business organizations provide high bonus premium on the high performance of the managers. Business organizations make the payment of this part of bonus or incentive in the form of cash or in the form of issue of share of the company. In this manner, the business organizations balance between these two considerations (Pepper 2016).

From the 2017 Remuneration Report of Woolworths, it can be seen that the company has paid both short-term as well as long-term remuneration based on the performance of the firm. As per the remuneration report, Brad Banducci, the CEO, has received $2,500,804 as total fixed remuneration in cash. In the same year, he has received $1,509,750 as short-term incentive in cash; he has also received $461,181 as other share right vested. Thus, the total remuneration is $4,471,735 for the year 2017 (Woolworthsgroup.com.au 2018).

From the same remuneration report, it can be observed that out of 100% of the remuneration of the group CEO, 25% is provided as the fixed remuneration that is provided in cash. Another 25% is considered as the target based short-term incentives (STI). In this 25% of STI, 12.5% is provided in cash and the rest 12.5% is provided in differed basis. The last 50% is considered as the long-term incentives (LTI) that is provided in three portions. 16.68% is provided based on relative Total Shareholder’s Return (TSR) with share price gateway, 16.66% is provided as share per trading square metre and the rest 16.66% is provided as Return on average funds employed (Woolworthsgroup.com.au 2018).    

From the remuneration report of Woolworths, it can be seen that the company uses three measures of accounting performance for determining the bonus of CEO. They are Sales and the target, Earnings before Interest and Tax (EBIT) and Working Capital (Woolworthsgroup.com.au 2018).

In order to maximize the bonus, the CEO is required to take decisions that can improve the performance of the company. Thus, the first accounting decision would be to increase the sales of company and decrease the operating expenses at the same time. This particular aspect would increase the EBIT of the company (Gill 2014). 

Reducing Agency Problems with Bonus Plans

Agency theory helps in addressing the problems arise due to the difference in goals and desires of the principal and the agent and this theory can be applied in the remuneration of CEO. As per the principle of agency theory, the companies develop various remuneration components to attract and retain the senior managers so that they can achieve organizational goals and objectives of the companies (Mallin, Melis and Gaia 2015).

In this context, the first issue can be the takeover attempt. Sometimes, the managers can grow the business in order to escape a takeover attempt so that their own job security can e increased. However, the shareholders can be largely beneficial from a takeover. Thus, this whole aspect crates agency problem between the managers and shareholders. In order to avoid this situation, companies can include both long-term bonus as well as short-term bonus so that the managers can perform well in order to avoid any takeover (Lin, Kuo and Wang 2013).

Another issue is the personal wealth of the managers as they are more concern about increasing their personal wealth that increasing the shareholder’s wealth; this aspect creates agency problem between the managers and the shareholders. In order to overcome this issue, the companies are required to include short-term performance bonus in the bonus contract in which the managers will be provided with both cash and non-cash incentives in achieving the short-term financial performance of the companies. This will help in increasing the wealth of the shareholders (Mallin, Melis and Gaia 2015).   

As per the given situation, the bank can use specific debt covenants or debt agreements in order to avoid the lending risk. For example, the bank can ask a company that want to lend money from the bank to maintain a specific and high liquidity margin to avail the loan. In this way, the bank will end up providing loan to the financially stable customers (Bruno and Shin 2015).

In this case, the agency problem related to the lending of bank is excessive risk taking by the bank. The bank takes the risk while provide loans as the possibility related to the non-recovery of the loan is there. Thus, the bank is required to take this into considerations (Black and Hazelwood 2013).

One major way to avoid this risk is to analyze the accounting information of the business institutions that wants to take loan from the bank. The bank will be able to get an idea about the past and current financial performance and position of the enmities by analyzing the accounting information of the companies. This will help the bank to provide loan to the correct person (Bruno and Shin 2015).

References

Black, L.K. and Hazelwood, L.N., 2013. The effect of TARP on bank risk-taking. Journal of Financial Stability, 9(4), pp.790-803.

Bruno, V. and Shin, H.S., 2015. Capital flows and the risk-taking channel of monetary policy. Journal of Monetary Economics, 71, pp.119-132.

Geiler, P. and Renneboog, L., 2016. Executive remuneration and the payout decision. Corporate Governance: An International Review, 24(1), pp.42-63.

Gill, S., 2014. Rewards for failure: an explanation for anomalous executive remuneration. Journal of Indian Business Research, 6(2), pp.90-127.

Lin, D., Kuo, H.C. and Wang, L.H., 2013. Chief executive compensation: An empirical study of fat cat CEOs.

Mallin, C., Melis, A. and Gaia, S., 2015. The remuneration of independent directors in the UK and Italy: An empirical analysis based on agency theory. International Business Review, 24(2), pp.175-186.

Pepper, S., 2016. Senior executive reward: key models and practices. Gower.

Woolworthsgroup.com.au. (2018). [online] Available at: https://www.woolworthsgroup.com.au/icms_docs/188795_annual-report-2017.pdf [Accessed 26 May 2018].