CEO Compensation and firm performance: A study of the relationship between compensation and performance in Finland

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Arttu Urkko

CEO COMPENSATION AND FIRM PERFORMANCE

A study of the relationship between compensation and performance in Finland

Faculty of Management and Business Master’s thesis April 2020

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Urkko, Arttu: CEO Compensation and firm performance: a study of the relationship between compensation and performance in Finland

Master’s Thesis Tampere University

Master’s Program in Business Studies, Accounting April 2020

Advisor: Ihantola, Eeva-Mari

The purpose of this research is to examine whether CEO compensation and firm performance are related in firms listed in the Finnish stock market. The contribution of this study to the previous literature is to examine the relationship in a country with scarce evidence on the subject compared to the widely studied areas such as the US and the UK. There is also a lack of recent evidence on the subject regardless of the area of study.

The most recent fully available data is used in this study, including CEO compensation for years 2015 through 2017 and performance measures for years 2014 through 2017. The data consists of CEO compensation and its’ components gathered from remuneration reports, corporate governance statements and annual reports available from the websites of the firms.

Firm performance is measured with three different ratios, including an accounting-based measure, a market-based measure and a combination of measures. Data for all firms listed in the OMX Helsinki were gathered, but after removal of some firms there are 63 to 80 firms in the analyses depending on the model used. Multiple linear regression analysis is utilized to test for the possible relationship of different variables, and a total of 7 tests are done.

The study finds some relationships between CEO compensation and firm performance. Re- turn on equity has a negative and statistically significant correlation with CEO total compensation and CEO fixed compensation, but the correlation is not very strong. There is also relatively significant, positive and weak correlation between CEO total compensation and stock performance. There is also a statistically significant and positive relationship between lagged stock performance and CEO variable compensation, which is the strongest correlation between any compensation component and firm performance variable. For most of the regres- sions, firm size measured as market cap seems to be by far the most dominant variable affecting CEO compensation level. No correlations are found using performance measures as dependent variables.

Given the findings, this study does not provide strong evidence for the agency cost mitigating role of compensation. However, the results do indicate that CEOs get directly rewarded for a better stock performance, but the impact of firm size is much larger than the impact of stock performance. The subject calls for more recent studies before definitive answers can be given, as the results are not exhaustive.

Keywords: conflicts of interest, agency problems, CEO compensation, compensation and performance relationship, efficient contracting

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Urkko, Arttu: CEO Compensation and firm performance: a study of the relationship between compensation and performance in Finland

Pro Gradu -tutkielma Tampereen yliopisto

Kauppatieteiden tutkinto, Yrityksen laskentatoimi Huhtikuu 2020

Ohjaaja: Ihantola, Eeva-Mari

Tämän tutkielman tarkoituksena on selvittää, että onko Helsingin pörssissä listattujen yhtiöi- den taloudellisen menestyksen ja toimitusjohtajien taloudellisen palkitsemisen välillä tilas- tollista yhteyttä. Tutkimus täydentää aihepiirin kirjallisuutta tarkastelemalla yhteyttä Suo- messa, jossa aihetta on tutkittu erittäin vähän ja joka kuitenkin eroaa monin tavoin laajasti tutkituista alueista kuten Yhdysvalloista ja Isosta-Britanniasta.

Tutkimus hyödyntää viimeisintä, materiaalin keräämishetkellä saatavissa ollutta tietoa. Tämä tarkoittaa toimitusjohtajien kompensaation määrää vuosina 2015, 2016 ja 2017, sekä yhtiöi- den talouden tunnuslukuja vuosilta 2014–2017. Analyysejä varten toimitusjohtajien kompensaation ja sen eri komponenttien määrät kerättiin yhtiöiden palkka- ja palkkioselvityksistä, hallinto- ja ohjausjärjestelmien selvityksistä ja tilinpäätöksistä, jotka olivat saatavilla yhtiöi- den verkkosivuilta. Yritysten taloudellista menestystä tarkasteltiin kolmella eri kategoriaan kuuluvalla mittarilla: kirjanpitoperusteisella mittarilla (oman pääoman tuotto), markkinape- rusteisella mittarilla (osakkeen kokonaistuotto) ja kombinaatiomittarilla (m/b -luvun muu- tos). Tutkimusta varten tiedot kerättiin kaikista Helsingin pörssin päälistalle listatuista yhti- öistä, mutta osa yhtiöistä poistettiin esimerkiksi raportoinnin puutteellisuuden vuoksi. Tes- teissä käytettiin pienimmän neliösumman regressioanalyysiä (OLS-regressio).

Tutkimustuloksissa havaittiin joitain tilastollisesti merkitseviä tuloksia. Oman pääoman tuot- toasteella oli negatiivinen ja tilastollisesti merkitsevä korrelaatio toimitusjohtajan kokonaiskompensaation sekä toimitusjohtajan kiinteän kompensaation osuuden kanssa. Tulokset osoittavat, että toimitusjohtajien kompensaatio on jossain määrin sidoksissa yhtiöiden osakkeen kokonaistuottoon, sillä sekä toimitusjohtajien kokonaiskompensaation, että toimitusjohtajien muuttuvan kompensaation ja osakkeiden kokonaistuoton välillä oli positiivinen ja tilastollisesti merkitsevä yhteys. Aikaisempien tutkimusten tapaan yhtiön koko kuitenkin vai- kuttaisi olevan kaikista merkittävin toimitusjohtajien palkitsemisen määrään vaikuttava te- kijä, sillä kaikissa testeissä, joissa löydettiin tilastollisesti merkitseviä tuloksia, oli yhtiön koon vaikutus kaikista suurin. Testattaessa yhtiön taloudellisen menestyksen riippuvuutta toimitusjohtajien palkitsemisesta niin, että yhtiön talouden mittarit olivat riippuvia muuttujia, yksikään testi ei antanut tilastollisesti merkitseviä tuloksia. Agenttiteorian ja palkitsemisen näkökulmasta tulokset eivät anna yksiselitteisiä ja tyhjentäviä vastauksia palkitsemisen roo- lista toimitusjohtajien ja osakkeenomistajien intressien yhdistämisen näkökulmasta.

Avainsanat: Intressiristiriidat, agenttiongelmat, toimitusjohtajien palkitseminen, kompen- saatio ja yhtiön suorituskyky

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1 INTRODUCTION ... 1

1.1 Background ... 1

1.2 Research objective ... 3

1.3 Methodology and data ... 5

1.4 Structure of the thesis ... 6

2 LITERATURE REVIEW ... 8

2.1 Agency theory ... 8

2.2 Solving agency problems ... 10

2.2.1 Efficient contracting ... 11

2.2.2 Monitoring ... 14

2.2.3 Equity ownership ... 16

2.3 Managerial power ... 18

2.4 Firm performance ... 20

2.4.1 Accounting-based measures... 21

2.4.2 Market-based measures ... 23

2.4.3 Combinations of measures ... 24

2.5 CEO compensation ... 26

2.5.1 Cash compensation ... 28

2.5.2 Incentive compensation ... 30

2.6 Literature review summary and hypotheses ... 35

3 RESEARCH DATA AND METHODS ... 38

3.1 Research data sample ... 38

3.1.1 CEO Compensation variables ... 40

3.1.2 Firm performance variables ... 41

3.1.3 Control variables ... 43

3.2 Research design and methods ... 44

3.2.1 Econometric model ... 45

3.2.2 Assumptions of linear regression ... 47

4 EMPIRICAL RESULTS AND DISCUSSION ... 50

4.1 Descriptive statistics ... 50

4.2 Relationship between CEO compensation and firm performance ... 54

4.2.1 Total, fixed and variable compensation as dependent variables ... 54

4.2.2 Firm performance measures as dependent variables ... 59

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5 CONCLUSIONS ... 65

5.1 Summary of findings ... 66

5.2 Reliability, validity and limitations ... 68

5.3 Suggestions for future research ... 70

REFERENCES ... 72

APPENDICES ... 80

APPENDIX 1: Correlation matrix for data used in models 2 and 6–8 ... 80

APPENDIX 2: Correlation matrix for data used in models 3 and 4... 81

APPENDIX 3: Correlation matrix for data used in model 5 ... 82

APPENDIX 4: Scatterplot of regression standardized residual and predicted value ... 83

APPENDIX 5: Normal Q-Q plot of CEO total compensation ... 83

APPENDIX 6: Normal Q-Q plot of the natural logarithm of CEO total compensation ... 84

APPENDIX 7: Normal Q-Q plot of firm market cap ... 84

APPENDIX 8: Normal Q-Q plot of the natural logarithm of firm market cap ... 85

FIGURES

Figure 1. Changes in the percentage of stock-based and options-based CEO compensation relative to total compensation between 2006 and 2018 (Mishel and Wolfe, 2019) ... 32

TABLES

Table 1. Summary of the differences and the key aspects of the three different datasets .... 39

Table 2. 3-year average CEO compensation descriptive statistics (in thousands) ... 50

Table 3. 3-year average performance measures, market cap (in millions) and total liabilities-to-assets descriptive statistics for 66 firms ... 51

Table 4. 3-year average performance measures, market cap (in millions) and total liabilities-to-assets descriptive statistics for 80 firms ... 52

Table 5. Lagged performance measures, market cap (in millions), total liabilities-to-assets, fixed and variable compensation (in thousands) descriptive statistics for year 2015 ... 53

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Table 10. Econometric model 4 showing variable compensation as dependent variable with

3-year average performance measures ... 58

Table 11. Econometric model 5 showing variable compensation as the dependent variable with lagged ROE, stock performance and change in market-to-book ratio ... 59

Table 12. Econometric model 6 showing ROE as the dependent variable ... 60

Table 13. Econometric model 7 showing stock performance as the dependent variable ... 61

Table 14. Econometric model 8 showing ΔM-t-B as the dependent variable ... 62

Table 15. Summary of statistically significant results ... 62

Table 16. Summary of the hypotheses ... 63

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1 INTRODUCTION

1.1 Background

CEOs are constantly criticized for being overpaid, setting their own pay and rent extracting when they find the opportunity (Kaplan, 2008). There is a widespread belief that CEO compensation should reflect firm performance (Duffhues & Kabir, 2008), and boards are facing criticism for not paying for performance, paying too much and being too friendly to the CEO (Kaplan, 2008). Today, executive compensation continues to be a subject of public discussion in many countries including Finland (see e.g. Rajala & Bhose, 2020), even though CEO compensation in Finland is relatively low compared to many other countries. For example, the data shows that the average annual compensation for the CEOs of publicly listed firms in Finland was 882 600 during 2015 through 2017 (see table 2), whereas in the US, the average annual compensation for a CEO in 350 biggest companies was 17.2 million in 2018, 278 times the salary of their average worker (Forbes, 2019). In Finland, the average salary for full a time job was approximately 36 thousand euros per year in 2018 (Statistics Finland, 2020b), meaning that the average salary of CEOs’ was approximately 24 times the salary of an average worker.

The public controversy revolves around whether high CEO salaries are justified or not. When shareholders and CEOs are trying to make self-maximizing decisions, it potentially leads into conflicts of interests (see e.g. Jensen & Meckling, 1976; Jensen & Murphy, 1990). Jensen &

Meckling (1976) point out that if both the agent¹ and the principal² aim to maximize their utility, then there is a reason to believe that their interests might not always align and therefore cause the agent to make decisions, which are not optimal for the principal. From an agency theory perspective, the problem arises due to managers initiating and implementing actions not getting a major share of the income, and therefore their actions have limited im-

1 In the context of CEO compensation, agent refers to a CEO or other top management

2 In this context, principal refers to a shareholder

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pact on their wealth (Fama & Jensen, 1983). CEO compensation plans are seen as one solution to agency problems by aligning the interests of CEOs’ with the interests of shareholders by rewarding the CEOs for desired actions (Holmström, 1979; Elsaid & Davidson, 2009;

Edmans & Gabaix, 2009), and it is a cornerstone instrument for the board of directors to use in corporate governance (Holmström, 1979). However, some argue that CEO compensation does not efficiently solve agency problems, because CEOs use their powerful position to affect their own compensation (see e.g. Bebchuk & Fried, 2004). In prior literatures, agency problem is the prevailing theory behind CEO compensation plans (see e.g. Attaway, 2000;

Cooper et al., 2009; Cieślak, 2018; Rouen, 2020), and agency theory is the core conceptual background behind this research as well.

The literature covering compensation is extensive and it widely covers the sensitivity of compensation to firm performance, also including how other firm characteristics affect compensation (Elsaid & Davidson, 2009). Studies from Finnish context using recent data are scarce, as searches using similar entries that resulted in numerous studies from other countries did not yield results from Finnish context. However, the relationship has been studied priorly in Finland using older data (see e.g. Mäkinen, 2007), and this study adds to the literature by examining the relationship with most recent data. Also, studies of relationship between incentive compensation and firm performance are still rather coarse and prior studies have given mixed results (Rodgers et al., 2012). This study tests the relationship using total, fixed and variable compensation, thus it further examines the role of different compensation components.

In prior studies, there is no obvious global linkage in between company performance and CEO compensation. In Norway and Sweden, Randoy & Nielsen (2002) did not find a significant relationship in between CEO compensation and firm accounting performance or stock performance. Very low or non-existent relationship between CEO compensation and firm performance has been documented in several other countries such as the United States (Mil- ler, 1995) Canada (Zhou, 2000), UK (Buck et al. 2003), Portugal (Fernandes, 2008) and South Africa (Bradley, 2013). Also, Rouen (2020) find no statistically significant relation between firm performance and the firm-level pay disparity between the CEOs and the firms’

workers. Contrary results have been documented by Attaway (2000) that find a small but

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statistically significant relationship between firm profitability and CEO compensation, Sigler (2011) that find statistically significant and positive relationship between CEO compensation and return on equity (see also Sigler & Haley, 1995) and Sun et al. (2013) that find a positive and significant relationship between the efficiency of US insurance firms and CEO compensation.. Also, while Jensen & Murphy (1990) find a statistically significant and positive relationship between top-management compensation and firm performance, they find that incentive pay does not seem to play an important role.

This paper extends the literature by investigating the relationship of CEO compensation and firm performance in Finnish context. Randoy & Nielsen (2002) point out that because of the differences in nations legal, political and regulatory systems, pay-for-performance needs to be addressed in the right context. The institutional context in Finland differs from the widely researched areas such as United states and United Kingdom (Mäkinen, 2007), where compensation of CEOs’ is significantly higher than in in Finland (for comparison, see Forbes, 2019 and table 2 of this study). Also, Finland is a country with relatively low differences in income distribution (see Statistics Finland, 2020a) and high tax-rate, but regardless of low net compensation compared to their peers, executive compensation is often criticized in public discussion as non-justified. Also, there is evidence (see. e.g. Clarkson et. al. 2011; De Franco et. al. 2013) that pay-for-performance sensitivity has increased with the implementation of new disclosure regulation and higher transparency. European commission has given several recommendations over the years (e.g. EC, 2009), which should lead into higher qual- ity of recent disclosures of CEO compensation with the aim of increasing the relationship between performance and compensation. However, Cieślak (2018) finds no evidence that the pay-performance sensitivity has increased following the implementation of the EC regulation.

1.2 Research objective

Three common solutions to agency problems in management-stockholder relationship are efficient compensation contracts, monitoring and equity ownerships (see e.g. Holmström,

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1979; Jensen & Murphy, 1990; Holmström 2017). This study focuses on the role of compensation contracts, sparking the main objective of this research which is to investigate whether there is a relationship between CEO compensation and firm performance in Finland. This goal is achieved by conducting an empirical and quantitative study of the relationship using economic models. The conceptual background for the study is to examine the agency cost mitigating role of compensation contracts in Finland. Quite detailed descriptive statistics are provided, as understanding the structure and size of compensation helps the reader to better understand the state of executive compensation in Finland, as it is essential (see Randoy &

Nielsen, 2002) to address pay-for-performance in the right economic context.

The main objective of this study is to investigate whether there is a relationship between CEO compensation and firm performance in Finnish listed companies. The study aims to provide empirical evidence whether CEO compensation in Finland is successful in aligning the interests of agent and principal, which is achieved by examining whether CEO compensation is related to firm performance. The relationship is tested both ways, meaning that whether firm performance affects CEO compensation, and whether CEO compensation affects firm performance are tested for. For this purpose, two commonly used financial ratios in firm performance measurement are adopted, which are return on equity (see e.g. Attaway, 2000; Sigler, 2011; Bradley, 2013) and stock return accounted for dividends and stock splits (see e.g. Core et. al., 1999: Duffhues & Kabir, 2008: Shaw & Zhang, 2010). In line with a study by Randoy

& Nielsen (2002), market-to-book value is chosen as the third performance measure to provide a slightly different approach. Total compensation of CEOs is typically formed by many different components, which are supposed to have different roles in the overall compensation contract (see e.g. Murphy, 1999). Different components of compensation are allocated into either fixed or variable compensation, and they are used as variables in different econometric models utilized by the study.

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1.3 Methodology and data

The relationship is studied using quantitative methods. It comprises of a total of seven econometric models to test the possible relationship between CEO compensation and firm performance. Firm size and debt-to-assets ratio are used as control variables in the tests to provide more precise results. In prior studies, CEO compensation has been rather strongly related to the size of the firm (see Veliyath 1999; Brick et al., 2006; Sigler, 2011), and therefore it is included as a control variable in the analysis. Second control variable used is debt-to-assets ratio, because debt holders have incentives to monitor the company more rigidly, reducing the possibility of excess compensation (Duffhues & Kabir, 2008). The relationship is ana- lyzed using multiple linear regression.

Boschen & Smith (1995) argue that compensation contracts often have a form of deferred compensation. Therefore, a similar strategy used in earlier studies is adopted, where the averages of three-year values are used in the analysis (see e.g. Eaton & Harvey, 1983; Randoy

& Nielsen, 2002) in attempt toreduce the lag-effect and year-to-year fluctuations in CEO compensation. For one of the analyses that examines whether performance affects variable compensation, a different, priorly used strategy utilizing one-year lagged performance measures as independent variables is used (see e.g. Duffhues & Kabir, 2008).

Three different performance measures are used for both methods, which of one is an accounting-based ratio, one is a market-based ratio and one is a combination of ratios. Return on equity is used as the accounting-based ratio and stock performance as the market-based ratio, defined as the average yearly total shareholder return accounting for dividends and stock splits. The change in market-to-book ratio is the combination of measures, measured in line with Randoy And Nielsen (2002) as the year-end ratio minus the year-end ratio of the last year, or for the method utilizing three-year averages it is defined as the year-end ratio of 2017 minus the year-end ratio of 2014. Averaged data for several years is used in all but one model, because agency theory does not attempt to explain year-to-year fluctuations in CEO compensation, but rather tries to explain long-term traits of the compensation plans (Eaton & Harvey, 1983).

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The analysis comprises of most firms that were listed in OMX Helsinki between 2014–2017, because these were the most recent years that had fully available information at the time data was gathered for the purpose of this study. Because the market is rather small, some outlier firms were removed to increase the normality of the data. Firms that did not disclose all required information were excluded, as were firms that were not listed for the whole period.

Also, firms listed in the First north growth market were excluded from the study due to possible differences in accounting practices, as they are allowed to apply local accounting standards instead of international financial accounting standards, which is required from firms listed in the main market (see Nasdaq, 2019). Finally, firms offering financial services were excluded from the study, because their high leverage ratios are not typical for non-financial firms, as such high leverage would probably indicate a non-financial firm to be in distress (Fama & French 1992, 429). Therefore, some ratios used in this study could be rather am- biguous for the financial firms as compared to non-financials and as such not comparable.

The data for the research is collected from two different sources. First, the compensation of CEOs is manually collected from annual reports, compensation reports and corporate governance statements published by the companies in their websites. The components of compensation are divided into fixed and variable compensation according to the reports of the firms. For example, if the firm reported that the CEO received extra pension benefits which were paid as a percentage of her base salary regardless of the firms’ performance, it is included in fixed compensation. Ratios of firm performance and ratios describing firm characteristics are obtained from Thomson & Reuters Datastream and calculated if the required ratio was not available readily.

1.4 Structure of the thesis

This study contains five different sections. First, there is introduction of the subject including background and motivation of the study, objective of the study and a short summary of methodology and data, which will be elaborated further in a later section. Some conceptual background is also provided in the first section.

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The following section contains extensive literature review with the emphasis on agency theory and some other essential concepts for CEO compensation. Agency theory is discussed from several angles and three common solutions to it are addressed: efficient contracting to incentive CEOs with compensation, monitoring to ensure that CEOs initiate desirable actions from the principals’ perspective, and equity ownership to tie CEO wealth directly to shareholder wealth. Second section includes a review of different types of firm performance measures including accounting-based-, market-based- and combination of measures. Also, second section expands the readers knowledge of different types of CEO compensation by reviewing common components used in CEO compensation. Finally, hypotheses for the study are set at the end of second section.

Third section elaborates further the collection and sources of the data, structure of the data sample and methods used to analyze it. Also, the data had to be slightly processed and mod- ified for the purpose of this study, and these modifications are presented. Reasons for exclud- ing some firms are discussed further. The design of the research is explained, and the statistical method and econometric models utilized in the study are described. The data and its’

collection are discussed and tested for some of the important assumptions of regression analysis.

Fourth section presents and discusses the empirical results including descriptive statistic and results from the analyses. Tables including statistical significance levels and correlation co- efficients are presented. The last section summarizes important findings and implications of this study. The main contributions to the literature are presented, and possible limitations to this study are discussed. Finally, some ideas for further research of this subject are provided.

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2 LITERATURE REVIEW

The most prominent theory concerning CEO compensation is agency theory, as it focuses on the conflicting interests between CEOs and shareholders and is commonly used as the conceptual background in similar studies (see e.g. Attaway, 2000; Cooper et al., 2009; Cieślak, 2018; Rouen, 2020). The literature review begins with a review of agency theory and three commonly offered solutions to it, which are efficient contracting, monitoring and equity ownerships (see e.g. Holmström, 1979; Holmström 2017). The theory of managerial power is reviewed, as it attempts to offer an explanation to why the three formerly mentioned solutions, and especially efficient contracting, are not efficient in solving agency problems (see e.g. van Essen et al., 2015).

There are countless different ways to measure firm performance, and this section addresses weaknesses, strengths and the theory behind different measures. Three main categories of measures are identified, which are accounting-based, market-based and combinations of measures. Different components that are typically used in CEO compensation are reviewed.

At the end of the section, hypotheses for this study are set.

2.1 Agency theory

A classic example of principal-agent problem is the conflict of interest between the shareholders and the CEO of a publicly listed firm (Jensen & Murphy, 1990). In publicly listed companies the ownership is usually widely spread, which means that stockholders have limited power over daily decisions made by the company. Because of widely spread ownership, it is almost mandatory for the stockholders to author someone else to make operative decisions on their behalf, which generally means the CEO, thus differentiating managerial decision making from ownership. This leads to a situation where the owners of the company and therefore risk bearers (principals) have less information and less power than the party making decisions on their behalf (agent), which needs to be controlled in a way that the relationship meets expectations and interests of both parties (Fama & Jensen, 1983). Holmström (1979)

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recognizes that when such information asymmetry exists, individual actions become difficult to monitor and observe and therefore they cannot be contracted upon, which leads into the possibility of moral hazard. Conflicting interests and moral hazard can cause suboptimal business decisions, which create agency costs (Barnea et al., 1981).

Jensen & Mecklin (1976) define agency relationship as a contract, where principals give agents authority to make decisions on their behalf, and that if both parties aim to maximize their utility, the decisions made by the agent might not always meet the best interests of the principal. Controlling principal-agent problem is important because the managers initiating and implementing actions do not get major share of the income, and therefore their actions have limited impact on their wealth (Fama & Jensen, 1983). Agency theory recognizes two potential problems incurring from agent-principal relationship. First, the agent and the principal might have different desires and objectives, and it is costly and difficult for the principal to monitor whether the agent is acting like she is expected to. Second, they might have dif- fering attitudes towards risk-taking, which causes the agent to take too little or too much risk compared to the preferences of the principal. (Eisenhardt, 1989: 58.) There are three common solutions attempting to solve agency problems in shareholder–CEO context, which are monitoring, equity ownerships and compensation policies (see e.g. Holmström, 1979; Jensen and Murphy, 1990; Holmström 2017)

One potential symptom of agency problems is empire building, because managers have incentive to grow their firms beyond the optimal size due to managers’ power raising when she has increased resources under her control. Empire building is directly related to CEO compensation because growth in sales often increases compensation levels. Also, firms’ have tendency to reward middle managers with promotions instead of annual bonuses, spreading the culture of empire building even to middle management. (Jensen, 1989.) Empire building brings several problems. According to Hope & Thomas (2008), aggressively growing the firm could be a self-maximizing decision of management, which in turn reduces firm profitability and destroys firm value. Also, aggressive growth usually requires capital, which could severely impair the firms’ ability and willingness to pay dividends regardless of shareholder preferences.

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Several different types of agency costs may occur in principal-agent relationship, caused by managers making sub-optimal decisions (Hope & Thomas, 2008). First, agency costs can arise when managers make self-interest decisions such as excess use of job benefits or other decisions that reduce shareholder wealth (Ang et al., 2000). Also, as suggested by Holmström (1979), information asymmetry can be to certain extent be controlled by monitoring, which creates costs such as fees paid to outside auditors to confirm the accuracy of the data. Finally, agency costs can occur as loss of revenues or other opportunity costs caused by bad investment decisions (Ang et al., 2000), which indirectly reduces the value of shareholders, and is generally harder to observe than previously mentioned more direct costs. Essentially, controlling agency costs via monitoring seem to be a balancing act in between costs caused by sub-optimal decisions and the costs that occur if the amount of monitoring is increased, as Holmström (1979) states that increased monitoring is expected to reduce agency costs but in turn it causes direct monitoring costs.

It also needs to be considered that if the compensation seems unjust for the agent, the principal faces a risk of losing a good agent. If the market for managerial labor is competitive, then a company faces the possible situation where it starts losing managers if they are not compensated according to performance, and the best managers are usually the ones to leave first.

(Fama, 1980.) Thus, it is possible that fair compensation plans have intrinsic value. Also, for motivation purposes the performance measures should be understandable, and the manager should have control over them (Merchant, 2006). It may sometimes also be optimal to pay a premium for attracting talented CEOs’ in a competitive labor market (Edmans & Gabaix, 2016).

2.2 Solving agency problems

Corporate governance is typically considered to be a set of complementary mechanisms that aim to encourage managers to make actions that align with shareholder interests. There are two important components of governance structure that attempt to mitigate agency costs.

First component is the compensation policy, generally meaning the creation of an efficient

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compensation contract that minimizes agency costs by aligning the interests of top management and shareholders. (Core et al., 2003.) Second component is monitoring, as the performance of an organization can be influenced by monitoring activities by the board of directors, institutional shareholders and debtholders (Jensen, 1989; Core et al., 2003). Boards of directors and compensation committees are the primary and most important governance mechanisms monitoring CEO compensation (Sanchez-Marin et al., 2017), as it is the responsibility of the board of directors to represent shareholder interests and to mitigate conflicts of interests between management and shareholders (Matsumura & Shin, 2005).

Jensen & Murphy (1990) suggest that equity-based compensation could give managers more incentives to maximize firm value, thus CEO stock ownership could be seen as one corporate governance mechanism to further align CEOs’ and shareholders' interests. Restricted stocks are a form of compensation, where the stocks received cannot be sold for three to five years (Ofek & Yermack, 2000), creating the grantee an incentive to increase shareholder wealth in long-term.

2.2.1 Efficient contracting

To align shareholders and managers interests, one cornerstone instrument to the board of directors is to use incentive contracts (Holmström, 1979). It is costly for the agent to provide the service, causing the need to have a financial incentive based on performance to guide the manager into making decisions that align with shareholder interests (Holmström, 2017). Ef- ficient contracting (or optimal contracting) hypothesis captures the role of CEO compensation plans as solution to potential agency problems (Vo & Canil, 2019). Core et al. (2003) define efficient contract as “…one that maximizes the net expected economic value to shareholders after transaction costs (such as contracting costs) and payments to employees”, and they conclude that the role of efficient contracts is to minimize agency costs. Conyon (2006) define the contracting approach to executive pay as compensation packages designed by shareholders to provide incentives to CEOs to align their mutual interests, and that efficient contract does not mean perfect contract, but a best contract the firm can create to avoid op- portunism of CEO. The role of efficient contract is to not completely eliminate agency problem, but to find the relative level where costs of implementing the contract and the benefits

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gained from it are optimal (Conyon, 2006). If manager actions could be easily observed, risk- neutral principal would give full insurance to the agent by paying a fixed salary independent of outcome. The agent would then give optimal effort, and shirking would be eliminated by monitoring. (Rosen 1990: 18.) However, real-life scenarios are often complex, there are many limitations to monitoring (Holmström, 1979), and in listed firms the solution is usually a mix of compensation related incentives and monitoring, as for example auditing is mandatory in most countries.

There are some contradictory views regarding efficiency of contracting arrangement practices. First, a number of scholars see contracting arrangements as widely inefficient and that they are unable to minimize agency costs (see e.g. Crystal, 1991; Jensen, 1993). In contrary, some argue that flawed compensation plans are limited to very few firms and most boards have managed to create efficient compensation plans. Alike, there are beliefs that flaws in compensation arrangements are widespread, but these flaws are results of honest mistakes done by boards of directors. (see Bebchuk & Fried, 2004.) Finally, there are views that firms create efficient contracts on average, but transaction costs cause constant revisions of contracts to be undesirable, causing deviations from the contract that would be optimal in the current state (Shleifer & Vishny, 1997; Core et al., 2003) Randoy & Nielsen (2002) see that the potential weak link in between CEO compensation and firm performance derives from falsely designed incentive contracts, which fail to reduce the conflicts of interest in between agent and principal. Also, Edmans and Gabaix (2009) observed that many compensation arrangements were inconsistent with optimal contracting while being falsely interpreted as evidence of rent extraction. According to their view, the problem with non-optimal contracts could be caused by difficulties in creation of efficient incentive contracts rather than rent- extracting by CEOs. Moreover, empirical evidence suggests that CEOs are rewarded for factors that are beyond their control, meaning that they are paid for getting lucky (DeVaro et al., 2018), indicating that compensation contracts are unable to capture only factors that the CEO can control. As a conclusion, scholars do not seem to widely agree whether incentive contracts are efficient on average or not, and even when they do, different views arise regarding the causes of inefficiency.

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There are several factors to consider regarding creation of efficient compensation contracts.

First, the rewards should be valuable to the executive because reward without value does not motivate. Second, the rewards need to be big enough to have an impact, because trivial rewards might have counterproductive effects. Third, rewards should be understandable, meaning that the executive understands the value and the reasons for the rewards, because if the executive is unable to understand the potential value of the reward, then the organization might have incurred large expenses without creating motivational effects. Fourth, rewards should be timely, as delay between performance and payment dilutes its motivational effect.

Fifth, good feelings created by receiving a reward should last long, making the motivational effect durable rather than short term. Sixth, because performance evaluators make mistakes, rewards should be reversible. Finally, rewards should create the desired motivation at a min- imal cost. (Merchant & Van der Stede, 2012: 379.) In the worst case, falsely implemented contracts can become counterproductive, as Kanniainen (2000) provides evidence that falsely implemented contracts create incentives for empire building.

Different preference of risks is also a significant factor to consider in efficient contracting. A shareholder can diversify his investments, making firm-specific risk less meaningful for him.

However, managers have rather undiversified interest in the firm, because of their employ- ment causes their whole human capital to be invested in it. For example, if the firm goes into distress, their actions could be seen as a cause of the distress, making their ability to find a new job difficult. (Harvey & Shrieves, 2001.) Ofek & Yermack (2000) provide evidence that when high-ownership managers receive stock options, they typically sell stocks that they already own, reducing the risk of the new grant, thus indicating that CEOs tend to reduce their inherent risk if they can. However, Elsilä et al. (2013) find that in listed Swedish firms, significant part of the total wealth of CEOs is invested in their firm.

Holmström (2017) emphasizes that properly designed incentive systems should not be seen just as a system of providing financial rewards, but that incentive systems must account for a much wider portfolio of activities, and they must consider non-financial factors that influence and motivate individuals. Finkelstein & Hambrick (1988) argument that prestige, power and challenge could be even more important than pay to executives. These views are sup- ported by studies from other branches of sciences, such as a study by Wiley (1997) putting

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together 40 years of employee motivation surveys, in which she lists top five factors affecting motivation:

1) good wages

2) full appreciation of work done 3) job security

4) promotion and growth in the organization 5) interesting work

A concept proposed by Wowak & Hambrick (2010) also illustrates how the personal characteristics of CEOs and incentives affect strategic decisions and firm performance. They suggest that incentives can be used, for example, to promote risk taking, but the magnitude of risk-taking depends on the personal characteristics of the CEO. They propose that the most important part is to pick the right executive and then to find out a way to motivate that par- ticular executive. Their concept indicates that there is not a universal best practice of com- pensating for aligning CEOs and shareholders’ interests, but it varies depending on the characteristics of different CEOs, thus highlighting the difficulty of creating efficient incentive schemes. (Wovak & Hambrick, 2020.)

2.2.2 Monitoring

Holmström (1979) presents that the source of the incentive problem is asymmetrical information caused by the unobservability of individuals actions. He continues that in a simple situation, this problem can be completely controlled by investing resources into monitoring, but generally, observing actions fully is either impossible or extremely costly. (Holmström, 1979.) Similarly, Edmans & Gabaix (2009: 489) argue that the more productive a firms’

governance is, the higher is the optimal amount of monitoring, thus reducing the need for financial compensation. Also, as argued by Beatty & Zajac (1994), the optimal level of monitoring depends on the significance and size of the incentive aspect of the agency problem.

Literature concerning agency problem has generally emphasized incentive contracting as the primary solution to agency problem, and that the role of monitoring would be based on the size of incentive gap between principals and agent. When the firm performance is only

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weakly tied managers’ incentives and the benefits of increased monitoring outweighs the costs, then it is appropriate to increase monitoring. (Beatty & Zajac, 1994.) Tosi & Gomez- Meija (1994) find that the positive effect of CEO monitoring on firm performance has dimin- ishing returns at a certain point, meaning that the value of extra monitoring actions become less valuable when a certain level of monitoring is already reached, and as such monitoring as the sole solution to agency problems is insufficient and not practical.

The role of boards of directors as the monitors and evaluators of CEO performance has been getting increased attention, facing them with rising pressure to increase executive accounta- bility (Epstein & Roy, 2005). If the responsibility to monitor and evaluate CEOs is given to the board of directors, then one could expect that the board structure would affect the effec- tiveness of monitoring. For example, outside directors can be qualified as experts of firms’

internal control (Fama & Jensen, 1983), while the use of insider directors can suggest rather weak monitoring or imply a situation of self-monitoring (Beatty & Zajac, 1994). Monitoring problem could also be dealt with by choosing outside directors that have equity ownerships, because they would more likely be rigid in their monitoring role (Morck et al., 1988; Beatty

& Zajac, 1994).

Also, there are other important stakeholders such as institutional shareholders, debtholders, and venture capitalists that generally practice active monitoring to mitigate agency costs (Jen- sen, 1989; Beatty & Zajac, 1994; Core et al. 2003). Sundaramurthy et al. (2005) argue that stock concentration within large institutional investors may increase external monitoring and reduce agency problems associated with diffusion of stock ownership. Because large institutional investors have a significant stake in the firms’ equity, their incentive to monitor decisions of top management closely should be obvious (Alchian & Demsetz, 1972). There is clear evidence that small stockholders have significantly less power over management than large stockholders do (Cubbin & Leech, 1983), and that institutions as major shareholders have power over corporate policies (Hartzell & Starks, 2003), thus emphasizing the role of large stockholders in guarding shareholder interests. Also, Hartzell & Starks (2003) find that there is a positive relationship between institutional ownership and the pay-performance sensitivity of CEO compensation, and a negative relationship between institutional ownership

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and the level of CEO compensation. Finally, there is evidence of independent, long-term institutional investors’ ability to mitigate agency costs (Chen et al., 2007).

Empirical evidence supports the idea that board structure, governance mechanisms and ownership structure can affect CEO compensation, firm performance and characteristics of the firm. Core et al. (1999) find that the structure of the board and ownership explains significant amount of the CEOs’ compensation even when controlling for other determinants of compensation. Their results suggest that CEOs earn more in firms with weak governance struc- tures and those firms are less profitable and deal with more substantial agency problems.

Ozkans’ (2007) findings in the UK are consistent with the existence of active monitoring done by institutional owners and blockholders, but he finds no evidence of outside directors being more efficient in their monitoring role. Chaganti & Damanpour (1991) find that U.S manufacturing firms having significant institutional investors have relatively low debt ratios and high return on equity -ratios. Baysinger et al. (1991) find a positive relationship between institutional ownership and firms spending in R&D. This indicates that institutional ownership might have a positive effect on shareholder value, because high risk-high reward strate- gies such as investing in R&D is attractive to shareholders that can diversify inherent risk (see e.g. Hay & Morris, 1991). In contrary, Graves (1988) find a significant negative relationship between spending in R&D and institutional ownership in the computer manufacturing industry, providing evidence that institutional ownership might suppress R&D spending.

2.2.3 Equity ownership

The impact of manager equity ownership on firm performance goes as far back as 1932, when Berle and Means (1932) noted that when managers have too little equity invested in the firm and the firm owners cannot enforce value-maximization effectively, managers may use firm assets to benefit themselves rather than the shareholders (Morck et al., 1988: 1). Jensen and Murphy (1990: 141) argument that the most powerful way to link shareholder wealth and CEO wealth is through direct ownership of shares by the CEO, causing CEOs to immediately experience the effects of changes in the market value. Hill & Snell (1989: 28–29) summarize they key idea behind manager equity ownership as: “…when managers are themselves significant stockholders, they are more likely to make decisions consistent with maximizing

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stockholder wealth, since that will maximize their own income and wealth”. Equity ownership can be used in compensation schemes by using restricted stocks as compensation components, because they force the CEO to hold a certain amount of equity in the firm due to the stocks not being sellable for a certain time period (Ofek & Yermack, 2000). CEO equity ownership is generally observed as the monetary value of the stocks held by the CEO, as a percentage comparing the monetary value to CEOs’ yearly cash compensation or as percentage of total outstanding shares held by the CEO (Jensen & Murphy, 1990: 141). In addition, Elsilä et al. (2013) argue that payment setters should also consider the value of the stocks held relative to the total wealth of the CEOs.

In the context of this study, occurrence of agency costs from too low equity ownership of managers can be explained through the behavior of manager owning 100 percent of the company compared to situation where she sells a portion of stock to outsiders. When the ownership drops under 100 percent, then the manager no longer gains 100 percent of residual claims, nor does she bear 100 percent of the costs of non-pecuniary benefits she gets from the company. Consequently, the incentive for the manager to give significant effort for creating residual income falls and the incentive to consume perks arises, which can lead into self-maximizing decisions. (Jensen & Meckling, 1976.)

The negative effects of manager equity ownership may start to occur, when the ownership of the CEO is big enough to give her more control, causing entrenchment effects reducing firm value (Sundaramurthy et al., 2005). For example, Shleifer & Vishny (1989) describe that managers may attempt to entrench themselves by making investments that are less valuable under different management, which makes replacement of managers more difficult and costly for the shareholder. When managers have significant amount of stocks, it may give them power over their own compensation (Finkelstein & Hambrick, 1989) or dismissal and direc- tor selection (Fredrickson et al., 1988). Also, managers have already invested their human capital in the firm and increasing the amount of total ownership further increases the managers’ non-diversified risk, which can lead into reduced risk-taking that is against shareholders’

interests (Sundaramurthy et al., 2005: 496).

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Empirical evidence on the impact of equity ownership is mixed. Tsetsekos & Defusco (1990) find that risk-adjusted returns of portfolio were not related to the degree of managerial ownership. Contrary results are reported by Mehran (1995), who find that firm performance measured by ROA and Tobin’s Q is positively related to the percentage of shares held by top managers. Ozkans (2007) findings suggest that CEOs are paid less in the UK when the ownership of directors is higher. Finally, Elsilä et al. (2013) find that CEOs equity ownership affects accounting performance but does not have effect on future stock performance. Elsilä et al. (2013) suggest that when appointing a new CEO and designing a compensation pack- age, boards of directors should consider the wealth of the CEO, as their wealth tied to the equity relative to their total wealth can affect the efficiency of compensation packages.

2.3 Managerial power

Managerial power theory takes a different view on agency theory, in which it does not attempt to invalidate agency theory, but to deepen it by expressing the potential impact of powerful CEOs interfering with compensation plans, challenging the view of efficient contracting. Efficient contracting theory generally predicts that board of directors engage in arm’s-length transactions³ with CEOs and mitigate agency problems by creating compensation plans which align the interests of CEOs’ and shareholders. (van Essen et al., 2015.) However, Bebchuk & Fried (2004) argument that we cannot expect directors to engage in arm’s-length bargains with powerful CEOs’ over their compensation, and the absence of such bargains is the primary cause of non-optimal compensation plans.

While adequate executive compensation aims to be a potential solution to agency problem, Bebchuk & Fried (2004) view executive compensation also as a part of the agency problem itself (Tran, 2011). Because of CEO’s extremely powerful position they often have influence over the re-nomination of board of directors, which is responsible for implementing CEO compensation plans. This causes an incentive for the directors to be in favor of the CEO and the bigger the managers power is, the greater is his ability to extract rents, which causes

3 Arm’s-length transaction means transaction under conditions where two independent parties do a transaction where they both act in their own self-interest

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deviations from the interests of shareholders. (Bebchuk & Fried, 2003.) Elsaid & Davidson (2009) conducted a research including 508 newly appointed CEO’s, and their results suggest that higher bargaining power of newly appointed CEO has a link to greater proportion of base salary in total compensation. Because higher base salary should be in the interest of a risk- averse CEO (Murphy, 1999), their finding indicates that CEOs are using their bargaining power to benefit themselves. Similar evidence is provided by Bebchuk et al. (2011) and Vo

& Canil (2019), who find that the compensation gap in between CEO and other top executives seems to hold consistent with managerial power theory and that managerial power does not extend to other top executives such as CFO.

There are several scholars critiquing managerial power -theory. First, Kaplan (2008) argument that the rise in CEO pay seems to be a part of the increasing economic inequality and there are several other groups with similar skills and backgrounds such as hedge fund managers or lawyers having at least as big rises in payments, which indicates that increases in CEO payments are run by market forces instead of rent-extracting through managerial power.

Second, Kaplan & Minton (2006) find that CEO turnover is strongly related to weak stock performance and in general CEO turnover rate has increased since 1970s, which Kaplan (2008) interpret as evidence of strong boards, suggesting that CEOs do not have significant power over boards. Third, Conyon (2006) shows that compensation committees setting executive compensation have become more independent over time, and at the same time CEO total compensation has increased significantly, which he interprets as a possible reflection of CEO labor market rather than CEOs using their power. Finally, Murphy & Zabojnik (2007) show that externally hired CEOs earn more than internally promoted CEOs in the US, which, argued by Murphy & Zabojnik (2004), is inconsistent with managerial power theory, because internally promoted executive should have closer ties to the board of directors, causing them to earn more.

Another important consideration of managerial power is possible outrage of relevant outsiders. How outsiders perceive a compensation arrangement has a large effect over whether a certain arrangement will be adopted or not. Outrage might cause reputational harm to managers and directors, which in turn can end up costing them in the eyes of different stakeholders. The more outrage a compensation arrangement is expected to cause, the less likely that

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arrangement will be accepted by directors or even proposed by the manager. (Bebchuk &

Fried, 2003.) Similar idea is captured by Fama (1980), who argues that efficient labor markets for CEOs should mitigate agency costs, because opportunistic behavior of the CEO could be punished by the markets.

2.4 Firm performance

Certain CEO behavior can be controlled through linking CEO compensation with firm performance (Sigler & Haley, 1995). Merchant (2006) classifies three categories of firm performance measurements, which are market-based measures, accounting-based measures and combinations of measures. Merchant (2006) continues by giving the following criteria for a measurement to be effective for motivation purposes:

• in line with organizations’ goals

• manager needs to be able to control it

• timely, i.e. no delay in between manager actions and measurement results

• accurate

• understandable

• cost-efficient

There are three features of performance measures that economists generally consider, which are informativeness, verifiability and costs (Barclay et al., 2005). Selecting a performance measure is however not easy, because many desirable features of a performance measure can only be obtained by reducing other desirable features, thus causing balancing issues (for comprehensive discussion, see Hurts, 1980). Also, measuring performance is imperfect, which causes variations in the compensation of the agent and therefore increases agent’s risk (Holmström, 2017). A good performance measure should correlate highly with abnormal shareholder returns, because shareholders are mainly concerned with return that they gain in excess of what they were expecting to (Bacidore et al., 1997).

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2.4.1 Accounting-based measures

Accounting-based measures are generally derived from rules created by standard setters for financial reporting purposes. Accounting-based measures can be divided into two different forms: residual measures (e.g. EBITDA, net income) and ratio measures (e.g. ROE, ROA).

Accounting-based measures are often used when evaluating firm performance, and most executive compensation plans have at least one accounting-based measure affecting compensation. (Merchant, 2006.) For example, in a study conducted by Murphy (1999), 161 firms out of 177 had bonus plans with at least one summary accounting measure.

There are several pros concerning the use of accounting-based measures. First, many managers believe that accounting figures such as net profit have major effect on market reactions and many managers define organizations’ goals in terms of accounting figures. Second, they can be used in a way that they capture the performance of top management as well as lower level management. Third, accounting returns are usually measured quarterly, monthly or in some companies even on daily basis, which makes them timely available. Fourth, there is detailed ruleset concerning measurement of accounting information in income statement and balance sheet, making the measures relatively accurate. Also, the measures are objective due to external auditing, thus reducing deviations in measurements. Fifth, every manager in general management should already understand accounting measures through formal studies or work experience. Finally, they are cost-efficient due to the requirements of producing them for financial reporting purposes anyway, creating very little incremental costs. (Merchant, 2006: 901–902.)

However, there are some problems with accounting measures that need to be considered.

According to Dechow & Sloan (1991), accounting measures look backwards and are short- term, which could lead executives to avoid actions that increase future profits but decrease current profits, e.g. investing in R&D (Murphy 1999: 2506). Also, accounting measures can be manipulated through earnings management such as accruals, and there is evidence of CEOs’ using it to their advantage (Bergstresser & Philippon, 2006). Finally, accounting measures are becoming less and less reliable for predicting future, providing to be only a

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weak surrogate of stock returns and only reflecting what has happened in the past (Otley, 2007).

Accounting measures also seem to be a poor reflection of value changes due to several things affecting accounting profits without having effect on economic profits. First, economic value derives from future cash flows and past performance does not guarantee future performance.

Second, accounting measures are based on transactions, but many actions such as regulatory approval of new drug do not trigger an accounting entry even though it creates huge value, thus making the created value not visible in accounting measures. Third, rules concerning accounting measures are conservatively biased, causing revenues and expenses to be loosely matched especially when measurement periods are shorter than investment payoff periods.

Fourth, investments in intangible assets such as R&D, human resources and information systems are often expensed immediately and not shown on the balance sheet, even though they can have significant importance on the market value of the firm. Fifth, profit does not account for increases in working capital even though it has real economic costs by tying up capital.

Also, accounting profits are unable to catch the risk changes in profits, even though less risky cash flows have more economic value. Finally, accounting profits ignore the cost of equity capital. (Merchant, 2006: 902–903.)

In a large sample study of Easton et al. (1992) they find that the correlations in between changes in the market value of the firm and its profits were 0.22, 0.39, 0.57 and 0.79 for one, two, five and ten years (Merchant, 2006: 903). According to Kothari & Sloan (1992), correlation increasing within longer measurement windows occur because there is lag-effect in place between accounting profits and economic income (Merchant & Van der Stede, 2012:

418). One could then argue that managers should be compensated for long-term performance, but that would in turn reduce motivational effects due to bad timeliness of provisions of rewards (Merchant, 2006). Finally, Merchant & Van der Stede (2003) argue that it is difficult to set meaningful, long-term performance targets that extend far into future, reducing the feasibility of too long-term targets (Merchant, 2006).

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2.4.2 Market-based measures

Market-based measures of performance are based on the changes of market value of the principals’ holdings, which, if taking dividends into account, is the same as total shareholder returns. Market-based measures are appealing because they directly inform whether shareholder value has been created or destroyed. Market-based measures also seem intuitively fair, because if managers are rewarded based on value creation, then they are just getting a share of rewards in direct proportion to earnings of the shareholders. (Merchant, 2006: 897–898.) Also, prior research shows that market-based measures are better measurements of performance than accounting-based measures (Barclay et al., 2005).

Bacidore et al. (1997) emphasize the importance of incentivizing manager by connecting manager compensation and shareholder wealth, but to consider, that the compensation should not be subject to randomness in the price of firms’ common stock. This idea aims to solve agency problem by rewarding CEOs for actions that maximize shareholder wealth, which in general is seen as the general interest of an investor investing in a common stock. Similar idea is captured by Rutledge (1996): “Shareholders get paid when managers create equity value, not when managers check off items on to-do lists. To align manager interests with owner interests, pay managers the same way shareholders are paid.”

Other pros of using market-based measures include factors such as timely available and accurate market values, because recent transaction prices of public companies can be easily found. The market value is objective, and therefore managers have limited ability to manip- ulate the value compared to accounting-based measures. Also, market-based measures are cost effective because they do not require measurement systems from the company. (Mer- chant, 2006.) Market value should also be easily understandable to a top-level executive, and according to Merchant (2006), top management should be able to influence it with their decisions. Finally, stock prices reflect the future cash flows of investments much faster than accounting-based measures, because accounting-based measures do not account for investment decisions that are expected to be profitable only in the future (Gibbons & Murphy, 1992). For example, investors can punish the company by reducing its’ market value for

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reduced spending on R&D, even though it could increase short-term accounting profits of the company.

Regardless of the pros just mentioned, market-based measures do not come without problems and limitations. First, market value cannot be used as a measure for private companies, wholly owned subsidiaries and divisions or non-profit organizations, because market value is only available for publicly traded companies. Second, the efforts of lower level managers generally affect stock performance only in a collective sense, causing only top management to have significant control over stock performance. (Merchant, 2006.) Also, even top management has limited power over stock performance because many factors outside of their control such as macroeconomic activity, exchange rates and competitor actions affect market prices (Kim & Suh, 1993). For example, Peiro (2016) find that interest rates have clear effect on stock prices, which is not a factor that a CEO can to a great extent affect with her decisions.

Finally, market-based measures are based on future expectations (Barclay et al., 2005), causing compensation based on market measures to be risky for the principal, because those expectations of performance might not be realized (Merchant, 2006).

2.4.3 Combinations of measures

Measures can also be used as combinations, using for example one market-based (e.g. shareholder return) and one accounting-based (e.g. cash flows) measure to determine the level of firm performance. Another possible combination is using financial measure (e.g. revenues) with a non-financial measure (e.g. customer satisfaction), and essentially combination of measures can be as simple as using more than one parameter in an incentive contract. How- ever, measurements combinations can also be extremely complicated and there are several quite complex systems such as performance prism developed by Neely et al. (2003) and balanced scorecard by Kaplan & Norton (1996a). (Merchant, 2006.) In addition, combinations of measures can be defined as single measure containing one market-based value and one accounting-based value, such as market-to-book ratio (see e.g. Randoy & Nielsen, 2002).

There are several considerations supporting the use of measurements as combinations. First, a single measure can never reflect the performance of an organization to motivate managers

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enough, while using several measures might be better at reflecting the performance of the firm. Second, observing critical components of performance with summary financial measures is difficult and large quantities can cause measurement errors, for example different revenues or costs might have different weights of importance, e.g. a dollar saved from general costs can be given higher value than a dollar saved from raw material costs. Third, some issues of market-based and accounting-based measures, such as short-term orientation of accounting measures, can be addressed by using a combination which uses a future-oriented measurement to balance short-term and long-term views. This should also address the timeliness of performance indicators because financial performance measures are often lagging.

Finally, combinations give managers better understanding and guidance of what they need to do create value, more so than a simple market-based of financial-based measure would do.

(Merchant 2006, 906–907.)

Even though combinations of measures are infinitely flexible, because in theory one could always modify them to find a fitting combination for certain situations, they still have several problems when used in practice. First, more complex measurement concepts lead into decisions of how to measure those things, and the decisions over measurement methods will likely affect the results of the measurement. Second, choosing the optimal amount of performance measures for motivational purposes is difficult and it could lead into situation, where managers will not pay any attention to certain measures. And even if the optimal amount of performance measures could be chosen, then there is a problem of setting the correct weight for each of those measures. Third, complex systems can be extremely costly to build compared to simple measures, thus creating incremental costs by direct payments to consultants and time spent by the firms’ own personnel. (Merchant, 2006: 908–910.) Finally, some companies implement wrong measures as key performance indicators without thinking if it is even fitting for their business, leading into low causality of the performance indicator and desired outcome (Ittner & Larcker, 2003).

Balanced scorecard created by Kaplan & Norton (1992) is arguably one of the most popular combination-of-measurements systems. It utilizes financial and non-financial measures and it is supposed to ensure that organizations can measure, manage and evaluate their success.

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(Albertsen & Lueg, 2014: 431–432.) Kaplan & Norton (1996b) argue that traditionally individual incentives are short-term and incentive compensation should be linked to the scorecard, because balanced scorecard gives managers a way to ensure that the long-term strategy is understood in all organization levels and that individual objectives are aligned with it.

However, Hoque (2013) raises the notion that there is still not sufficient enough knowledge of how balanced scorecard can be used to create incentives for agents (Albertsen & Lueg, 2014), and Bromwich (2009) highlights the need of more studies to develop relevant balanced scorecards to find incentive plans that minimize agency costs. Drawing from all this, it seems that combination-of-measures systems have potential to be used in the creation of efficient incentive plans, but they are rather complex, causing problems when using them in real-life situations.

2.5 CEO compensation

Compensation system for executives attempt to accomplish three things: attracting and re- taining the right executives at lowest cost and motivating executives into actions that maximize long-run shareholder value. Three dimensions should be considered when designing a compensation plan that aims to accomplish the aforementioned things, which are the expected total benefits from the job, the composition of compensation plan and the pay-for- performance relation. (Jensen & Murphy, 2004: 19.) Therefore, CEO compensation is not only a matter of magnitude, but the components of CEO compensation play an important role (Finkelstein & Hambrick, 1988). Drawing from those views, CEO compensation attempts to provide a way to financially motivate skilled CEOs to work for the principal and to guide them into desired actions. It is the task of the board of directors to set up a payment schemes that incentive the CEO to work in the mutual interest with shareholders (Conyon, 2006), so the boards should have sufficient knowledge of CEO compensation.

CEO compensation typically contains five basic components, which are base salary, an annual bonus based on accounting performance, payouts from long-term incentive plans, stock options and restricted stock plans (Murphy, 1999: 2491; Frydman & Jenter, 2010: 5). The components of CEO compensation can be divided into cash compensation and incentive