The Australian Financial Review Essay
The Australian Financial Review
This assignment aims to present in a clear and concise manner our viewpoint towards remuneration disclosure, considering steps to improve this matter of contention is taken voluntarily by the boards as recently stated by The Australian Financial Review. Section I explains our disposition about amendments done concerning disclosing remunerations. Financial accounting principle theories utilised, along with published printed information came to our conclusion which suggests executive pay reports simplification is substantial to shareholders understanding of remuneration outline. Section II takes up voluntary remuneration disclosure and its likely consequences applying IASB Conceptual Framework of qualitative characteristics. Analytical thinking and apprehension lead us to conclude that an increase in participation over the matter results to a much better comprehension from the shareholders. Section III logically analyses the argument about share based payment having to cost the company anything or not. Upon critical evaluation of published views, adding our sensible and sound judgment, the process itself of issuing share options consumes resources, meaning that, it falls down as an expenditure.
The motivation to improve remuneration disclosure
A fierce debate is raging about the legitimacy of executive pay rises. The evidence is mixed about how efficient remuneration disclosure has been, but what is clear is that the responsibility to ensure it is appropriate resides with the boards, and that there is a need for greater shareholder participation (Fels, 2010). The Australian Securities and Investments Commission (ASIC) have called for companies to provide more clarity on remuneration arrangements for their directors and executives (Gibson, 2013). As a challenge, we will discuss and analyse the motivations to improve remuneration disclosure. The following are the reasons why there is a need to improve disclosure of executive pay: * Assessing the `efficiency’ of executive pay is consequently problematic. Many performance indicators used by companies are not publicly disclosed and risk preferences vary across companies and individuals (Fels, A. 2010). * There has been a widespread perception that executives have been rewarded for failure or good luck – receiving rewards for rises in the share market price that had little to do with their contribution to company performance, and much to do with what was happening in global stock markets and asset valuations (Fels, A. 2010). * Boards voluntarily taking steps to improve remuneration disclosure by adding take home pay tables to annual reports are one step ahead of the game as demands for increased disclosure persist (Weggins, J. 2012). * Corporations and Market Advisory Committee (CAMAC) review the disclosure of executive pay reports and the report include providing more relevant information to shareholders, streamlining pay reports and disclosure of all termination payments for executives (Disclosure on Aust Exec`s Pay Need To Be Simplified: Report, 2011). * Boards are compensating for bonus cuts by inflating base pay and long term incentives. As share prices and earnings decline, board of directors keep changing the mix of cash, bonuses and short-term incentives. Long term incentives now account for a greater percentage of total pay than they have in previous years (Smith, M. 2012).
* The desire to comply with legal and professional requirements. There could be benefits for the company in appearing to act responsibly by their employees and this could be deemed to be more important than acknowledging other social responsibilities of the company (Deegan, 2002). * An attempt to be an accountable or responsible company by reporting information voluntarily. Managers are likely to consider that stakeholders have a right to certain information, and that they should fulfil that entitlement despite the related costs (Donaldson and Preston, 1995).
This paper provides an overview of the current debate and the theories that attempt to explain executive remuneration disclosure. Attention is given to underlying accounting theories such as Positive Accounting Theory, Normative Accounting Theory, Stakeholder Theory, Legitimacy Theory, Institutional Theory, Public Interest Theory, Capture Theory and Economic Interest Group Theory. We will now analyse motivations to improve remuneration disclosure using the theories of financial accounting. Accounting theories typically either explain or predict accounting practice or they stipulate unambiguous accounting practice. Positive Accounting Theory (PAT) aims to make good predictions of actual world events and convert them to accounting transactions. Its general objective is to understand and predict the choice of accounting policies across conflicting firms. It recognises that economic consequences exist. In relation to PAT, because there is a need to be efficient, the firm will want to minimise costs associated with the performance indicators used by the firm. PAT uses hypotheses around which its predictions are organised. One of the most utilised hypotheses is the bonus plan hypotheses. Companies with bonus plans choose accounting procedures that modify reported earnings from future periods to current period. In doing so, the company can increase their bonuses for the current period. There was a need to simplify pay reports to executives. The report`s current length and complexity can make it intricate for shareholders to understand and time-consuming on companies to prepare. It is important that remuneration report is easy to understand. It is vital for the shareholders to have all the information they need to be able to hold company directors to account (Disclosure on Aust Exec`s Pay Need To Be Simplified: Report, 2011).
Simplifying remuneration report applies a Positive Accounting Theory wherein it explains what information the company will use and will not use for the shareholders. Stakeholder theory refers to the concerns of stakeholder power, and how the power impacts their ability to persuade the company into complying with the stakeholder’s demands. Stakeholder power is viewed as a function of the stakeholders’ degree of control over resources required by the company and how critical these resources are to the unrelenting viability of the company. (Voluntary Employee Disclosures in Australian Annual Reports Applying Ullmann’s Stakeholder Theory, 2011) Legitimacy Theory seeks to ensure that the company operates within their rules, bounds and norms. Company should attempt to ensure that their activities are perceived to be legitimate. Rewards given to the executives for failure or good luck indicates that they operate beyond the company`s norms. This append to the needed improvements for remuneration disclosure. If remuneration is disclosed properly to the public, such erroneous transactions will be avoided. Companies disclose actual take home pay for key management, irrespective of whether the remuneration was granted in the current or previous financial year (Weggins, J. 2012). Many companies have started providing the public how much money their executives are taking home. Public Interest Theory supplies regulations that respond to the demand of the public to correct inefficient and inequitable market practices. By disclosing actual take home pay helps the companies counter claim that executives are overpaid.
The possible consequences of voluntary remuneration disclosure Literature Review
In the aftermath of the global financial crisis (GFC), public interest ensured spotlight being thrown on the pay of the senior executives and its regulations (Morrow M. & Limnalong B., 2011). Remuneration disclosure has been progressively strengthened in Australia over the last quarter of a century. Before 1986, the only requirement for disclosure of remuneration was the combined total level of collective remuneration aid to all executives of a listed company (Fels, A., 2010). As motivations to improve remuneration disclosure are presented on the previous discussion, we are now looking at the consequences of voluntary remuneration disclosure and analyse
the current practices: * Many Directors hold more than one directorship across a range of publicly listed, private and not-for-profit organizations (Fels, 2010). * There is also a possibility of entrenchment of incumbent directors. It is difficult for shareholders to work out whether an individual director is underperforming from the outside. Later we will also see how the current practices help address this issue (Fels, 2010). * Another consequence of voluntary remuneration disclosure is to have a ‘clubbish’ practice amongst the board. A clubbish practice occurs when boards declare that the maximum number of directors is the number of directors presently on the board when shareholders nominate a candidate (Fels, 2010). * Recent remuneration reforms which commenced on July 1st, 2011, were directed to improve shareholder trust, thus granting the board to concede with the compensation process and be held responsible for strategy and structure (Morrow & Limnalong, 2011). * Productivity Commission proposed a two strike rule intended to strengthen the non-binding shareholder vote, giving shareholders the opportunity to cast votes against a company’s director under special circumstances in an Annual General Meeting (Morrow & Limnalong, 2011). * The new law, in addition, was particularly structured to allow shareholders to have more say over the pay of senior executives and also so that the boards are better informed on remuneration dissemination that might result in a shareholder casting a negative vote (Morrow & Limnalong, 2011). * The use of remuneration consultants as a requirement by the new amendment charges a potential conflict of interest in which their existence provides advice to boards on their pay (Morrow & Limnalong, 2011).
In this section, we will were to give analysis on the possible consequences we discussed earlier in our review using the qualitative characteristics in the IASB Conceptual Framework focusing mainly on relevance, reliability, comparability, verifiability, timeliness and understandability.
The introduction of the two strikes rule implies that the boards might become more cautious to avoid difficulties with shareholders and remuneration consultant reinforces that conformity (Durkin & Tadros, 2012). Since we
will be analysing the consequences in accordance with the IASB Conceptual Framework, we shall start at looking into the relevance of voluntary remuneration disclosure. ‘Remuneration issues are now taking up so much time that boards are in danger of neglecting other issues such as risk management and succession planning’. Also it makes it harder for the shareholders to work out whether an individual director is underperforming or over performing from the outside (Wiggins, 2012).
As we have discussed, the importance of remuneration disclosures has been felt more since the GFC. ‘This recent financial crisis has increased the saliency of reliability concerns about fair value disclosures’. Examination of voluntary disclosures in audited financial statements shows clear unreliability towards the mandated fair value estimates (Blacconiere et al., 2011). In addition, it is difficult to find authenticity with voluntary remuneration disclosure, as to many Directors hold more than one directorship across a range of publicly listed, private and not-for-profit organizations. Hence we can conclude that reliability is very low with voluntary remuneration disclosure.
Pay policy has been a major pre occupation and distraction in the past year as reported by Graham Bradley, chairman of Stockland and HSBC Australia and a former Business Council of Australia president (Bradley, 2012). Dean Paatsch, director and co-founder of governance and proxy firm Ownership Matters was quoted saying that without transparency, the bad practices of the past like outsized termination benefits, non-executive director retirement schemes, paying dividends on unvested shares and dodgy options valuations could easily return (Paatsch, 2012). We know that recent reforms were directed to improve shareholder trust, thus granting the board to concede with the compensation process and be held responsible for strategy and structure.
Local executive pay trends do not constitute the kind of picture that lends itself to establishing simple casual links between executive greed and the financial crisis. Assessing the efficiency of executive pay is considered problematic. Many performance indicators used are not publicly disclosed.
There are various forms of pay and different types of hurdles and they all have different effects on incentive. In practice, company prefers to adopt a combination of hurdles (Fels, 2010). This encourages the need for remuneration consultants as well, but is considered as a conflict of interest. In a study by Dr. Idlan Zakaria of the University of Essex published on March 2011, he stated that remuneration consultants have a significant positive effect on disclosure quantity but with no impact on disclosure quality. (Morrow & Limnalong, 2011).
Along with this, ‘Remuneration committees are more time consuming and more complex than audit committees’ warned the chairman of Stockland, Graham Bradley (Durkin & Tadros, 2012). We know that remuneration calculation is a complicated process in itself and involvement of the shareholders would further complicate things in turn affecting the timeliness factor for both practices. Mr Pablo Berrutti, the head of responsible investment for Asia Pacific at Colonial First State Asset Management stated that ‘the introduction of the two-strikes rule had encouraged companies to spend more time discussing remuneration and corporate governance issues with investors (Wiggins, 2012). A huge amount of time is said to be spent on remuneration and less on strategy. Hence, we can see that voluntary disclosure is good in a timely manner in comparison to the recent practices. Pablo Berrutti also acknowledged that companies were receiving unclear and mixed messages from a number of significant investors. Some of the investors wanted pay packages to be better aligned with shareholders interest which are less complex. We know that the new law allows the shareholders more say over the board regarding the matter thus, being more actively involved is a very important factor to be considered (Wiggins, 2012).
Share-based payments did not cost the company anything?
As per AASB2, companies must value and record employee options granted as an expense in their financial statements. Previously, the share based payments was just recorded in the notes of the financial statements. Argument arises to whether share-based payments recorded as an expense did or did not cost the company anything. Asness (2004) strongly believes it is reasonable to recognise the employee share options as an expense. He discussed several aspects in his article to convince his readers that options must be expensed. He emphasises options are something of value and they will be exercised only when employees have more advantages than the shareholders. In his article, he rebutted that options do not have value until they are exercised. However, Ronen (2008) advocated that the expense of share based payments should be borne by the pre-existing shareholders rather than the company itself. He suggests the companies to adopt separate statement to record the cost of the share options separately. Suggested separate financial statements are “Corporation Income Statement”, “Statement of Cost and Benefits to Pre-existing Shareholders” and “Statement of Enterprise Income”. With this, he deliberately concludes that the share options granted to employees should not be an expense in the corporation.
Similarly, Hagopian (2006) believes that it is not ideal to recognise the employee share options (ESO) as an expense in the financial statements. Logically, the shareholders who will reap the gain from an ESO must bear the cost by themselves as well. He mainly discussed the three basic reasons why ESO should not be expensed. First, ESO is a kind of “gain-sharing instrument”, which, by its nature, means it cannot be an expense of the granting entity. Second, the cost of it has already been fully accounted. Lastly, expensing ESOs cannot meet the expense definition in the standard accounting.
There was a controversial issue on implementation of share based payment under AASB 2 since it had been released. Arguments emerged as to which expensing options do cost the company an entity or not at all. The supportive parties believe that share-based options will cost the company, signifying that, options are of valuable entity when the future market price is higher than the price exercised. The optionholders will put to use their options and thus take part of the company from the pre-existing shareholders at below-market prices. To some extent, the optionholders obtain something of value, which means an expense. In addition, if the company sells options to the outside investors, they have to pay cash for the options and the executives usually get options for free. This means issued options are an expense (Asness, 2004). Advocates likewise mention the cost of stock buyback program which is the real cost of employee options. In order to manage dilution, the company has to buy some shares back. Even if a company will not act on buyback shares, the earnings will still be reduced because of issuing options and dilution. Therefore, options have a certain value and should be recorded like regular salaries (Wayman, 2011). On the other hand, the opponent parties argue that share-based payment costs the business firms nothing. Instead, the shareholders will bear the cost of the share options by themselves. In fact, the shareholders will get extra value even after the cost of dilution (Ronen, 2008). They consider ESO a kind of ‘gain- sharing instruments’, which does not have a cost until there is a substance to accumulate. At the same time, the cost will be located where the related gain is. Since shareholders par take the benefits with the optionholders, the cost must be a portion of the stock appreciation. Hence, it cannot cost the granting entity (Hagopian, 2006). The Australian Venture Capital Association Limited (AVCAL) places their confidence on the fact that there are improprieties in standards which includes ESO as an expense. For high growth unlisted companies, it is not an accurate method to value those firms because the securities of private companies are not trading on the open market; it is likely to misuse the models in the context of expensing ESOs. Therefore, the valuations cannot reflect actual costs to the company (Deegan 2012, p. 621).
Based on our combined judgment, it is not reasonable and logical to say share-based payments did not cost the company anything. To a certain extent, it costs value to the resources of the company. The process of issuing share options and equally dividing it to the employees consumes resources in which, therefore is considered an expense for the company. For the option itself, it has certain value even if it is out of the money. Otherwise, it is impossible to be accepted by its employees.
Employees get the share options for free whereas the outside investors have to pay the company cash to buy the options if the company issues the share options to outsiders, thus it would mean an apparent expense for the company. To counter this action, instead of allotting new options to employees, the company bought the options from the market and gave them to its employees. This further proves that it is the initial outlay of the option’s cost for the company (Asness 2004). Furthermore, when the options are utilised, the employees usually buy them at a discounted rate. Comparatively, the company will lose the opportunity to sell some of their stocks at the market value (Pirraglia, n.d.). Without a doubt the company has sacrificed some value for exchanging its employees’ service. Additionally, share-based options are type of compensation expense. Logically thinking, would the employees accept $1 less in their salary because of receiving the options? The answer is clearly no. Hence, we have to admit that options are a substitute for salary (Asness, 2004). In remuneration disclosure, the government will require to provide a more accurate data including the shares and options executives in the remuneration reports (Durkin & Tadros, 2012). Therefore, it is impossible to realise aforementioned argument without having to pay out a single cent.
Remuneration pay for executives evolved into a delinquent juncture to those who seek a substance to blame for the disintegration of the world’s financial system following the global financial crisis. Demands for increased disclosure persisted causing the boards to make necessary actions to reform remuneration disclosure. In an attempt to explain executive remuneration disclosure, principled theories of financial accounting were applied as they have the ability to account for or express in advance a specific accounting practice. Attenuation of costs while remaining efficient in which, nowadays, is highly essential relates to Positive Accounting Theory. To attain this, applying the idea of Legitimacy Theory, properly disclosed remuneration as to public is seen to avoid faulty transactions. In accordance, acknowledging remuneration in the interest of the public marks a strategy to aid business firms to express that executives are given proper compensation. Carrying through to reforms in disclosing executive remuneration, Stakeholder Theory is being adapted in the form of implying the recently approved two strikes rule in the financial system. This method is directed to give shareholders the capability to exhort power over remuneration issues. Amendment also allows the board to focus on compensation strategy and structure as what they are responsible for. Share-based payment entail companies to assess the fair and equal value of the employee stock options granted to employees and recognise it as an expense. Share-based payments match the service provided by employees with the expense of their compensation. Employee share-based options arguably cost value to the resources of the company. The process of issuing share options and company buy back elucidate the costs incurred. It is concluded that, a firm’s competitive edge lies in the business’ policy and strategy regarding remuneration thus drawing attention to confining key executives. Remuneration disclosure makes board of directors more accountable and supply information about company projections, and can thereby bolster investors. In line with this, top executives and ordinary employees are expected to perform at their best to justify the pay they are receiving. To have an accurate remuneration report, execution of appropriate accounting procedures and policies must be exercised.
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