Management Compensation Issues - Research Paper Example

Management Compensation Introduction Management compensation encompasses all forms of financial returns and other benefits that employees receive in their tenure of employment in return for their enviable contribution to the organization. In the contemporary corporate world, compensation is perceived as a measure of justice; an outcome of productivity. Management compensation is a means of enhancing the balance of work-employee relation by the provision of financial and nonfinancial gains to employees. Compensation is an essential component of human resource management, which aids in motivation of employees, besides enhancing organizational effectiveness. Types of Management Compensation Management compensation encompasses both intrinsic and extrinsic components in the form of monetary benefits and non-monetary benefits such as paid holiday. Compensation incorporates salary, as well as other rewards and allowances given to employees in return for their outstanding services. Compensation can be depicted as representing base pay, long-term incentives, bonuses, stock options, and benefits (Davis and Edge 2). The goal based incentive (stock options, bonuses, and long-term incentives) is fashioned at aligning the corporation’s interests (financial success) with those of top managers. Description Management compensation is an effective means of enhancing the productivity of the employees and ensuring that deserving employees feel appreciated for their efforts. Some companies utilize management compensation as a tool for fostering a performance-oriented culture where the employees focus on the company’s overall strategic goals. Management compensation is meant to motivate the employees, especially the top management within a company. The motivation of management compensation is to align the employee performance with the business goals, besides enhancing employee satisfaction and retention. Compensation programs also respond to the employee’s psychological and self-actualization needs (Davis and Edge 3). Management compensation is fashioned to reward employees based on the actual value they give to the company (Davis and Edge 5). The advantages of management compensation include enhancing job satisfaction, employee motivation, and low turnover. Management compensation also enhances self-confidence, leading to self actualization. Management Compensation: An Incentive to Manipulate Accounting Reports Managers commit fraud because of the resultant economic benefits flowing from it. Given management’s self interest, executives may manipulate accounting earnings in pursuit of personal agenda, such as bonuses (Armstrong, Jagolinzer & Larcker 225). Income smoothing tends to be dominant in corporations applying internal performance standards compared to those using external standards. The downside of goal based incentives is that, besides encouraging managers to work smarter to deliver positive results (desired results), they also induce executives to manipulate financial results such as profit and share prices. This is an attempt to enhance their pay, which is itself a violation of executive’s fiduciary duty and a fraud (Laux and Laux 870). In most cases, companies design equity-based compensation contracts in order to provide executives with incentives meant to enhance stock prices via legitimate means. However, the contracts may also generate enhanced incentives to produce fraudulent financial statements or engage in actions geared at misleading analysts and investors on the stock value of the company. The incentives to engage in fraudulent activities may be serious in occasions where the executives believe that competition or other constrains limit their ability to enhance the value of the firm legitimately, and consequently reduce the incentives. Some studies show a likelihood of fraud in relation to incentives from unrestricted stock holdings compared to incentives from restricted stock. Managers at fraud firms tend to exercise larger portions of their vested options and are awarded greater compensation during fraud years. Predisposition of accounting fraud is commensurate with executive compensation in cases where management compensation is on stock-based mix. In most cases, stock prices experience an approximate 20% drop in average value upon the disclosure of potential fraud, which imply that the stocks prices were inflated during the fraud years (Armstrong, Jagolinzer & Larcker 226). Whereas the presence of equity-based compensation does not necessarily imply predisposition to fraud, the size or strength of the incentives availed by the equity-based compensation may affect the likelihood of choice to engage in fraudulent activities. Executive Compensation Disclosure and Related SRO Rules The Dodd-Frank Wall Street Reform and Consumer Protection Act demands certain disclosure on aspects such as executive compensation and golden parachutes, as well as disclosures on the role of, and possible conflicts involving compensation consultants. The Act demands additional disclosures centering on compensation matters, inclusive of pay-for-performance. The proposed reforms also impose obligatory “say-on-pay” shareholder vote requisites and new demands for compensation committee independence. The legislation, which covers companies listed in the national securities exchange, requires companies to establish “Say-on-Pay” shareholders votes. One of the requirements demands the companies to source for shareholder consent or censure of disclosed executive compensation (Maher, Stickney and Weil 424). Principles of Management Compensation Principles of management compensation are designed to guide development of standards that reward innovation and prudent risk taking devoid of creating misaligned incentives. The goal of the principles is to employ management compensation as a behavior modification tool and reinforce management compensation with employee value. Management compensation should be fashioned at rewarding performance (Lipman and Hall 4). The goal of incentives for performance should be enhancing the long-term value creation in a company as measured by a broad range of internal and external metrics. The rewarding should not solely rest on stock prices, but also exceptional performance of the management during turbulent times. This calls for blending of performance metrics inclusive of aspects such as stock prices, performance appraisal, risk management, and measures fashioned at maintaining long-term success of the firm. The compensation should also be structured in a manner that guarantees time horizon of risks. Management compensation measures should be structured in ways that are closely allied with the lasting value and success of the company. The attempt should match compensation outcomes with risk outcomes. In addition, management compensation practices should be allied to sound risk management (Lipman and Hall 5). The rationale of this principle is to discourage imprudent risk taking that may accompany compensation programs. Compensation management revolves around aligning golden parachutes and supplemental retirement packages interests of the executives with those of the shareholders. This principle is geared at making management compensation well intentioned and is not an entitlement to the executives. It is essential to align the interest of the executives with those of the shareholders so that in the course of motivating performance, the rewarding of top executives will not result to loss of value for the shareholders (Caruth and Handlogten 6). Lastly, management compensation process should be guided by transparency and accountability. The compensation committees should enhance independence and accountability and promote greater clarity in disclosure of compensation practices. Controversy The proponents of management compensation claim that stock option and other “pay-per-performance” programs are justified by the global war for talent and the emergence of private equity. The proponents argue that management compensation is not in essence a conspiracy, but a byproduct of supply and demand for executive talent (Caruth and Handlogten 5). Management compensation can be considered as a complex and contentious topic. Overtime, there has been an intense debate revolving around the pay-setting process and the results it produces. Management compensation is sometimes perceived as excessive and sometimes inappropriate. Some critics question compensation packages and label it as out of balance. Critics argue that most compensation packages are too large compared to the employee’s salary, and greater than shareholder’s perceived rate of return on investment. Some people argue that management compensation packages depict corporate greed, while other view it as a noble way of contracting managerial talent (Goel 12). The issue concerning management compensation raised a storm on corporate governance and inspired reforms within U.S. public companies, especially after the 2008-2009 economic recession. The scale of the 2008-2009 financial crisis and subsequent perception that the ensuing global recession was fuelled, in part by management compensation programs, heightened calls for regulation of the programs. It was alleged that compensation programs encouraged executives to take inappropriate risks, which contributed to the economic meltdown. As a result, there was a popular dissatisfaction with the prevailing pay practices and corporate governance standards (Laux and Laux 869). Conclusion As demonstrated, management compensation packages are ineffective in attaining their objective of interest alignment when they are ill structured. In some cases, the management may resort to unscrupulous practices, and fraud in pursuing their financial reward, which is itself a violation of their fiduciary duty. The prevalent disincentives such as risk of being caught for violating fiduciary duty are at times inadequate in shielding shareholders from management malpractices. Thus, there is a need to develop effective compensation packages that ensure legitimate practices by managers. The high predisposition to fraud in stock-based compensation does not necessarily imply that stock-based compensation is inefficient. Instead, this is an impetus to compensation committees, which face a trade-off between maintaining effective compensation programs afforded by stock-based compensation and negative effects orchestrated by earnings manipulation. Management compensation should be tied to company performance in order to align the interests of both the shareholders and the managers. Shareholders should be at the forefront in actively questioning why and how the executives are compensated. Managers should be compensated for not only meeting the targets, but also creating wealth for shareholders. In order to avoid abuse, stock options plans should exhibit shorter option terms so as to minimize windfall gains or longer vesting periods to ensure executive retention. The compensation programs should also reflect market realities. It is vital to make management compensation fair, competitive, and results oriented in order to ensure that it serves its purpose. Works Cited Armstrong, Chris, Jagolinzer, Alan, & Larcker David. Chief executive officer equity incentives and accounting irregularities. Journal of Accounting Research 48.2 (2010): 225-271. Print. Caruth, Donald, and Handlogten Gail. Managing Compensation (and understanding it too): A Handbook for the Perplexed. Westport: Greenwood, 2001. Print. Davis, Michael, and Edge Jerry. Executive Compensation: The Professional’s Guide to Current Issues & Practices. San Diego: Windsor Professional Information, 2004. Print. Goel, Dewakar. Performance Appraisal and Compensation and Compensation Management: A Modern Approach. New Delhi: PHI Learning, 2008. Print. Laux, Christian. & Laux, Volker. Board committees, CEO compensation, and earnings management. The Accounting Review 84.3 (2009): 869-891. Print. Lipman, Frederick, and Hall Steve. Executive Compensation Best Practices. New Jersey: John Wiley & Sons, 2008. Print. Maher, Michael, Stickney Clyde and Weil Roman. Managerial Accounting: An Introduction to Concepts, Methods and Uses. Mason: South-Western, 2012. Print. Read More