Executive Pay in Australia

Remuneration & Other Subjects

The authors of this report have been asked to assess a number of subjects surrounding remuneration of employees and the overall corporate/social ethics involved in the same in Australia. There are also some tangential and related subjects that will also be spoken of. In total, there are five broad-based questions. The first question speaks about risk aversion, profit/wealth maximization, wealth management, different stances that different people and personnel take vis-a-vis risk and financial reporting manipulation. The second question references the horizon problem. This second question looks at the different motivations and perspectives that different people in an investment and accounting situation might take. Managers have their axe to grind and stakeholders typically have a different one. How bonuses for investment managers figure in will also be explored. Finally, there will be a review for the fifth question that pertains to the transparency and visibility of remuneration consequences for even the stakeholders and investors for a firm. While some people including investors and analysts just like to stir the pot, there are indeed some valid concerns relating to the ethics, motivations, decisions and biases of investors, stakeholders and others involved in the accounting and/or investing within an organization.

Question I - Risk Aversion

The underlying assumption of accounting theory, which is used to explain and predict behaviours, is that all individuals will act to further their own self-interest (Rankin et.al 2012). According to Kolb (2010), agency theory indicates that managers as agents, are assigned the task of day-to-day operation of a company by the shareholders as principals. However, a conflict arises as the self-interest of these two parties are not aligned. Classical economic theory suggests a higher risk strategy can result in higher rewards than those achievable from low risk approach. Shareholders are desirable of the higher returns, and typically, shareholders diversify their risk by having shares in multiple companies, and likely have other sources of income (Rankin 2012). Shareholders seek to maximize their personal wealth, which equates to a maximization of share price and dividends paid which increases with higher risk strategies (Kolb 2010).

In contrast, managers are likely to follow a risk averse strategy as their current salary and career prospects are tied to their current employment situation (Ferrarini & Moloney 2004). Managers are also likely to only focus on the short-term earnings that impact their current employment (Kolb 2010). To counter this risk aversion, incentive-based contracts are used in order to encourage managers to engage in more risky behavior (Rankin et.al. 2012). According to Ferrarini & Moloney (2004), the simplest way to do this is tying remuneration to performance indicators such as share price. This provides an incentive for management to act in a manner that maximizes shareholder wealth, because it will also be in their best interest to do so. To achieve the outcomes that shareholders desire, executive remuneration thus comprises multiple elements balanced in such a way to minimize management risk aversion. This includes fixed base salaries, short-term cash bonuses linked to specific targets, and longer term target based incentives including both shares and share options (Ferrarini & Moloney 2004).

There are many challenges in the use of contracts to reduce management risk aversion, and the correct balance in the use of bonus tools is critical. Rankin et.al. (2012) identify there is a point, where bonuses in the form of shares can actually serve to increase risk aversion. This is because managers will have an even greater investment tied to the company which they are unable to diversify. Ferrarini & Moloney (2004) identify that contracts that tie short-term bonuses to share performance can provide an incentive to management to manipulate financial reporting to increase short-term share increases and earnings.

Question II - Horizon Problem

The underlying theory that individuals will act in their own self-interest also relates to what is known as the horizon problem. Managers will naturally only be concerned with bettering the interests of a company for the period of time that impacts their current employment. This affect is amplified when managers approach retirement as there will be greater incentive to cut back on long-term projects, in order to maximise current earnings (Conyon & Florou 2006). Thus, managers can be expected to focus on a short-term horizon. Shareholders by contrast, are concerned with the long-term growth of the company, where the value of the entity is in part measured by expected future cash flows (Rankin et.al. 2012). Shareholders desire managers to make investment decisions which will maximise future cash flows (Rankin et.al. 2012).

One way to counter the horizon problem is through use of equity instruments as a component of executive remuneration. Equity ownership and share options encourage managers to care not only about the short-term but also about the future (Conyon & Florou 2006). If a manager has shares and share options that cannot be exercised until after a period of time post-retirement, then they will be unlikely to engage in short-term firm value destroying actions (Conyon & Florou, 2006). As previously discussed, it is often the accounting measure of earnings which drives the calculation of bonuses paid to managers. Managers can manipulate accounting information in a manner such that a company will display short-term profitability. This could be achieved directly, through a reduction in spending on research and development or indirectly through reduced depreciation as a result of lower capital expenditure (Conyon & Florou 2006). It could be argued that as a result of this, there must be a reduced reliance on accounting information to drive the calculation of bonus plans that are designed to address the horizon problem. Managers, in particular CEOs and CFOs, have the greatest ability to manipulate this information. Bonus plans based on share payments and share options then force the manager to make decisions that result in an appropriate balance of both short-term performance as well as long-term growth and viability. Conyon & Florou (2006) suggest that this may even act as a substitute, allowing for reduced monitoring of executive activity.