Balancing 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.
The provided situation indicates towards the fact that the business entities formulate the managerial pay contingent for their senior level managers on the basis of the performance of those managers or their performance to achieve the organizational goals or objectives. For this reason, the senior managers of the business organizations can get major motivations to achieve the provided target of the entities for them as they can get the opportunity to get higher pay based on their performance. At the same time, they come under immense pressure in the presence of the fact that failure in achieving the provided target can reduce their compensations as well as there can be question about their positions within the organizations (Shields et al. 2015). This can be considered as a serious issue related to the compensation of the senior managers of the companies and the business entities have become successful in getting the solution of this issue. In order to create a perfect balance between these two aspects, business entities use to segregate the compensation of the senior managers into two parts; one is fixed salary and the other is performance based bonus or incentives. According to this strategy, it is the obligation on the business entities to pay the senior managers with the fixed salary irrespective of the achievement of the provided target. Thus, the implication is that this fixed salary does not depend on the performance of the senior managers (Boeri, Lucifora and Murphy 2013).
Bonus Plans to Reduce Agency Problems
On the contrary, the other part of the compensation; that is the verifiable portions largely depends on the set target by the companies. For this reason, this part of the compensation is also regarded as the performance bonus or the performance incentives. In this context, it needs to be mentioned that the business entities measure the performance of the senior managers based on certain KPIs (Key Performance Indicator) for the payment of this performance bonus or performance incentives. Business organizations use to provide this incentive on the achievement of the target set by the companies based on the KPIs (Ntim et al. 2015). With the help of this strategy, business organizations become able to establishing a balance between these two aspects at the time to choose managerial pay and performance measures.
The analysis of the remuneration report of Woolworths for the financial year 2017 indicates towards the payment of both the short-term remuneration as well as the long-term remuneration to the CEO, Brad Banducci. From the remuneration report of Woolworths, it can be observed that the CEO has received $2,500,804 as total remuneration in the form of cash (woolworthsgroup.com.au 2018). Apart from this, in 2017, Woolworths has provided the CEO with $1,509,750 as short-term incentive in the form of cash. Lastly, in the same financial year, the CEO of Woolworths has received $461,181 as short term incentive in the form of share right. Hence, the CEO has received $4,471,735 in 2017 as total remuneration (woolworthsgroup.com.au 2018).
It can be observed that some proportion of the compensation of the CEO of Woolworths is based on performance. According to the remuneration report, Woolworths provides 25 percent of the total remuneration as fixed remuneration and it is provided in the form of cash. Woolworths provides another 25 percent of the total remuneration in the form of STI (Short-term Remuneration). In this portion, Woolworths provides 12.5 percent in the form of cash and another 12.5 percent in defied basis (woolworthsgroup.com.au 2018). Woolworths provides the CEO with the rest 50 percent of the total remuneration in the form of Long-term Incentives (LTI) and the payment of this is divided into three portions. The company provides the first 16.68 percent in the form of relative TSR (Total Shareholder’s Return); Woolworths provides the next 16.66 percent to the CEO in the form of share per trading square metre; and the Woolworths makes the payment of the last 16.66 percent in the form of return on average funds employed (woolworthsgroup.com.au 2018).
Covenants in Debt Agreements to Reduce Lending Risks
From the 2017 remuneration report, it can be observed that Woolworths have used three major measures of accounting performance for the determination of the bonus of their CEO. Sales are the first accounting measure. It can be observed that the sales target for the year 2017 was $54.9 billion and the company achieved $55.5 billion (woolworthsgroup.com.au 2018). The second accounting measure is Earnings before Interest and tax (EBIT). It can be observed that the target EBIT was $2.53 billion and the achieved amount is $2.48 billion. Working Capital is the third accounting measure for the determination of bonus of the CEO. The targeted working capital was -1.8 days and the achieved working capital was -5.1 days (woolworthsgroup.com.au 2018).
The CEO of Woolworths would required to take accounting decisions that help the company in improving the financial performance as it would create opportunity for the CEO to get higher bonus. For this reason, the CEO was required to adopt the strategy to increase the sales of Woolworths by decreasing the operating expenses of the business. Increase in sales and decrease in operating expenses would eventually lead to increase in EBIT of the company. At the same time, the CEO could also take the decision to improve the working capital of the company by emanating short-term debts, selling long-term assets for cash, ensuring faster recovery of the amounts from the debtors, earning more profit and others (Francis et al. 2015).
The application of Agency Theory is done for explaining the relationship between the principals and the agents of the business. More specifically, agency theory helps in addressing the issue in the presence of different goals and desire between the principal and the agent (Pepper and Gore 2015). This theory can be applied in the case of Woolworths as shareholders are the principal and senior management is the agent. As per the regulations of agency theory, the main aim for different components of remuneration is to motive the senior management of the company to achieve better financial performance so that the shareholder’s wealth can be maximized.
The following discussion shows two of the problems related to the relationship between the shareholders and the managers:
1St Issue: The takeover attempt of the business organizations can be considered as one of the major issue between the shareholders and the senior managers. In most of the cases, the managers are more concerned about their job security than increasing the shareholder’s wealth. For the takeovers, business takeovers bring major benefits for them (Bosse and Phillips 2016). At the same time, the managers use to grow the business so that they can escape business takeover for their own job security benefits. This aspect creates major conflict between the managers and the shareholders. As the remedy of this situation, it is required to include the long-term incentive plan in the bonus contract. In the presence of this plan, the managers will achieve the long-term financial targets of the companies for earning more bonuses and the wealth of the shareholders will be increased (Eisdorfer Giaccotto and White 2013).
2nd Issue: Another major issue can be seen related to the maximization of the manager’s wealth than the shareholder’s wealth. It needs to be mentioned that main focus of the managers is to increase their own wealth than the shareholder’s wealth. For this reason, managers take some decisions that are against the wealth maximization of the shareholders. For this reason, conflict between these two parties can be seen. The remedy of this issue is the inclusion of short-term inceptive plan in the bonus contract. In order to avail the opportunity of this, the managers will take decisions that will lead to better financial performance of the company (Singla, Veliyath and George 2014). As a result, the wealth of the shareholders will be increased.
The following discussion shows three major ways to safeguard the bank against the risk f lending:
1st Way: In order to eliminate the risk of lending, the bank can go into special dent covenant as a part of the debt agreement for making the organization maintain strong financial position. For example, in the dent agreement, the bank can impose the obligation on the company that wants to take loan to maintain a minimum margin of net profit, or current ratio or working capital or others. In the presence of this covenant, the will be able to provide loans to the companies having string financial position (Berger, Kick and Schaeck 2014.).
2nd Way: In this context, the main agency problem related to the bank is the taking of excessive amount of risk while lending money. It implies that there is huge uncertainty related to the recovery of loan amount that increases the lending risk of the bank (Agoglia, Hatfield and Lambert 2015).
3rd Way: The bank can use the accounting information of the business enmities that want to take loan in order to avoid the risk. In case the bank conduct analysis and evaluation on the accounting information of those companies, the management of the bank will be able in judging the past trend of the financial performance along with the present financial performance of the companies. This will help the bank in taking better lending decisions (Hilton and Platt 2013).
Agoglia, C.P., Hatfield, R.C. and Lambert, T.A., 2015. Audit team time reporting: An agency theory perspective. Accounting, Organizations and Society, 44, pp.1-14.
Berger, A.N., Kick, T. and Schaeck, K., 2014. Executive board composition and bank risk taking. Journal of Corporate Finance, 28, pp.48-65. Berger, A.N., Kick, T. and Schaeck, K., 2014. Executive board composition and bank risk taking. Journal of Corporate Finance, 28, pp.48-65.
Boeri, T., Lucifora, C. and Murphy, K.J. eds., 2013. Executive remuneration and employee performance-related pay: a transatlantic perspective. Oxford University Press.
Bosse, D.A. and Phillips, R.A., 2016. Agency theory and bounded self-interest. Academy of Management Review, 41(2), pp.276-297.
Eisdorfer, A., Giaccotto, C. and White, R., 2013. Capital structure, executive compensation, and investment efficiency. Journal of Banking & Finance, 37(2), pp.549-562.
Francis, B., Hasan, I., Park, J.C. and Wu, Q., 2015. Gender differences in financial reporting decision making: Evidence from accounting conservatism. Contemporary Accounting Research, 32(3), pp.1285-1318.
Hilton, R.W. and Platt, D.E., 2013. Managerial accounting: creating value in a dynamic business environment. McGraw-Hill Education.
Ntim, C.G., Lindop, S., Osei, K.A. and Thomas, D.A., 2015. Executive compensation, corporate governance and corporate performance: a simultaneous equation approach. Managerial and Decision Economics, 36(2), pp.67-96.
Pepper, A. and Gore, J., 2015. Behavioral agency theory: New foundations for theorizing about executive compensation. Journal of management, 41(4), pp.1045-1068.
Shields, J., Brown, M., Kaine, S., Dolle-Samuel, C., North-Samardzic, A., McLean, P., Johns, R., O'Leary, P., Robinson, J. and Plimmer, G., 2015. Managing Employee Performance & Reward: Concepts, Practices, Strategies. Cambridge University Press.
Singla, C., Veliyath, R. and George, R., 2014. Family firms and internationalization?governance relationships: Evidence of secondary agency issues. Strategic Management Journal, 35(4), pp.606-616.
Woolworthsgroup.com.au. (2018). [online] Available at: https://www.woolworthsgroup.com.au/icms_docs/188795_annual-report-2017.pdf [Accessed 26 May 2018].
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