Compensation Package Essay

Question:

Write an essay on Elements of Compensation Package.

Answer:

Introduction

In this report an attempt is made to address the issues of profitability and compensation of executive raised by the directors in their last meeting. The aim of this report is to suggest concrete measures after analyzing Agency Theory, Motivating factors and other important elements

Elements of Compensation Package

Compensations are the benefits provided to the employees by the employers in exchange of services to them (Lin 2015). For any business a huge part of their business expenses consists of employee’s compensation so it is very important to ascertain the appropriate compensation for a particular job. The typical compensation package includes elements like:

  • Base salary;
  • Short term incentives and bonuses;
  • Long term inducements;
  • Perquisites;
  • Other supplementary benefits.

The single largest component of a compensation package of an employee is the Base salary. It is generally ascertained on the basis of skill and experience of the employee and any subsequent increase is generally dependent on the performance and contribution of the employee (Siciliano 2014).

There are various kinds of short term benefits that may be provided to employees but among them most popular is the bonus payment. Bonus is a lump sum amount paid to employees as performance incentives. It acts as motivational factors for employees to work hard.

Apart from the short term benefits employees are also given long term inducements that includes stock options, stock grants etc. These benefits generally help business retain valuable employees.

Perquisites and other supplementary benefits also forms an important part of compensation package. While hiring top executives that are receiving offers from multiple companies in such cases the types of perquisites offered by a company makes all the differences (Ellig 2013).

So it can be said that a suitable compensation package always blends the needs of both the company and the employees.

Agency Theory for determining Compensation

An agency relationship is said to exist when an individual called principal engages another individual called agent to perform some services and also delegate’s authority to make decision. The two most important agency relationships in business are between:

  • share holders and managers; and
  • Bond holders and share holders.

The Traditional Agency Theory deals with the conflict of interest between key stake holders in an organization. This theory makes an attempt to align the interest of both principals and agents so that conflict of interest could be resolved. Further it also tries to reconcile the difference of risk tolerance level between the principal and agent (Pepper and Gore 2015). There are certain assumptions that are made in Traditional Agency Theory and they are:

  • It is assumed that self interest is the motivating factor for both principal and agent;
  • It assumes that contracts are complete and there is no scope of ambiguity;
  • It assumes that contracting will eliminates agency costs;
  • It is assumed that share holders are only interested in financial performance;
  • It is assumed that managers and directors should always act in the interest of share holder;
  • It is also assumed that the agent will always be adequately compensated by the principal for their services.

The assumption of self interest in the agency theory leads to inevitable conflict between both party’s managers and share holders (Cuevas?€ђRodr?guez et al. 2012). The manger will then act in their self interest to maximize their wealth and ignore the interest of the share holders. Under such circumstances a manger could only be encouraged to act for the interest of share holders by offering attracting incentives or by constantly monitoring their activity (Bridoux et al. 2014). The Agency Theory suggests that the managers can be effectively perused to act for the interest of share holders by:

  • Linking performance with incentives;
  • Direct control and intervention by share holders; and
  • Threat of taking strict actions.

It can be concluded that as per Agency Theory compensations should be high and adequate so that managers are motivated to act in the interest of business and share holder. So the argument provided by Bill Strong for justifying high compensation and monetary benefit to employees for motivating them is valid as per Agency theory.

Two Types of Motivation- Relationship & Difference

Motivating factors energizes people’s behavior for achieving goals so the key to any successful business is motivated employees. Motivation is defined as the desire or need that contributes to the behavioral change of an employee. Motivation in a workplace can be classified into two categories they are intrinsic motivation and extrinsic motivation (Reiss 2012). Intrinsic motivation is the pleasure or satisfaction that is derived from the work itself. The most important feature of intrinsic motivation is that it comes from inside and it is dependent on one’s own self. The extrinsic motivating factors comes from outside in the form of compensation and promotion. In most cases managers uses a combination of both intrinsic and extrinsic motivation for creating a motivated and energized workforce (Dysvik and Kuvaas 2013). There is a conflicting relationship between intrinsic and extrinsic motivation because they are the opposite ways of motivating an employee. Various studies that have been conducted show that too much emphasis on extrinsic motivation not only reduces the intrinsic values but also has negative impact on the profitability of the business (Cerasoli et al. 2014).

The primary difference between intrinsic and extrinsic motivation is the motivating factor. In the case of intrinsic motivation motivating factors comes from inside whereas in case of extrinsic motivation motivating factors comes from outside (D?rnyei and Ushioda 2013).

So it can be concluded that Susan Bolds argument that intrinsic motivating factors should be considered at the time of determining executive compensation is valid.

Relationship between Risk & Compensation

Risk is the uncertainty that exists about the future outcome or event of a business. The business risk is a matter of concern for both the employer and the employee and any increase in business risk increases the risk exposure of the employee (Chen et al. 2015). The attitudes towards risk return tradeoff is not the same for every employee. Thus from the point of view of taking risk employees can be classified into risk taking employees and risk averse employees. Most of the employees in workplace are risk averse and there are various reasons for such attitude but most important among them is the job security. If the consequence taking risks are too high like job loss, pay cut etc then employees will naturally be not inclined in taking risk. The risk averse employees prefers to take fixed salary because it has no variability and hence less risk. As they avoid the variable component of the salary the salary of risk averse employees remains fixed and does not increase with increase in performance. In contrast a risk seeking employee prefers to have a larger variable component in salary so that they can increase their earning with improving performance. On analyzing big organization it could be found that naturally employees seeking lees risk and engaged in routine gets a fixed salary whereas higher managements and executive who are responsible for making important business prefer more variable component in the salary. On studying the relationship between employees risk preference and compensation it can be concluded that risk averse employees prefer fixed salary for them security of salary is the main concern. On the other hand risk seeking employees prefer salary with large variable components like compensation for them performance based salary is the main concern.

The relation relationship between business risk and compensation can also be studied through Agency Theory. The study of agency theory has shown that there are two major relationships between business risk and compensation package.

The Agency theory suggests that there is a positive relationship between the base pay and the business risk. This means that an employee (agent) is willing to undertake more business risk if such risk is mitigated by increasing its base pays (Chen et al. 2014).

Secondly, Agency theory implies that there is a negative relationship between incentive compensation and business risk. In high risk business environment increase in incentive payment will further increase the risk exposure of the employee (agent).

So from the above discussion it can be concluded that compensation package depends upon the employee’s assessment of risks. If an employee expects high risk then the desired compensation package shall include high base pay and low incentives (Tao 2013). But if the employee asses low risk then the compensation package shall include higher compensation.

Influence of time on financial benefits

In finance there is a concept of time value of money. The time value of money suggests that any money received at the present time is worth more than it will have worth in future. It happens because over the period of time the purchasing power of the money reduces. The purchasing power of money reduces because of increase in inflation (Lewin and Cachanosky 2015). So it is natural that employee will be more interested in receiving financial benefit at present moment than in future. Thus it can be concluded that as the time of receiving benefit increases the desire to receive such benefit decreases (Gupta and Shaw 2014). In the given case employees are provided financial benefit in terms of share which can be sold by them after three years. The assertion made by the board members that this has leaded to low employee morale is justified.

Fairness & Compensation

Compensation is the reward earned by an employee in return of their service or labor. The determination of appropriate compensation involves consideration of various factors and one of the key components among them is fairness or equity (Elbers et al. 2013). The employees perceive fairness both internally and externally. The internal fairness is said to exist when employee perceives that there is an equality of pay among all employees of same stature. The external fairness is said to exist when employee perceives that their compensation is according to the industry standard. If the perception of internal or external unfairness exists then it will lead to low employee moral which will ultimately result in low profitability of the business (Kingsley 2013). So it can be concluded that considering fairness is a very important factor while determining compensation.

Executive Compensation Committee Benefit

The responsibility of determining the executive compensation is with the board of directors (Hermanson 2012). In most cases it is found that due to shortage of time it is not possible for all the board of directors to deliberate on the issue of executive compensation. The directors for want of time have delegated this responsibility to executive compensation committee. The committee acts on behalf of the board of directors and are responsible for managing and designing the executive compensation. The responsibility of executive compensation committee includes development of an annual executive incentive plan (Dittmann et al. 2015). Further they are also responsible for execution and administration of such plan. The committee develops concrete performance goals for executives so that annual compensation can be determined on the basis of well established parameter. So it can be said that executive committee is beneficial in determining executive compensation.

Structure of the Committee

The function of the executive compensation committee is to determine the compensation the executives. This requires the committee to function independently from the management (Joseph et al. 2014). To maintain independence it is necessary that the managers should not have automatic access to committee meetings whenever necessary committee members should have access to managers (Sirkin et.al. 2015). The compensation committee, to achieve the best outcome should adopt the following best practices:

  • Special attention is required to be given while choosing committee members. It is advisable that at least one director is chosen having experience in executive compensation;
  • It is advised that the company should adopt a committee charter so that it can act as the governing document of the committee;
  • The company should develop a philosophy for designing executive function;
  • The committee should review the compensation level at regular intervals;
  • The committee should also review its own functions annually.

Conclusion

The above study has adequately dealt with all the required information for determining the compensation. The study has shown that compensation package should be adequately designed so that the objective of the employer and employee both can be achieved. The agency theory suggests that the compensation should be high enough so that managers could overcome self interest. The motivation of an employee is not only dependent on compensation it is very essential that intrinsic motivating factors should also be considered. Further it is essential that employees should not perceive unfairness in their treatment then it will have a very negative impact in motivation of employees.

Recommendations

From the analysis the concrete suggestion that can be given are as follows:

  • The construction industry is in down turn so risk has increased. In such case it is suggest that executive compensation package should not include high incentives but it will further increase risk exposure;
  • The incentive plan of employees should be revised because it has lead to a fall in motivation. It is suggest that the restriction imposed on employees for not allowing them to sell shares which are given as incentives should be changed;
  • The Agency theory is very popular so compensation based on the theory should continue;
  • The intrinsic and extrinsic motivating factors should be considered whiledetermining compensation.

References

Bridoux, F. and Stoelhorst, J.W., 2014. Microfoundations for stakeholder theory: Managing stakeholders with heterogeneous motives. Strategic Management Journal, 35(1), pp.107-125.

Cerasoli, C.P., Nicklin, J.M. and Ford, M.T., 2014. Intrinsic motivation and extrinsic incentives jointly predict performance: A 40-year meta-analysis.Psychological Bulletin, 140(4), p.980.

Chen, J., Hill, P. and Ozkan, N., 2015. Financial Distress Risk, Executive Compensation and the Executive Labour Market. Executive Compensation and the Executive Labour Market (January 8, 2015)

Chen, Y. and Jermias, J., 2014. Business strategy, executive compensation and firm performance. Accounting & Finance, 54(1), pp.113-134.

Cuevas?€ђRodr?guez, G., Gomez?€ђMejia, L.R. and Wiseman, R.M., 2012. Has agency theory run its course?: Making the theory more flexible to inform the management of reward systems. Corporate Governance: An International Review, 20(6), pp.526-546.

Dittmann, I., Yu, K.C. and Zhang, D., 2015. How important are risk-taking incentives in executive compensation?. Available at SSRN 1176192.

D?rnyei, Z. and Ushioda, E., 2013. Teaching and researching: Motivation. Routledg

Dysvik, A. and Kuvaas, B., 2013. Intrinsic and extrinsic motivation as predictors of work effort: The moderating role of achievement goals. British Journal of Social Psychology, 52(3), pp.412-430.

Elbers, N.A., Akkermans, A.J., Cuijpers, P. and Bruinvels, D.J., 2013. Procedural justice and quality of life in compensation processes. Injury,44(11), pp.1431-1436.

Ellig, B.R., 2013. Attracting, Motivating and Retaining Executives Lessons From Years as an HR Executive. Compensation & Benefits Review, 45(2), pp.75-87.

Gupta, N. and Shaw, J.D., 2014. Employee compensation: The neglected area of HRM research. Human Resource Management Review, 24(1), pp.1-4.

Hermanson, D.R., Tompkins, J.G., Veliyath, R. and Ye, Z.S., 2012. The Compensation Committee Process*. Contemporary Accounting Research,29(3), pp.666-709.

Joseph, J., Ocasio, W. and McDonnell, M.H., 2014. The structural elaboration of board independence: Executive power, institutional logics, and the adoption of CEO-only board structures in US corporate governance.Academy of Management Journal, 57(6), pp.1834-1858.

Kingsley Westerman, C.Y., 2013. How people restore equity at work and play: Forgiveness, derogation, and communication. Communication Studies,64(3), pp.296-314.

Lewin, P. and Cachanosky, N., 2015. The Time-Value of Money and the Money-Value of Time: Duration, Roundaboutness, Productivity and Time-Preference in Finance and Economics. Roundaboutness, Productivity and Time-Preference in Finance and Economics (June 2, 2015).

Lin, F., 2015. Essays in Corporate Governance and Executive Compensation.

Pepper, A. and Gore, J., 2015. Behavioral agency theory new foundations for theorizing about executive compensation. Journal of management, 41(4), pp.1045-1068.

Reiss, S., 2012. Intrinsic and extrinsic motivation. Teaching of Psychology,39(2), pp.152-156.

Siciliano, M., 2014. Beyond the Basics of Executive Compensation: Researching What Corporate Executives Are Really Worth. Journal of Business & Finance Librarianship, 19(4), pp.306-318.

Sirkin, M.S. and Cagney, L.K., 2015. Executive compensation. Law Journal Press.

Tao, N.B. and Hutchinson, M., 2013. Corporate governance and risk management: The role of risk management and compensation committees.Journal of Contemporary Accounting & Economics, 9(1), pp.83-99.

The International Accounting and Assurance Standard Board (ISAB) have issued a revised International standard on Auditing 700 which became effective on or after 31, December, 2012. The revised standard was issued to reduce the audit expectation gap between the users of financial statement and the Audit profession. As per the revised ISA 700 an auditor is required to provide explanation in the audit report so that it could improve the users understanding of audit (Gold et. al. 2012). The main aim of this research paper is to ascertain the current state of expectation gap under revised IAS700. Further this research paper also aims to determine whether providing explanation in the audit report as required by the IAS700 actually reduces the expectation gap.

Table showing groups and information received

Complete Unqualified Audit Report with explanation as required by IAS700.

Complete unqualified audit report containing only auditors opinion and not the explanation

Auditors

Auditors

Financial Analyst

Financial Analyst

Student

Student


The table has shown that there are three subject groups Auditors, Financial Analysts and students and two factors one, audit report with explanation from auditor and in another case audit report with opinion only. The purpose of this research is to ascertain whether the opinion of the subject group changes with the change in available information’s.

Manipulation check is an important part of the research method. It is conducted to determine whether a change or manipulation in independent variable has its intended effect on the participants (Moroney and Trotman 2015). In this research project two strong manipulations were used they are:

  • In one case only auditors opinion section of the audit report was shown to the participants;
  • In another case, complete auditor’s report fulfilling all the conditions as stated in ISA 700 was shown to the participants.

The purpose of this manipulation check was to ascertain the effectiveness of the explanation provided by the auditor in the audit report under IAS700. The result of this manipulation check would ultimately help to derive the conclusion of this research (Kotzian 2015). So it can be concluded that manipulation check is very important part of the research.

The responsibility of the auditor is to form an opinion on the true and fair view of the financial statement. But the study of “An Assessment of Expectation Gap in Ghana” has clearly shown that as per public perception it is the responsibility of the auditors to detect fraud and errors in the financial statements. This difference in perception of responsibility is known as Audit Expectation Gap. There is no research that has been conducted on Audit expectation gap in Ghana. Therefore the main aim of this study is to ascertain the existence of audit expectation gap in Ghana.

The main aim of the study “Narrowing the expectation Gap in Auditing: The Role of Auditing Profession” is to ascertain whether the public at large have the knowledge of responsibility of the auditors. Further this study also aims to provide ways in which audit professional can reduce audit expectation gap.

The study of “An Assessment of Expectation Gap in Ghana” has found that the audit expectation gap exists primarily because of the subjective terms that are used in auditing. This study has included various sampling techniques for performing the research. In the study of “Narrowing the expectation Gap in Auditing: The Role of Auditing Profession” it is found that expectation gap exist because of lack of knowledge about the responsibility of the auditor. This method used detail questioner method for collecting data. So from the analysis it can be said that the study of “Narrowing the expectation Gap in Auditing: The Role of Auditing Profession” is more rigorous as it focuses on quantitative research.

In the study of “An Assessment of Expectation Gap in Ghana” non probability sampling techniques were used in selecting participants. The techniques of sampling included both convenience and purposive technique. In selecting the users of the financial statement a purposive sampling techniques were used and in case of choosing respondents to questionnaires convenient sampling techniques were used. The research participants were auditors and stock brokers from Greater Accra Region. The stock brokers were chosen from Ghana stock exchange and auditors were selected from the central business district of Accra. In case of the study of “Narrowing the expectation Gap in Auditing: The Role of Auditing Profession” the participants were selected randomly from various students, teachers, professionals and investors. So it can be said that in the study of “An Assessment of Expectation Gap in Ghana” research participants were selected more rigorously.

In the study of “Narrowing the expectation Gap in Auditing: The Role of Auditing Profession” it was found that 67.12% of the respondent is unaware of the role of the auditor. It is clearly established in the study that there exist a positive relationship between the audit expectation gap and the ignorance about the responsibility of the auditor. In the study of “An Assessment of Expectation Gap in Ghana” it was found that 45% of the respondent auditors agree to the statement and 45% of them disagree. It was found that out of total stock brokers only 65% of them agree to the frauds that were detected in financial statements. So it can be concluded that response rate in “Narrowing the expectation Gap in Auditing: The Role of Auditing Profession” is more accurate.

In the study of “Narrowing the expectation Gap in Auditing: The Role of Auditing Profession” data was collected by providing questionnaires to 130 respondents who were chosen randomly. The data that was generated from the respondent were analyzed using descriptive and statistical analysis. In the study of “An Assessment of Expectation Gap in Ghana” the data was collected primarily through questionnaires. This data’s were analyzed using statistical package for social science. So it can be concluded that in the study of “Narrowing the expectation Gap in Auditing: The Role of Auditing Profession” the data is more rigorously analyzed with the help of accurate financial and audit data.

The two flaws that can be noticed in the studies are

  • Users of the financial statement need to be more aware of the responsibility of the auditor. It is advisable that an audit report should explicitly provide that it does not vouch for financial accuracy and audit report is not a certificate or guarantee given by the auditor ;
  • It was also found that there is high expectations from audited financial statements which should be properly addressed to reduce the audit expectation gap.

References

Gold, A., Gronewold, U. and Pott, C., 2012. The ISA 700 auditor's report and the audit expectation gap–Do explanations matter?. International Journal of Auditing, 16(3), pp.286-307.

Kotzian, P., Stoeber, T., Hoos, F., Wei?enberger, P. and Barbara, E., 2015. To Be or Not to Be in the Sample? On the Consequences of Using Manipulation Checks in Experimental Accounting Research. Barbara E., To Be or Not to Be in the Sample.

Moroney, R. and Trotman, K.T., 2015. Differences in Auditors' Materiality Assessments When Auditing Financial Statements and Sustainability Reports. Contemporary Accounting Research.

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