Why is the structuring of directors’ remuneration important and what are the implications of failing to structure remuneration appropriately?

A director’s remuneration is a remuneration package consisting of elements which maximises through the integrated delivery of salary, share option schemes and short and long term performance rewards. A reward for the delivery of business results is connected with the reward for value flowing to shareholders. The incentive arrangements are structured in such a way that rewards cannot be maximised through inappropriate short term risk-taking. Its important to have such a remuneration package because it keeps directors motivated to act in the best interest of the shareholders. Failure to have this could lead to agency problems between the managers and the shareholders.

To begin with, it’s important to define agency theory. Agency theory is a relationship between the principal and the agent. A principal (shareholder) is a person who delegates the authority to make decisions to the other party where as an agent is the person who is given the authority to make decisions on behalf of the principal (Drever et al, 2007). It is based on this theory which has got some agency problems such as risk aversion, dividend retention and horizon disparity. A bonus incentive is an effective solution to solving this problems and that’s where director’s remuneration package comes in. A long term incentive integrated into director’s remuneration package would help avoid horizon disparity problems because directors would then reflect the long-term value of the company and will make investments and decisions that are best for the long term of the company. An example of this incentive was illustrated in Ralph Norris’s (CBA CEO) remuneration package which would motivate him to stay with his company for a long period of time. On the other hand, a short term incentive can be linked to accounting earnings such as profits and dividends for a particular period which would allow directors to engage in activities in order to maximise profits and dividends for the company and also achieve their short term incentive. Therefore, the structuring of directors remuneration is important because it clarifies the platform on which the director’s rewards are based on. Another reason structuring is important is for disclosure purposes. When a company has received media attention, especially when it is specifically named in the press, in relation to the remuneration packages of its executives and directors, it is likely to react by publicly providing its own information about the topic being publicised (Liu and Taylor, 2008).To comply with the appropriate disclosure of information through the annual reports, companies will need to structure their remuneration packages effectively well because they are communicating this information to stakeholders such as investors and the public.

There are some implications of failing to structure remuneration appropriately. Firstly, if the remuneration package isn’t well constructed and isn’t clear about what performance rewards are based on which part of the package, then this would become less transparent to other shareholders and investors meaning it would be less decision useful (decision usefulness theory). If a company has a poor structure of director’s remuneration package, then most likely it may affect many investors’ decision or change their opinion of that company. This could also lead to bad image of the company because of its inability to disclose proper and useful information to its stakeholders. Also, as laws and society values are changing, a shift from voluntary disclosures to mandatory disclosure of remuneration package leaves the company with no choice but to disclose the information and in this case, the company cannot afford to disclose inaccurate information. Secondly, in Forster’s (2010) article, it was mentioned that board of directors and especially non-executive directors must assume responsibility for the remuneration packages. In times of crisis, most companies will be placed under increased financial distress because of slashed dividends, job cuts and lower profits and questions will be raised as to why pay packet’s of senior executives is increasing (Williams, 2009). This can act as noisy signal of the agent’s efforts, and therefore, the non-executive directors would need to explain that certain bonuses included in the remuneration package was based upon past performance of directors and not on present situation. Therefore, this type of information should be well structured in the remuneration package when disclosing it in the annual reports. This would allow users to make informed decisions or form an opinion of the company. Failure to do so will have an impact on the company as a whole.

In conclusion, its important to have a director’s remuneration package because it would encourage directors to perform in the best interest of the shareholders and not just only that, the company would also need to disclose the remuneration information to the public. It’s important to structure the director’s remuneration in appropriate manner so that its easy to understand and decision useful for outside investors. However, on the other hand, there are some consequences of failing to structure the remuneration package appropriately. Poor and unclear remuneration information would confuse investors and therefore would neglect the two main qualitative characteristics of decision usefulness theory which is reliability and comparability. Its vital for companies to consider the importance of director’s remuneration package because it is a great way of motivating director’s performance and reducing agency problems.

What is Agency theory and what are the agency problems faced by entities?

Agency theory is a theory explaining the relationship between principals (shareholders) and agents (managers). In this relationship, the principal delegates or hires an agent to perform work in the best interest of the principal. The delegation of decision-making authority can lead to a loss of efficiency and consequently increased costs. For example, if the owner (the principal) delegates decision-making authority to a manager (the agent), it is possible that the manager will not work as hard as the owner would, given that the manager does not share directly in the results of the organisation. Therefore, this could lead to agency problems because this theory involves the cost of resolving conflicts between the principals and agents and aligning interests of the two groups. The agency problems that arise as a result of delegating decision-making authority from the owner to the manager are referred to positive accounting theory as agency costs of equity. PAT investigates how particular contractual arrangements based on accounting numbers can be put in place in order to minimize agency costs associated with the problems.

There are three main agency problems. They are risk aversion, dividend retention and horizon disparity. Risk aversion is a problem caused by the relationship between risk and return (Drever et al, 2007). According to the shareholders, it is generally accepted that the higher the risk, the higher is the potential return. This view is quite different from managers as they are willing to take less risk of the company because that is normally their key source of income. If managers continue to take less risky projects then this would lead to lower profits or return which is not what the shareholders want. However, this problem can be narrowed by providing bonus incentives (remuneration packages) linked to accounting earnings so that managers would engage in taking higher risks in order to achieve those bonuses. The second problem is called dividend retention which is the ability of managers to pay out less of the company’s earnings in dividends and retain more so that they could invest in the company’s growth which would benefit them in return. Once again, this view is opposed by shareholders because they would prefer more in dividends so that they could invest further wherever they want. The third problem is horizon disparity and can be easily linked to long term bonus incentives in order to overcome this problem. This is particularly a problem if the manager expects to stay with the company for a short period of time and is concerned with the performance of the company while they manage it. After they leave, they will have no interest in the company. (Drever et al, 2007). To avoid this problem by ensuring that the manager takes a longer-term view, their bonuses are linked to share price or rewards in the form of shares.

The measurement questions that Accountants face around emissions trading schemes will make financial reports less decision useful.

Carbon accounting is the process of putting a price on the carbon emission by entities in order to decrease the release of polluted greenhouse gases in the atmosphere. Emissions trading scheme is a market based scheme for environmental improvement that allows buying and selling permits for emission of credits in order to reduce emissions of certain pollutants. Its important to have such a scheme because having a price on the exceeded amount of carbon polluted will help companies reduce the release of carbon to the environment, thus having less impact on the environment and the society. However, it can be argued that accounting for carbon is hard to account for and may create some problems in the financial reports, and therefore, it would be less decision useful to the users of the financial statements. For example, since carbon emissions trading would be accountable for the amount used, it cannot be estimated the exact amount which was used, therefore figures come into calculation where the company has to pay tax for the amount of carbon used. This would then be related to decision usefulness theory.

 The assumption behind the theory of decision usefulness is that ‘if we can’t prepare theoretically correct financial statements, at least we can try to make financial statements more useful’ (Scott, 2009). In saying that, the decision usefulness theory tries to provide the constituencies of the financial reports with more relevant and reliable information that will help investors in making short and long-term economic decisions, like whether or not to invest in a company. Accountants face problems when accounting for carbon accounting referring to the allowances distributed by governments to firms as the IASB states that these allowances meet the definition of assets, and decided to measure at fair value. However, allowances are distributed free from charge (Cook, 2009); therefore obtaining the value of allowances would rely on the market mechanism and the efficient market hypothesis. However, it has been proved that the market is inefficient, as according to Kothari (2001), the stock market under reacts to information as soon as the information is released. Instead, the market recognises information impact gradually, in which it leaves room for investor’s irrationality which would lead to volatility in the prices of such allowances. Therefore, adopting FV as a sole measurement can be subject to managerial subjectivity in measuring the value of the allowances, and much further can lead to market crash at the time of financial distress in the allowances market similar to what happened during the global financial crises and how would this have a negative impacts on the reports and its usefulness (Laux & Leuz, 2009).

Fair value accounting (FVA) shows evidence that it discloses informative values to the investors; however the level of the information efficiency is based on professional estimates and judgments. There are various approaches in determining a value for accounting purposes. Fair value measurement is one of the measurement techniques practiced in the world. There is no specific definition of FVA in the IASB or AASB, however, under accounting standard AASB 139, it talks about the Recognition and measurement of financial instruments and AASB 7 discusses the discloser of the financial instruments. Under FAS 157 (similar to AASB 139), mentions that the board's standard on fair-value measurements, of financial assets recorded in fair-value must explain on how they came up with their values.

It would be hard to measure the actual value of carbon emissions trading due to black box issues. This is evident in Mackenzie’s article which states that ‘different gases are made commensurable and the inscription of the mid-1990s’ estimates of global warming potential (GWPs) into the Kyoto Protocol means that uncertainties and changing estimates of GWPs remain inside the black box’. Another issue describe in the article was that GWP was measured for 100 years and was arbitrary if the gas has been emitted in the air which would stay there up to nearly 1000 years which would not  be accounted for. Also, according to Mackenzie (2009) and scientists, the GWP estimates were acknowledged to be subject to significant uncertainty of the order of +/- 35% accuracy. HFC23 as an example was measured to the equivalents of 11700 tonnes of CO2 for the year 2009. This figure has increased by 3100 in the year 2010 to reach 14800 tonnes of CO2. Since carbon emissions trading is considered as an intangible asset, then it would be difficult to revalue the asset in its early years of the plan. Even if revaluation at its fair value is allowed to be used, any changes to the value will not go to the profit and loss. It will go into the equity division of the other comprehensive income. With that if there might be any changes to the liability section then that would go in the profit and loss. This will mismatch the assets and liabilities when carbon is considered.

In conclusion, the accounting standard for carbon emissions would represent a number of challenges for companies when preparing financial reports. Many companies will have to go through a few changes in order to build an effective and efficient conceptual framework so that the information presented in the reports is decision useful to the public. The financial statements have to fulfill the qualitative characteristics of relevance and reliability, while the subsequent presentation of the financial information should be both understandable and comparable (Henderson et al, 2006). This is reflected in decision usefulness theory.

What is Carbon accounting? If an emissions trading scheme becomes law in Australia, how will it affect financial statements?

Carbon accounting is a process of undertaking measurements and accounting for greenhouse gas emissions from the land based activities and other types of pollution. To reduce carbon emissions, many various market mechanisms are being introduced. One of them is carbon emissions trading scheme which has been adopted by many countries for a number of years now. Carbon emissions trading is a scheme based on market for improvements in environment. It allows parties to buy and sell sanctions for emissions or credits for reduction in emissions of certain toxic wastes.Introducing a new accounting standard on carbon emissions trading can be argued as it may create problems in financial statements. One of the problems is linked to fair value measurement issue when accounting for carbon.

Decision-usefulness theory states that information provided in the financial reports will help users decide whether the past decision and the information used to make them were correct, and can also help in making better economic decisions in the future. If the voluntary social and environmental information disclosed to the public doesn’t give a true and fair view, then there would be a breach of corporate social responsibility by firms and organisations involved in carbon trading. This would be followed by legitimacy theory which proposes that organisations would always have to ensure that they operate within the bounds and norms of their societies. It is assumed that the society allows the organisation to continue its operations as long as it generally meets society’s expectations. Legitimacy theory emphasizes that the organisation must appear to consider the rights of the public at large and not merely those of its investors. Therefore, disclosing of incorrect financial information on carbon trading would make organisations hard to meet general societal norms and expectations as the information provided would be less reliable and comparable.
Throughout the years, traditional accounting measurements have been developed and amended for reporting purposes. Hence, the transition from historical cost accounting to fair value accounting (FVA) occurred because the values that appear on financial statements are not economically relevant since they were incurred. Fair value shows evidence that it discloses informative values to the investors, however the level of the information efficiency is based on professional estimates and judgments. There are various approaches in determining a value for accounting purposes. Fair value measurement is one of the measurement techniques practiced in the world. Consistent with other standards, fair value is defined within the accounting standard as ‘the amount for which an asset could be exchanged between knowledgeable, willing parties in an arm’s length transaction’. Because of the unique nature of many intangible assets, in most cases an ‘active market’ will not exist (Whittington, 2010). Therefore, there is a connection between accounting for carbon and fair value. In financial accounting, carbon emissions trading is considered an intangible asset, meaning if there is any asset revaluation, then it would be hard to revalue the intangible asset in its early years. The requirements of AASB 138 states that intangibles may be revalued only if there is an ‘active market’. An active market is defined as ‘a market exhibiting all of the following: the items are homogenous, willing buyers and sellers can normally be found and prices are publicly available’.

In conclusion, a carbon emission trading is an environmental strategy which uses the markets to produce a cleaner environment. Implementing a new accounting standard for carbon emissions would represent a number of challenges for companies when preparing financial reports. Many companies will have to go through a number of changes in order to follow the conceptual framework effectively. The financial statements have to fulfill the qualitative characteristics of relevance and reliability, while the subsequent presentation of the financial information should be both understandable and comparable (Henderson et al, 2006). This is reflected by the measurement issue of fair value accounting when accounting for emissions trading as an intangible asset. Finally, it is clear that accounting for carbon emissions trading is a very vital step and it will definitely benefit many companies, but at the same time, will create some disadvantages.

The disclosure of social and environmental information is not decision useful because it is motivated by self-interest, and is not comparable and reliable.

Social and environmental reporting is defined as ‘the process of communicating the social and environmental effects of organisation’s actions within the society and to society at large’ (Gray et al, 1987). General purpose financial statements contain information to satisfy different stakeholders, each with its own individual economic decision-making needs and therefore, the disclosure of environmental and social information of the company is required for a range of stakeholders with different needs and different purposes (Drever, 2007). This could be one simple reason as to why managers would disclose information voluntarily. However, is the disclosed information intended to be useful to stakeholders in making economic decisions?

Decision usefulness theory suggests that the selected financial information has to fulfill the qualitative characteristics of relevance and reliability, while the subsequent presentation of the financial information should be both understandable and comparable in order to be decision useful to stakeholders and other interested groups. The major stakeholder when it comes to disclosing social and environmental information is the society. It is due to this fact that many organisations consider the society’s expectations as high value because corporations only exist because the society has provided them with the means to do so; therefore they have obligations to society. This view is derived from legitimacy theory which suggests that there is a social contract between society and organisation (Liu and Taylor, 2008). An organisation’s survival will be threatened if society perceives that it has breached its social contract. This is one idea of motivation for managers to disclose social and environmental information in the reports. Another idea could be represented in Institutional theory. This theory assumes that organisations would be influenced by other institutions or pressure is created from outside stakeholders to establish a code of conduct (Deegan and Blomquist, 2006). Over-time, institutions in an industry take a similar characteristic of following what others are doing. This would motivate managers to follow other companies to disclose social and environmental information. At the end of the day, different groups are interested in different types of information to accommodate their needs. However, the real issue here is whether the social and environmental information presented in the reports is important and suitable to meet these differing needs of different stakeholders.

One can argue that it’s hard to measure the monetary figures of damages cause to the environment e.g. disposal of factory waste into river, carbon pollution etc. In an extreme case like this, many companies would either ignore the figures for the information or give an estimate of the figures for disclosing in the annual reports and balance sheet. For the accounting profession to include social and environmental activities in the annual report, it would be difficult to ensure that right emphasis is placed on the information. A problem can occur where a company with a poor environmental record can change the society’s perception of that company, where as the inability of management to put a financial value on those activities will not give a true and fair view of the balance sheet because management is not being able to determine the correct value of the environment. This would not satisfy the qualitative characteristics of reliability and comparability of decision usefulness theory and would eventually be misleading to potential stakeholders and affect their decision. Sometimes enormous pressure from stakeholders could result in companies producing overly complex social and environmental information which once again could be less decision useful for certain user groups of the annual reports. On the other hand, Watts and Zimmerman’s PAT would predict that some firms may use Fair value to measure environmental issue such as carbon. If revaluation at its fair value is allowed to be used, any changes to the value of carbon will not go to the profit and loss. It will go into the equity division in other comprehensive income. With that if there might be any changes to the liability section, then that would go in the profit and loss. This will create difference between the assets and liabilities when carbon is considered. This would once again have an impact on the reliability and comparability characteristics of the financial statements and therefore, will be less decision useful.