Governance and Audit

Question 1

During last decade a lot of attention was given to the issue of executive compensation from shareholders, media and policy. In this essay I intend to identify what agency problem and executive compensation means. Also I will express arguments for viewing executive compensation as a solution to agency problem and also as a part of agency problem.

Given the fact that development of corporate governance was influenced by many disciplines, the theories that fall into it are quite varied. One of the main theories that may be associated with the development of the corporate governance is agency theory. Agency relationship appears when there is a contract under which a principal delegates work to an agent. In a corporate case, usually shareholder is the principal and director is the agent. Principal is incapable of monitoring every detail of the work and therefore has to give the agent some decision-making authority. So limited companies result in separation of ownership and control. Shareholders are the owners of the company but they do not have detailed oversight, managers are those who control the company on the day-to-day basis.

Therefore a conflict appears between self-interest of shareholder and director which is called an agency problem. There is a risk that agent will not act in the best interest of the principal, or the agent will act only partly in the best interest of the principal. One possible scenario could be that agent will refuse to take appropriate risks in pursuance of the principal interests because he and the principal could have different attitudes towards risks and agent may think that those risks are not appropriate. Also agent could misuse his power for financial and other advantages. Usually shareholders interested in increase in dividends, company survive and growth and directors may not be concerned about company's long-term performance but interested only in high salaries and perquisites. Directors are able to subvert the controls built into the system because law and regulation cannot stop them, and there is always will be a danger of dishonesty, inefficiency and favoritism because rewords are too high to prevent it (Mallin, C.A. 2007)

Also there is a problem of information asymmetry. Shareholder and director have access to different levels of information and in practice this is a disadvantage to the shareholder because by controlling the business on day-to-day basis director will have more information, therefore he know better than shareholder whether or not he is able to meet objectives of shareholder. Moreover there is always a certain percentage of uncertainty. Innumerable numbers of factors influence on final outcomes, and it may not be possible to say whether or not the agent caused a given outcome. So it is clear that agency problem raises a fundamental problem in organizations self-interested behavior.

Therefore in order to encourage directors to maximize shareholders wealth rather than behave in their own self-interest, shareholders have to spend extra money. These extra spending called agency costs and executive compensation is a part of those costs. Size of the compensation should be decent to attract those directors who will be able to run company successfully, but a company should elude to pay more than is required. There are six basic types of compensation: basic salary; short term incentives or bonus; long-term incentives plans; employee benefits; perquisites and compensation protection also known as golden parachute.

Basic salary is not related to the director performance or to the performance of the company itself. Salary is received by director according to his contract. Usually the size of the salary will depends on director's qualification and experience, the size of the company, the industry sector and level of the salary in similar companies. Short-term incentives are formula-driven and they include performance criteria, which depends on the role of the director. Bonuses are usually discretionary and not formula-driven. They are linked to the firm accounting performance and paid annually. Perquisites can include such benefits as health insurance, retirement plans, interest free loans and other bonuses. Golden parachute is an agreement between company and director which guarantee certain benefits to director in case if employment is terminated. These benefits could include cash bonuses, severance pay or stock option. But all these types of compensation increasing agency cost dramatically and will not guarantee that directors will work towards maximization of shareholder wealth, thus the agency problem will not be solved.

Economic literature show that compensation received buy executives should be connected to company performance for incentive reasons (Canyon and Mallin 1997). Therefore an effective way of executive compensation would be an incentive-based compensation because this type of compensation is tied to performance. Most of the companies today prefer incentive-based compensation, for example compensate directors with shares. Shares of stock that given to executives on the basis of performances are defined by financial measures such as: return on asset, earnings per share, return on equity and stock price change. If company performance is above the performance targets, than directors earn more shares. Stock option gives directors a right to purchase shares at a specified exercise price over a specified time period.

Incentive-based compensation plans, for example performance share, are planned to fulfill two objectives. Firstly, they give directors incentives to take action that will enhance shareholder wealth. Secondly, these plans assist firms to find those directors which will be prepared to risk their own financial future on their own abilities, which should lead to better performance. If compensation contract is designed well it will help to align the objectives of shareholders and directors, therefore share options and other long-term incentives are a fundamental way to ensure harmony between shareholders and directors objectives. Use of Incentive-base compensation will decrease the agency cost but it would be very difficult to find such talented manager under these contractual terms because the company's earnings would be affected by economic events that are not under director's control. Also nowadays there is a big discussion whether performance criteria are appropriate and demanding enough. Thus there could be situations where incentive-based compensation will not solve the agency problem.

"The board should establish a remuneration committee of at least three, or in the case of smaller companies, two members, who should all be independent non-executive directors" (Combined Code 2006, para B.2.1). Non-executive directors "are effectively chosen by or only with the full