Executive Compensation, Firm Performance and Corporate ...prr.hec.gov.pk/.../1/Muhammad_Fayyaz_Manag_Sciences... · I Muhammad Fayyaz CIIT/FA11-PMS-004/ISB hereby state that my PhD

Executive Compensation, Firm Performance and

Corporate Governance: Evidence from Pakistan

By

Muhammad Fayyaz

CIIT/FA11-PMS-004/ISB

PhD Thesis

In

Management Sciences

COMSATS Institute of Information Technology,

Islamabad Campus, Pakistan

Fall, 2016

ii

COMSATS Institute of Information Technology



A Thesis Presented to

COMSATS Institute of Information Technology, Islamabad

In partial fulfillment

of the requirement for the degree of

PhD (Management Sciences)

By

Muhammad Fayyaz


Fall, 2016

iii



A Post Graduate Thesis submitted to the Department of Management Sciences as

partial fulfillment of the requirement for the award of Degree of PhD in Management

Sciences

Name Registration No.

Muhammad Fayyaz CIIT/FA11-PMS-004/ISB

Supervisor

Dr. Syed Zulfiqar Ali Shah

Professor, Department of Management Sciences

COMSATS Institute of Information Technology (CIIT)

Islamabad, Campus.

iv

Certificate of Approval

This is to certify that the research work presented in this thesis entitled “Executive

Compensation, Firm Performance and Corporate Governance: Evidence from Pakistan” was

conducted by Muhammad Fayyaz (PhD Scholar) under the supervision of Dr. Syed Zulfiqar

Ali Shah. No part of this thesis has been submitted anywhere else for any degree. This thesis

is submitted to the Department of Management Science, COMSATS Institute of Information

Technology, Islamabad Campus in the partial fulfillment of the requirement for the degree of

Doctor of Philosophy in the field of Management Sciences.

Student Name: Muhammad Fayyaz Signature: _________________

Examination Committee:

Dr. Eatzaz Ahmad

Professor,

University of Peshawar

----------------------------------------------------

----------------------------------------------------

Dr. Abdul Qayyum

Professor,

Pakistan Institute of Development Economics

----------------------------------------------------

----------------------------------------------------


Supervisor,

Department of Management Sciences

CIIT, Islamabad.

Dr. Muhammad Tahir

HoD,


CIIT, Islamabad.

Dr. Farzand Ali Jan

Chairman, Management Sciences

CIIT

Dr. Khalid Riaz

Dean, Business Administration

CIIT

v

Author’s Declaration

I Muhammad Fayyaz CIIT/FA11-PMS-004/ISB hereby state that my PhD thesis titled

“Executive Compensation, Firm Performance and Corporate Governance: Evidence from

Pakistan” is my own work and has not been submitted previously by me for taking any

degree from this University i.e. COMSATS Institute of Information Technology or anywhere

else in the country/world.

At any time if my statement is found to be incorrect even after I graduate the University has

the right to withdraw my PhD degree.

Date: __________________

Muhammad Fayyaz


vi

Plagiarism Undertaking

I solemnly declare that research work presented in the thesis titled “Executive Compensation,

Firm Performance and Corporate Governance: Evidence from Pakistan” is solely my research

work with no significant contribution from any other person. Small contribution/help

wherever taken has been duly acknowledged and that complete thesis has been written by me.

I understand the zero tolerance policy of HEC and COMSATS Institute of Information

Technology towards plagiarism. Therefore, I as an author of the above titled thesis declare

that no portion of my thesis has been plagiarized and any material used as reference is

properly referred/cited.

I understand if I am found guilty of any formal plagiarism in the above titled thesis even after

award of PhD degree, the University reserves the right to withdraw/revoke my PhD degree

and that HEC and the university has the right to publish my name on the HEC/university

website on which names of students are placed who submitted plagiarized thesis.

Date: __________________

Muhammad Fayyaz


vii

Certificate

It is certified that Mr. Muhammad Fayyaz, CIIT/FA11-PMS-004/ISB has carried out all the

work related to this thesis under my supervision at the Department of Management Sciences,

COMSATS Institute of Information Technology Islamabad and the work fulfills the

requirement for award of PhD degree.

Date: ____________________

Supervisor:

______________________________


Professor

Head of Department:

______________________________

Dr. Muhammad Tahir

Assistant Professor,


viii

DEDICATION

I dedicate my work to my beloved Parents and Family

ix

ACKNOWLEDGEMENT

First and foremost, I am grateful to my ALLAH Almighty who bestowed upon me the

knowledge, skills, courage and strength to complete this thesis. I pay my sincere gratitude

from the core of my heart to Holy Prophet Hazrat Muhammad (S.A.W) who is the sole reason

for creation of this universe and is the role model for the whole mankind.

I wish to pay my thanks to my supervisor, Dr. Syed Zulfiqar Ali Shah, Professor, Department

of Management Science, CIIT, Islamabad, who imparted his knowledge, broad experience

and positive vision to me. He has always been a source of inspiration for me since I started

my research work. I would never forget his unflinching readiness to help me out whenever I

was in a trouble, no matter how trivial the trouble was.

I am obliged to Dr. Khalid Riaz, Dean Faculty of Social Sciences and Dr. Qaiser Abbas,

former Dean Faculty of Social Sciences for their guidance and help in research work as well

as in administrative matters whenever I seek. Likewise, I am also grateful to Dr. Muhammad

Tahir, Head of the Department of Management Sciences and Dr. Zahid Iqbal, former Head of

the department of Management Sciences for their great help in administrative matters.

I owe my heartily gratitude to my lovely wife, Sadia Fayyaz Sheikh, sweet daughters,

Fareeha and Sabaina, and a charming son, Muhammad Ibraheem, as without their love,

cooperation and continuous encouragement this research work was not possible. They

cooperated in every respect throughout my PhD program right from the beginning till the

end. I would like to pay special thanks to my brothers and sisters particularly my brother

Muhammad Asad for his never ending encouragement and moral support throughout the PhD

program.

Finally, I am pleased to pay my thanks to my colleagues, friends and classmates especially

Mr. Ahsin Waqas, Senior Joint Director SBP, Mr. Shahid Mahmood, Mr. Fahim Javed, Mr.

Muhammad Shahid, Mr. Abdul Qayyum and Mr. Muhammad Waqas Maharvi for their

continuous support.

Muhammad Fayyaz

x

ABSTRACT



The study aims at examining how compensation of chief executive officer (CEO) is

influenced by firm performance and corporate governance mechanisms such as

concentrated/family ownership and board structure in Pakistan. It further extends its

scope to analyzing the motivation aspects of CEO compensation towards future firm

performance and earnings management. The study uses a sample of 1508 firm-year

observations from 225 non-financial listed companies in Karachi Stock Exchange

(KSE) for period 2005 to 2012. Robust methodological procedures that control for

heteroskedasticity, serial correlation and endogeneity issues are used.

The study finds that current and previous year firm accounting performance as

measured by return on assets has significant influence on CEO compensation.

However, firm market performance does not have positive influence on CEO

compensation. Ownership concentration appears to have positive influence on CEO

compensation, indicating some sort of collusions between management and largest

shareholder to get personal benefits. CEOs who are also chairman board of directors

receive lower compensation as compared to their counterparts. Board size and board

independence have no convincing influence on CEO compensation in any direction,

indicating irrelevance of these mechanisms in CEO compensation decisions making.

There is weak evidence that CEOs in family firms receive lower pay as compared to

their counterparts. Further, it is found that CEOs are not rewarded for expected

future firm performance. Similarly, CEOs do not appear to induce earnings

management to receive higher compensations.

The study indicates that incentive based CEO compensation does not exist in

Pakistan. In addition, behavior of corporate governance variables in setting CEO

compensation appears to be pretty different from what is expected. Therefore, all

the stakeholders should be concerned and need to notice the decision-making

process within the boards in addition to ensuring the effective internal control

system to align the CEO interests with that of shareholders and restrain the possible

expropriation of minority shareholders’ interests.

xi

Keywords: Executive Compensation, CEO Pay, Corporate Governance, ROA, Stock

Returns, Earnings Management, Fixed Effects, Endogeneity, Non-Financial

Firms.

xii

TABLE OF CONTENTS

CHAPTER 1 ....................................................................................................................... 1

INTRODUCTION ............................................................................................................. 1

1.1 INTRODUCTION ............................................................................................................ 2

1.2 MOTIVATION AND RESEARCH OBJECTIVES .................................................................. 4

1.3 RESEARCH QUESTIONS ................................................................................................ 7

1.4 INSTITUTIONAL CONTEXT OF PAKISTAN ...................................................................... 7

1.4.1 The Code of Corporate Governance ......................................................................... 9

1.4.2 Brief Overview of Corporate Governance Practices in Pakistan ............................ 10

1.4.3 Corporate Governance under Concentrated/Family Ownership in Pakistan .......... 11

1.5 BRIEF SUMMARY OF RESULTS AND STUDY CONTRIBUTION ....................................... 12

1.6 STRUCTURE OF THE THESIS ....................................................................................... 15

CHAPTER 2 ..................................................................................................................... 17

LITERATURE REVIEW ............................................................................................... 17

2.1 THEORETICAL BACKGROUND .................................................................................... 18

2.1.1 Overview of Agency Theory ................................................................................... 18

2.1.2 Optimal Contracting Approach ............................................................................... 22

2.1.3 Managerial Power Approach .................................................................................. 23

2.1.4 CEO Compensation and Corporate Governance..................................................... 25

2.1.5 CEO Compensation and Ownership Structure ........................................................ 26

2.1.6 CEO Compensation and Performance Manipulation .............................................. 28

2.2 EXISTING EMPIRICAL EVIDENCE ................................................................................ 31

2.2.1 Executive Compensation and Firm Performance .................................................... 31

2.2.1.1 US Context ............................................................................................................... 31

2.2.1.2 Australian and European Context ............................................................................. 38

2.2.1.3 Asian Context ........................................................................................................... 43

2.2.1.4 Pakistani Context ...................................................................................................... 51

2.2.2 Effect of Executive Compensation on Firm Future Performance ........................... 52

2.2.3 CEO Compensation and Earnings Management ..................................................... 57

2.2.4 Summary of Empirical Research ............................................................................ 62

CHAPTER 3 ..................................................................................................................... 69

METHODOLOGY .......................................................................................................... 69

3.1 RESEARCH PHILOSOPHY ............................................................................................ 70

3.1.1 Ontological Considerations ..................................................................................... 70

3.1.2 Epistemological Considerations .............................................................................. 71

3.1.3 Methodological Considerations .............................................................................. 72

3.2 HYPOTHESES DEVELOPMENT ..................................................................................... 74

3.2.1 CEO Compensation and Firm Performance ............................................................ 74

3.2.2 CEO Compensation and Corporate Governance..................................................... 75

3.2.2.1 Ownership Concentration, Family Ownership and CEO compensation .................. 75

xiii

3.2.2.2 Board Size and CEO Compensation ......................................................................... 76

3.2.2.3 Board Independence and CEO Compensation ......................................................... 77

3.2.2.4 CEO Duality and CEO Compensation ..................................................................... 78

3.2.3 CEO Compensation and Future Firm Performance ................................................ 79


3.3 MEASUREMENT OF KEY VARIABLES.......................................................................... 80

3.3.1 CEO Compensation ................................................................................................. 80

3.3.2 Firm Performance ................................................................................................... 81

3.3.3 Corporate Governance Variables ............................................................................ 82

3.3.3.1 Family Ownership .................................................................................................... 82

3.3.3.2 Ownership Concentration ......................................................................................... 82

3.3.3.3 Board Size ................................................................................................................ 83

3.3.3.4 Board Independence ................................................................................................. 83

3.3.3.5 CEO Duality ............................................................................................................. 83

3.4 DATA ......................................................................................................................... 83

3.5 MODEL SPECIFICATIONS ............................................................................................ 86

3.5.1 CEO Compensation, Firm Performance and Corporate Governance ..................... 86

3.5.2 CEO Compensation and Past Firm Performance .................................................... 90

3.5.3 Controlling for Endogeneity ................................................................................... 90

3.5.3.1 Regressing on Lagged Values of Explanatory Variables ......................................... 90

3.5.3.2 Dynamic Panel Estimation using Generalized Method of Moments (GMM) .......... 91

3.5.4 CEO Compensation and Future Firm Performance ................................................ 93


3.5.5.1 Detecting Earnings Management .............................................................................. 95

3.5.5.2 Regression Model ..................................................................................................... 96

CHAPTER 4 ..................................................................................................................... 99

CEO COMPENSATION, FIRM PERFORMANCE AND CORPORATE

GOVERNANCE: EMPIRICAL RESULTS AND DISCUSSION .............................. 99

4.1 DESCRIPTIVE STATISTICS ......................................................................................... 100

4.1.1 CEO Compensation ............................................................................................... 100

4.1.2 Firm Performance ................................................................................................. 100

4.1.3 Corporate Governance .......................................................................................... 101

4.1.4 Control Variables .................................................................................................. 104

4.2 CEO COMPENSATION AND REALIZED FIRM PERFORMANCE .................................... 105

4.2.1 Correlation Analysis ............................................................................................. 105

4.2.1.1 Addressing Multicollinearity .................................................................................. 106

4.2.2 Regression Results ................................................................................................ 108

4.2.2.1 Total Compensation ................................................................................................ 108

4.2.2.2 Cash Compensation ................................................................................................ 113

4.2.2.3 Regression on Lagged Explanatory Variables ........................................................ 118

4.2.2.4 Dynamic Panel Model – GMM Estimation ............................................................ 120

4.2.3 Robustness Checks ................................................................................................ 122

4.3 CEO COMPENSATION AND FUTURE FIRM PERFORMANCE ....................................... 125


xiv


4.3.2 Regression Results: Compensation and Future Firm Performance ....................... 127


CHAPTER 5 ................................................................................................................... 130

CEO COMPENSATION AND EARNINGS MANAGEMENT: EMPIRICAL

RESULTS AND DISCUSSION .................................................................................... 130

5.1 CEO COMPENSATION AND EARNINGS MANAGEMENT ............................................. 131

5.1.1 Descriptive Statistics ............................................................................................. 131



5.1.3 Regression Results: Compensation and Earnings Management ........................... 135

5.1.3.1 Income Increasing Discretionary Accruals ............................................................. 137

5.1.3.2 Income Decreasing Discretionary Accruals ........................................................... 138


CHAPTER 6 ................................................................................................................... 142

CONCLUSIONS AND POLICY IMPLICATIONS .................................................. 142

6.1 CONCLUSIONS.......................................................................................................... 143

6.2 POLICY IMPLICATIONS ............................................................................................. 146

6.3 LIMITATIONS AND SCOPE OF FUTURE RESEARCH .................................................... 147

REFERENCES .............................................................................................................. 149

xv

LIST OF FIGURES

Figure 3.1 Research Philosophy………………………………....………... 73

Figure 4.1 Average CEO Compensation over the Sample Period.………... 104

xvi

LIST OF TABLES

Table 3.1 Industry wise Observations ……………………………….……………. 85

Table 3.2 Observations by Pay Components ……………………………………… 85

Table 3.3 Heteroskedasticity and Serial Correlation tests ………………………... 87

Table 3.4 Hausman specification test for random effect model ……………….…. 88

Table 4.1 Descriptive Statistics……………………………………………………. 103

Table 4.2 Correlation Matrix (Variables of Model 1, 2, 3 & 4) ……………………. 107

Table 4.3 Variance Inflation Factor (Variables of Model 1, 2, 3 & 4) …….………. 108

Table 4.4 Total Compensation and Firm Performance (Results)………………...... 116

Table 4.5 Cash Compensation and Firm Performance (Results)………………....... 117

Table 4.6 CEO Compensation and Firm Performance (Regression on lagged

explanatory variables) ………….…………………………………….…. 119

Table 4.7 CEO Compensation and Firm Performance (Dynamic Panel Model-

GMM Estimation) ……………………………………………….………. 124

Table 4.8 Correlation Matrix (Variables of Model 6) ……………………...………. 126

Table 4.9 Variance Inflation Factor (Variables of Model 6) ………………………. 127

Table 4.10 CEO Compensation and Future Firm Performance (Results)…………… 129

Table 5.1 Descriptive Statistics (CEO Compensation and Earnings Management). 133

Table 5.2 Correlation Matrix ………………………………………………….…… 134

Table 5.3 Variance Inflation Factor ….….….….….….….….….….….….….….…. 135

Table 5.4 CEO Compensation and Earnings Management (Results)…………….... 139

Table 5.5 CEO Compensation and Income Increasing Discretionary Accruals….... 140

Table 5.6 CEO Compensation and Income Decreasing Discretionary Accruals…... 141

xvii

LIST OF ABBREVIATIONS

CEO Chief Executive Officer

OCA Optimal Contracting Approach

MPA Managerial Power Approach

BMH Bonus Maximization Hypothesis

SECP Security and Exchange Commission of Pakistan

SBP State Bank of Pakistan

KSE Karachi Stock Exchange

AGM Annual General Meeting

OLS Ordinary Least Square

GMM Generalized Methods of Moment

TMT Top Management Team

ROA Return on Assets

EPS Earnings per Share

SOE State Owned Enterprise

1

Chapter 1

Introduction

2

1.1 Introduction

There has been enormous growth in research on executive compensation over the last

two decades with primary focus on compensation of chief executive officer (CEO). For

instance, Murphy (1999) notes that “CEO pay research has grown even faster than CEO

paychecks”. The research on CEO compensation has become multidisciplinary with greater

part coming from finance and management disciplines. Most of the finance literature on CEO

compensation is grounded in agency theory (Murphy, 1999).

Agency theory, proposed by Jensen and Meckling (1976), analyzes the relationship that

emerges between managers (agents) and owners (principals) in an economic environment

when principals delegate authority to the agents to act in their name, so that their wealth is

maximized by the agents’ decisions (Cuevas-Rodríguez et al., 2012). The agents, presumed to

be self-interested in agency theory, may not act in the best interests of the principals, giving

rise to costs, called agency costs, to the principals. Agency theory focuses on minimizing the

agency costs by aligning the interests of agents with those of principals using efficient

compensation contracts. This is called optimal contracting approach (OCA) (see, Bebchuk

and Fried, 2003). Optimal contracting does not mean “ideal” contracting; instead it means

that firm makes best effort to construct a contract within the contracting restraints to avoid

managers’ opportunistic behavior (Conyon, 2006). Optimal contracting attempts to trade-off

between marginal benefits and marginal costs related to the contract. Evolutions in corporate

governance or regulations may possibly change these costs and benefits and hence the

structure of the contract (Conyon, 2006). Therefore, today’s efficient contract may not be

efficient tomorrow.

In optimal contracting approach, the corporate boards, assuming the power to look after

the firm, involve in arm’s length transaction1 with CEO and design such compensation plans

which provide CEO with efficient incentives to maximize the shareholder value. This

predicts a link between CEO compensation and corporate performance. Better monitoring as

induced by effective board, concentrated/family ownership and board independence

contributes towards the level of CEO compensation and its relationship with firm

performance (see, Devers et al., 2007).

Contrary to optimal contracting approach, the other view to analyze the CEO

compensation is the managerial power approach (MPA) advocated by Bebchuk and Fried

(2003). MPA defies the fundamental assumption of optimal contracting that boards involve in

1 An arm’s length transaction is one in which two parties act independently in their own self-interest with balanced bargaining power and without any pressure or any duress from the counter party.

3

arm’s length transactions with managers over compensation arrangements and that such

transactions help reduce the agency problems by designing pay contracts that align the

interests of managers with those of shareholders (van Essen et al., 2012b). MPA states that

CEOs, being in power in a dispersed shareholding environment, set their own pay. However,

this pay is not unlimited rather subject to some potential “outrage” constraints and costs

stemming from an “outrage” – a negative reaction of relevant outsiders to the proposed

compensation contract. The optimal contracting approach considers executive compensation

as a tool to align the interests of agents and principals while MPA considers executive

compensation as an agency problem itself (see, Bebchuk and Fried, 2004).

Bebchuk and Fried (2003) and Bebchuk and Fried (2004) mention that MPA is not a

replacement for principal-agent model rather simply that pay practices cannot be explained

by principal-agent model alone. MPA predicts that CEOs compensation will be greater and/or

less sensitive to firm performance if CEOs are relatively more powerful than the board of

directors (see, Bebchuk and Fried, 2003). Weak boards in relation to CEO, CEO duality,

higher percentage of outside shareholders and less board independence, all contribute to

relative power of CEO (see, van Essen et al., 2012b).

The empirical evidence does not fully support any of the two approaches (OCA or

MPA). For example, several studies (e.g., Chalmers et al., 2006, Conyon and He, 2011, Frye,

2004, Hermalin and Wallace, 2001, Jensen and Murphy, 1990b, Laan et al., 2010, Mehran,

1995, Murphy, 1999, Ozkan, 2011) document a significant positive link between CEO

compensation and firm performance which is consistent with optimal contracting approach.

However, several other (see, Bebchuk et al., 2002, O'Reilly and Main, 2010, van Essen et al.,

2012b) find insignificant or weak pay-performance link along with excessive CEO

compensation which is consistent with MPA. Therefore, empirical evidence is mixed.

In a recent meta-analytic study assessing MPA against optimal contracting, van Essen et

al. (2012b) suggest that executives can and do influence their compensation and their power

can be controlled by principals. However, they do not endorse MPA as the only explanation

for executive compensation especially when it comes to pay-performance relationship. In

sum, both optimal contracting and managerial power influence the pay setting process.

Concluding their study, van Essen et al. (2012b) state that MPA and optimal contracting “do

not represent competing explanations but describe points on a continuum of types of

contracting arrangements that can be encompassed within agency theory”.

Although CEO compensation has spawned a large body of literature, however, most of

the literature is focused on developed countries like USA, Canada, UK and other European

4

countries (see, Devers et al., 2007, Frydman and Jenter, 2010, Gomez-Mejia and Wiseman,

1997, Tosi et al., 2000, van Essen et al., 2012a, van Essen et al., 2012b). This literature may

not have implications for developing countries as many economists strongly argue that there

are basic structural and institutional differences in markets and organizations of developing

and developed countries (Ghosh, 2006). In developing countries, the institutional

environment makes application of agency contracts difficult and costly (Young et al., 2008),

leading to dominance of concentrated ownership (Dharwadkar et al., 2000). In addition,

emerging markets are also characterized with weak corporate laws such as listing agreements,

codes of corporate governance and bankruptcy laws (Ghosh, 2006). When concentrated

ownership combines with ineffective external governance system, more conflicts emerge

between controlling shareholders and minority shareholders (Young et al., 2008). Besides

that, managerial markets are not well developed in emerging markets (Ghosh, 2006). All

these characteristics of developing economies are materially different from the characteristics

of developed economies (see, Fan et al., 2011), hence, provide an interesting framework to

study the relationship between CEO compensation and firm performance in the light of

theories evolved in developed economies.

1.2 Motivation and Research Objectives

In Pakistan, concentrated and family ownership environment accompanied with weak

governance systems suggests a tendency of expropriation of minority shareholders’ interests

by controlling shareholders through various rent seeking activities. For instance, Abdullah et

al. (2011) show that insider-controlling shareholders in Pakistan play a dominant role and

expropriate the external shareholders’ interests by not paying out dividends especially in the

absence of powerful external shareholders. Similarly, executive compensation is another way

by which interests of minority shareholders can be expropriated. In Pakistan, executives are

generally part of controlling families or have direct association with controlling shareholders

Therefore, CEOs tend to be more powerful than the boards of directors. The boards of

directors act more like rubber stamps and just approve the decisions made somewhere else

(Javid and Iqbal, 2008, Kamran and Shah, 2014). Bebchuk and Fried (2003) argue that

powerful CEOs set their own pay excessively which may not be justified against firm

performance. However, whether CEO compensation in Pakistan is justified against firm

performance is virtually an unexplored issue in Pakistan.

Securities and Exchange Commission of Pakistan (SECP) issues the first Code of

Corporate Governance in March 2002. The purpose of the Code is to improve corporate

5

governance practices and reduce the trust deficit among the business community, owners, and

agents. One of the primary focuses in the Code is improvement of board structure. Board

independence and separation of position of chairman board of directors from CEO are the

main focal points. However, no provision of compensation committee exists until 2012. In

addition, unlike many other Asian countries, executive compensation decisions do not require

approval from the shareholders in Pakistan. Further, the adoption of best practices of

corporate governance such as board independence and separate positions for CEO and

chairman remains a voluntary choice for the companies until 2012. In this context, how board

structure contributes towards CEO compensation decisions draws attention especially when

executive pay packages are sole responsibility of the boards and are not discussed with the

shareholders in annual general meetings.

A well-established fact is that Asian socio-economic and institutional settings (formal

and informal) are different from Western World and studies conducted in Western World

have limited implications for Asian countries (Fan et al., 2011, Ghosh, 2006, Hofstede, 1980,

Sun et al., 2010, van Essen et al., 2012a). However, within Asia, Pakistani context is different

from other Asian countries like China, Japan and Korea where most of the Asian studies on

executive compensation are based. Amongst others, Pakistani context is different in respect

of CEO pay disclosure and concentrated/family control. Disclosure requirement about CEO

compensation is stronger in Pakistan. Companies are required to report all the components of

CEO compensation. This is not the case for most of the other Asian countries (see, e.g., Basu

et al., 2007, Conyon and He, 2011, Kato et al., 2007). Therefore, there is more accurate data

available in Pakistan which can provide better insight into CEO compensation relationships

with firm performance and corporate governance. Similarly, concentrated and family

ownership is more common in Pakistan than in Japan and Korea. Although, in China, firms

have more ownership concentration than in Pakistan however that ownership concentration is

due to high stake of the government. In Pakistan, concentrated ownership is maintained by

non-government shareholders. Concentrated/family ownership can reduce CEO entrenchment

because of better monitoring incentives which in turn lead to lower CEO compensation.

However, very little is known about how concentrated/family ownership affect CEO

compensation in Pakistan.

Despite considerable importance of the subject of CEO compensation, the evidence from

Pakistan is virtually absent. To the best of my knowledge, there are only two published

studies (i.e., Kashif and Mustafa, 2012, Shah et al., 2009) that focuses on CEO compensation

in Pakistani context. Both studies explore the determinants of CEO compensation and finds

6

that firm performance is not an important determinant. However, they are limited in scope.

They do not control for unobserved heterogeneity in the firms and used only pooled

regression model. Introduction of firm fixed effects and time fixed effects to control for

unobserved heterogeneities may change the entire results. Further, they ignore the

endogeneity problem which has been vastly documented in the corporate governance field

(see, e.g., Conyon and He, 2012, Devers et al., 2007). In addition, they consider only current

firm performance, however, several studies have documented the relationship of CEO

compensation with past firm performance (see, Devers et al., 2007, Frydman and Jenter,

2010, Sun et al., 2010).

Besides that, in Pakistan, Shah et al. (2009) report that about 99% of variation (as

measured by R-square) in CEO compensation is explained by the variables they introduce in

the pooled regression. This casts some doubts on their findings especially when they have not

used fixed effects to control for unobserved heterogeneity. On a soft side, previous studies

(Kashif and Mustafa, 2012, Shah et al., 2009) in Pakistan use relatively short data period and

small sample size. The current study attempts to account for all the shortcomings of previous

which makes this study different from them.

Several other studies (e.g., Awan, 2012, Ibrahim et al., 2010, Javed and Iqbal, 2006,

Javid and Iqbal, 2008, Khatab et al., 2011, Nishat and Shaheen, 2006-2007, Yasser et al.,

2011) examine the impact of corporate governance on firm performance in Pakistan,

however, none of these examines the relationship of executive compensation with firm

performance and corporate governance. This reflects lack of research on the subject area,

thus, providing great incentive to study CEO compensation in Pakistan.

Given the above discussion, the study has the following objectives:

1. To examine the relationship between CEO compensation and firm performance in

Pakistan.

2. To explore how concentrated/family ownership and board structure influence the

CEO pay setting process.

3. To investigate the relationship between CEO compensation and manipulation of firm

accounting performance.

4. To overcome the methodological difficulties of the existing studies on CEO

compensation in Pakistan and perform rigorous analysis using more robust

estimation techniques including Generalized Methods of Moments (GMM).

7

1.3 Research Questions

The literature on the executive pay-performance relationship has two prominent

dimensions. One considers the pay as reward for the realized (current and past) firm

performance or as a mean of ex-post settling up (e.g., Fama, 1980) and test the influence of

firm performance on pay while, other conceptualizes the pay as a motivational tool and test

the effect of pay on firm performance (Devers et al., 2007). These two lines of research are

fairly grounded in agency theory. And agency theory posits that CEO compensation is related

to firm performance (past, current and future). Further, the recommended best practices in the

Code of corporate governance in Pakistan are generally justified using arguments based in

agency theory such as separation of CEO position from chairman board of directors and

provision for independent directors in the boards.

Therefore, given the research objectives and framework of agency theory, this study

investigates the following research questions in Pakistani context which is characterized by

concentrated/family ownership structure and weak legal environment.

1. Does realized (current and past) firm performance contribute towards CEO pay

setting process in Pakistan?

2. Does CEO compensation have any relationship with future firm performance in

Pakistan?

3. Does concentrated/family ownership structure influence CEO compensation in

Pakistan?

4. Does the board structure have any effects on CEO compensation decisions in

Pakistan?

5. Does CEO compensation affect earnings management decisions in Pakistan?

1.4 Institutional Context of Pakistan

Pakistani context is complex and unique in respect of its Indian sub-content origin with

traits of a collectivist society, with higher preference for uncertainty avoidance, and relatively

higher power distance (Hofstede, 1980). Further, Pakistani context is characterized by the

influence of British legacy, US influence, and its portrayal as an Islamic republic (see, e.g.,

Khilji, 2003) in the face of heightened political instability, prolonged and fragile law and

order situation, and corrupt social and economic environment. Pakistani context is considered

to be highly vulnerable to opportunistic behavior due to weak governance and political

systems (Mujtaba and Afza, 2011). This opportunistic behavior in general may have effects

on CEO compensation contracts. For example, opportunistic and powerful CEOs as

8

compared to the boards can set their own pay without the fear of check and balance, and that

is not justified against firm performance.

After the Asian financial crisis 1998 and corporate failure like Enron, effective

institutional framework becomes an important consideration (Javid and Iqbal, 2010). The

establishment of the Security and Exchange Commission of Pakistan (SECP) represents an

important milestone in the development of the regulatory framework of the capital markets in

Pakistan. The commission is established in under SECP Act, 1997 and becomes operational

in January, 1999. The continuing challenges of the Commission has been 1) to develop

regulatory principles to modernize the corporate sector of Pakistan to meet the international

standards and 2) to develop an efficient and dynamic regulatory body to foster principles of

good governance and protect investors through responsive policy measures and enforcement

practices (Javid and Iqbal, 2010).

To encourage corporate governance in Pakistan, Pakistan Institute of Corporate

governance (PICG), a not-for-profit organization, is established under Section 42 of

Company ordinance, 1984. SECP, State Bank of Pakistan (SBP), stock exchanges of Pakistan

and certain other banking/insurance institutions are founding members of PICG under public

private partnership. In 2006, PICG in collaboration with International Financial Corporation

(IFC) and SBP conducts a conference on reforms in Pakistan. The primary objective of the

conference is to develop understanding of the need for good governance among Pakistan’s

banking and financial sectors.

Stock markets play a vital role in channeling the investments for corporations in

developed world as well as in developing countries. Three stock exchanges, Karachi Stock

Exchange (KSE), Lahore Stock Exchange (LSE) and Islamabad Stock Exchange (ISE) were

working in Pakistan. However, recently in 2016, these are merged to form one stock

exchange, Pakistan Stock Exchange (PSX). The stock exchange is linked to Central

Depository System (CDS). Central Depository Company of Pakistan Limited (CDC) is

established in 1993 which became operational in 1997 to manage and operate the Central

Depository System (CDS). CDS is an electronic book entry system to record and transfer

securities without changing hands physically. Almost all the settlements of the stocks are

done through CDS. Thus, CDC is backbone of smooth and efficient settlement in Pakistani

capital markets.

9

1.4.1 The Code of Corporate Governance

SECP issues the first corporate governance Code in March 20022 to improve governance

practices and transparency and to protect investors’ interest by upgrading disclosure

requirements. Issuance of the Code is result of the joint efforts by SECP and Chartered of

Pakistan in collaboration with Institute of Cost and Management Accountants of Pakistan

(ICMAP). The Code includes more than 40 clauses in line with international good practices

of corporate governance. All the listed firms are required to publish and circulate a statement

of compliance with the best practices of corporate governance along with annual reports.

However as noted by Ibrahim (2006) that “Pakistan’s common law background, the country’s

legal system resembles the Anglo-American model; however, Pakistan’s ownership structure

is the opposite of the Anglo-American structure of dispersed ownership. The issuance of the

Code ignores this distinction and benefits from the U.K. and South African reform

initiatives” (p.328).

Primarily, the Code is aimed at establishing systems whereby companies are directed and

controlled by their boards of directors in compliance with the best practices around the world

to protect diversified shareholders’ interests. The Code proposes restructuring the

composition of the board of directors in order to introduce broad based representation by

minority shareholders and by executive and nonexecutive directors. Transparency and

openness is emphasized in decisions making and corporate affairs, and directors are urged to

perform their fiduciary duties in the largest interests of all the shareholders in diligent,

informed, transparent and timely fashion. The salient features of the Code include, emphasis

on separation of CEO position from chairman board of directors and appointment of

independent directors, and setting up of audit committees and internal audit functions by all

listed firms.

In August 2002 SECP, in collaboration with UNDP and Economic Affairs Division of

Government of Pakistan, launches a project for implementation of the best corporate

governance practices prescribed in the Code of corporate governance and strong regulatory

framework for the corporate sector in Pakistan. In 2007, SECP, IFC and PICG conduct a

Survey on “Code of Corporate Governance of Pakistan”. The survey is targeted to the

financial institutions, listed and large non-listed firms. The survey comes up with key finding

among others that there is a strong need for creating awareness amongst the directors of the

companies about the benefits of the Code so that they could go further than the tick-box

2 The Code of corporate governance is revised by SECP in March, 2012 applicable from year 2013 with some tightened corporate governance requirements.

10

approach to implement the Code (Javid and Iqbal, 2010). SECP develops a board

development series (BDS) with the help of IFC. PICG has conducted many workshops for the

purpose of understanding corporate governance and responsibilities of boards of directors.

SECP has been making efforts to enforce corporate governance regulations. SECP has

received technical help from Asian Development Bank (ADB) to improve corporate

governance enforcement program and from World Bank to improve awareness and training.

Other elements of enforcement system such as ICAP and stock exchanges are not that

convincing (see, Javid and Iqbal, 2010).

1.4.2 Brief Overview of Corporate Governance Practices in Pakistan

In Pakistan, the basic shareholders’ rights are protected at least by laws in the book. The

registration is secured through CDC. Shareholders are able to get variety of information

directly from the company. They have right to participate in Annual General Meetings

(AGM). Shareholders have cumulative voting rights to elect the directors who can be

removed as well through shareholder resolution. Shareholders’ approval is required for

alteration on the company articles, change in authorized capital, sale of company’s assets and

mergers and acquisitions. While compliance has improved through effective enforcement

however some companies do not seem to be interested in holding annual general meetings

(AGM) (Javid and Iqbal, 2010). The law does not support electronic voting or voting by post.

Influence of minority shareholders is very limited due to concentrated control which

effectively reduces the protection of minority shareholders’ interests from abuse.

The board meetings and directors’ accountability to non-family directors are virtually

absent in many family dominated firms. Some companies also do not pay dividend on time,

and take longer than 5 days to re-register shares in the name of depository (Abdullah et al.,

2011, Javid and Iqbal, 2010). As appointment of independent director is encouraged but not

mandatory in the Code till 2012, therefore it remains a voluntary choice. Also the assessment

of independence directors is based on very scanty criteria till 20123. In addition, since

separating the CEO position from chairman is encouraged in the Code but not mandatory till

2012 therefore many companies do not separate offices of the chairman board and CEO

which is contradicting with best corporate governance practices4. Since compliance with the

Code is weakly defined therefore listed companies are prone to submit so called verified

3 In the revised Code issued in 2012, it is a mandatory requirement that board should include at least one independent director. The assessment criteria for independent director have also been improved. 4 This requirement has been improved with mandatory separation of position of chairman from CEO in the new Code issued in March, 2012.

11

statement of compliance verified by auditors who may sign the statement without ensuring

the actual position. Further, the boards are not evaluated for their performance.

1.4.3 Corporate Governance under Concentrated/Family Ownership in

Pakistan Similar to other emerging markets, corporate governance and ownership structure in

Pakistan is tempting. Family and concentrated ownerships are common in Pakistani firms.

Family owned firms are typically managed by owners themselves, presumably to avoid

agency problems such as misappropriation or power abuse which may arise if executives are

hired from outside family (Kamran and Shah, 2014). In business groups, corporate boards are

dominated by executive and non-executive members from controlling family or by proxy

directors employed to act on behalf of the family. Majority control is often maintained

through interlocking directorship, complex pyramid structures, cross shareholdings, voting

agreements and/or dual class voting shares. This way, the ultimate owners keep (voting)

control while having a smaller fraction of ownership (cash flow rights) (Javid and Iqbal,

2008). Consequently, the dominant shareholders make the decisions without bearing the full

cost.

In instances where firms are multinational or state owned, typically, there is a direct

relationship between management and state/foreign owner, bypassing boards in making

important corporate decisions5 (Ameer, 2013, Kamran and Shah, 2014, World Bank, 2005).

In such a corporate environment more shareholder to shareholder conflicts arise than the

conflicts between shareholders and managers. Controlling shareholders or families promote

their own objectives and expropriate minority shareholders through tunneling or other rent

seeking activities. This environment is different from the environment in developed countries

like US and UK where ownership is diffusely held and where agency problems generally

arise between managers and shareholders (see, Fan et al., 2011). Although agency theory

predicts that concentrated and family ownership provide strong incentives for monitoring,

leading to reduced agency problems. However, the situation in Pakistan seems different due

to higher opportunities of expropriation.

Given the Pakistani context, it is worth exploring that how CEO compensation contracts

are related to firm performance and whether performance manipulation is related to CEO pay

in Pakistan. Understanding top executives’ compensation in Pakistan would benefit

stakeholders in other Asian markets as they can update their executive pay setting processes

5 For detail discussion on corporate governance in Pakistan see Cheema (2003), Cheema et al. (2003),Ibrahim (2006) and Burki (2012)

12

and take measures to solve the manager-shareholder and shareholder-shareholder agency

problems.

1.5 Brief Summary of Results and Study Contribution

Using a dataset consisting of 1508 firm-year observations from 225 listed firms in KSE

for period 2005 to 2012 and modern methodological procedures, this study finds that current

and previous year firms’ accounting performance have significant influence on CEO

compensation in Pakistan. However, market performance does not significantly affect CEO

compensation positively. Thus, CEOs in Pakistan are rewarded against realize firm

accounting performance only. As of motivation aspect of CEO compensation, higher CEO

compensation does not appear to induce better future firm performance. Similarly, no

evidence is found for compensation induced earnings management by CEOs.

As of corporate governance variables, ownership concentration appears to have a

positive relationship with CEO compensation, indicating that higher ownership concentration

leads to higher CEO pay. This is an indication of some sort of collusions between

management and largest shareholder to get personal benefits. Contrary to managerial power

hypothesis, CEOs who also hold the position of chairman board of directors (CEO duality)

agree to receive lower compensation as compared to their counterparts. This is contrary to

existing evidence in US, Europe and other Asian countries. Further analysis shows that this

negative association of CEO duality with CEO compensation is driven by family firms in

Pakistan which means that most of the CEOs in family firms who are also chairman board of

directors receive lower compensation as compared to CEOs holding only one position. The

findings also suggest that CEOs in family firms are paid lower compensation as compared to

CEOs in non-family firms. However, this finding is not consistently found in all model

specifications.

Board size and board independence, have no convincing influence on CEO

compensation in any direction, indicating irrelevance of these variables in CEO compensation

decisions. This seems consistent with Pakistani context as there is common perception that

boards are just rubber stamps in the hands of large shareholders. Thus, board size or number

non-executive do not matter in corporate decision making process.

An important finding of the study is that dynamic panel model shows that CEO pay is

persistent and takes time to adjust to long-run equilibrium. This indicates that boards of

directors in Pakistan adjust CEO compensation to target levels as they learn more about CEO

13

actions over time. Firm size appears to be a very important factor that contributes towards

higher CEO compensation.

Given the results, the study contributes in a number of ways. First, Fan et al. (2011)

notes that “Until now, we still do not know much about how managers of emerging market

firms are paid and promoted and factors that influence these decisions” (p. 211). Thus, by

analyzing CEO compensation in an emerging market of Pakistan, the study provides

important contribution in international literature on executive compensation. The findings of

this study can be used to shed light on host of other Asian markets with similar institutional

settings.

Second, the study provides first hand evidence in Pakistan that firm accounting

performance does contribute towards CEO compensation decisions. This is contrary to

existing evidence in Pakistan. Thus, this study challenges the existing studies, Shah et al.

(2009) and Kashif and Mustafa (2012), which find no contribution of firm accounting

performance in CEO compensation decisions. In addition, since Pakistani firms are

dominated by family ownership therefore positive contribution of firm accounting

performance towards CEO compensation seems to be contradicting to the view that family

firms do not have pay-performance relationship. This view seems true in case of some Asian

countries like Korea (Kato et al., 2007) where pay-performance relationship is not found for

family firms. Thus, by finding a positive pay-performance relationship for accounting

performance, this study adds to the debate on pay-performance relationship in family

dominated ownership environment in Asian context.

Third, the study highlights that corporate governance variables do not influence or

influence CEO compensation opposite to the expected direction. For example, board structure

variables (board size and board independence) have no influence while CEO duality has

unexpected negative association with CEO compensation. Similarly, ownership concentration

has positive association with CEO compensation which is opposite to the view of agency

theory. All these findings have important policy implications for practitioners and regulators

in Pakistan. For example, according to agency theory on which Code of Corporate

Governance based, combining CEO position with chairman board of directors is considered

to be an unhealthy practice which should lead to misalignment of mutual shareholders-

management interests. However, negative association of CEO duality suggest it is beneficial

for the firm as it leads to lower CEO compensation and better alignment of mutual interests.

Thus, this cast some important policy implications. Similar is the case with ownership

concentration. The positive association between ownership concentration and CEO

14

compensation is indicating some sort of hidden arrangements between largest shareholders

and CEOs which needs attention of policy makers and regulators.

Fourth, an important finding of the study is that CEO duality is negatively associated

with CEO compensation. This finding challenges the managerial power hypothesis. Also, it

contradicts with the existing empirical evidence. The study shows that this finding is driven

by family firms in Pakistan. Thus, this study highlights that behavior of CEO duality in

family firms is different as compared to non-family or diffusely held firms. This is an

important contribution of the study which warrants more research on the behavior of CEO

duality in area of management and finance.

Fifth, an important feature of studying influence of firm performance and corporate

governance practices on CEO compensation in Pakistani context is that the corporate

governance regulations in Pakistan have been paid a great attention during the last decade or

so with strong emphasis on board independence and separation of CEO position from

chairman board of directors. This study conducts the first in-depth examination of the

relationship between CEO pay practices and board structure variables with rich dataset and

using advance methodological procedures since the issuance of Code of Corporate

Governance (2002) in Pakistan. It is particularly important when the Code confers all the

responsibility to set executive compensation to the boards and itself provides no guidelines

and when remuneration committee is not required until the reissuance of the Code in 2012.

This study is expected to shed light on the effectiveness of the recommendations provided in

the Code for improvement of corporate governance practices. In addition, it would guide the

remuneration committees in firms which are mandatory from year 2013 on what different

factors can contribute towards devising executive compensation contracts. Moreover, in

future, this study would server as anchor for comparing the effectiveness of the recommended

corporate governance practices related to board structure and remuneration committee in the

Code of Corporate Governance (2002) and revised Code of Corporate Governance (2012).

Sixth, the study provides first hand evidence that CEO compensation in Pakistan neither

influences future firm performance nor it induces earnings management behavior. This

provides important directions for future research on the causes of these insignificant

relationships and influence of compensation on other actions of CEOs, for example, on

dividend policy, capital structure decisions and asset management decisions etc.

Seventh, the study is one amongst few international studies and first in Pakistan that

investigate dynamic nature of CEO pay using dynamic panel model. Thus, unlike most of the

15

existing studies on CEO compensation, this study accounts for adjustment process of CEO

compensation as indicated by Conyon and He (2012).

Finally, the study also has important contributions on methodological front. For example,

study uses fixed effect models which control for unobserved heterogeneity across the cross-

sectional groups. To control for heteroskedasticity and serial correlation in error terms, robust

standard errors clustered at firm level are also used. Certain measures are also taken to

control the endogeneity problems. Importantly a dynamic panel model is also estimated using

three well-known generalized methods of moment (GMM) techniques. In sum, rich

methodological procedures are adopted to produce robust results. Thus, the results provided

in this study are robust and not likely to be plagued with methodological difficulties like

existing studies (Kashif and Mustafa, 2012, Shah et al., 2009) in Pakistani context.

1.6 Structure of the Thesis

This chapter of the thesis provides background of the subject area, motivation and

objectives of the research followed by specific research questions, institutional context of

Pakistan and brief summary of results and study contributions. The remainder of thesis is

organized as follows. Chapter 2 presents the literature review which is divided into two

sections. While, first section provides overview of theoretical frameworks such as agency

theory, optimal contracting and managerial power hypothesis that are mostly used in the

literature to explain the relationship of CEO compensation with firm performance and

corporate governance practices, the second section compiles the empirical evidence related to

these relationships. The empirical evidence is further divided on the bases of the contexts

under examination, for example, US context, European context and Asian context. Chapter 3

describes the research methodology adopted in this thesis. The chapter starts with research

philosophy followed by development of hypotheses, measurement and operationalization of

key variables such as CEO compensation, firm performance and corporate governance

variables. Then, econometric models used in this research are discussed. The tests for choice

of appropriate models such as fixed effect or random effect models are also discussed in

detail. Chapter 4 and 5 describes the empirical results. Chapter 4 presents results related to 1)

the influence of firm performance and corporate governance practices on CEO compensation

and 2) the effect of CEO compensation on future firm performance, while Chapter 5 presents

the empirical results related to the influence of CEO compensation of earnings management

decisions. Each chapter starts with discussion of descriptive statistics followed by correlation

matrices, variance inflation factors, regression results and robustness checks. Finally,

16

conclusions are presented in Chapter 6 followed by policy implications and limitations and

scope of future research at the end.

17

Chapter 2

Literature Review

18

The research on CEO compensation is voluminous and multidisciplinary. Financial

economists, sociologists and psychologists are putting their efforts to understand the

determinants of CEO compensation. Accordingly, much theoretical and empirical work has

been done. A number of theories have been applied to explain the CEO compensation and its

relationships with firm performance and corporate governance and socio-economic variables.

Countless empirical studies can also be found on the subject area which examines the

implications of theoretical explanations. As focus of this study is on the association of CEO

compensation with firm performance and manipulation of firm performance, therefore only

related work is reviewed. The review is divided into two sections. First section aims to

discuss dominating theoretical work in analyzing CEO compensation. Second section

compiles the related empirical work.

2.1 Theoretical Background

Several theories can and have been used to understand CEO compensation. However, the

most dominant approach used as a theoretical background is optimal contracting approach

derived from agency theory. In fact, Bebchuk and Fried (2004) label this approach as

“official story” which contends that executive compensation is a tool to mitigate agency

problems and to align executives’ interests with that of shareholders. The other dominant

approach is managerial power approach which argues that executive compensation is an

agency problem itself because executives are relatively more powerful than the boards

therefore they can significantly influence their own pay. This section first provides overview

of agency theory then review optimal contracting and managerial power approaches and

documents their implications about the relationship between CEO compensation and firm

performance. After that theory about how corporate governance and ownership concentration

may influence CEO compensation is discussed. Finally, theoretical work regarding CEO

compensation and manipulation of firm performance is covered.

2.1.1 Overview of Agency Theory

Agency relationship exists when actions of one person affect his/her own interests as

well as interests of another person or a group of persons in an implicit or explicit contractual

relationship. Jensen and Meckling (1976) define agency relationship as “a contract under

which one or more persons (the principal(s)) engage another person (the agent) to perform

some service on their behalf which involves delegating some decision making authority to the

agent”. However, the agent, assumed to have his own interests, may not always act in best

19

interests of the principals. This gives rise to conflicts between agents and principals, called

agency problems. Agency theory resolves the agency problems by aligning the interests of

agents with that of principals using efficient (optimal) compensation contracts. Primarily, the

theory explains that how contracting parties design contracts to minimize the costs related to

agency problems. The review of literature suggests that agency theory has been the most

widely used theoretical framework to analyze the executive compensation (see, Bebchuk and

Fried, 2004, Bratton, 2005, Devers et al., 2007, Eisenhardt, 1989, Frydman and Jenter, 2010,

Gomez-Mejia and Wiseman, 1997, Murphy, 1999, van Essen et al., 2012b). Therefore, it is

important to understand the agency theory and how this theory addresses the agency

problems.

The agency literature has developed in two dimensions: a mathematically complex

agent-principal literature and a more empirically-oriented Positive Agency Theory (Shapiro,

2005). Both literatures use the agency cost minimizing tautology under same set of

assumptions and address the issue of contracting between self-interested utility maximizing

agents and principals (Cuevas-Rodríguez et al., 2012, Eisenhardt, 1989, Jensen, 1983) but, by

modeling the effects of different factors on contracts between parties. Positive literature

focuses on identifying situations in which agent is likely to have conflicting goals with that of

principal and explaining governance mechanism that curtails agent’s self-interested behavior

(Eisenhardt, 1989). Furthermore, positive agency theory deals almost exclusively with special

case of agency relationship between managers and owners of large public corporations

(Cuevas-Rodríguez et al., 2012). Conversely, agent-principal literature is concerned with

general theory of agency relationship which can be applied to any type of agency relationship

such as lawyer-client, doctor-patient and buyer-supplier (Eisenhardt, 1989). The agent-

principal research involves logical deduction and mathematical proof under carefully

specified assumptions. In addition, agent-principal literature has a broader focus and greater

interest in general theoretical implications. Although the two streams of agency literature

differ epistemologically, they are complementary: positive agency theory identifies different

contract alternatives and agent-principal theory identifies the most efficient contract under

varying level of outcome uncertainty, information, risk aversion and other factors (Cuevas-

Rodríguez et al., 2012, Eisenhardt, 1989).

Basically agency theory deals with resolving two problems that exist in agency

relationship (Eisenhardt, 1989). First is the agency problem that emerges from either goal

misalignment or information asymmetry between agent and principal. Second is the problem

of risk sharing that emerges from difference in attitudes of agents and principal towards risk.

20

Agency theory focuses on finding the most efficient contract governing the agent-principal

relationship given certain assumptions. Gomez-Mejia and Wiseman (1997) identify three

main assumptions of agency theory. First, agent is self-interested as he is also a utility

maximizer. Second, agent is risk averse because he cannot diversify his employment across

the firms. Third, there is misalignment of interests between agent and principal. Given these

assumptions two cases can be identified. First is the complete information case. In this case

principal has complete information about the agent’s behavior and actions. Because principal

is well aware of how results would be achieved therefor transferring risk to a risk-averse

agent by providing him/her outcome based incentives would be unnecessary (Eisenhardt,

1989). The second case is incomplete information case. In this case, principal is not fully

aware of agent’s behavioral tendencies and actions, implying that principal would not

completely know when agent departs from principal’s interests. Technically, there is a

problem of information asymmetry between agent and principal (Jensen and Meckling,

1976). Information asymmetry can lead to two types of agency problems. One is moral

hazard and other is adverse selection.

Moral hazard may be referred to as “actions of economic agents in maximizing their own

utility to the detriment of others, in situations where they do not bear the full consequences

or, equivalently, do not enjoy the full benefits of their actions due to uncertainty and

incomplete or restricted contracts which prevent the assignment of full damages (benefits) to

the agent responsible” (Kotowitz, 1987). A moral hazard problem arises when the agent’s

actions are unobservable by the principal. This can possibly be because of two reasons. First,

due to positive cost associated with getting information about agent’s actions; second, the

principal is unable to completely deduce agent’s actions from the outcome because outcome

may not be resultant of agent’s actions. The cost of getting information (monitoring cost) and

uncertainty about the contribution of agent’s actions in the outcome make it difficult for

principal to design an efficient contract that make agent compensation subject to actions of

the agent or the outcome of agent’s unobserved actions (Eisenhardt, 1989). Put it differently,

principal is unable to contractually make the agent bear complete fallouts (positive or

negative) of his/her actions. Consequently, agent may choose to act in his/her own interests at

the expense of interests of principal.

Adverse selection occurs when agent possesses some information that may prove fruitful

in agent’s decision making and he/she does not disclose this information when making

compensation contract with principal. Therefore, the principal would not know if agent has

taken the most appropriate decision on the basis of hidden information. Agent’s access to

21

privileged information about company’s environment and agent’s knowledge and expertise in

the area are the potential source of hidden information. Making an attempt to have this hidden

information is costly to the principal, making it difficult to reach an efficient contract.

Principal makes a trade-off between costs and benefits of acquiring this information when he

designs a compensation contract. The difference between adverse selection and moral hazard

is that in an adverse selection, agents have more information than principal which they can

use to benefit themselves during the contract, and in moral hazard agents develop actions that

are unobservable or immeasurable to the principal and can benefit agents while incurring

losses to principals.

To solve the agency problems, the principal has two choices (Eisenhardt, 1989). First,

obtain more information about agent’s behavior and actions (effort) with better monitoring

and curtail self-interested behavior. Second, provide agent with incentive in a way that

agent’s interests become aligned with interests of principals. As it is assumed that agent is

risk-averse and self-interested, therefore presumably, agent will adhere to the incentives and

make more effort, leading to an outcome that is more desirable by the principal. By providing

incentives, the risk of divergence from principal’s interests would also be shifted back to the

agent (Eisenhardt, 1989).

Agency theory focuses on the costs related to the agency problems and use cost

minimizing tautology to reach a pay contract that align the agent’s interests with that of

principal and adequately transfer the risk to the agent (Cuevas-Rodríguez et al., 2012). These

costs are called agency costs. Jensen and Meckling (1976) identify three types of agency

costs: monitoring cost, bonding cost and residual losses. Monitoring costs can include cost of

efforts that principal make to monitor agent’s actions and cost of incentives that are provided

to the agent. Bonding costs can be referred to as pecuniary and non-pecuniary expenses

incurred by principal or agent to guarantee that agent will act in the best interest of the

principal and if he/she does not in principal’s interests, the principal will be compensated for

agent’s actions. The bonding costs may take the form as contractual guarantees to do or not to

do certain actions such as to have the financial accounts audited by a public account (Jensen

and Meckling, 1976). Finally, residual losses are dollar equivalent of the reduction in

principal’s wealth due to deviation of agents’ decisions from decisions which would

maximize principals’ wealth given the optimal monitoring and bonding costs (Jensen and

Meckling, 1976).

Jensen (1983), subsequently, presents a broader definition of agency costs as “the sum

of the costs of structuring, bonding and monitoring contracts between agents… [which] …

22

also include the costs stemming from the fact that it doesn’t pay to enforce all contracts

perfectly” (p: 331). Positive agency theory suggests that these agency costs can be mitigated

by making an appropriate incentive package for the agents and by incurring monitory costs

(Pepper and Gore, 2015). Eisenhardt (1989) formalizes monitoring and incentivizing agents

for interest alignment in two propositions: first, regarding incentives: “when the contract

between the principal and agent is outcome based, the agent is more likely to behave in the

interests of the principal” (p: 60), second, regarding monitoring, “when the principal has

information to verify agent behavior, the agent is more likely to behave in the interests of the

principal” (p: 60).

2.1.2 Optimal Contracting Approach

In large corporations where ownership is separated from control, shareholders

(principals) are assumed to design efficient compensation contracts that attract, retain and

motivate CEOs (agents) to perform in the best interest of the shareholder i.e. to maximize

shareholders’ wealth (Conyon, 2006). This is labeled as “optimal contracting approach”

(Bebchuk and Fried, 2003). Under optimal contracting approach, compensation contracts are

viewed as an instruments or tools to solve the agency problems. Bebchuk and Fried (2003)

observe that “Optimal compensation contracts could result either from effective arm’s length

bargaining between the board and the executives or from market constraints that induce these

parties to adopt such contracts even in the absence of arm’s length bargaining”. A

compensation contract is efficient one if it (1) is able to retain talented executives, (2)

properly incentivize executives to take decisions in shareholders’ interests and (3) reduces the

overall agency costs (Bebchuk and Fried, 2004, Jensen and Murphy, 1990b). Core et al.

(2003) state this in a broader way that an efficient (or an optimal) contract is one “that

maximizes the net expected economic value to shareholders after transaction costs (such as

contracting costs) and payments to employees”.

Bebchuk et al. (2002) argue that in order to retain the CEO, his/her compensation should

exceed his/her opportunity cost, labeled as “reservation value”. A CEO’s reservation value is

partly a function of willingness to take risk. If a firm wishes a risk-averse CEO to accept

risky components (that are linked to firm performance) of a compensation contract, it would

have to offer larger total compensation on an expected value basis to offset CEO risk-bearing

(Bebchuk and Fried, 2004, Bebchuk et al., 2002). Although CEO’s reservation value places a

lower limit on CEO pay however, a firm may be willing to set CEO compensation level well

beyond CEO reservation value to provide incentives to make him/her behave in a way that

23

maximize shareholders’ wealth (Bebchuk et al., 2002). A firm would give value to CEO until

the marginal benefits are greater the marginal costs of doing so. Therefore, boards

considering the compensation plans to maximize shareholder value would focus on

alternative choices both in term of plans’ costs and incentive benefits to the shareholders

(Bebchuk and Fried, 2004, Gomez-Mejia et al., 2010).

There are several implications of an optimal contract. First, it reduces executive

opportunism, second, it links executive compensation with firm performance, third, it

motivates CEO to work against his “assumed” risk-averse behavior and last but not the least

it motivates CEO for future performance. Optimal contract does not imply an “ideal” contract

that totally eliminate agency problems, only that board of directors designs the best contract

that is possible under contracting constraints to avoid opportunistic and malfeasant behavior

of the executives. Accordingly, in optimal contacting, the board does not essentially eliminate

the agency costs but make a trade-off between (marginal) costs and (marginal) benefits of

implementing the contract (Conyon, 2006).

2.1.3 Managerial Power Approach

Contrary to optimal contracting approach, Bebchuk and Fried (2003) advocate another

view to analyze the CEO compensation, labeled as managerial power approach (MPA).

Bebchuk and Fried (2003) argue that CEOs have substantial influence over their own pay.

The board of directors and compensation committee, being influenced by CEO, compromise

their fiduciary duties and settled upon CEO compensation that is not in the interest of

shareholders. Basically, Bebchuk and Fried (2003) challenge the fundamental assumption of

optimal contracting approach that boards involve in arm’s length transaction with managers

over compensation arrangements. Bebchuk and Fried (2003) contend that “Just as there is no

reason to presume that managers automatically seek to maximize shareholder value, there is

no reason to expect a priori that directors will either. Indeed, directors’ behavior is also

subject to an agency problem, which in turn undermines their ability to address effectively

the agency problems in the relationship between managers and shareholders” (p: 73). Thus,

directors may not be true representatives of shareholders.

Bebchuk and Fried (2003) provide several reasons as to why directors would

compromise their fiduciary duties to shareholders and would not effectively challenge the

CEO compensation. First, CEO can affect directors’ compensation and perks; going against

CEO compensation may fire back. Second, CEO has significant influence over directors’

nomination process. As directors wish to be reappointed to get attractive compensation and

24

maintain the prestige; opposing CEO on the matters dear to him (such as compensation)

would not be a good choice for directors. Third, directors would not wish to lower their

chances of being invited to join other companies by having a reputation of quibbling up with

CEO over compensation. Last, directors usually have little access to independent information

regarding compensation practices to challenge the CEO compensation. Overall, there are

plentiful reasons to why directors have incentives to go along the desires of the CEO (see,

Weisbach, 2007). Bebchuk and Fried (2003) further contend that market forces are not strong

enough and prepared to assure the arm’s length contracting.

Although CEOs can influence the directors to settle upon the compensation that is

beyond the level of what optimal contracting suggests. However, this excessive compensation

is not unlimited rather subject to some potential “outrage” constraints and costs stemming

from an “outrage” – a negative reaction of relevant outsiders to the proposed compensation

contract. Outrage might cost CEO and directors a reputational loss or embarrassment, or it

might lead to unwillingness of shareholders to support executives in takeover bids or proxy

contests (Bebchuk and Fried, 2003). The gravity of these costs depends upon the gravity of

outrage. Therefore, facing potential outrage costs and constraints, how far directors and

compensation committee can go in favoring CEO will depend not only on how much

expected compensation plan will actually benefit CEO but also on how this plan will be

perceived by relevant outsiders (Bebchuk and Fried, 2003). The greater the outrage a

compensation contract is expected to cause, greater the reluctance will be to approve the

contract by directors and greater the hesitation will be to propose it by the executives

(Bebchuk and Fried, 2003). All this leads to consider that executive compensation is an

agency problem itself rather than a tool to solve agency problems between shareholders and

executives (see, Bebchuk and Fried, 2004). The major implication of MPA is that CEOs’

compensation would be greater and/or less sensitive to firm performance if CEOs are

relatively more powerful than the board of directors (see, Bebchuk and Fried, 2003). Weak

boards in relation to CEO, CEO duality, higher percentage of outside shareholders i.e., less

concentrated ownership, less board independence and possibly less institutional holding, all

contribute to relative power of CEO (see, van Essen et al., 2012b), leading higher

compensation with less sensitivity to firm performance.

Although MPA is a direct challenge to optimal contracting approach and view CEO

compensation with different lens, however, Bebchuk and Fried (2003) and Bebchuk and

Fried (2004) mention it clearly that MPA is not a replacement for optimal contracting rather

simply that pay practices cannot be explained by optimal contracting approach alone. In a

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recent meta-analytic study assessing MPA against optimal contracting, van Essen et al.

(2012b) suggest that executives can and do influence their compensation and their power can

be controlled by principals. However, they document that MPA is unable to provide single

combined explanation for all the outcomes of executive compensation, especially for

arrangements that related compensation to performance. In sum, both optimal contracting and

managerial power influence the pay setting process. Concluding their study, van Essen et al.

(2012b) document that MPA and optimal contracting “do not represent competing

explanations but describe points on a continuum of types of contracting arrangements that

can be encompassed within agency theory”.

2.1.4 CEO Compensation and Corporate Governance

Agency theory focuses on two mechanisms to solve agency problems: first, an efficient

compensation contract, second, better monitoring. Both mechanisms go side by side in

solving agency problems. A weak monitoring system would exacerbate the agency problems

and increases the agency costs to the firm. In order to mitigate the agency costs, firms need to

devise internal system to effectively separate control decisions (ratification and monitoring

decisions) from management decisions (initiation and implementation decisions) (Fama and

Jensen, 1983). Such a system would lead to better monitoring and control, and would curb

managerial opportunism, leading to reduced agency costs.

Corporate governance assumes this role of monitoring and curbing managerial

opportunism so that shareholder’s interests are protected (Fama, 1980, Fama and Jensen,

1983, Shleifer and Vishny, 1986). Daily et al. (2003) define corporate governance as “the

determination of the broad uses to which organizational resources will be deployed and the

resolution of conflicts among the myriad participants in organizations” (p.371). Therefore,

corporate governance is meant for designing effective control mechanisms (internal or

external) that enhance firm performance, mitigate agency problems, align the interests of

agents and principals and protect shareholders’ wealth.

A number of governance mechanisms are used to accomplish this which can be

categorized into two broad categories: internal governance mechanisms and external

governance mechanisms (Gillan, 2006). These mechanisms include effective boards, board

independence, well designed compensation plans to motivate agent to work in shareholders’

interest, concentrated ownership to monitor and discipline executives, and an effective

outside controls by market of corporate governance where internal governance mechanisms

are inefficient to discipline executive (Clarke, 2007, Walsh and Seward, 1990). The major

26

participants of internal corporate governance mechanism include boards, shareholder,

debtholders, executives, employees, suppliers and customers (Gillan, 2006). All these make

nexus of contracts view of an organization as formulated by Jensen and Meckling (1976).

The participants of external governance mechanism include law/regulations, markets,

politics, culture and communities (Gillan, 2006). External factors have significant importance

in designing internal governance systems as they provide an environment in which firm is

working (Gillan, 2006).

Agency theory predicts that more information about executives’ actions through better

monitoring system would result in less performance based remuneration (Eisenhardt, 1989).

This would lead to less total executive compensation. As an efficient corporate governance

structure provides close monitoring and oversight of management, therefore in the presence

of strong corporate governance, the total executive compensation would be low. On the other

hand, weak corporate governance may make executives more powerful relative to board of

directors, leading to more influence on pay-setting process for higher compensation.

2.1.5 CEO Compensation and Ownership Structure

Agent-principal paradigm predicts that in a dispersed ownership structure, individual

owners have weak incentives to exercise the power over major corporate decisions and to

invest in monitoring of management (Fama and Jensen, 1983, Jensen and Meckling, 1976).

This problem of management’s free-ride may be reduced through concentrated ownership.

Concentrated ownership has significant impact on the pattern of executive pay and CEO

equity incentives (Core et al., 1999). In a concentrated ownership structure, large

shareholders have strong incentives to oversee agents’ activities (Jensen and Warner, 1988).

Therefore, concentrated ownership generally suggests that shareholders are able to better

protect their interests in their companies, leading to mitigating potential CEO entrenchment

and relatively strong association between CEO pay and firm performance.

A family ownership is a special form of concentrated ownership. The unique nature of

family firms affects the top executive compensation contracts and the impact of these

contracts on firm performance and managerial actions. Several features of family ownership

reduce agency problems which consequently influence executive compensation. For example,

concentrated family ownership provides strong monitoring incentives, mangers from family

as being insiders can improve monitoring by providing information to other family members

outside (see, Harris and Raviv, 2008, Villalonga and Amit, 2010), strong commitment and

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firm specific knowledge of family members make them better monitor (Bertrand and Schoar,

2006).

Although concentrated ownership provides special monitoring incentives and seemingly

enforce the relationship between executive compensation and firm performance however, it

may introduce the conflicts between controlling shareholders and minority shareholders

(principal-principal agency problems), leading to expropriation of minority interests by

controlling shareholders. This expropriation is very likely in emerging markets where formal

institutions are weak to support mutually beneficial impersonal exchange between economic

players (Young et al., 2008).

Expropriation can be achieved through many ways – legal or illegal, or the ways that are

in grey areas (La Porta et al., 2000). For example, it can be achieved 1) through appointing

unsuitable friends, family members and cronies in important positions (Faccio et al., 2001,

Yeung, 2006), 2) devising such strategies that promote family or political interests against

firm performance (Young et al., 2008), 3) engaging in transactions with associated firms or

owned by controlling shareholders at prices unfavorable to the firm. In addition, controlling

shareholders may collude with management, called tunneling, for rent extraction. For that

matter they are willing to pay executives excessively but in return they demand convenient

way to expropriate minority interests (Su et al., 2010). Since tunneling has negative effects on

firm performance (Cheung et al., 2006, Jiang et al., 2010a), a strong pay-performance

relationship would induce executives to increase firm performance and reduce the incentives

to collude with controlling shareholders. Therefore, controlling shareholders involved in

tunneling activities may compromise the pay-performance link. Further, in the presence of

tunneling activities, controlling shareholders are somewhat responsible for firm performance.

Therefore, performance measures are likely to become less informative of executive effort

and less useful in executive pay setting process (Wang and Xiao, 2011). Thus, when

management and controlling shareholders collude, they attempt to maximize their private

benefits at the expense of minority shareholders. In sum, concentrated ownership may lead to

expropriation of minority interests and excessive pay to executives presumably not linked to

firm performance (Su et al., 2010, Wang and Xiao, 2011).

Similarly, although family ownership help reduces the agent-principal conflicts, it also

introduces new conflicts between family and non-family shareholders due to existence of

private benefits of control. These private benefits include utility derived from preserving the

family legacy for future generations or ensuring the well-being of other family members

(Becker, 1981, Bertrand and Schoar, 2006, Burkart et al., 2003).

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2.1.6 CEO Compensation and Performance Manipulation

Agency theory assumes that CEOs are self-interested and may behave opportunistically

at the expense of shareholders’ interests. Accordingly, corporate boards are presumed to

restrain CEO opportunism and align the CEO actions with shareholders’ interests by

designing efficient compensation contracts that typically link CEO compensation with firm

performance. However efficient compensation contracts may encourage managers to

manipulate performance because their compensation is tied to some pre-specified

performance criteria (Sun, 2012). These performance criteria generally include earnings

targets, share price performance and some specific financial ratios that signal the financial

well-being of the company (Ibrahim and Lloyd, 2011, Puffer and Weintrop, 1991).

Watts and Zimmerman (1978) develop a hypothesis that managers tend to manipulate

earnings through the choice of accounting policies because their compensation is tied to firm

performance. Similar to agency theory, Watts and Zimmerman (1978) assume that there is

misalignment of interests between shareholders and managers and, managers are self-

interested and tend to maximize their own utility. They further assume that management's

utility is a positive function of the expected compensation in future periods (or wealth) and a

negative function of the dispersion of future compensation (or wealth). Watts and

Zimmerman (1978) focus on performance related components of managerial pay i.e.

incentive cash bonuses and stocks or stock options. They contend that through the choice of

accounting methods, managers can increase incentive cash bonuses or value of the firm share,

leading to increase in managers’ wealth. Thus, managers are prone to pick those accounting

policies which transfer reported earnings from future to current period, or vice versa, under

specific situations (Watts and Zimmerman, 1986). Watts and Zimmerman (1978) identify

various factors by which the choice of accounting policies can affect both components of

managerial compensation directly or indirectly. These factors include 1) taxes, 2) political

costs, 3) regulatory procedures if the firm is regulated, 4) information production costs and 5)

managerial compensation plans. The first four factors increase cash flows which in turn have

positive effect on share price, leading to increased managerial wealth. The last factor can

increase managerial wealth through the alteration in the terms and conditions of incentive pay

plans (Watts and Zimmerman, 1978).

Management can increase (decrease) current reported tax by adopting certain accounting

methods which in turn decrease (increase) the reported cash flows. To cope with political

interventions, firms employ different methods such as government lobbying, social

29

responsibility movement and adopting certain accounting procedures to avoid high reported

earnings. Management reduces chances of adverse political actions by avoiding public

attention due to high profits that may be perceived as monopoly rents, hence, reduces

political costs and increases cash flows indirectly (Watts and Zimmerman, 1978).

Management can take benefit from favorable regulation that can increase current earnings

and cash flows. A new accounting standard may provide the managers an excuse to raise the

prices in a regulated firm due to standard’s tendency to reduce firm’s reported income (Watts

and Zimmerman, 1978). Changes in accounting method can increase information production

costs that may include book keeping costs, salaries to accountants and any additional training

costs. Managers would favor those methods that incur minimum information production

costs.

One of the major components of management compensation is incentive (bonus) plans.

These plans are typically linked to accounting income. Any change in accounting policy or

method that increases the firm’s reported income would lead to higher incentive earnings for

managers. However, this would probably reduce company cash flows, leading to decline in

share price. Managers would favor change in accounting method as long as the present value

of incentive income (after tax basis) is greater than the reduction in value of manager’s

portfolio (Watts and Zimmerman, 1978, Watts and Zimmerman, 1986). Existing literature

finds evidence that executive compensation is related to earning manipulation driven by a

managers’ desire to meet the performance targets, leading to higher compensation (see,

Devers et al., 2007, Frydman and Jenter, 2010, Ibrahim and Lloyd, 2011).

Recently, Sun (2014) theoretically examines the implications of earnings management

for executive compensation in the context of corporate governance reforms and where

managers may take costly decisions to manipulate earnings. She presents that increased

chances to manipulate earnings calls for equilibrium pay-performance sensitivities to be

stronger. In her optimal contracting model, shareholders are faced with the information

asymmetry about the accuracy of financial information presented by the management. An

opportunity to manipulate earnings serves as protection against lower compensation pay offs

to executives and thereby reducing the incentives to exert costly effort. Therefore, when

earnings manipulation is possible, high-powered pay contracts are required to incentivize

executive efforts. Her model also suggests that tightened corporate governance reforms may

lead to lower pay-performance sensitivity because they generate the incentives for executive

efforts and increase the cost of performance manipulation.

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Theoretical arguments presented above suggest that executives have different incentives

to manipulate firm accounting performance depending upon the circumstances and

motivations. However, given the assumption that executives are self-interested, one of the

motivational factors of manipulating performance is to increase executives’ own

compensation and wealth. Further, such choice and opportunity of manipulating performance

depends on prevailing corporate governance policies and practices. Given the Pakistani

corporate governance context, this study empirically examines the proposition that CEOs

tend to manage earnings to get higher compensation while controlling for corporate

governance practices. The existing empirical evidence to such propositions is discussed in the

end of next section.

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2.2 Existing Empirical Evidence

This section aims at discussing the empirical evidence on the relationship of executive

compensation with firm performance and manipulation of firm performance. It contains two

subsections. The first subsection covers the relationship between executive compensation and

firm performance. Because several studies have pointed out institutional differences across

the world and institutional context is likely to have significant influence on the relationship

between executive compensation and firm performance (see, Fan et al., 2011, Ghosh, 2006,

Sun et al., 2010, van Essen et al., 2012a), therefore within this first subsection empirical

studies are grouped according to the contextual settings in which studies are performed, for

example, US context, European context etc. The first subsection ends with review of

empirical studies that examine the relationship between executive compensation and future

firm performance. The second subsection reviews the empirical studies that examine the

relationship between executive compensation and performance manipulation. In the last, a

brief summary of empirical work is presented.

2.2.1 Executive Compensation and Firm Performance

Optimal contracting approach, derived from Agency theory, views the CEO

compensation arrangements as one of the tools to reduce the conflicts of interest between

agents and principals. Under this approach corporate boards are presumably responsible to

devise such compensation arrangements that provide agents with efficient and reasonable

inducements to maximize shareholder value (Bebchuk and Fried, 2003). This leads to the

argument of aligning the CEO compensation with firm performance. However, findings of

the empirical literature are mixed regarding the relationship of CEO compensation with firm

performance (see, Bebchuk and Fried, 2004, Devers et al., 2007, Sun et al., 2010)

2.2.1.1 US Context

In a seminal paper, Jensen and Murphy (1990b) examine the relationship between CEO

compensation and shareholders’ wealth – the ultimate goal of shareholders. They use data for

2,213 CEOs listed in the Executive Compensation Surveys published in Forbes from 1974 to

1986. Their final sample after eliminating observations with missing entries includes 7750

first differences in yearly compensation for 1688 executives from 1049 firms. Using least

square regressions, they document that for every $1,000 increase in shareholder wealth there

is about $3.25 increase in CEO pay including compensation, stockholdings and dismissal.

They show that, out of $3.25 change in CEO compensation, seventy-five cents correspond to

32

wealth consequences associated with outstanding stock options, salary revisions and

performance-related dismissals while, $2.50 correspond to firms’ common stock held by

CEOs including common stock and exercisable stock options held by their family members

or associated trusts. Given that higher pay for performance sensitivity should represent

greater interest alignment, they conclude that although their results are statistically significant

but sensitivity of CEO compensation to firm performance is very low which seems

inconsistent with agency theory. The potential reasons for this inconsistency they quote are:

boards may not consider CEO as an important input in production process as CEO actions

may be monitored and evaluated easily; there may be political forces internal and external to

the organization that influence the contracting process between shareholders and

management; public condemnation of higher compensation may truncate the up side of the

earnings distribution of executives.

Although findings of Jensen and Murphy (1990b) seem inconsistent with agency theory,

however, it is observed that pay-performance sensitivity varies considerably with the time

period examined, sample used and variables included (Devers et al., 2007). For instance,

using sample period from 1980 to 1994 and incorporating more comprehensive data on CEO

stock and option holdings for 478 companies from Forbes, Hall and Liebman (1998)

document that pay-performance sensitivity is nearly four times higher than it is in Jensen and

Murphy (1990b). They argue that CEO are not paid like bureaucrats as it was stated by

Jensen and Murphy (1990a). In fact, by using different measures of the pay-performance

relationship they find a strong association between wealth of CEO and wealth of the firm

CEO manage. Hall and Liebman (1998) incorporate broad measures of compensation that

include change in value of stock and stock options and employ ordinary least square

regression, median regression and robust regression models to analyze pay-performance

relationship. They report that both level of CEO compensation and pay-performance

sensitivity have risen considerably over their study period. The substantial increase in pay-

performance sensitivity is because of the fact that most of the pay increase is attributed to

increase in stock options. Indeed, they find that, for a given change in firm value, the

contribution of stock and stock option revaluation toward change in CEO wealth is more than

50 times greater than the contribution of salary and bonus. Overall the findings of Hall and

Liebman (1998) challenge the claim of Jensen and Murphy (1990b) that there is weak

relationship between CEO pay and firm performance.

In the same vein, Frydman and Saks (2010) also reject the position of Jensen and

Murphy (1990a) that CEOs are paid like bureaucrats. They examine the level and structure of

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executive compensation of 101 firms for period 1936 to 2005. They show that compensation

increases with slow rate from mid-1940s to mid-1970s but after mid-1970s it rises at an

increasing rate till the end of sample period. Important finding, they show, is that pay-

performance sensitivities are remarkable during all the sample period except 1940s. They

pose this finding as indication of utilization of pay-performance relationship to align the

executive incentives with shareholders’ interests for most of the sample period.

As research on executive compensation flourishes in 1990s, scholars start examining the

pay-performance relationship by controlling for the influence of other variables. For example,

Aggarwal and Samwick (1999b) include firm risk as measured by volatility of stock returns

in their analysis of pay-performance sensitivities. They argue for an economic trade-off

between the amount of unobservable effort that an agent makes and minimizing the amount

of risk an agent is supposed to bear. Basically, they test the prediction of principal-agent

model that pay-performance sensitivity would decrease as variance of firm performance

increases. In other words, executives in firms with more volatile stock returns are less likely

to have performance based compensation. Using the data on compensation of top executives

at 1,500 of the largest US publicly traded firms for period 1993 to 1996 from ExecuComp

database and controlling for stock return volatility, they find that median CEO pay–

performance sensitivity is $14.52 for every $1,000 change in shareholder value which is

greater than the sensitivity documented by Jensen and Murphy (1990b) i.e., $3.25 per $1,000.

However, they find that median pay–performance sensitivity for executives other that CEO is

$3.30 per $1,000. Further they find that pay-performance sensitivity is greater for the

executives at the firms having less volatility of stock returns as compared to the executives at

firms having higher volatility of stock returns. They conclude that without accounting for the

volatility, the examinations of pay–performance sensitivity may be biased toward zero.

Similarly, Guillet et al. (2012) examine the influence of executive characteristics and

firm performance on executive compensation. They use 16-year data from 1992 to 2007

consisting of 2200 firm-year observations from restaurant industry. Both accounting

performance and stock performance are considered along with executive characteristics such

as gender, age and tenure. Using generalized least square (GLS) model, they find that equity

based compensation varies with the type of executive and it is tied not only to firm

performance but also to executive characteristics such as executive age and tenure. Firm size

also appears to have significant positive influence on executive compensation.

Brick et al. (2006) also model directors and CEO compensation using governance

variables, CEO characteristics and firm characteristics. However, they test slightly different

34

hypothesis that excessive compensation of both CEO and directors is related to firm

underperformance. They use fixed effect to control for unobserved heterogeneity. Using

ExecuComp and COMPUSTAT data sets and hand collected data for 1163 to 1441 firms for

the period from 1992 to 2001, they find that the two compensations (CEO’s and directors’)

are negatively related to firm performance. They further find that there is a strong

relationship between CEO compensation and directors’ compensation. They argue that a

positive relationship between CEO compensation and directors’ compensation coupled up

with a negative relationship of both the compensations with firm performance is consistent

with cronyism hypothesis in which protection of shareholders’ interests in undermined.

Moreover, they show that excessive pay has an effect on firm performance that is

independent of poor governance variables.

A position in management hierarchy is another factor which may lead to different pay-

performance sensitivities for executives. Building on this, Aggarwal and Samwick (2003)

show that pay-performance sensitivity increases with the level of responsibility in an

organization hierarchy. They use data for the period 1993 to 1997 from ExecuComp for

13109 executives with 33607 executive-year observations. By employing regression with

executive fixed effects and year fixed effects, and controlling for level of compensation and

variables associated with firm’s contracting environment, Aggarwal and Samwick (2003)

show that the median pay-performance sensitivity of CEO is $5.65 per $1,000 increase in

shareholder value greater than that of executives with divisional responsibility. They further

show that aggregate median pay-performance sensitivity for top management team (TMT) is

$32.32 per $1,000 and CEO accounted for 42% to 58% of these aggregate incentives.

Concentrated ownership and governance factors are important factor that can redefine

pay-performance relationship. Amoako-Adu et al. (2011) examine executive compensation in

two types of concentrated ownerships using 3620 executive-firm-year observations and 700

firm-year observations from all listed companies in Toronto Stock Exchange for the period

1998 to 2006. They show that dual class firms as compared to single class firms with

concentrated control pay more to executives who belong to the controlling family. This

excessive pay appears in the form of either bonuses or stock options. This finding is claimed

to be consistent with optimal contracting approach in that higher compensation prevents

executives in dual class firms from taking benefit of greater voting power.

Core et al. (1999) show that board structure also affects CEO compensation along with

ownership structure. They examine 495 observations over a three-year period (1982 to 1984)

for 205 publicly traded U.S. firms and document that CEO compensation is lower when

35

percentage of inside directors is higher in the boards. Further, large board size, greater

number of outside directors appointed by the CEO, greater percentage of gray outside

directors, greater percentage of outside directors over ag 69, greater percentage of directors

serving in three or more other boards and CEO duality are associated with higher CEO

compensation. With respect to ownership structure, they find that CEO compensation is

lower when CEO ownership is higher, external blockholders or non-CEO internal board

member owns more than 5% shares.

Conceptualizing as if CEO compensation may be an outcome of abnormal performance,

Boschen et al. (2003) study the effects of performance surprises on CEO compensation. They

use vector autoregression (VAR), a time series model, to examine the effects of accounting

and stock performance surprises on CEO compensation. Their dataset consists of 1,110 firm-

year observations of 30 firms for period 1959 to 1995. They show that in the long run, stock

performance and accounting performance have different impact on CEO compensation. Both

positive accounting and stock performance surprise lead to higher CEO compensation

initially. However, in the long run, responses of performance surprises are different. In case

of positive accounting performance surprise, the higher initial compensation is offset by

lower compensation in later years, leading to no effect on CEO compensation in the long run.

Contrary to this, CEO continues to receive higher compensation (although diminishing) for

many years in response to a positive stock performance surprise.

While Boschen et al. (2003) document different long term effect of accounting and stock

performance on CEO compensation, Leone et al. (2006) document an asymmetric

relationship between cash compensation and stock returns. They use data from ExecuComp

for 2,751 CEOs (9,858 year-observations) for period 1993-2003. They argue that as the board

of directors include most unrealized losses and exclude most unrealized gains in CEO cash

compensation to reduce the cost of ex-post settling up for the shareholders, and since stock

returns include both unrealized losses and unrealized gains therefore, cash compensation

would be less sensitive to positive stock movements due to unrealized gains than to negative

stock movements due to unrealized losses. However, they argue that the response of other

types of compensation to stock returns would be different. For example, the response of

equity-based compensation to stock returns would be symmetrical because of vesting

constraints. If unrealized gains disappear before the equity claim vests, this information

would be impounded in claim’s price, therefore there would be no ex post settling up problem

for the stockholders, hence symmetrical response to positive and negative movements of

stock prices. Consistent with their arguments, they find that the sensitivity of cash

36

compensation to negative stock returns is twice more than the sensitivity to positive stock

returns and sensitivity of equity-based compensation is symmetrical to positive and negative

stock returns.

Given ex post setting up explanation to asymmetric pay-performance sensitivity of cash

compensation to stock returns by Leone et al. (2006), Dechow (2006) argues that importance

of ex post settling up explanation is of second-order, hence, she provides alternative

explanations. Compensation includes several components which are adjustable according to

the alignment of agents’ interests with that of principals. Consistent with optimal contracting

approach, she takes the position that bonus contracts (part of cash compensation) are typically

designed to offer more downside risk and limited upside risk, while equity compensation is

typically designed to offer more upside risk and limited downside risk. Therefore, pay-

performance sensitivity may be asymmetric to firm performance for different components of

compensation. However, overall, total compensation is sensitive to both upward and

downward stock price movements. She also provides explanation consistent with managerial

power approach. Excessive cash compensation is very visible thing and difficult to

camouflage and it may ignite significant outrage especially when firm is not performing well.

In order avoid this problems board being influenced by CEO under managerial power

approach can offer substitute forms of compensations such as stock options and perks. The

board of directors, possibly due to outrage concerns, wants to be able to assert that bonus

payment to CEO is based on performance and is tax deductible, leading to potential

asymmetric pay-performance sensitivities.

Shaw and Zhang (2010) defy the findings of Leone et al. (2006) that CEO cash

compensation is more sensitive to lower stock performance than to positive stock

performance because of ex post settling up. They argue that Leone et al. (2006) results are

due to misclassification of firms into good and bad performers. By classifying firms into

good and bad performers in a more sophisticated way, named as “three-way performance

partition”, and using a sample of14,632 firm-years over 1993–2005, Shaw and Zhang (2010)

find no evidence that cash compensation is more sensitive to lower stock returns than to

higher stock returns. Further, they find that sensitivity of cash compensation with firm

performance is lower for poor earnings performance than for better earnings performance.

Thus, they find no support for ex post settling up for poorly performing firms. This is even

true for worst performing firms with efficient corporate governance. They report similar

results when firms are partitioned on the basis of earnings-based measures. Overall, they

conclude that CEO cash compensation is not punished for poor firm performance.

37

A level of competition in the industry may have impact on the CEO compensation.

Aggarwal and Samwick (1999a) argue that in a more competitive industry, executive are

incentivized more on the basis of minimizing the value of other firms in the industry as

compared to maximizing the value of their own firm. They predict that the level of

competition in the industry decreases the ratio of pay-performance sensitivity of own-firm to

pay-performance sensitivity of rival firm. To test the predictions of their model, they employ

median regression with executive fixed effects using compensation data on 1,519 CEOs and

6,305 other executives from ExecuComp database for period 1992-1995. They find positive

pay-performance sensitivities for both own and rival firm. However, the ratio of own-firm

pay-performance sensitivity to rival-firm pay-performance sensitivity is lower in a more

competitive industry.

While Aggarwal and Samwick (1999a) examine compensation relative to other firms in

the industry, Bebchuk et al. (2011) explore the CEO compensation relative to other top five

executives in the firm. Specifically, they examine the relationship between CEO’s share in

compensation of top-five executive, namely CEO pay slice (CPS), and performance (value)

and behavior of publically traded firms. The dataset they used consists of 12,011 firm-year

observations representing 2,015 firms and 3256 CEOs for period 1993 to 2004. After

controlling for firm, corporate governance and CEO characteristics in regressions, they find

that as CPS increases the value of firm as measured by industry-adjusted Tobin’s Q

decreases. They further find that accounting profitability is negatively related to CPS.

Increase in CPS is negatively related to stock market returns accompanying the filing of

proxy statements. The CEOs with high CPS are more likely to be granted opportunistically

timed options. Finally, they conclude that higher CPS exacerbates the agency problems.

Again building on agency theory, Sun et al. (2013) relate CEO compensation to firm

efficiency as proxy for firm performance. First, they estimate cost efficiency (CE) and

revenue efficiency (RE) by applying data envelopment analysis (DEA). In the second step,

these efficiencies are used as explanatory variables in a regression model with CEO

compensation as dependent variable. The dataset they used consists of 139 year-observations

from 31 unique firms during 2000 to 2006. The result show that total CEO compensation as

measured by sum of cash compensation (base salary and bonus) and incentive based

compensation (stock grants, stock options and long term cash incentive payments) is

positively related to CE as well as to RE. Further analysis shows that CE is positively related

to incentive based compensation while RE is positively related to cash compensation.

38

Similarly, Nyberg et al. (2010) develop their arguments on agency theory but considers

firm’s CEO as significant co-investor instead of an employee only. They gauge the financial

alignment between shareholders and CEOs by assessing the relationship between CEO return

and shareholder return. After analyzing a sample of 9,469 CEO-year observations from 2,166

companies in US, they report that intensity of interest alignment between CEO and

shareholder is larger than reported earlier. They also show the moderating effect of relative

share of total shareholder return and CEO’s wealth on this relationship.

In a recent meta-analytic study, van Essen et al. (2012b) focus on finding evidence on the

relationship between CEO compensation and proxies of managerial power and pay-

performance sensitivities of CEO. In fact, they assess which approach is dominant in

explaining the CEO compensation: optimal contracting approach or managerial power

approach. The results based on 219 US-based studies indicate that managerial power theory is

good at predicting the level of cash and total compensation but not very successful in

predicting pay-performance sensitivities. They use four proxies for relative power of

management: board size, CEO tenure, CEO duality and fraction of independent directors in

the board. In most of the cases where CEOs are likely to have more relative power than the

boards to influence the pay-setting process, CEOs cash and total compensation are higher. In

contrast, where boards are more powerful relative to CEOs, CEO cash and total

compensation are lower. Furthermore, directors with more relative power seem to be able to

create a stronger relationship between CEO compensation and firm performance even against

the powerful CEOs they restraint. Although managerial power approach can explain level of

compensation however, this approach cannot be taken as a single unifying approach to

explain CEO compensation as it is not very successful in explaining the pay-performance

relationship. They finally conclude that managerial power has important influences on

compensation setting process but optimal contracting also exists at the same time. Therefore,

both optimal contracting and managerial power approaches do not seem to compete with each

other in describing CEO compensation. They rather describe points on a continuum of types

of contracting arrangements that can be encompassed within agency theory.

2.2.1.2 Australian and European Context

Deviation from efficient compensation structure may lead to demotivated CEOs which in

turn, can lead to firm underperformance. Matolcsy and Wright (2011) test this hypothesis

using data from Australian market for period 1999 to 2005. They select 3503 year-

observations for Top 500 firms from Connect 4. Using both accounting and stock based

39

performance criteria they find consistent results with their hypotheses. The firms having CEO

compensation structure inconsistent with the firm characteristics underperform as compared

to the firms having CEO compensation consistent with the firm characteristics. The firm

characteristics they used include firm size (market value of equity), market-to-book ratio,

number of subsidiaries, number of foreign subsidiaries, standard deviation of ROA over prior

3 years, operating cash flows to total assets ratio, prior year stock return (dividend adjusted),

ROA, CEO share ownership, debt-to-equity ratio, total equity owned by all blockholders with

more than 5 per cent of the shares outstanding.

In a study on a sample of 1152 managers from 160 Danish firms for period 1990 to 1994,

of which 120 are CEOs, 302 are upper-level managers and rest of 730 are lower-level

managers, Eriksson and Lausten (2000) find that the compensation of CEO and other

mangers is positively related to return on firm’s own capital. However, CEO compensation is

not driven by the changes in firm accounting performance as operationalized by different

dummy variables. Further, they show that, contrary to existing evidence, pay-performance

sensitivity is slightly different among various levels of managers in an organizational

hierarchy. Moreover, they find that CEO tenure and time left to retirement do not affect CEO

compensation.

In a survey study held on privately owned firms, Banghoj et al. (2010) conjecture that

pay-performance relationship in Denmark is weak. This is because of a couple of convincing

reasons. First, corporate governance practices are relationship oriented and there is less

variability in wage levels in Demark. Second, about 99 percent of the companies in Denmark

are privately owned. In privately owned firms, owners have better incentives for monitoring

executive, leading to less moral hazard problems and consequently, less performance based

compensation. Third, size of privately owned firms is generally small as compared to the size

of the public firms therefore it is not likely that privately held firms choose performance

based compensations. Finally, noisier nature of earnings as a measure of performance in

privately held firms may distort the pay-performance relationship. Banghoj et al. (2010) also

test the influence of corporate governance characteristics, executive characteristics and

quality of bonus on compensation. By employing two-stage and three-stage least square

regression, as expected, they find weak relationship between executive compensation and

firm performance in privately held firms of Denmark. Only ownership concentration and

board size appear to influence executive compensation among different corporate governance

variables. This finding is in contrast to several other studies (see, Devers et al., 2007, van

Essen et al., 2012b) in which many of corporate governance characteristics influence

40

executive compensation. One possible explanation they provide for this discrepancy is

difference in institutional context. In executive characteristics, executive position, educational

background and executive skills appear to have influence on executive compensation.

However, contrary to the expectations, they do not find strong pay-performance relationship

in firms with better designed bonus contracts.

Brunello et al. (2001) hypothesize that given the characteristics of Italian institutional

context such as family ownership and pyramidal groups, developing capital markets and

absence of relative hostile takeovers, the ratio of incentive pay with respect to total pay is low

and there is weak relationship between incentive pay and firm performance. To test their

hypotheses, they employ log-linear specifications using a survey data consisting of 2996

observations from 107 firms exclusive of state owned firms. They find that executive

compensation is positively related to firm performance as measured by real accounting

earnings per head. However, pay-performance semi-elasticity is low. They estimate that an

increase of 1billion lire in real accounting earnings lead to an increase of only 31 thousand

lire for middle and upper level managers which is 25 thousand more than for lower level

managers. The firms that are listed in stock exchange, belong to multinational group or

owned by foreign capital appear to have higher pay-performance sensitivity. As firms

associated with multinational groups and/or owned by foreign capital are less likely to be

influenced by unique Italian context therefore it is implied that characteristics of specific

Italian economic environment lead to weaker pay-performance relationship.

In another study in Italian context, Barontini and Bozzi (2011) examine the relationship

of board compensation with ownership structure and future firm performance. The sample

examined consists of 1722 year observations related to 215 firms listed in Milan Stock

Exchange. Using OLS regression, they find that many corporate governance variables

influence the board compensation however excess board compensation is never found to be

associated with future firm performance. Smaller board size and greater representation of

family members on the board are associated with higher board compensation and higher

board compensation appears to reduce future firm performance. Overall, Barontini and Bozzi

(2011) conclude that their evidence favors the rent extraction view of pay setting process

against the social network view which they quote as “high board compensation … could be

related to the need to hire directors with higher professional standing and also to the desire to

create a network with other companies through the enlargement of the board”

Scandinavian countries are characterized by extensive public sector, high taxes and

economic transparency. Randøy and Nielsen (2002) examine the relationship between CEO

41

compensation, corporate governance practices and firm performance in these countries. They

use a sample of 224 companies for the year 1998, of which 120 belong to Norway and 104

belong to Sweden. For financial variables they use 3-year (1996-1998) averages. Using a

cross section OLS regression, they find that CEO compensation and CEO tenure are not

significantly related to firm performance as measured by return on equity, total stock return

and market to book ratio. However, they find CEO compensation to be positively related to

board size, firm size (market capitalization) and foreign board membership. In addition, they

find that CEO compensation is negatively associated with CEO ownership as measured by

total percentage of equity held by CEO.

Similarly, in Portuguese context, Fernandes (2008) focus on the relationship between top

management compensation, firm performance and board structure. They document

significant influence of non-executive directors on compensation level. The top executive

compensation is higher in firms that have larger number of non-executive directors in the

board. They document an interesting result that pay for performance sensitivity is stronger for

the firms in which non-executive directors do not exist. Therefore, fewer agency problems

exist in firms with zero non-executive directors. This questions the effectiveness of

independent board members in aligning the principal-agent interests, especially when major

index firms mostly rely on non-executive directors in Portuguese Market.

In The Netherlands context, Laan et al. (2010) find that there is a positive relationship

between pay and performance after controlling for firm size as measured by number of

employees. They analyze hand collected data on 523 executives in 107 Dutch listed

companies for period 2002 to 2006. They use different components of pay as dependent

variables in panel regression. The performance variables they used include sales, profit,

relative total shareholder return, and earnings per share (EPS). Nevertheless, they conclude

their study by positing two broad questions. First, what drives the pay arrangements? With

regard to this they suggest that the context, especially corporate governance practices,

country settings (legal systems, regulations and the like) and social network are important

factors. Second, how pay arrangements affect executive behavior and firm performance?

In a cross section study on 414 large UK firms from FTSE all share index, Ozkan (2007)

examines the effect of corporate governance practices on the level of CEO compensation.

After controlling for firm characteristics in OLS and Tobit regressions, she shows that the

level CEO compensation is higher in firms that have larger board size and have higher

proportion of non-executive directors. This suggests inefficient monitoring by non-executive

directors. Further, she finds that higher block-holder and institutional ownership reduces the

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level of cash and total CEO compensation, indicating an active role of block holders and

institutional shareholders in monitoring CEOs. However, in case of equity based

compensation, only block holders seem to have negative impact. Additionally, she documents

that higher directors’ ownership is associated with lower CEO compensation (both cash and

equity-based), while higher CEO ownership is associated with lower equity-based

compensation only.

In another study in UK context, Liu and Stark (2009) empirically examine the cash

compensation of boards of directors. They focus on 169 UK non-financial listed firms that

existed during the period from 1971 to 1998. The performance measures they use include

pre-tax accounting earnings and stock market returns for both own-firm and the industry. By

employing time series model and panel regression, they find that own-firm accounting

earnings have positive effects on cash compensation of board of directors, while value

weighted industry accounting earnings have negative effects on cash compensation of the

board of directors. However, there is weak evidence that stock returns (of both own-firm and

peer group) have impact on cash compensation.

In a more recent study in UK context, Ozkan (2011) examine link between CEO

compensation and firm performance while controlling for corporate governance variables,

CEO characteristics and firm characteristics. She uses hand-collected data on 390 non-

financial companies from FTSE all share index for six years from 1999 to 2005. She focuses

on cash compensation that includes (salary and bonus), equity-based compensation that

includes long run incentive plans and options, and CEO wealth measured by CEO

shareholdings, stock awards and stock options. The set of corporate governance variables

includes institutional ownership, blockholder ownership, number of block holders, executive

directors’ ownership, non-executive directors’ ownership, board size and proportion of non-

executive directors. Firm characteristics include market capitalization, firm sales and Tobin’s

Q, while CEO characteristics include CEO age, CEO tenure. The performance measure she

uses shareholder returns and shareholder wealth. Controlling for year-fixed effects and

industry fixed-effects, she finds that CEO pay-performance elasticity is 0.095 (0.075) for

total direct compensation (cash compensation) which seem to be lower than US CEOs

documented in previous studies. The stock-based sensitivity and median share holdings of

UK CEOs are also lower than that of US CEOs. She further finds that higher institutional

ownership increases the CEO pay-performance sensitivity of option grants. Moreover, pay-

performance sensitivity of option grants appears to be negatively related to CEO tenure

which indicates an entrenchment effect of CEO tenure.

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Similar to Pakistan, concentrated family ownership is common in Continental Europe.

Building on this, Croci et al. (2012) examine the influence of family and institutional

investors on CEO compensation in 14 Continental European countries. A sample of 3731

year observations from 754 listed firms is used and sample period is from 2001 to 2008.

Regression analysis that controls for specific CEO and firm characteristics reveals that family

control does curb the level of CEO cash and total compensation. It also limits the ratio of

CEO stock-based compensation. The results suggest that CEO compensation is not a choice

for controlling families to expropriate the minority interests. Concerning institutional

investors, the analysis indicates that institutional ownership is positively correlated with CEO

total and cash compensation and this relationship is more pronounced in family firms.

Foreign institutional investors also appear to have positive influence on CEO compensation.

Finally, fraction of stock-based compensation both in family and non-family firms appears to

be positively influenced by institutional holdings.

The pay-performance relationship may change when endogeneity problem is addressed

in the regression models. Taking the lead from this argument, Ntim et al. (2013) show that

pay-performance relation becomes stronger when the research design is controlled for

possible endogeneity in South African context. They use data for 169 companies listed in

Johannesburg Securities Exchange (JSE) for the period 2002 to 2007. Using single equation

model, they find that pay-performance relationship is relatively weak. However, use of three-

stage-least-square model to account for endogeneity in corporate governance variables

significantly improves the estimates of pay-performance relationship. The results confirm the

simultaneous interdependencies among executive compensation, corporate governance

variables and firm performance. Further, it is shown that institutional ownership and presence

of debt lead to lower compensation, consistent with agency theory in that both creditors and

institutional investors engage in executive monitoring. In addition, board size appears to be

positively correlated with executive compensation, consistent with the argument that larger

boards are sign of weak corporate governance.

2.2.1.3 Asian Context

The research on CEO compensation in Asian context is relatively limited. However, like

in the Western World, CEO pay-performance relationship has been the most studied topic in

Asia. Various empirical studies find a link between top executive pay and firm performance.

For example, Firth et al. (2006) show that CEO pay is positively related to firm accounting

performance measures (return on sales) as well as to stock market performance measures

44

(stock returns). However, statistical significance of the results is conditioned to certain

ownership structures. This is consistent with their argument that different kinds of controlling

shareholder induce distinct types of incentive pay. They use a sample of 1647-year

observation from 549 non-financial listed firms in China for period 1998 to 2000. In addition

to positive association between CEO pay and firm performance, Firth et al. (2006) find that

firms that have ownership dominated by State agency do not exercise performance based

compensation plans. In contrast, firms that have ownership dominated by private

blockholders and SOEs do exercise compensation plans that are based on stockholders’

wealth and firm profitability respectively. They further show that foreign ownership also

induces the use of performance (stock returns) based compensation. They argue that these

differences in pay plan adoption between State agency ownership and SOEs and private

blockholders can be explained by the differences in cash flow rights. Although they find that

pay-performance sensitivity is statistically significant for certain ownership structures,

however the magnitude is very small - close to one for every 1,000 RMB change in

shareholder wealth.

In a subsequent study, Firth et al. (2007) examine the impact of firm performance and

evolving corporate governance systems on CEO compensation in China using a similar

dataset as used by Firth et al. (2006). They find a positive link between CEO compensation

and firm accounting performance as measured by return on assets. However, stock returns do

not appear to have significant influence on CEO compensation. Thus, more importance is

given to accounting performance than market performance in setting CEO compensation.

Further findings suggest that the state ownership tends to decrease the pay levels whereas

foreign holdings tend to increase the pay levels. However foreign holdings have positive

effect on the pay-performance sensitivity. Regarding governance mechanism, they find that

firms with joint position CEO/chairman tend not to support performance based compensation.

Firms with greater number of directors on the board also tend to pay less to their CEOs.

Lastly, presence of many non-executive directors on the board has positive effect on pay-

performance sensitivity.

Mengistae and Xu (2004) examine the implications of agency theory mainly by

examining effect of variance of firm performance on pay-performance sensitivity. They use

10-year data in 1980s on around 400 state owned enterprises from a survey conducted by

Chinese Academy of Social Sciences. Consistent with agency theory arguments, they find

that sensitivity of CEO pay to firm performance is negatively related to variance of the firm

performance. Further, CEO compensation is positively related to firm performance as

45

measured by marginal return to executive action. The pay elasticity to sales is somewhat

lower than that is documented in studies conducted on Western data. However, estimated

semi-elasticity of compensation to profitability is comparable with that estimated for

regulated industry in US. The CEO semi-elasticity to profitability is found to be between 0.08

to 0.77 in China compared to between 0.2 to 0.7 in US found by an earlier study. Moreover,

they find that pay-performance sensitivity is greater when there is more competition in

product market in which the company operates.

Using a relatively rich dataset than previous studies in China consisting of 942 firms for

period 1998-2002, Kato and Long (2006) find a positive elasticity of cash compensation

(salary and bonus) of top executives to shareholder value in China. The magnitude of

estimated elasticity of cash compensation appears to be 3.6 percent for every 10 percent

change in shareholder value, whereas, the magnitude of estimated sensitivity appears to be

0.053RMB for every 1,000RMP change in shareholder value. In addition, they find that

executive compensation is positively associated with sales growth. The results further suggest

that although executives in China are neither rewarded for increased profits and nor punished

for lower profits, they are penalized for losses. They also document the effect of ownership

structure on pay-performance relationship. Specifically, they show that State owned firms

have weak pay-performance relationship, whereas, this relationship is strong for private and

listed firms, suggesting that State ownership is less effective in resolving agency problems.

Again consistent with agency theory predictions, Conyon and He (2011) find that

executive compensation is significantly positively associated with firm performance. They

use fixed effects models and a relatively large sample of 1342 Chinese listed firms with 5928

firm-year observations during 2001 to 2005. They further find that the positive pay-

performance relationship is stronger in firms with more independent directors on the board.

In addition, more State ownership and concentrated ownership lead to lower CEO incentives

and executive compensation. Firm size, firm growth opportunities and presence of

compensation committee have positive effect on executive compensation, while firm risk has

negative effect. Lower firm performance leads to higher CEO turnover. Importantly, firms

with higher percentage of independent directors on the board and lower State control are

more likely to penalize CEOs for poor firm performance resulting in CEO replacement. They

also compare compensation of US and Chinese executives and find that the compensation as

measured by sum of salary and bonus in US is nearly seventeen times greater than the

compensation in China. And these US-China differences in executive compensation persists

even after controlling for general economic and governance variables, suggesting that

46

unobserved factors such as institutions and private benefits of control in China and social

norms might play their role.

In another study, Conyon and He (2012) use a more comprehensive dataset to address

the relationship between CEO compensation and firm performance in China. They use the

dataset that includes 2104 unique companies listed on the two Chinese stock exchanges for

period 2000 to 2010. However, the main regression is estimated using sample of 8600 firm-

year observations from 2024 unique firms for period 2005 to 2010. They relax the

assumption of traditional agency models that CEO pay is in equilibrium. They gain insight

from wage dynamic theory and append it with traditional agency theory. They view executive

pay decision as a dynamic process in which incomplete information and learning are equally

important as interest alignment. For this they use dynamic panel model estimated using

generalized method of moments (GMM). They show that CEO compensation is positively

associated with firm performance (both accounting and stock). However, this association is

stronger for accounting performance as measured by return on assets. They further show that

CEO compensation is highly persistent. Last year CEO compensation has significant positive

influence on current level of CEO compensation, indicating that compensation is set

dynamically and adjusted towards target equilibrium level. In addition, they show that

ownership structure and board have strong influence on CEO equity grants and equity

ownership. Moreover, they find that economic determinants of CEO compensation such as

firm performance, firm size and CEOs’ human capital are more important than ownership and

corporate governance. Especially, effects of corporate governance variable are significantly

weaker when the regression models are controlled for pay persistence and unobserved firm

level heterogeneity.

In China again, Su et al. (2010) focus on the relationship between executive

compensation and ownership concentration. They study state owned enterprises (SOE) and

non-state owned enterprises (non-SOE) separately. Using data on 967 firms (307 SOEs and

660 non-SOEs) for the year 2005, they find no significant evidence of the relationship

between ownership concentration and executive compensation in SOEs however results

suggest a U-shaped association in non-SOEs. In addition, results of all the models suggest a

significant positive association between executive compensation and return on assets.

Presumably, concentrated ownership and blockholders have better incentives to monitor

managers through incentive based pay contracts which in turn lead to stronger pay-

performance relationship. However, Wang and Xiao (2011) argue that agency problems

between minority shareholders and controlling shareholders can impede the adoption of

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incentive based compensation in China. This is possibly due to tunneling effect refers to as

extracting private benefits from controlling shareholders’ position through making self-

dealing transactions such as transferring assets to member companies under controlling

shareholders’ control at favorable prices. Using 6670 year-observations from Chinese listed

companies during 1999 to 2005, Wang and Xiao (2011) show that tunneling effect does

influence the pay-performance relationship. Firms with controlling shareholders tunneling the

economic resources for their private benefits have lower pay-performance sensitivity of

executive compensation. Large amount of tunneling transactions disturb the firm

performance and reduce the demand of controlling shareholders to adopt performance based

compensation contracts. Typically, these transactions are not under managerial control,

making performance measures less informative of executive effort and less suitable for

setting executive pay. Wang and Xiao (2011) assert that tunneling effect can explain the

weak but statistically significant positive relationship between executive compensation and

firm performance in China and suggest that interest alignment between minority and majority

shareholding is an important determinant of adopting performance based compensation

schemes.

While other studies in China study the implications of agency theory, Chen et al. (2011)

test the implications of managerial power theory and tournament theory of executive

compensation in Chinese market. Concerning managerial power theory, they study influence

of three types of managerial power on executive compensation: structural power, prestige

power and political power. The data includes all the firms that disclose compensation for

three highest paid executives in eleven-year span from 1999-2009 (432 firms in 1999 and

1458 firms in 2009). They find that structural power as measured by executive share

ownership and prestige power as measured by executive education are strongly positively

related to executive compensation. In case of relationship between political power, as

measured by executive/party secretary duality, and executive compensation, the sign is

positive but of the significance is weak. Further, they find that position in top organization

hierarchy, as indicated by executive pay level for each of the three highest paid managers, has

positive influence on executive compensation. However, this influence is diminishing

(convex) and when government ownership interacts with executive position in top

organization hierarchy, the influence becomes negative. In addition, executive pay is not

influenced by the number of persons competing for the executive position. Moreover, firm

performance as measured by EPS is positively related to contestants’ compensation gaps and

this relationship becomes negative when government ownership interacts with these gaps.

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Similar to studies in Chinese context, Kato and Kubo (2006) study the CEO pay-

performance relations in 51 Japanese firms using 10-year panel data on CEOs’ salary and

bonuses from 1986 to 1995. The data is from a private survey of CEO compensation

conducted annually by the consulting firm. Using panel regression, they find that CEO cash

compensation is sensitive to firm performance (especially firm’s accounting performance).

They report that “semi-elasticity” of CEO cash compensation with respect to return on assets

varies from 1.3 to 1.4. Consistent with the argument that Japanese corporate governance

tends to restrain the role of shareholder and emphasizes the role of banks and employees, they

find that stock market tends to have a limited role in CEO compensation decisions. Contrast

to the literature on employee compensation in Japan arguing that bonus is a disguised base

wage; they find that bonus system makes CEO compensation more sensitive to firm

performance.

In a comparative study between US and Japan, using a sample of 613 year-observations

from Japan and 2399 year-observations from US during 1992 to 1996, Mitsudome et al.

(2008) examine the significance of the relationship between CEO wealth and firm value. The

CEOs in both countries appear to be rewarded for contemporaneous firm performance

(operating income and stock returns). However, it is stated that this relationship is more

persistent for Japanese firms than for US firms, suggesting that Japanese managers are

rewarded for both short-term and long term performance. Further, there is no link found

between CEO compensation and sales growth for both countries’ firms. This result seems

inconsistent with the general view in Japan that firms emphasize more on maximizing market

shares than on short-term profitability.

The ‘keiretsu” culture is common in Japan. Basu et al. (2007) use this cultural dimension

and focus on top executive’s pay and firm performance within the corporate governance

environment of Japan. They use data of 300 executives from 174 large Japanese firms during

1992-1996. Using different model specifications and controlling for standard economic

variables, they find that weak corporate governance practices lead to higher executive pay

and vice versa. Further they find that CEO pay is lower in firms associated with keiretsu or

have at least one outside director. Similarly, lower CEO pay is also associated with lower

board size. However, higher stock ownership by the board and family-influence appear to be

related to higher executive compensation, suggesting an entrenchment effect of management.

Finally, they argue that if set of monitoring and ownership variables they used is a good

proxy for decreased agent-principal conflicts, then excessive compensation associated with

poor governance should lead to poor future firm performance. Consistent with their

49

hypothesis, they find that compensation explained by ownership and monitoring variable is

negatively associated with future accounting performances. Therefore, ownership and

monitoring echo the effectiveness of governance structure instead of proxies for neglected

determinants of executive equilibrium compensation. Overall results suggest that weak

corporate governance in Japan leads to increased agency problems which subsequently lead

higher executive pay and finally poor future firm performance. However, keiretsu and outside

directors help reduce agency problems in Japan.

Similar to keiretsu in Japan, a popular institutional setting common in Korea is

“Chaebol” – a conglomerate business structure often run by a family. The presence of

Chaebols make Korean market an interesting environment to study the CEO compensation,

Kato et al. (2007) do this. Using a panel dataset covering 246 firms included in KOSPI200

index for at least two consecutive years between 1998 and 2001, they show that cash

compensation of Korean executives is significantly related to firm stock performance. The

magnitude of this relationship is quite comparable to what has been documented for Japan

and US. Alternative measures such as accounting performance and sales seem to have limited

influence on Korean executive compensation. An important result uncovered is that pay-

performance sensitivity does not exist for firms that are associated with Chaebol and that all

the pay-performance sensitivity is driven by non-Chaebol firms. This suggests that Chaebol

firms in Korea lack in well-functioning internal corporate governance.

In Indian context, Ghosh (2006) investigates determinants of CEO and directors’

compensation using 462 firms from the Indian manufacturing sector for period 1997 to 2002.

Specifically, he examines the influence of firm performance, corporate governance practices

and firm diversification on board and CEO compensation. He finds that both last-year and

current firm performance as measured by ROA and diversification largely influence the board

compensation. However, CEO compensation is influenced by current firm performance only.

Number of outside directors on the board appears to have inverse relationship with fixed as

well as total directors’ compensation. CEO duality increases the board compensation. The

presence of founder CEO and more than one CEO also tend to increase the board

compensation. CEO compensation appears to be more influenced by firm size rather than

firm performance. Regarding influence of CEO characteristics on CEO compensation, only

CEO tenure appears to have positive influence on CEO compensation. This is seemingly

contradicting with existing studies which find positive influence of CEO characteristics such

as age, education and experience on CEO compensation.

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In another study in Indian context, using cross section data on 324 Indian manufacturing

companies for the year 2005, Ghosh (2010) examine the association between CEO

compensation and firm performance. While controlling from industry effects he finds that

firm performance has significant influence on CEO compensation however, the magnitude is

apparently small. He also reports that big size firms pay more to their CEOs. Further analysis

shows that group associated firms, privately owned firms and foreign private firms have

higher CEO compensation compared to state owned firms.

In three South American emerging markets: Brazil, Argentina and Chile, Gallego and

Larrain (2012) examine the relationship between CEO compensation and types of

concentrated ownership. Using data of about 1700 executives from 720 firms, they show that

large shareholders do not represent a uniform class of “hands-on” principals when it comes to

compensating the executives. They find that ownership concentrated in families is related to

higher CEO compensation but not to the compensation of other executives lower in the

organizational hierarchy. There is a compensation premium of 30 log points for professional

CEOs employed in family firms. Contrary to this, CEOs in foreign concentrated ownership,

shareholder coalitions and the state concentrated ownership do not get any premium. It is

hard to distinguish the contribution of managerial skills, career risk and private benefits or

rent extraction towards family premium. All these might contribute simultaneously and their

relative importance and contribution may vary with time and firm. However, most of the

family premium comes from firms where founders are absent but their children are involved.

This distinguishes the family ownership from other concentrated ownerships.

Recently in a meta-analytic research paper based on 332 studies on compensation in 29

countries, van Essen et al. (2012a) document that the relationship between compensation and

firm performance is moderately positive but statistically strongly significant. This suggests a

modest support for optimal contracting theory. However, there is a considerable cross-

country variability in pay-performance relationship. They find that this variance is due to the

differences in formal and informal institutional settings that protect investors from executive

underperformance and overcompensation. Both formal (rule of law and investor protection)

and informal (ownership concentration and code of good corporate governance) institutions

have significantly positive moderating effect on pay-performance relationship. Further they

find that formal and informant institutions complement each other in influencing the pay-

performance sensitivity. Pay-performance sensitivity appears to be stronger when

concentrated ownership accompanies access to well-effective law courts and when

shareholder protection laws accompany informal norms of good corporate governance.

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Finally, they suggest supplementing the institutional-based view of compensation with

agency theory in order to account for conditional influences of formal and informal

institutions on national pay practices.

2.2.1.4 Pakistani Context

In Pakistan, Shah et al. (2009) explore the determinants of CEO compensation and use

data on 114 KSE listed companies for period 2002 to 2006. Using pooled regression without

controlling for firm fixed effects and time fixed effects, they find that larger firms pay more

to their CEOs. Larger board and ownership concentration also lead to higher CEO

compensation. However, board independence lead to lower CEO compensation, indicating

that independent board members do have some monitoring role and influence the CEO

compensation decisions. Besides these finding, Shah et al. (2009) report that about 99% of

variation (as measured by R-square) in CEO compensation is explained by the variables they

introduced in the pooled regression. This casts some serious doubts on their findings

especially when they have not used fixed effects to control for unobserved heterogeneity.

Moreover, their research design account for only current CEO compensation and current firm

performance. No lagged values of firm performance are introduced in their empirical model

thus ignoring a very important factor. If compensation paid to CEOs is a reward for their

performance (ex-post) then past firm performance would be an important determinant of

current compensation. Several studies find positive link between CEO compensation and past

firm performance (see, Devers et al., 2007, Frydman and Jenter, 2010, Sun et al., 2010).

Like Shah et al. (2009), Kashif and Mustafa (2012) also study the determinants of CEO

compensation in Pakistan. They focus on only 66 family firms listed in KSE for period from

2010 and 2012. Using pooled model, they find that CEO compensation is conditioned to firm

size only. All other factors such as firm performance, board size, number of independent

directors, CEO duality and family CEO are reported to have no impact on CEO

compensation. However, Kashif and Mustafa (2012) is also plagued with similar difficulties

as Shah et al. (2009). For example, they do not control for unobserved heterogeneity and

endogeneity problem. In addition, lagged firm performance is missing in their analysis.

Besides Shah et al. (2009) and Kashif and Mustafa (2012), a number of studies explore

the impact of corporate governance and family ownership on firm performance in Pakistani

context. For example, using survey data for 37 corporate governance factors from 226 firms

of KSE, Nishat and Shaheen (2006-2007) make a broad summary measure (Gov-Score) of

corporate governance. Their performance measures include profit margin, return on equity,

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sales growth, Tobin’s Q and dividend yield. All of firm performance measures except

Tobin’s Q appear to be positively related to Gov-Score. Javed and Iqbal (2006) make an

index for corporate governance using 22 corporate governance variables from sample of 50

firms and find that corporate governance is positively linked to firm performance. The

corporate governance index they formulate is based on subjective weight assignment to 22

corporate governance variables which is debatable. Javid and Iqbal (2008) investigate the

factors which influence ownership concentration, and the link between ownership

concentration and firm performance using representative sample of 60 firms for the period

2003 to 2008. They find that Pakistani firms have more concentrated ownership which is

interpreted as response of weak legal environment. Further, concentrated ownership, family

ownership and foreign ownership have positive association with firm performance. They

argue that the identity of ownership matters more than the concentration of ownership.

Ibrahim et al. (2010) examine influence of board size, board independence and

ownership concentration of firm performance in chemical and pharmaceutical industries.

They find that return on equity (ROE) is positively influenced by corporate governance

variables. Yasser et al. (2011) test the relationship between four corporate governance factors

(board size, board composition, CEO/chairman duality and audit committee) and two firm

performance measures (profit margin, PM, and return on equity, ROE), for a sample of 30

Pakistani listed firms between 2008 and 2009. Their major finding includes positive

relationship of PM and ROE with three corporate governance factors (board size, board

composition and audit committee). However, the study does not find impact of CEO duality

on performance. In a recent study Jabeen et al. (2012) empirically examine the impact of

ownership structure on firm’s performance while controlling for contextual variables such as

firm size, firm age, risk, leverage using data from 62 non-financial firms for period 2006 to

2009. They find that family firms in Pakistan under perform as compared to non-family

firms. However, founder family and descendant family firms show no significant difference

in the performance.

2.2.2 Effect of Executive Compensation on Firm Future Performance

Besides considering pay as reward for performance, many studies investigate the

motivational role of pay including its components. Specifically, these studies examine how

CEO compensation is related to future firm performance however fewer studies examine this

relationship. For example, Hayes and Schaefer (2000), using data from Forbes Executive

Compensation Surveys from 1974 through 1995, find positive relation between cash pay and

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future performance. They argue that, under optimal contracting approach, if both observable

and unobservable performance measures are incorporated in CEO compensation and

unobservable performance measures are correlated with observable future performance

measures, then current compensation that is not explained by current observable performance

measures would be correlated to future observable performance measures. This leads to

hypothesize that current compensation can predict future performance. They further

hypothesize that when less preference is given to observable performance measures as basis

for compensation contracts, the current compensation becomes strong predictor of future

performance.

Regarding first hypothesis, Hayes and Schaefer (2000) find strong evidence suggesting

that future performance can be predicted using unexplained variation in current

compensation. This finding is robust to alternative model specifications. For the second

hypothesis, they find that higher variation in publically observable performance measure

leads to stronger relationship between current compensation and future firm performance

because higher variance in observable performance measure makes it noisier and less

preferable to use in devising compensation contracts. This finding is true for both market and

accounting measures of performance. Overall, the evidence is consistent with the argument

that boards of directors use unobservable information (to outsiders) as function of implicit

incentive pay contracts which makes current compensation a reasonable predictor of future

firm performance.

In the same vein, Kubo (2005) examines how pay-performance link motivates executives

to performance in future. Specifically, he tests the hypothesis that firms with higher pay-

performance sensitivity of directors outperform those with lower pay-performance sensitivity.

He uses sample of 210 firms listed in Japan for period 1993 to 1995. Basic characteristics of

directors’ pay show that, for most of the firms, in response to 1 percent increase in firm

performance the directors’ pay increases from zero to 0.33 percent and there are several firms

which have negative sign for pay-performance sensitivity. This suggests that overall pay-

performance relationship is weak in Japan. To test the implications of pay-performance

sensitivity for future firm performance, Kubo (2005) regresses the future performance on the

direct measure of pay-performance sensitivity. The results show that there is no support for

the hypothesis of positive relationship between pay-performance sensitivity and firm

performance. The results also confirm that there is no relationship between change in pay

policy and firm performance. Therefore, performance improvements induced by highly

geared incentive pay plans offered by firms are doubtful in Japan. Moreover, pay-

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performance sensitivity does not seem to motivate directors to perform in shareholder

interest.

Similarly, in a proclaimed to be the first study in UK context, Balafas and Florackis

(2014) examine whether excessive pay to CEOs lead to superior future stock and accounting

performance. They utilize the argument of Hayes and Schaefer (2000) that boards of directors

use unobservable (to outsiders) performance measures to reward CEOs for actions that may

increase the firm value (observable performance) in the long run. Importantly, consequences

of such actions may not reflect in the current observable performance. This implies that

efficient pay contracts, especially that include incentive-based compensation, may encourage

executives to exert significant effort to enhance the growth prospective of their firms which

in turn reduce the agency problems and creates the long-run value to the shareholders. These

arguments give rise to the potential relationship between current compensation and future

firm performance – ex-post effects of CEO pay on firm value. Using a sample of 1787 listed

firms on London Stock Exchange for the period 1998 to 2010, Balafas and Florackis (2014)

show that excessive CEO incentive compensation is inversely related to short-term future

stock returns. Interestingly, firms with CEOs getting incentive pay at the bottom of the pay-

distribution produce significantly positive abnormal returns and completely outperform their

counterparts that pay their CEOs at top of the incentive-pay distribution. Additional tests

show that the outperformance of low-incentive-compensation firms can be explained by their

excessive exposure to idiosyncratic risk. A panel regression analysis confirms the negative

relationship between incentive pay and future performance including operating performance.

Adithipyangkul et al. (2011) address the motivational aspect of perks (non-cash

compensation) in China. Specifically, they examine relationship of perks with current and

future firm performance. Using manually collected data (3706 firm-year observations) for

period 1999 to 2004, they document that, as expected, perks are positively related to both

current and future firm performance as measured by return on assets, indicating that perks are

used to reward the performance as well as to motivate the executives for future profitability.

In addition, analysis on stratified samples confirms that perks may motivate executives for

firm performance, even after controlling from firm characteristics such as leverage, growth

opportunities and firm size.

Using Granger causality tests, Buck et al. (2008) analyze the role of compensation as

reward and as motivation in China. They argue that although analyzing the sensitivity of

CEO compensation to stock price performance is a dominant approach to explore CEO pay-

performance relationship however, researchers normally ignore the motivational component

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and possibility of two-way causation in pay-performance relationship despite the fact that

commonly cited rationale for pay-performance relationship is motivation. Keeping in view

the Chinese institutional settings and compensation practices (absence of stock options based

compensation), they formulate two typical hypotheses related to two-way causation. First,

“there will be a positive relation between executive pay and past and current firm

performance, running from performance to pay” and second, “firm performance will be

positively related to levels of executive rewards, running with pay leading performance”.

They use four-year data on executive compensation from 2000 to 2003 for 601 firms out of

934 listed firms in 2000. Controlling for firm size and board size, they document that

executive pay-performance sensitivity is quite comparable to the sensitivity reported in

studies on Western markets. However, importantly, estimates depict that causality also run

from pay to performance, meaning that executive compensation and firm performance have

mutual effects on each other through both reward and motivation.

Option grants are advocated to be an instrument to reduce moral hazard problems and

align the mutual interests of agents and principals however, according to rent extraction view,

option grants can be used to compensate executives excessively if executives are in control of

the pay setting process (see, Bebchuk and Fried, 2003).

Consistent with former, Hanlon et al. (2003) show that stock option grants to top

management team (TMT) positively influence the future firm performance as measured by

operating income. Using 2,627 firm-year observation for the period 1998 to 2000 and

employee stock option (ESO) grants from 1992 to 2000, they find that one dollar value

(Black Scholes) of an option grant to TMT is related to approximately $3.71 operating

income over the next five years. However, tests of specification indicate that this relationship

between future operating earnings and option grant values is concave (increase with

decreasing rate). They further analyze option grant values using two- stage regression. In the

first stage, they regress option grant values on economic determinants such as growth

opportunities and cash constraints, and proxies for governance quality such as CEO duality,

interlock directorship and board structure. They find that ESO grant values are strongly

related to economic determinants however they do not find expected association between

ESO grant values and proxies for governance quality as predicted by rent extraction view. In

the second stage, future earnings are regressed on the predicted and residual ESO grant

values estimated in the first stage. The results show that earnings payoffs to ESO grant values

due to economic determinants are strongly positive, consistent with incentive alignment view.

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The payoffs to grant values attributed to governance variables are also positive, inconsistent

with rent extraction view.

Contributing to the debate between self-serving view and interest alignment view of

stock option grants, Kato et al. (2005) show that adoption of stock options, following a

regulatory change in 1997, has significant impact on operating performance in Japan. This is

consistent with the view that Japanese firms use stock options primarily to better align the

agents’ incentives with that of principals. Further, using event study methodology on 562

announcements of adoption of stock option plan by 344 firms, Kato et al. (2005) document

that adopting firms experience about 2% 5-day cumulative abnormal returns around the plan

adoption announcement. In addition, they find that abnormal returns are more positive for the

firms that grant larger portion of shares to board members and abnormal returns are less

positive for the firms that grant larger portion of shares to the lower level employees.

Moreover, firms with higher growth opportunities are more likely to adopt stock option plan.

High leverage and ownership of other corporations in the firm lead to less probability of

adopting stock option plans, indicating less use of incentive pay in the presence of other

monitoring mechanisms.

Relatedly, Fich and Shivdasani (2005) examine the effects of provision of stock option

plan on firm value. Using a sample of 2088 observations from 774 firms for the period 1997

to 1999 and fixed effect models, they show that presence of stock option plans for outside

directors have positive influence on market to book ratios. On average, the positive change in

magnitude of market to book ratio is 0.14 in response to presence of stock option plan for

outside directors. The relationship is consistently positive when various measures of

accounting performance are used instead of market to book ratio. Further analysis based on

an event study indicates favorable investor reaction to the announcement of stock option plan

for outside directors. Analysts also seem to revise their earnings forecasts following the

announcement of the option plan. Appointments of outside directors in firms with option plan

generate cumulative abnormal returns (CARs) near to zero but these CARs are significantly

negative when outside directors are appointed in firm without option plans. Thus, market

responds differently to appointment of outside directors when stock option plans are available

for directors. This leads to conclude that directors’ stock-option plans help align the

shareholder-director incentives, which in turn improves the firm value.

Malmendier and Tate (2009) examine firm performance subsequent to CEO awards

conferred by national media groups. Using hand collected list of award winning CEOs during

1975 to 2002, they document that both stock and operating performances decline following

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CEO awards. Parallel to that, award winning CEOs extract greater pay, mainly in the form of

shares and share options and this increase in pay following award is not shared by other top

executives in the firm. Further, winning CEOs appear to get involved in those activities (e.g.,

sitting on outside boards, writing books, playing golf) which provide more personal benefits

than benefiting to the firm. In addition, winning CEOs are more likely to involve in earnings

management. Moreover, these value destruction effects of CEO award are more prominent in

firms with poor shareholder rights and poor corporate governance practices.

2.2.3 CEO Compensation and Earnings Management

As discussed earlier in related theoretical section, the literature on performance

manipulation is based on the bonus maximization hypothesis (BMH) initially introduced by

Watts and Zimmerman (1986). BMH posits that managers in firms with cash bonus plans are

more prone to pick that accounting method which transfers reported earnings from future to

current periods, or vice versa, under specific situations. In a well cited paper, Healy (1985)

shows a strong link between accounting accruals and executives’ income-reporting incentives

under bonus contracts. He hypothesizes that executives are more likely to manipulate

earnings downward when their bonus plans are binding to some lower or upper threshold

level of earnings and in contrast, executives are more likely to manipulate earnings upward

when such bindings do not exist. In simple words, when income is so low that the choice of

accounting procedure would not lead to required level of income to earn bonus, executives

have incentives to further decrease the current income by adopting a ‘taking a bath’ strategy -

choosing accelerated write-offs or deferring sales. This decrease in current income would be

offset in the next period earnings. Similarly, if bonus touches its maximum that further

increase in income would not affect the bonus, executive have incentives to limit the earnings

at upper threshold.

Using a sample of 1527 year-observation for 94 companies from Fortune 250 over the

period 1930 to 1980, Healy (1985) shows that managers manipulate earnings upward when

earnings lag behind the minimum threshold level of bonus pay and in case, if managers’

bonus pay touches its maximum they manipulate earnings downward. Also, managers tend to

manipulate earnings downward when income is not likely to cross the minimum threshold

level. Further, he documents that adoption or change in bonus contract lead to greater chances

of voluntary changes in accounting procedures. But, executives do not seem to alter

accounting methods to reduce income in the presence of binding bonus plan lower or upper

bounds. Overall, the results are consistent with their hypotheses.

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Extending work of Healy (1985), Holthausen et al. (1995) investigate the confidential

data (443 year-observations) on CEO-specific short-term annual bonus plans for period 1980

to 1990. Consistent with Healy (1985), they find that in order to increase the present value of

bonus compensation contracts, managers manipulate earnings downward when bonus

payments touch their maximum. However, contrary to Healy (1985), they find no evidence of

downwards earnings manipulation by executives when earnings are below the lower limit

necessary to receive any bonus. These results are obtained using model developed by Jones

(1991) to estimate the discretionary accruals. They point out that Healy’s findings at lower

bound might be affected by his methodology.

Again extending work of Healy (1985), Gaver et al. (1995) examine bonus data of 102

firms in US for period 1980 to1990. However contrary to Healy (1985) they find that

executives choose income-increasing accruals when minimum targets of income before

discretionary accruals at which bonus would be paid are not met. Other results appear to be

consistent with Healy’s results. They argue that their results are more consistent with the

income-smoothening hypothesis than the bonus maximization hypothesis6.

Once again, Guidry et al. (1999) test the bonus maximization hypothesis through accrual

management however they focus on business unit level data of large conglomerates in US

arguing that business unit level data enhance the power of the test in two ways: 1) reduction

in potential aggregation problem that exists in firm level data, 2) elimination of potentially

confusing effects of equity-based compensation and long-term performance. Using 179 year-

observations over period 1993 to 1995, they show that business unit managers do manipulate

earnings to increase their bonus compensation. The results are consistent when different

proxies for discretionary accruals are used. However, the results are more pronounced for

inventory reserve account possibly. This is possibly because greater information asymmetry

that may exist between upper management and business unit managers in case of inventory

valuation.

Change in accounting policy can affect the accrual income and so the executive bonuses.

Healy et al. (1987) examine the link between change in accounting policy and CEO salary

and bonus compensation. They select two changes in accounting policies. One is change of

inventory method i.e. from FIFO to LIFO and the other is change in depreciation method i.e.

from accelerated to straight-line. They first examine the adjustment of earnings based

6 When income before discretionary accruals remains below the lower bound, the bonus-maximization hypothesis predicts negative (income decreasing) discretionary accruals while the income-smoothening hypothesis suggests positive (Income increasing) discretionary accruals.

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compensation subsequent to change in accounting policy and then adjustment of

compensation model parameters to cancel out the earnings effect of change in accounting

method. Using data on 52 firms that shift from FIFO to LIFO and 38 firms that shift from

accelerated to straight-line depreciation method over period 1967 to 1976, overall, they find

that potential decrease in CEO salary and bonus subsequent to shift to LIFO is 2.3 percent per

year. CEOs do not appear to resist the switch to LIFO despite adjustment to their

compensation does not occur and they bear loss in their remuneration. In the same way,

potential increase in CEO salary and bonus subsequent to shift to straight-line depreciation is

nearly 1.5 percent per year. Therefore, CEO benefit appears to be small even if adjustment to

their remuneration subsequent to accounting policy change does not occur.

As research on earnings management flourished, researchers start examining the

relationship between executive compensation and earnings management using discretionary

accruals. For example, Balsam (1998) uses 3439 firm-year observations over period 1990 to

1993 and finds a positive association between discretionary accruals and CEO cash

compensation after controlling for increase in share price and nondiscretionary components

of income. However, the association varies with the sign of discretionary accruals. CEO cash

compensation appears to be associated with positive discretionary accruals only. Further, this

association varies with the firm situation i.e., cash compensation is more strongly associated

with positive discretionary accruals when discretionary accruals are used to attain the firm’s

earnings goals. In addition, as level of discretionary accruals increases, the relationship

between CEO cash pay and reported net earnings gets stronger. However, at extreme level of

high discretionary accruals, the relationship appears to be insignificant. This is consistent

with the argument of putting a limit on the management’s ability to increase its pay using

discretionary accruals.

Relatedly, Carter et al. (2009) report that changes in the executive bonus compensation

structure are associated with changes in earnings management behavior. They examine the

relationship between executive bonuses and earnings during pre and post period of

implementation of Sarbanes-Oxley act and other related reforms. Using a sample of 11,113

CEOs and 8,814 CFOs for period 1996 to 2005, they document that as chances of earnings

management decrease after the reforms due to less flexible financial reporting environment,

firms start placing more weight on earnings variations (a greater effort incentive) in the bonus

contracts. The relation between earnings increases and bonuses is stronger in the post

implementation period. The most affected firms by the reforms that show the largest

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reduction in positive discretionary accruals present the largest increase in the weight on

earnings variations in bonus contracts.

In the same vein, using a sample of 1407 Chinese listed firms during the period from

2002 to 2008 Ye (2014) examines the relationship between independent directors’ cash

compensation and earnings management. Contrary to incentive hypothesis advocated by

Adams and Ferreira (2008) that high cash compensation to independent directors provides

incentives for effective monitoring which in turn restrain earnings management, he

documents that directors’ cash compensation is positively related to the magnitude of

earnings manipulation. He maintains that his results are consistent with reciprocity hypothesis

which states that independent directors receiving higher cash compensation may compromise

their independence and reciprocate higher cash compensation by decreasing the level of

monitoring of insiders (Brick et al., 2006).

The performance manipulation by executives may also be influenced by stock

ownership, long term incentives and equity compensation (Ibrahim and Lloyd, 2011). For

example, using a sample of 266 restated firm-years and around 8,000 non-restated firm-years

during 1995 to 2001, Burns and Kedia (2006) show that CEO’s option portfolio sensitivity to

stock value is positively associated with tendency to misreport. However, they do not find

any significant impact of cash compensation, bonuses, restricted stock, equity and long term

incentive on tendency to misreport the financial statements. The stronger incentive to

misreport in case of stock option is claimed to due to 1) less downside risk on detection of

misreporting due to convexity in CEO wealth brought by stock options, 2) facilitation by

stock option in exit strategies for CEOs for example, CEOs may pool with other managers

that exercise options for diversification and liquidity reasons.

Similarly, Armstrong et al. (2010) examine the relationship of CEO compensation and

equity holdings with accounting irregularities. They use a broader sample relative to prior

studies consisting of 9,118 CEO-firm-year observations (4,559 matched pairs). By employing

a propensity-score matched-pair research design, argued to be more robust as compared to

traditional logistic regressions, they observe that level of CEO equity incentives is weakly

related to shareholder complaints of manipulating accounts, events of accounting related

restatement and Accounting and Auditing Enforcement Releases (AAERs). In fact, they

observe some evidence of lower number of incidents of accounting irregularities in firm with

CEOs receiving higher equity-based compensation compared to firms with CEOs receiving

lower equity-based compensation in a similar contracting environment. Therefore, equity

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incentives are argued to be effective in aligning shareholder-management interests with

respect to financial reporting.

Using Standard & Poor's ExecuComp database for the period 1993-2000 Cheng and

Warfield (2005) examine the relationship between equity incentives (stock ownership and

stock based compensation) and earnings manipulation. They find that executives receiving

higher equity incentives are more likely to offload their stock in the year subsequent to

earnings announcement. Further, when executive compensation packages contain high

proportion of equity incentives, executives seem to be more involved in earning manipulation

to meet or beat analysts’ forecasts. However, they show that consistently higher equity

incentives to the executives lead to lower chances of reporting larger positive earnings shocks

which is consistent with earning smoothing hypothesis.

While study Cheng and Warfield (2005) suggest that equity incentives provide incentives

to executives to manage earnings, Duellman et al. (2013) document that equity incentives

lead to lower (higher) level of earnings management in the presence of higher (lower) level of

monitoring. They argue that intense monitoring has an interest alignment effect on the

relationship between equity incentives and earnings management, leading to lower level of

earnings management. On the other hand, as monitoring intensity decreases, executive would

likely to behave opportunistically and consequently possibility of earnings management

would increase. They use a sample of 4780 firm-year observations from 1074 distinct firms

during 2001 to 2007.

Timing of exercise the stock option is important especially when CEOs are rewarded in

form of stock options. Bartov and Mohanram (2004) examine the executives’ ability to time

stock option exercise and how that is related to earnings management. After analyzing more

than 1200 firms for the period 1992 to 2001, they document stock price reversal around the

year in which top executives unusually exercise large stock options. They further show that

managers use private information to time the large exercise of stock options. In addition,

earnings are found to be abnormally high in the pre-exercise period, whereas in the post-

exercise period earnings are abnormally low. Overall, evidences suggest that executives have

the ability to time the abnormally larger exercise of options and inflate earnings before

exercising these options to receive greater payouts.

In a similar study Bergstresser and Philippon (2006), using about 4,500 year-observation

during 1990s, show that when CEOs total compensation is more strongly linked to value of

shares and stock options, the use of discretionary accruals to manipulate reported income is

more prevalent. In addition, abnormally higher option exercises and sale of stocks by CEOs is

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significantly linked to period in which high discretionary accruals make up large part of

reported earnings.

Likewise, Alves (2012) examines 33 non-financial Portuguese listed firms for the period

2003 to 2010 and finds that likelihood of earnings management increases when executives

hold stock options. This seems consistent with opportunistic financial reporting by the

executives. She suggests stock option grants to management appear to be affecting the

information quality, leading to lower value relevance of publically available information.

Since chief financial officer (CFO) is supposed to be responsible for financial reporting,

therefore equity incentive offered to CFO may induce earnings management. Taking on this

argument Jiang et al. (2010b) examine the relationship between CFO equity incentives and

earnings management. Using a sample of 17,542 firm-year observations on CEO and CFO

compensation available with ExecuComp database during 1993 to 2006, they find that CEO

and CFO equity incentives appear to be inducing earnings management however earnings

management as measured by the likelihood of beating analyst forecast and level of accruals is

more responsive to CFO equity incentives. In addition, influence of CFO equity incentives on

earnings management is independent of CEO equity incentives. These findings are claimed to

support new disclosure requirement on CFO compensation by Security and Exchange

Commission (SEC). Moreover, analysis shows that the association of equity incentives of

CEO and CFO with accrual-based earnings management seems to fade away in the post

Sarban Oxley Act (SOX) period.

2.2.4 Summary of Empirical Research

A profound review of relevant literature suggests that it is difficult to establish a straight

forward relationship between CEO compensation and firm performance. Overall, the

empirical literature seems to partially support both optimal contracting and managerial power

approaches (see, Bebchuk and Fried, 2003, Chen et al., 2011, Devers et al., 2007, Frydman

and Jenter, 2010, van Essen et al., 2012b). Importantly, pay-performance relationship is

largely conditioned to socio-economic and institutional peculiarities prevailing in the

economies under examination (Hüttenbrink et al., 2014, Sun et al., 2010, van Essen et al.,

2012a, van Essen et al., 2012b). Thus, the relationship in question is complex and somewhat

country specific.

In US where ownership is diffusely held and legal institutions are strong, the evidence

suggest that the relationship between CEO compensation and firm performance is statistically

significant and pay for performance sensitivities have increased over the last three decades

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(see, e.g., Frydman and Saks, 2010, Guillet et al., 2012, Sun et al., 2013). This indicates the

utilization of pay for performance relationship to align the executive incentives with

shareholders’ interest. Further, pay for performance sensitivities are higher for top

management as compared to middle management (Aggarwal and Samwick, 2003). However,

although, the pay-performance link seems statistically significant but it is considered to be

weak economically (Tosi et al., 2000). Regarding governance factors, ownership

concentration appears to be reducing the CEO entrenchment effect and related to lower CEO

compensation (Amoako-Adu et al., 2011, Core et al., 1999). Board size, greater number

outside directors appointed by CEO, greater number of gray outside directors and CEO

duality are related to higher CEO compensation in US (Core et al., 1999).

In European countries, family ownership structure is more common than in US (Croci et

al., 2012) however laws of investor protection are well enacted and formal institutions are

effective. The empirical evidence on Europe suggests that there is weak or insignificant pay

for performance relationship. For example, in UK, while Ozkan (2007) finds insignificant

pay-performance relationship, Ozkan (2011) find statistically significant but lower pay for

performance sensitivity as compared to the sensitivity in US. Similarly, pay for performance

link appears to be weak in Italy, Portugal, Denmark and Scandinavian countries (Banghoj et

al., 2010, Brunello et al., 2001, Fernandes, 2008, Randøy and Nielsen, 2002) with exception

of Netherlands where Laan et al. (2010) find some strong evidence of pay-performance

relationship. Nevertheless, using data from 14 Continental European countries, Croci et al.

(2012) report that firm performance as measured by market adjusted stock return, does not

have any significant impact on CEO compensation. Regarding corporate governance

variables, it appears that family ownership, blockholders and institutional ownership are

related to lower CEO pay in European studies (Croci et al., 2012, Ozkan, 2007, Ozkan,

2011). However, Banghoj et al. (2010) show that ownership concentration is related to higher

CEO pay in private firms of Denmark. Higher board size is generally related to higher CEO

compensation in European countries. Higher percentage of non-executive director is also

related to higher CEO compensation (Ozkan, 2007). In addition, pay-performance sensitivity

is low in firms with greater number of non-executive directors sitting in the board

(Fernandes, 2008).

Most of the Asian economies are considered to be emerging. In these countries, firms

face heavy government intervention on business activities through taxation, regulation, and

state ownership (Fan et al., 2011). Governments influence and control various aspects of

business: from output, production process, to input such as labor, energy, land, mines,

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infrastructures, and financing (Fan et al., 2011). In addition, many emerging markets share

weakness in their financial market development and many governments still control or

influence allocating financial resources based on not just market rules but also other strategic

criteria (La Porta et al., 2002). Overall, formal institutional setup is weak in these markets.

Contrary to US and European countries, executive compensation research in Asia has

come up with more complex findings. Although, the majority of studies find a statistically

significant positive association between pay and firm performance however, there are some

inconsistencies across different sectors and companies. For example, Firth et al. (2006) and

Firth et al. (2007) find that overall CEO compensation is positively related to firm accounting

performance as well as to stock market performance measures in China. However, firms that

have ownership dominated by State agency do not exercise performance based compensation

plans. Similarly, Kato and Long (2006) report positive pay-performance relationship in China

in general however, this association is weak for state owned firms, indicating ineffectiveness

of state-owned firms in resolving agency problems. Su et al. (2010) find significant positive

association between executive compensation and return on assets for both SOEs and non-

SOEs. Mengistae and Xu (2004) find that although pay for performance relationship is

positive however, CEO semi-elasticity to profitability is lower in China than in US. Conyon

and He (2011) show that sum of salary and bonus in US is nearly seventeen times greater

than the compensation in China. However, they find that executive compensation is

significantly positively associated with firm performance in China. In another study, Conyon

and He (2012) find that association of CEO compensation with firm performance is stronger

for accounting performance than market performance in China. Further, they show that

economic determinants of CEO compensation such as firm performance, firm size and CEOs’

human capital are more important than ownership and corporate governance after accounting

for pay persistence and unobserved firm level heterogeneity. Mitsudome et al. (2008) find

that CEOs in Japan and US are rewarded for contemporaneous firm performance however,

pay for performance relationship is more persistent in Japanese firms. Kato et al. (2007)

show in Korea that CEO cash compensation is significantly associated with stock

performance only and the magnitude of the relationship is quite comparable to Japan and US.

However, this pay for performance relationship is mainly driven by non-Chaebol firms. In

Indian market, Ghosh (2010) find positive association between pay-performance however the

magnitude is small.

Concentrated ownership appear to have significant influence on CEO compensation in

US, UK and other European countries. However, only handful of studies examine the

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relationship between ownership concentration and executive compensation in Asia. These

studies report mixed results. For example, Conyon and He (2011) report that concentrated

ownership lead to lower CEO incentives and executive compensation in China. However,

Conyon and He (2012) find that concentrated ownership does not have significant influence

on CEO compensation. Similarly, Su et al. (2010) find no such evidence for SOEs in China

but find U-shaped association between concentrated ownership and CEO compensation in

non-SOEs. Wang and Xiao (2011) show that majority shareholding is an important

determinant of adopting performance based compensation schemes. Basu et al. (2007) report

that higher stock ownership by the board appears to be related to higher executive

compensation, suggesting an entrenchment effect of management. Surprisingly, influence of

family ownership on CEO compensation is rarely studied in Asia. However, the results

support the expropriation view. For example, Kato et al. (2007) examine influence of family-

group, Chaebol, on pay-performance relationship in Korea and report insignificant directors’

pay-performance relationship in Chaebol firms. Basu et al. (2007) investigate family

influence on level of executive compensation in Japan and report that executive receive

higher pay in family firms.

The studies examining influence of board structure variables on CEO compensation are

also limited in Asia and report mixed results. For example, in China, Firth et al. (2007) report

that higher board size leads to lower CEO compensation. While higher number of non-

executive directors has positive impact on CEO pay-performance sensitivity, CEO duality

tend to reduce pay-performance sensitivity. In contrast to this, Conyon and He (2011) show

that board size, number of independent directors and CEO duality do no significantly affect

level of executive compensation or executive pay-performance sensitivity. Similarly, using

more comprehensive data from China and robust methodology, Conyon and He (2012) find

that effects of these corporate governance variables on the level of CEO pay and CEO pay-

performance sensitivity are insignificant. In Japan, Basu et al. (2007) find that presence of

outside director reduces the executive compensation but board size does not have any effect.

Ghosh (2006) also reports for India that board size does not affect CEO compensation.

However, number of non-executive directors and CEO duality are positively related to CEO

compensation in India.

Although pay as reward for performance is extensively studied area however research on

influence of pay on future performance being as motivation to perform in future is important

and exists concurrently. Overall, the empirical literature reviewed here suggests that pay does

have influence on future firm performance directly (e.g., Adithipyangkul et al., 2011, Balafas

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and Florackis, 2014, Hayes and Schaefer, 2000) and indirectly in response to stock options

included in the pay plans (e.g., Fich and Shivdasani, 2005, Hanlon et al., 2003, Kato et al.,

2005). However, similar to pay-for-performance relationship, performance-for-pay

relationship also seems to be moderated by the same institutional, socio-economic and socio-

cultural factors.

In sum, CEO compensation research is puzzling and lack consensus and generalization.

The pay-performance relationship is considerably different across the countries of different

regions. Similar differences exist for the effects of concentrated/family ownership and board

structure variables on the level of executive compensation and pay-performance sensitivity.

These differences appear to be due to the differences in formal (rule of law and legal investor

protection) and informal institutional (ownership concentration and code of good corporate

governance) settings that protect investors from executive underperformance and

overcompensation (van Essen et al., 2012a). Given the countrywide differences in the

institutional contexts, it is important to understand how firm performance and corporate

governance practices contribute towards CEO compensations contracts indigenously in

different regions. This study aims to examine how CEO compensation is influenced by firm

performance and corporate governance practices in an emerging market, Pakistan, which is

characterized by high concentrated ownership and family control environment and where

institutional environment is weak.

It is an established fact that Asian socio-economic and behavioral peculiarities, and

institutional settings (formal and informal) are different from Western World and studies

conducted in Western World have limited implications for Asian countries (Fan et al., 2011,

Ghosh, 2006, Hofstede, 1980, Sun et al., 2010, van Essen et al., 2012a). However, within

Asia, Pakistani context is different from other Asian countries like China, Japan and Korea

where most of the Asian studies on executive compensation are based. For example, first,

disclosure requirement about CEO compensation is stronger in Pakistan. Companies are

required to report all the components of CEO compensation. This is not the case for most of

the other Asian countries (see, e.g., Basu et al., 2007, Conyon and He, 2011, Kato et al.,

2007). Therefore, there is more reliable and accurate data available in Pakistan which can

provide better insight into CEO compensation relationships with firm performance and

corporate governance.

Second, concentrated and family ownership is more common in Pakistan than in Japan

and Korea. Although, in China, firms have more ownership concentration than in Pakistan

however that ownership concentration is due to high stake of the government. In Pakistan

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concentrated ownership is maintained by non-government shareholders. Non-government

ownership concentration makes firms like private owned firms which may have different

implications for CEO compensation. However, the evidence on how concentrated/family

ownership affects CEO compensation almost does not exist in Pakistan.

Third, legal and political environment is weaker and overall governance is poor

(Rehman et al., 2012). Laws are often passed but their implementation is a big issue in

Pakistan due to political influences. In addition, there is more foreign influence on

governance and corporate environment. Pakistan has been under the influence of

International Monetary Fund (IMF) and other funding agencies for so long. Moreover,

Pakistani economy is plagued with more corruption than many Asian countries. According to

Transparency International, the Corruption Perception Index (CPI) never cross 30 for

Pakistan (100 shows no corruption), indicating highly corrupted economy. Also government

effectiveness index and regulatory quality index estimated by World Bank remained negative

in the last decade or so. All this makes executives more prone to unethical and opportunistic

behavior (Mujtaba and Afza, 2011) which might lead to opportunistic executive

compensation not justified against performance. Therefore, it is important to examine how

firm performance and corporate governance practices affect executive compensation in

Pakistan.

Given all the differences, Pakistani market provides a unique context to study CEO

compensation and its implications. Pakistani context is not only different from Western

World but also different from other Asian countries. Moreover, as reforms in corporate

governance deepen in Pakistan and all the responsibility of setting CEO compensation lies

with the board of directors, it is important to study how boards see firm performance as a

determinant of CEO compensation, what role concentrated/family ownership plays in setting

CEO pay, how board structure affect CEO compensation decisions and finally whether CEO

compensation motivate manipulation of firm performance. Thus, overall, this study adds to

the debate in international literature especially in Asian literature on CEO compensation, and

respond to the recent calls (e.g., Fan et al., 2011, Sun et al., 2010) for more research on

executive compensation in Asian context.

With regard to the relationship between executive compensation and earnings

management, several studies (e.g., Balsam, 1998, Carter et al., 2009, Guidry et al., 1999,

Healy, 1985), in general, seem to support the argument that managers do manipulate earnings

to maximize their bonus compensation. The empirical evidence also suggests that managers

receiving equity incentives involve in earnings management and tend to give signals to the

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market that favor their trade of stock they hold and exercise of stock options. Nevertheless,

better monitoring and sensitivity of pay-performance relationship seem to be some of the

important factors that determine the intensity of the relationship between executive

compensation and earnings management (see, e.g., Burns and Kedia, 2006, Duellman et al.,

2013). However, as discussed earlier corporate governance practices and pay-performance

sensitivity varies with institutional settings under examination therefore may lead to different

results across the countries. The examination of the influence of CEO compensation is an

added contribution of this study in Asian context as there are very limited studies that focus

on this issue in Asia.

On the methodological front, the extant literature shows inconsistencies in the

methodological procedures while examining executive compensation. For example, many

executive compensation studies are cross sectional however in the last decade panel models

seem to replace the cross section models (Devers et al., 2007). But, most of the studies use

only pooled regressions and does not control for unobserved heterogeneity across industries

or firms. In addition, assumptions of heteroskedasticity and serial correlation seem to be

violated which may lead to biased results. Furthermore, there are very few studies (e.g.,

Conyon and He, 2012, Croci et al., 2012, O'Connor and Rafferty, 2010, Ozkan, 2011,

Yoshikawa et al., 2010) in executive compensation that take into account the problem of

endogeneity, indicating methodological limitations in the extant literature.

The existing evidence on CEO compensation in Pakistan is very limited. There are only

two published studies. However, these studies only examine the effect of current firm

performance on CEO compensation but not of the previous firm performance, therefore,

ignore the influence of an important factor. Further, there is no evidence in Pakistan on the

motivational aspects of CEO compensation, for example, 1) evidence related to influence of

CEO compensation on future firm performance and 2) CEO compensation induced earnings

management. In addition, many studies in Pakistan on corporate governance including studies

on CEO compensation use small sample size with relatively shorter time period. For

example, most of the Pakistani studies discussed in literature review section use sample data

consisting of 30 to 114 firms for period of maximum 5 years. Given that there are about 400

non-financial and 250 financial listed companies in Pakistan, the possibility of sampling

biased is greater in these studies. The current study controls for methodological difficulties

and attempt to examine CEO compensation using the most recent and robust methodologies.

Therefore, this study has important policy implications for investors, practitioners and

regulators.

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Chapter 3

Methodology

70

3.1 Research Philosophy

A research philosophy is an idea or belief about the way in which data about a

phenomenon is collected, examined and interpreted (Saunders et al., 2012). The researchers

need to be aware of their philosophical commitments in terms of choice of research strategy

because this has significant impact not only on what they do but they understand what it is

they are researching (Johnson and Clark, 2006). The decision about an appropriate and

relevant research philosophy depends upon the ontological, epistemological and

methodological considerations. The following lines describe these considerations and

research philosophy adopted for this study.

3.1.1 Ontological Considerations

Ontology is defined as “…claims and assumptions that are made about the nature of

social reality, what exists, what it looks like, what units make it up and how these units

interact with each other. In short, ontological assumptions are concerned with what we

believe constitutes social reality” (Blaikie, 2000, p. 8). The primary point of concern here is

the question whether social entities can and should be regarded as objective entities having a

reality external to social actors, or whether they can and should be regarded as social

constructions built up from the perception and actions of social actors (Bryman, 2012). These

positions are often referred to as objectivism and constructivism respectively.

Objectivism implies that social phenomena and the categories that we come across have

an existence that is separate or independent from actors (Bryman, 2012). For example, as

Bryman (2012) states, an organization can be discussed as a tangible object. It has

standardized procedures to get things done. It has rules and regulation. There exists an

organizational hierarchy. It has goals and a mission statement. The existence of these features

vary from organization to organization, however in thinking we tend to view that an

organization has a reality which is independent and external to the people who inhabit it. The

organization corresponds to a social order in that people working in the organization are

under pressure to conform to the requirements set by the organization. They learn and follow

rules and regulations. They do their jobs according to their job descriptions. They follow

standardized procedures. They are made to learn and apply the organizational values. They

may be penalized or even fired if they do not work as per the organization requirements.

Thus, the organization shapes the people as per its own requirements.

Contrary to that, constructivism also known as subjectivism implies that social

phenomena and categories that we come across are not only created through social interaction

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of actors but that they are constantly changing (Bryman, 2012). For example, a psychiatric

hospital as an organization can be thought of as social entity constructed through social

interactions of individuals because relatively little of the spheres of action of doctors, nurses,

and other personnel is generally prescribed, the social order of the hospital can be an outcome

of agreed-upon patterns of action that are themselves the products of negotiations between

the different parties involved and it can be in constant state of change (see, Bryman, 2012,

Strauss et al., 1973).

Given the objectives of current study, it is assumed that the relationships between CEO

compensation, firm performance and corporate governance (phenomena) do exist in real

(single reality) and are independent and external to social actors. This reality can be

observable and regarded as objective. Thus, ontologically, this study implies the objectivists

position.

3.1.2 Epistemological Considerations

Epistemology is concerned with the acquisition of knowledge and is related to the

question that how we know what we know. It is defined as “…the possible ways of gaining

knowledge of social reality, whatever it is understood to be” (Blaikie, 2000). Bryman (2012)

states that “An epistemological issue concerns the question of what is (or should be) regarded

as acceptable knowledge in a discipline”. Epistemology has two fundamental positions. One

is positivism and the other is interpretivism. “Positivism is an epistemological position that

advocates the application of the methods of the natural sciences to the study of social reality

and beyond” (Bryman and Bell, 2011). Positivism maintains that the knowledge can

genuinely be regarded as acceptable knowledge if it is confirmed by the senses in a scientific

way. The objective of theory is to generate testable hypotheses. These hypotheses are

confirmed or rejected through data collection and analysis and contribution is made towards

the explanation or development of theory. This requires the use of an optimal and well-

structured research methodology and techniques by the researcher (Bryman and Bell, 2011).

Positivism further stresses that the scientific research must be conducted objectively and

should be independent of values. In addition, positivism asserts to make clear distinction

between scientific and normative statements and advocates the supremacy of scientific

statements over normative ones (Bryman, 2012).

On the other hand as stated by Bryman (2012), “interpretivism is a term that usually

denotes an alternative to the positivist orthodoxy that has held sway for decades. It is

predicated upon the view that a strategy is required that respects the differences between

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people and the objects of the natural sciences and therefore requires the social scientist to

grasp the subjective meaning of social action”. Interpretivism requires researchers to try to

understand and make sense of the surroundings. And this is done in a continuous way by

interacting with others and giving meaning to the perceptions about others based on this

interaction (Saunders et al., 2012).

Given the ontological position of the study as objectivist, epistemologically, this study

implies the positivist position. Different theories are used to develop hypotheses about the

reality then these hypotheses are tested using a well-structured methodology and inference is

made about the observed phenomena. The observer remains external to the reality and is not

influenced, or does not influence the observed phenomena. Overall, the research is conducted

in a scientific way.

3.1.3 Methodological Considerations

There are two research approaches, deductive and inductive. In deductive approach,

hypotheses are developed about the relationships between the concepts or variables from an

existing theory, a set of theories or existing literature. These hypotheses are expressed in

operational terms indicating how variables in questions are to be measured. Data is collected

and analyzed. Then based on the findings, hypotheses are confirmed or rejected. Finally,

theory(theories) is(are) updated if necessary. On the other hand, in inductive approach, data is

collected and analyzed first and then generalizable inferences are drawn from the analysis to

make a theory (Bryman, 2012).

Bryman and Bell (2011) suggest that the deductive approach in research is typically

related to positivist position. Therefore, given the ontological position of the study as

“objectivist” and epistemological position of the study as “positivist”, this study employs a

deductive research approach as a methodological consideration. The contribution of firm

performance and corporate governance practices towards CEO compensation is explored.

The arguments are derived mainly from agency theory and managerial power theory. The

extant theoretical and empirical literature provides a strong background for the relationships

under consideration. This enables the researcher to advance the research hypotheses. Then

data is collected and analyzed, and outcomes are used to confirm or reject the hypotheses.

And finally explanations are provided for confirming or rejecting the hypotheses.

Another challenge in methodological consideration is the choice of quantitative vs

qualitative approaches to data collection and analysis. The quantitative approach is referred to

as “a research strategy that emphasizes quantification in the collection and analysis of data”

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(Bryman, 2012, p. 35). The quantitative approach represents objectivist ontological position

and view social reality as external, embodies positivist epistemological position and

incorporate the norms and practices of the natural scientific model, and involves a deductive

approach to research with emphasis on testing of theories (Bryman and Bell, 2011, Saunders

et al., 2012). On the other hand, qualitative approach is referred to as “a research strategy that

usually emphasizes words rather than quantification in the collection and analysis of data”

(Bryman, 2012, p. 36). The qualitative approach represents constructivist ontological

position, embodies interpretivist epistemological position and rejects the norms and practices

of the natural scientific model, and accentuates an inductive approach to research with

emphasis on the creation of theories (Bryman, 2012).

The study adopts a quantitative approach in data collection and analysis based on

objectivist ontology position, positivist epistemology position and a deductive approach to

research. A survey database methodology is used for data collection based on

longitudinal/panel data for eight time horizons through secondary data sources.

Ontology

Objectivist

Epistemology

Positivist

Methodology

Deductive Approach

Quantitative Analysis

Figure 3.1

Research Philosophy

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3.2 Hypotheses Development

3.2.1 CEO Compensation and Firm Performance

Agency theory (Jensen and Meckling, 1976) is the standard approach to executive

compensation. In this theory, shareholders have two options to solve the agency problems.

First, they obtain more information about managers’ behavior and actions (effort) with better

monitoring and curtail self-interested behavior. Second, they design such compensation plans

that provide managers with incentives in a way that managers’ interests become aligned with

shareholders’ interests. Since shareholders can only imperfectly monitor managers’ actions,

or doing so incur heavy monitoring costs therefore, as a result, shareholders opt to design

optimal compensation plans that attract, retain and motivate executives to perform in the best

interest of the shareholders i.e. to maximize shareholders’ wealth. As managers are assumed

to be risk-averse and self-interested therefore, they would adhere to the incentives provided

by optimal compensation contracts and would make more effort, leading to an outcome that

is more desirable by the shareholders. This predicts a link between executive compensation

and firm performance.

Family and concentrated ownerships are common in Pakistani firms. Ownership

concentration and family ownership provide strong incentives to large shareholders to

oversee managers’ activities (Jensen and Warner, 1988). Therefore, concentrated ownership

generally suggests that shareholders are able to better protect their interests in their

companies, leading to mitigating potential CEO entrenchment and relatively strong

association between CEO compensation and firm performance.

Code of corporate governance in Pakistan makes board of directors responsible for

designing CEO compensation contracts. However, direct relations between controlling

shareholders/families and management in Pakistan, generally, lead to bypassed boards in

decision making (Kamran and Shah, 2014, World Bank, 2005), resulting in more powerful

CEOs than the boards of directors. In addition, formal institutions such as legal system and

investor protection are weak in Pakistan, making CEOs more prone to behave

opportunistically. Thus, given this context, CEOs are more likely set their own pay

opportunistically which is less likely to be correlated with firm performance. However, going

with standard approach i.e. agency theory, this study makes the main hypothesis that:

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Hypothesis 1: Firm performance has a positive effect on CEO compensation.

3.2.2 CEO Compensation and Corporate Governance

Designing optimal contracts for executives and better monitoring go side by side in

solving agency problems. As an efficient corporate governance structure provides close

monitoring and oversight of management, therefore in the presence of strong corporate

governance, the total executive compensation would be low and be linked to firm

performance. On the other hand, weak corporate governance may make executives more

powerful relative to board of directors, leading to more influence on pay-setting process for

higher compensation which may not be linked to firm performance.

A number of corporate governance indicators have been reported to influence the CEO

compensation (see, e.g.,Core et al., 1999, Devers et al., 2007, van Essen et al., 2012b). In

Pakistan, several studies (e.g., Awan, 2012, Ibrahim et al., 2010, Javed and Iqbal, 2006, Javid

and Iqbal, 2008, Khatab et al., 2011, Nishat and Shaheen, 2006-2007, Yasser et al., 2011)

examine the impact of corporate governance on firm performance, however, none of these

examine the relationship between executive compensation and corporate governance. The

only exceptions are Shah et al. (2009) and Kashif and Mustafa (2012). Both suggest that

board size has positive effect on CEO compensation. However, Shah et al. (2009)

additionally suggest that ownership concentration is also positively while board independence

is negatively related to CEO compensation.

A number of corporate governance variables have been reported to influence the CEO

compensation, however, there influence seems to be conditioned to the context under

examination. (see, e.g.,Core et al., 1999, Devers et al., 2007, Sun et al., 2010, van Essen et

al., 2012b). Since concentrated and family ownership is an important feature of corporate

governance environment in Pakistan and board composition has been one of the major

focuses in the Code of corporate governance to mitigate the agency conflicts (see, SECP,

2002, SECP, 2012), therefore we focus on concentrated/family ownership and board structure

(Board size, Board Independence and CEO duality) in this study. The hypotheses related to

each variable are discussed in the following section.

3.2.2.1 Ownership Concentration, Family Ownership and CEO compensation

Concentrated and family ownership can affect CEO compensation contract in two

competing ways, 1) interest alignment effect and 2) entrenchment effect. According to

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interest alignment effect, which relates to agency theory, large or family shareholders have

strong incentives to oversee agents’ activities because of being insiders, strong commitment

and better firm specific knowledge (Bertrand and Schoar, 2006, Harris and Raviv, 2008,

Jensen and Warner, 1988, Su et al., 2010). Therefore, concentrated and family ownership

generally suggests that shareholders are better able to protect their interests in their

companies, leading to reduced managerial opportunism, higher interest alignment and lower

CEO compensation.

However, according to entrenchment effect, family or controlling shareholders can

expropriate minority shareholders’ interests through many ways including excessive

compensation packages (Croci et al., 2012, Su et al., 2010, Wang and Xiao, 2011). Similarly,

CEOs in close relation with controlling shareholders or a family may set their own pay

opportunistically high, thereby expropriating the minority shareholders’ wealth. Although, a

few studies (e.g., Abdullah et al., 2011) suggest that there is likelihood of expropriation of

minority interests by controlling/family shareholders in Pakistan however going with interest

alignment effect, this study hypothesize that:

Hypothesis 2: Ownership concentration has a negative impact on CEO compensation.

Hypothesis 3: Family firms pay lower CEO compensation as compared to non-family

firms.

3.2.2.2 Board Size and CEO Compensation

Board size is considered to be an important determinant of board effectiveness, leading

to significant contribution to quality of governance (Jensen, 1993, Lipton and Lorsch, 1992).

Large board size is likely to have a greater level of expertise. However, it may become so

heavy, leading to ineffective executive monitoring (Jensen, 1993). Boards are less likely to

function effectively and are easier to be controlled by executive when board members exceed

seven or eight (Jensen, 1993). Similarly, Lipton and Lorsch (1992) suggest that larger board

size leads to problem of dysfunctional boards and recommend limiting board size to ten

directors. Larger boards may also suffer from communication and coordination difficulties,

leading to board ineffectiveness (Ozkan, 2007, Yermack, 1996). Thus, larger boards are

assumed to compromise their monitoring role and hence weaken the internal governance

structure. Consequently, executives gain more power over the internal control mechanisms,

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leading to more influence on their own pay, resulting in higher executive compensation.

Many studies find that larger boards are related to higher executive compensation (e.g., Core

et al., 1999, Croci et al., 2012, Fahlenbrach, 2009, Kashif and Mustafa, 2012, Ozkan, 2011,

Shah et al., 2009, van Essen et al., 2012b).

In Pakistan, board size generally tends to be driven by directors appointed from the

controlling families or by proxy directors working on behalf of controlling shareholders.

Consequently, it is less likely that board size has any effective role in reducing agency

conflicts. In that case, board size should not be negatively correlated with CEO

compensation. Thus, this study makes the hypothesis that:

Hypothesis 4: Large board size leads to higher CEO compensation.

3.2.2.3 Board Independence and CEO Compensation

Agency theory suggests that independent directors are likely to play important role in

aligning shareholder-manager interests by providing adequate monitoring. Accordingly,

board independence is encouraged in the Code of corporate governance (2002)7 issued by

SECP to improve the quality of governance. If pressure of independent board reflects a

tendency for increased quality of corporate governance, we can expect to observe different

patterns of executive compensation and incentives. Independent outside directors are less

subject to collude with management and have reputation to protect shareholders in the labor

market (Core et al., 1999, Fama and Jensen, 1983), therefore, have strong incentives to

effectively monitor the CEO. On the other hand, inside directors are more obligated to CEO

and can be under greater CEO influence, leading to compromised CEO monitoring to get

personal benefits from CEO such as career opportunities (see, Bebchuk and Fried, 2003,

Weisbach, 2007). Nevertheless, external directors are also prone to have negative impact on

internal governance if they have some secret relationship with management (Core et al.,

1999). Thus, overall, board independence is expected to be related to efficient compensation

contracts and less managerial opportunism.

Empirically, available evidence is mixed over the relationship between board

independence and executive compensation. For example, Boyd (1994), Lambert et al. (1993)

and Core et al. (1999) find positive association, while others (e.g., Byrd and Cooperman,

7 New Code issued in March, 2012 makes a mandatory requirement to have at least one independent director on board.

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2010, Conyon and He, 2011, Conyon and He, 2012) find no or negative relationship between

number of independent directors in board and executive compensation. Given the Pakistani

context where non-executive directors are generally hired from within the family or obligated

to work on behalf of controlling shareholders (Javid and Iqbal, 2008, World Bank, 2005), we

may expect so-called board independence to become irrelevant in corporate decision making,

leading to non-negative relation between CEO pay and board independence. However, an

earlier study in Pakistan, Shah et al. (2009), finds negative association between CEO

compensation and board independence. Thus, going with agency theory argument this study

hypothesizes that:

Hypothesis 5: Board independence reduces CEO compensation.

3.2.2.4 CEO Duality and CEO Compensation

Code of corporate governance 2012 in Pakistan requires companies to separate CEO

position from chairman of the board of directors, indicating that CEO duality (CEO as

chairman board of directors at the same time) is a potential agency problem in Pakistan. CEO

duality suggests `concentrated power in one person. This provides opportunity to “self-

interested” CEOs to influence the major decisions in order to maximize their own utilities

instead to maximizing shareholders’ wealth (Core et al., 1999, Jensen, 1993). Thus,

separation of CEO from chairman position is suggested to improve board effectiveness

(Jensen, 1993). CEO duality reduces the board independence and increases the executive

powers over control decisions including designing executive compensation contracts, leading

to higher executive compensation.

Empirically, several studies (e.g., Boyd, 1994, Brick et al., 2006, Conyon and He, 2012,

Core et al., 1999, Fahlenbrach, 2009, van Essen et al., 2012b) find positive association

between CEO duality and executive compensation, indicating CEO entrenchment and

excessive payment to CEO when he/she is also a chairman board of directors. In Pakistan,

Shah et al. (2009) and Kashif and Mustafa (2012) find no evidence of the relationship in

question. However, taking the view the Code of corporate governance in Pakistan that CEO

duality leads to ineffective governance structure this study makes the hypothesis that:

Hypothesis 6: CEO duality has positive impact on CEO compensation.

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3.2.3 CEO Compensation and Future Firm Performance

A common feature of much of the literature is that it views CEO compensation as reward

for the materialized firm performance and examines the relationship of CEO compensation

with current and past performance. Nevertheless, the other view is that board may reward

executives for value-maximizing activities with outcomes that have not yet materialized, and

hence that are unobservable to outside shareholders (see, Balafas and Florackis, 2014, Cooper

et al., 2013, Hayes and Schaefer, 2000). The former perspective believes that a positive

relationship between CEO compensation and materialized firm performance is ascribed to the

fact that materialized performance signals the ability of CEO to effectively manage the firm

(see, Danker et al., 2013). While, latter suggests that efficient compensation packages

especially that includes incentive-based compensation may motivate executives to exert

costly effort to enhance the growth opportunities of their firms, leading to long term value

creation to shareholders and reduced shareholder-manager agency problems (see, Balafas and

Florackis, 2014).

Accordingly, under agency theory, if boards compensate CEOs for both observable and

unobservable performance measures and unobservable performance measures correlate with

future observable performance measures then current compensation that is unexplained by

current observable performance measures is likely to be correlated to future observable

performance measures (see, Balafas and Florackis, 2014, Cooper et al., 2013, Hayes and

Schaefer, 2000). This leads to the deduction that current CEO compensation can predict

future performance, leading to the hypothesis that:

Hypothesis 7: CEO compensation has positive effect on future firm performance.

Several studies find that current compensation packages influence future performance

(see, e.g., Balafas and Florackis, 2014, Buck et al., 2008, Cooper et al., 2013, Hanlon et al.,

2003, Hayes and Schaefer, 2000). However, in Pakistan, this study would be the first to

explore this relationship in concentrated/family ownership and weak legal environment.


Corporate boards are presumed to restrain CEO opportunism and align the CEO actions

with shareholders’ interests by designing efficient compensation contracts that typically link

CEO compensation with firm performance. However efficient compensation contracts may

encourage managers to manipulate performance because their compensation is tied to some

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pre-specified performance criteria (Sun, 2012). These performance criteria generally include

earnings targets, share price performance and some specific financial ratios that signal the

financial well-being of the company (Ibrahim and Lloyd, 2011, Puffer and Weintrop, 1991).

Therefore, managers tend to manipulate earnings through the choice of accounting policies

because their compensation is tied to firm performance (Watts and Zimmerman, 1978).

Through the choice of accounting methods, managers can increase incentive cash

bonuses or value of the firm share, leading to increased manager’s wealth. Therefore,

managers are prone to pick those accounting policies which transfer reported earnings from

future to current period, or vice versa, under specific situations (Watts and Zimmerman,

1986). Now, if executive in Pakistan are prone to exert a costly effort8 to manipulate earnings

in order to increase their pecuniary benefits then we can expect that CEO compensation

would be related to earnings manipulation.

Existing literature finds evidence that executive compensation is associated with earning

manipulation driven by a managers’ desire to meet the performance targets, leading to higher

compensation (see, Devers et al., 2007, Frydman and Jenter, 2010, Ibrahim and Lloyd, 2011,

Ye, 2014). However, in Pakistan, I could not trace any study that explores the motivation for

earnings management related to executive compensation. Given the institutional and

corporate governance structure in Pakistan (see, Cheema, 2003, Ibrahim, 2006, Kamran and

Shah, 2014, Rehman et al., 2012, World Bank, 2005), management may tend to window

dress the firm performance opportunistically in order to increase their compensation. CEO

compensation can be linked to firm performance on one hand in order to give the impression

that CEO is being rightly compensated while on the other hand performance is manipulated.

Thus, I make the hypothesis that:

Hypothesis 8: CEO compensation has positive impact on earnings management.

3.3 Measurement of Key Variables

3.3.1 CEO Compensation

Typically, CEO compensation has been reported to have the forms: base salary, annual

bonus, perks, long-term incentive plans, stock options, restricted stocks and post-employment

8 Costly effort in the sense that if managers get caught for manipulating earnings to gain pecuniary benefits, this would be fatal for their career

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benefits (Frydman and Jenter, 2010, Murphy, 1999). The literate classifies executive

compensation into two broad classes i.e., cash compensation (short-term compensation) and

non-cash compensation (long-term compensation) based on nature and/or time-horizon of the

award. Cash compensation is the remuneration paid to the executives during the fiscal year. It

may include base salary and cash bonuses (see, e.g., Cooper et al., 2013, Core et al., 1999,

Croci et al., 2012, Ozkan, 2011, Shaw and Zhang, 2010) or may include base salary, cash

bonuses and other cash benefits (see, e.g., Balafas and Florackis, 2014, Conyon and He,

2011, Conyon and He, 2012, Ntim et al., 2013). Other forms are included in non-cash

compensation.

In Pakistan, long term incentive plans, stock options and restricted stocks are virtually

absent. CEOs are paid in the form of base salary, cash bonuses, perks and benefits and post-

employment benefits. These elements of pay can easily be located in the financial statements

of the companies because under International Accounting Standard (IAS 24), companies are

required to disclose all remuneration paid to CEOs during the year. However, companies use

many accountings heads in disclosure and nomenclature of the accounting heads is

inconsistent across the firms. The most used accountings heads include managerial

remuneration, bonus, leave encashment, house rent, utilities, medical expenses, gratuity,

provident fund and retirement benefits. These heads are clear in their nature that to which

category they would fall in such as base salary, bonuses, perks or retirement benefits.

Consistent with existing literature, this study uses two measures of CEO compensation i.e.,

cash compensation and total compensation. Cash compensation includes managerial

remuneration and bonuses while total compensation is the sum of all the components.

3.3.2 Firm Performance

Both accounting and market measure of firm performance is analyzed. Accounting

performance is represented by return on assets (ROA) estimated by ratio of income before

interest (EBIT) and taxes to total assets (see, e.g., Banghoj et al., 2010, Bebchuk et al., 2011,

Conyon and He, 2012, Matolcsy and Wright, 2011). Another popular measure of accounting

performance i.e. EPS (see, e.g., Chen et al., 2011, Laan et al., 2010) is also calculated but that

is for robustness purposes. EPS is estimated as earnings before taxes divided by number of

shares outstanding.

Market performance is measured as total return to shareholders calculated as current

market price share plus dividend for the current year divided by previous year market price

(see, e.g., Basu et al., 2007, Boschen et al., 2003, Guthrie et al., 2012, Liu and Stark, 2009).

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In Pakistan, companies are required to lay annual financial statements in the annual general

meeting (AGM) which must be held within 4 months after the close of financial year9. For

example, if company’s financial year closes on 30th June, the AGM must be held by the end

of October. Thus, it takes no more than four months for shareholders to see the information

contained in the annual reports. Keeping this in view, market price per share is taken on the

date that is 4 months after the closing date10. One advantage of this measure is that no

adjustment is needed for the announcement of final dividends for the year as ex-dividend date

resides within the 4-month span. Nevertheless, market price on the closing date is also

collected for robust analysis.

3.3.3 Corporate Governance Variables

3.3.3.1 Family Ownership

Many definitions of a family firm exists (see, e.g., Anderson and Reeb, 2003a, Anderson

and Reeb, 2003b, Gómez-Mejía et al., 2007, Villalonga and Amit, 2006), however, following

Anderson and Reeb (2003a), Wang (2006) and Achleitner et al. (2014), this study define a

family firm that fulfills one of the following conditions.

1) a person or family group holds at least 25% of voting right as measured by

percentage of shares owned directly or indirectly. An indirect voting right can be

achieved through a trust or holding company.

2) two or more family members sit in the board of directors.

To identify the firm’s family status, initially, family members are identified in the board of

directors by their family names from company-information page in the annual reports. In the

next step, pattern of shareholding (part of annual report) is examined for family ownership. It

is important to note here that in some instances control is achieved through holding company

or trust. Therefore, holding company or trust is followed on the internet to know the

ownership status of the holding company. If that belongs to a family and its stake in the

company is more than 25% then the company is recognized as family firm.

3.3.3.2 Ownership Concentration

Consistent with existing literature on ownership concentration (see, Holderness, 2014, La

Porta et al., 1999), this study uses a simple measure of ownership concentration i.e.,

ownership of largest shareholder. However, ownership stake of three largest shareholders is

9 See section 233 of Companies Ordinance, 1984 10 Several studies (e.g., Callen et al., 2010, Jiang et al., 2010a, Lara et al., 2011) adopt similar approach

83

also collected for robustness purposes. Three largest shareholders and their ownership stakes

are obtained from pattern of shareholding included in the annual reports.

3.3.3.3 Board Size

Board size is measured as number of sitting directors on the board as mentioned in the

annual reports.

3.3.3.4 Board Independence

Although Code of corporate governance (2012) in Pakistan requires the representation of

independent director on the board however, this was a voluntary requirement until year 2013.

Further, disclosure regarding independent director was very much inconsistent across the

companies. Therefore, this study uses ratio of non-executive directors to board size as a

measure of board independence. The number of non-executive directors is mentioned in the

Statement of Compliance with Code of Corporate Governance annexed with annual reports in

Pakistan.

3.3.3.5 CEO Duality

CEO-duality is incorporated as a dummy variable taking the value one if CEO is also the

chairman of board of directors and zero otherwise.

3.4 Data

The study focuses on all the non-financial firms listed at Karachi Stock Exchange (KSE),

Pakistan for the period 2005 to 201211. The list of companies is taken from annual balance

sheet analysis (BSA) published by State Bank of Pakistan (SBP) in 2013. The financial firms

are excluded because they have different accounting and regulatory requirements and

structures of valuation ratios and profits. Similar exclusion is made in other studies in

Pakistan (see, e.g., Javid and Iqbal, 2008, Shah et al., 2009).

There are total of 399 non-financial listed companies in BSA classified in 12 economic

(industry) groups by SBP. In the first step 86 companies are dropped because they are

declared defaulted by KSE, newly listed, merged or demerged during the sample period,

leading to inconsistent and missing financial data in BSA. For remaining 313 companies,

attempt is made to collect data for the variables that are not included in BSA such as

11 Since new Code of corporate governance is issued in March 2012 (applicable from year 2013), therefore, to avoid any structural change in the variables due to amended requirements of the Code, the data period ends at year 2012.

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corporate governance variables, cash flows and the main variable CEO compensation. Since

no database is available in Pakistan that covers these variables so data is extracted from hand

collected annual reports of the companies. The annual reports are collected from different

sources including SBP, KSE and companies’ websites. As I go farther from 2012, the

availability of annual reports decreases therefore sample period is restricted to start from

2005. One benefit to start data period from 2005 is that the Code of corporate governance is

implemented from 2003 therefore the choice of starting period as 2005 gives two-year

adjustment period to listed firms because provisions of the Code, 2002 are not mandatory.

Out of 313 companies 53 companies are dropped due to non-availability of annual

reports. For the remaining 260 companies, I manage to collect data for at least three

consecutive years, making an unbalanced panel data containing 1836 firm-year observations

from 260 companies categorized in 12 industrial groups. However, for compensation

analysis, out of 1836 firm-year observations, 328 observations are dropped because in those

observations CEO compensation is zero. Final sample contains 1508 firm-year observations

from 225 firms for the period 2005 to 2012. In the final step, market data is matched and

collected from official website of KSE.

Table 3.1 describes the industry wise distribution of observations. Industry wise

maximum observations (505 observations) are coming from textile group because it is the

biggest group in KSE. Food and, chemicals and pharmaceuticals groups are second and third

largest contributors to the dataset with 222 and 212 observations respectively. The last two

columns of Table 3.1 show the percentage representation of each group in the sample and the

whole population respectively. Despite some discrepancies, sample data has fair

representation of all the sectors.

Table 3.2 reports the observations by pay components. Out of 1508 observations, only

374 (24.80%) observations have bonus payments, suggesting that smaller number of firms

pay bonuses to CEOs. 657 (43.57%) observations have retirement benefits while 1399

(92.77%) observations have perks (such as club fee, house rent, utility bills and other

benefits). This suggests that CEOs are drawing maximum pay in the form of basic pay and

perks.

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Table 3.1 Industry Wise Observations

Economic/Industry Group as per BSA Observations

Representation (%age)

Sample Population

Textiles 505 33.49 38.85

Food 222 14.72 13.53

Chemicals and Pharmaceuticals 212 14.06 10.78

Other manufacturing n.e.s 102 6.76 7.52

Other non-metallic mineral products 118 7.82 7.02

Motor vehicles, trailers and auto parts 86 5.70 5.51

Fuel & Energy 77 5.11 4.51

Information, Communication & transport Services 39 2.59 3.26

Coke and refined petroleum products 70 4.64 2.26

Paper, paperboard and products 25 1.66 2.26

Electrical machinery and apparatus 24 1.59 2.01

Other services activities 28 1.86 2.51

Total 1508 100 100

Table 3.2 Observations by Pay Components

Basic Pay Bonus Perks Retirement

Benefits Total

Observations

1508 374 1399 657 1508

100% 24.80% 92.77% 43.57% 100%

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3.5 Model Specifications

3.5.1 CEO Compensation, Firm Performance and Corporate Governance

To test the association of CEO compensation with firm performance and corporate

governance (first six hypotheses), following model is estimated. Similar models are used in

the extant literature (e.g., Gallego and Larrain, 2012, Murphy, 1999, Sun et al., 2013, Wang

and Xiao, 2011)

𝐿𝑁𝐶𝑂𝑀𝑃𝑖𝑡 = 𝛽1𝑅𝑂𝐴𝑖𝑡 + 𝛽2𝑇𝑅𝐸𝑇𝑖𝑡 + 𝛽3𝐵𝐷𝑆𝐼𝑍𝐸𝑖𝑡 + 𝛽4𝐵_𝐼𝑁𝐷𝑖𝑡 + 𝛽5𝐹𝐴𝑀𝑂𝑊𝑁𝑖𝑡

+ 𝛽6𝑂𝑊𝑁𝐶𝑂𝑁𝑆𝑖𝑡 + 𝛽7𝐷𝑈𝐴𝐿𝐶𝐸𝑂𝑖𝑡 + 𝛽8𝐹𝐼𝑅𝑀𝑆𝐼𝑍𝐸𝑖𝑡 + 𝛽9𝐹𝐼𝑅𝑀𝑅𝑆𝐾𝑖𝑡

+ 𝛽10𝑀𝑇𝐵𝑖𝑡 + 𝛽11𝐹𝑀𝐴𝐺𝐸𝑖𝑡 + 𝛽12𝐶𝐸𝑂𝐶𝐻𝑁𝐺𝑖𝑡 + 𝛼𝑖 + 𝜔𝑡

+ 𝜀𝑖𝑡 (1)

Where

LNCOMPit Log of cash compensation and total compensation, cash compensation

includes managerial remuneration and bonuses while total compensation

includes cash compensation, perks and retirement benefits

ROAit Return on assets, earnings before interest and taxes divided by total assets

TRETit Total return to shareholder, sum of current year market value and dividend

divided by previous year market price

BDSIZEit Board size, number of directors on the board

B_INDit Board independence, ratio of non-executive directors to board size

FAMOWNit Family ownership, a dummy variable taking value 1 for family firms and zero

otherwise

OWNCONSit Ownership concentration, percentage of shares held by largest shareholder

DUALCEOit CEO Duality, a dummy variable taking value 1 if CEO is also chairman board

of directors and zero otherwise

FIRMSIZEit Firm size, log of total assets

FIRMRSKit Firm risk, standard deviation of monthly stock returns for the fiscal year

MTBit Market to book value, market value per share divided by book value per share

FMAGEit Firm age, as mentioned in the annual reports

CEOCHNGit Interaction term of a dummy variable taking value 1 if CEO is replaced during

the year and number of CEOs drawing remuneration during the year

αi group fixed effects for firm or industry

ωi Time fixed effects

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Two important issues that must be addressed in regression analysis are heteroskedasticity

and serial correlation. Both problems lead to biased standard errors which in turn lead to

inefficient regression results. To test the heteroskedasticity in the panel data, two well-known

tests are performed. These tests include 1) Breusch-Pagan / Cook-Weisberg

heteroskedasticity test and 2) White heteroskedasticity test. In Table 3.3, both tests indicate

the presence of heteroskedasticity however Breusch-Pagan test’s p-value is slightly above the

conventional level of significance of 5%, indicating that heteroskedasticity may not be a

problem.

To test the serial correlation in error terms (testing independence of error term),

Wooldridge test, proposed by Wooldridge (2002), for serial correlation in panel data is

performed. In Table 3.3, the test rejects the hypothesis of no serial correlation, thereby

suggesting presence of serial correlation in error terms.

Table 3.3

Heteroskedasticity and Serial Correlation Tests

Test Statistic p-value

Breusch-Pagan / Cook-Weisberg test for heteroskedasticity 3.77 0.0520

White's test for heteroskedasticity 318.57 0.0000

Wooldridge test for autocorrelation in panel data 85.64 0.0000

As for now, there is statistical evidence that the data is prone to heteroskedasticity and

serial correlation in error terms which may lead to biased results therefore, standard errors

need to be adjusted to account for potential difficulties due to heteroskedasticity and serial

correlation. Accordingly, to account for these difficulties, Huber-White robust standard errors

clustered at firm level are used. This combination for adjustment in standard errors account

for both heteroskedasticity and serial correlation (Greene, 2011).

One advantage of panel data is that it allows for controlling variations due to unobserved

group-specific heterogeneity or omitted variables. Fixed effect or random effect models can

be used for this purpose in panel data analysis (see, Greene, 2011, Wooldridge, 2002). Fixed

effect models assume that effects of unobserved heterogeneity or omitted variables are time-

invariant within cross sectional groups and are correlated with independent variables. In fixed

effect models, these time-invariant effects can be captured or removed by using dummy

variables for cross sectional groups or by differencing. Fixed effect models capture much of

the error variance resulting from distortions due to omitted variables or unobserved

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heterogeneity between cross sectional groups. In contrast to fixed effect models, random

effect models assume that effects due to omitted variables or unobserved heterogeneity

between groups are not fixed or constant over time rather randomly distributed within groups

and between groups and these effects are uncorrelated with independent variables (see,

Greene, 2011, Wooldridge, 2002).

Table 3.4 Hausman Specification test for random effect model

b = consistent under Ho and Ha; obtained from fixed effect model

B = inconsistent under Ha, efficient under Ho; obtained from random effect model

Test: Ho: difference in coefficients not systematic

chi2(12) = (b-B)'[(V_b-V_B)^(-1)](b-B) = 514.14

Prob>chi2 = 0.0000

(V_b-V_B is not positive definite)

The choice of fixed or random effect model depends upon the assumption of correlation

between group-specific effects and independent variables. If assumption of no correlation

between group-specific effects and independent variables holds, the random effect model is

more efficient and would be preferred over fixed effect model (see, Greene, 2011,

Wooldridge, 2002). However, if this assumption does not hold, the random effect model

would be inconsistent and would lose its preference over fixed effect model. Statistically,

Hausman (1978) test is widely used to check the validity of random effect assumption of no

correlation between group-specific effects and independent variables. This test compares

parameters estimated using fixed effect and random effect models, and suggests the use of

random effect model if the difference between two parameters is sufficiently small otherwise

use of fixed effect model is suggested. Table 3.4 reports the results of Hausman test. The

results strongly support the use of fixed effect model as p-value of the test is zero, rejecting

the null hypothesis of no systematic difference between parameters. Accordingly, fixed effect

models are used in this study. Both industry and firm fixed effects are used. Time (year) fixed

effects are also included in the model to control for macroeconomic shocks that affect the

entire cross sectional units.

Control Variables

Besides firm performance and corporate governance variables, there are contextual

factors that play an important role in devising CEO compensation contracts. Literature review

suggests that amongst many, firm size, firm risk, firm growth opportunities and firm age are

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the most widely used control variables in executive compensation research. Accordingly, this

study introduces these variables in regression models.

Large and complex firms are hard to manage therefore these firms attract executives with

better managing abilities which in turn lead to higher executive compensation. In theorizing,

Jensen and Meckling (1976) argue that larger firms hire better performing executive to

maximize their productivity. Firm size is perhaps one of the most cited determinants of CEO

compensation across the world. Countless studies report that firm size is positively related to

executive compensation (see, e.g., Conyon and Murphy, 2000, Croci et al., 2012, Devers et

al., 2007, Frydman and Jenter, 2010, Ghosh, 2006, Kaplan, 1994, Ye, 2014). In Pakistan,

Shah et al. (2009) and Kashif and Mustafa (2012) also find positive association between CEO

compensation and firm size. Two popular proxies for firm size are total assets and net

revenues. Following extent literature (e.g., Gallego and Larrain, 2012, Wang and Xiao,

2011), this study uses total assets as proxy for firm size. However, data on net revenues is

also collected for robustness checks.

Firm risk is also an important constituent of CEO compensation contract. Managing a

risky company needs better managerial skills, leading to higher compensations. Following

several studies (e.g., Brick et al., 2006, Conyon and He, 2011, Core et al., 1999, Lippert and

Moore, 1994, Lippert and Porter, 1997), this study controls for firm risk as proxied by

standard deviation of monthly stock returns for the fiscal year.

Firms with greater growth opportunity are expected to hire the executives with better

skills who can exploit the available growth opportunities to maximize the shareholder value.

This leads to positive link between growth opportunity and CEO compensation. Consistent

with existing literature (e.g., Brick et al., 2006, Conyon and He, 2011, Conyon and He, 2012,

Ho et al., 2004), this study controls for firms’ growth opportunities as proxied by Market to

Book ratio.

Consistent with existing literature (Conyon and He, 2012, Ho et al., 2004), firm age is

another control variables introduced in this study. Firm age is related to maturity and

experience of the firm. Intuitively, mature firms are more likely to devise more efficient

compensation contracts. Firm age is measured in years as mentioned in the annual reports.

If CEO is replaced in a firm, the new contract is unlikely to be the same as the previous

one. New CEO might start with lower or greater compensation. Further, if CEO is replaced in

the middle of a year, there would be 2 persons drawing the compensation in a year.

Therefore, to account for such instances, this study controls for interaction term of a dummy

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variable taking the value 1 for new CEO and another variable indicating number of CEOs

drawing compensation in a year.

3.5.2 CEO Compensation and Past Firm Performance To test association of CEO compensation with past firm performance, current

performance variables are replaced by their lagged values (see, e.g., Conyon and He, 2012,

Laan et al., 2010, Murphy, 1999). Thus, model (1) becomes:

𝐿𝑁𝐶𝑂𝑀𝑃𝑖𝑡 = 𝛽1𝑅𝑂𝐴𝑖𝑡−1 + 𝛽2𝑇𝑅𝐸𝑇𝑖𝑡−1 + 𝛽3𝐵𝐷𝑆𝐼𝑍𝐸𝑖𝑡 + 𝛽4𝐵_𝐼𝑁𝐷𝑖𝑡 + 𝛽5𝐹𝐴𝑀𝑂𝑊𝑁𝑖𝑡

+ 𝛽6𝑂𝑊𝑁𝐶𝑂𝑁𝑆𝑖𝑡 + 𝛽7𝐷𝑈𝐴𝐿𝐶𝐸𝑂𝑖𝑡 + 𝛽8𝐹𝐼𝑅𝑀𝑆𝐼𝑍𝐸𝑖𝑡 + 𝛽9𝐹𝐼𝑅𝑀𝑅𝑆𝐾𝑖𝑡

+ 𝛽10𝑀𝑇𝐵𝑖𝑡 + 𝛽11𝐹𝑀𝐴𝐺𝐸𝑖𝑡 + 𝛽12𝐶𝐸𝑂𝐶𝐻𝑁𝐺𝑖𝑡 + 𝛼𝑖 + 𝜔𝑡

+ 𝜀𝑖𝑡 (2)

The definitions of the variables are same as in model (1). The model also is estimated

using industry and firm fixed effects as well as time fixed effects.

3.5.3 Controlling for Endogeneity

3.5.3.1 Regressing on Lagged Values of Explanatory Variables

Several studies in executive compensation and corporate governance literature indicate

the potential endogeneity problem (see, e.g., Cornett et al., 2007, Croci et al., 2012, Gillan,

2006, Hartzell and Starks, 2003, Mura, 2007, O'Connor and Rafferty, 2010). Endogeneity

may arise from different sources, for example, presence of unobserved heterogeneity,

simultaneity or measurement errors. Unobserved determinants of executive compensation

may also be the determinants of firm performance (Himmelberg et al., 1999), leading to

endogeneity. Similarly, performance and corporate governance variables may have two way

causal effects (simultaneity problem), again leading to endogeneity. If endogeneity is not

controlled, the results may be biased and inconsistent (Conyon and He, 2012, Mura, 2007,

O'Connor and Rafferty, 2010).

A number of studies in Pakistan (e.g., Awan, 2012, Ibrahim et al., 2010, Javed and Iqbal,

2006, Javid and Iqbal, 2008, Khatab et al., 2011, Nishat and Shaheen, 2006-2007, Yasser et

al., 2011) show links between corporate governance variables, firm performance and other

firm specific contextual variables. Any shock that is unobserved may affect these variables

and compensation simultaneously, leading to potential problem of endogeneity. Therefore,

following a number of studies (e.g., Cornett et al., 2007, Croci et al., 2012, Hartzell and

91

Starks, 2003, Ozkan, 2011) current values of all independent variables except FIRMAGE and

CEOCHNG in Model (1) are replaced with their lagged values treating them as potential

cause of endogeneity. Thus, model (1) becomes:

𝐿𝑁𝐶𝑂𝑀𝑃𝑖𝑡 = 𝛽1𝑅𝑂𝐴𝑖𝑡−1 + 𝛽2𝑇𝑅𝐸𝑇𝑖𝑡−1 + 𝛽3𝐵𝐷𝑆𝐼𝑍𝐸𝑖𝑡−1 + 𝛽4𝐵_𝐼𝑁𝐷𝑖𝑡−1

+ 𝛽5𝐹𝐴𝑀𝑂𝑊𝑁𝑖𝑡−1 + 𝛽6𝑂𝑊𝑁𝐶𝑂𝑁𝑆𝑖𝑡−1 + 𝛽7𝐷𝑈𝐴𝐿𝐶𝐸𝑂𝑖𝑡−1

+ 𝛽8𝐹𝐼𝑅𝑀𝑆𝐼𝑍𝐸𝑖𝑡−1 + 𝛽9𝐹𝐼𝑅𝑀𝑅𝑆𝐾𝑖𝑡−1 + 𝛽10𝑀𝑇𝐵𝑖𝑡−1 + 𝛽11𝐹𝑀𝐴𝐺𝐸𝑖𝑡

+ 𝛽12𝐶𝐸𝑂𝐶𝐻𝑁𝐺𝑖𝑡 + 𝛼𝑖 + 𝜔𝑡 + 𝜀𝑖𝑡 (3)

The definitions of the variables are same as in model (1). This model also is estimated

using industry and firm fixed effects as well as time fixed effects.

3.5.3.2 Dynamic Panel Estimation using Generalized Method of Moments (GMM)

To control for endogeneity, instrument variable (IV) approach is also adopted.

Specifically, a linear dynamic panel model of the following form is estimated using GMM

technique. Similar models are used in the extant literature (see, e.g., Conyon and He, 2012,

Mura, 2007, O'Connor and Rafferty, 2010, Yoshikawa et al., 2010).

The model is:

𝐿𝑁𝐶𝑂𝑀𝑃𝑖𝑡 = 𝛼 + 𝛾𝐿𝑁𝐶𝑂𝑀𝑃𝑖𝑡−1 + 𝛽1𝑅𝑂𝐴𝑖𝑡 + 𝛽2𝑇𝑅𝐸𝑇𝑖𝑡 + 𝛽3𝐵𝐷𝑆𝐼𝑍𝐸𝑖𝑡 + 𝛽4𝐵_𝐼𝑁𝐷𝑖𝑡

+ 𝛽5𝐹𝐴𝑀𝑂𝑊𝑁𝑖𝑡 + 𝛽6𝑂𝑊𝑁𝐶𝑂𝑁𝑆𝑖𝑡 + 𝛽7𝐷𝑈𝐴𝐿𝐶𝐸𝑂𝑖𝑡 + 𝛽8𝐹𝐼𝑅𝑀𝑆𝐼𝑍𝐸𝑖𝑡

+ 𝛽9𝐹𝐼𝑅𝑀𝑅𝑆𝐾𝑖𝑡 + 𝛽10𝑀𝑇𝐵𝑖𝑡 + 𝛽11𝐹𝑀𝐴𝐺𝐸𝑖𝑡 + 𝛽12𝐶𝐸𝑂𝐶𝐻𝑁𝐺𝑖𝑡 + 𝜔𝑡

+ 𝜀𝑖𝑡 (4)

The definitions of the variables are same as in model (1).

The dynamic panel models estimated using GMM technique simultaneously control for

unobserved heterogeneity, serial correlation and endogeneity. The approach relies on internal

instrument variables that are based on lagged values of dependent and explanatory variables.

Three approaches have evolved for estimation of the dynamic panel model using GMM.

Arellano and Bond (1991) suggest estimating equation in differences (GMM_DIFF) to

control for unobserved heterogeneity and using the lagged levels of the variables as

instruments. Arellano and Bover (1995) suggest using first differences as instrument

variables for equation in levels that leaves the unobserved heterogeneity in errors (GMM-

Orthogonal). They also propose a new transformation of variables, forward orthogonal

deviations, that preserves orthogonality in error terms, leading to a computationally

convenient alternative for models that include predetermined variables. Blundell and Bond

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(1998) propose a technique that uses both level equation with differenced values as

instrument variables and differenced equation with lagged values as instrument variables,

making a system GMM estimator (GMM-SYS). These techniques are basically developed to

account for 1) small number of periods i.e. small T and large number of cross section units

i.e. large N, 2) relaxing the assumption of strict exogeneity of independent variables i.e.

independent variables are allowed to correlate with current and past realization of the error

term, 3) fixed group effects and 4) heteroskedasticity and autocorrelation within groups but

not across the groups (Roodman, 2009).

This study reports the results using three GMM estimation techniques. Initially, the

dynamic panel model is estimated using GMM-DIFF following Arellano and Bond (1991)

then variables are transformed as proposed by Arellano and Bover (1995) and model is

estimated, and in the last, GMM-SYS estimation technique is used12. All models also include

time fixed effects to control macroeconomics shocks.

The choice of instrument variables is crucial in GMM estimation techniques. Two

conditions must be met for a valid instrument; 1) instrument variable must be uncorrelated to

error terms (instrument exogeneity) and 2) instrument variable must be correlated with

endogenous variables (instrument relevance). The validity of the instruments can be tested

using Sargan (1958) and Hansen (1982) tests of over-identification restrictions under the null

hypothesis of joint validity of instruments13. The Sargan/Hansen tests are standard for joint

validity of the instruments in GMM estimation. In addition, Arellano and Bond (1991)

develop a test for autocorrelation in error terms that may invalidate some lags as instruments.

For example, if there is an autocorrelation of the order 2 in error terms then second lag cannot

be used as instrument, thereby suggests using third or earlier lags as instruments. This study

uses Sargan/Hansen over-identification tests and Arellano and Bond autocorrelation test for

validity and suitability of the instrument variables.

12 GMM models are estimated using xtabond2 in STATA developed by David Roodman, see Roodman (2009) for details 13 See Roodman (2009) for details

93

3.5.4 CEO Compensation and Future Firm Performance

When unexpectedly high CEO compensation is due to the information that CEO effort

was greater than implied by current observable firm performance measures alone then one

should find future firm performance to be higher than implied by current firm performance

alone (Balafas and Florackis, 2014, Hayes and Schaefer, 2000). This can reasonably be tested

using three-step procedure as proposed by Hayes and Schaefer (2000):

1. regress CEO compensation on current performance and take residuals

2. regress future firm performance on current firm performance and take the residuals

3. regress residuals of (2) on residuals of (1)

This is equivalent to regressing future firm performance on current CEO compensation

and current firm performance. This way the effects of current firm performance would be net

out. Thus the model would be:

𝑅𝑂𝐴𝑖𝑡+1 = 𝛼 + 𝛽1𝑅𝑂𝐴𝑖𝑡 + 𝛽2𝑇𝑅𝐸𝑇𝑖𝑡 + 𝛽3𝐿𝑁𝐶𝑂𝑀𝑃𝑖𝑡 + 𝛼𝑖 + 𝜔𝑡 + 𝜀𝑖𝑡 (5)

Where

ROAit+1 Measure of future performance, return on assets, earnings before interest and

taxes divided by total assets

ROAit Measure of current performance, return on assets, earnings before interest and


TRETit Measure of current performance, total return to shareholder, sum of current

year market value and dividend divided by previous year market price

LNCOMPit Measure of current CEO compensation, log of cash compensation and total

compensation, cash compensation includes managerial remuneration and

bonuses while total compensation includes cash compensation, perks and

retirement benefits

Note here that in step 1 above, objective is to measure the degree of information

contained in CEO compensation that is not explained by current firm performance. Therefore,

two measures of current performance, ROA and total shareholder return, are incorporated in

the model. As measure of future performance, ROA is used as it is more convenient to be

used as a measure of future observable performance (see, Adithipyangkul et al., 2011,

Balafas and Florackis, 2014, Hayes and Schaefer, 2000). Group fixed effects and time fixed

94

effects are also incorporated to control for unobserved heterogeneity and macroeconomic

shocks.

In addition, corporate governance and firm specific variables also correlate with CEO

compensation and firm performance therefore to provide as much explanatory power as

possible, most widely used corporate governance and firm specific variables are incorporated.

Thus, following model is estimated.

𝑅𝑂𝐴𝑖𝑡+1 = 𝛼 + 𝛽1𝑅𝑂𝐴𝑖𝑡 + 𝛽2𝑇𝑅𝐸𝑇𝑖𝑡 + 𝛽3𝐿𝑁𝐶𝑂𝑀𝑃𝑖𝑡 + 𝛽4𝐵𝐷𝑆𝐼𝑍𝐸𝑖𝑡 + 𝛽5𝐵_𝐼𝑁𝐷𝑖𝑡

+ 𝛽6𝐹𝐴𝑀𝑂𝑊𝑁𝑖𝑡 + 𝛽7𝑂𝑊𝑁𝐶𝑂𝑁𝑆𝑖𝑡 + 𝛽8𝐷𝑈𝐴𝐿𝐶𝐸𝑂𝑖𝑡 + 𝛽9𝐿𝑁𝑆𝐴𝐿𝐸𝑆𝑖𝑡

+ 𝛽10𝑀𝑇𝐵𝑖𝑡 + 𝛽11𝐹𝐼𝑅𝑀𝑅𝑆𝐾𝑖𝑡 + 𝛼𝑖 + 𝜔𝑡

+ 𝜀𝑖𝑡 (6)

Where

ROAit+1 Measure of future performance, return on assets, earnings before interest and


ROAit Measure of current performance, return on assets, earnings before interest and


TRETit Measure of current performance, total return to shareholder, sum of current

year market value and dividend divided by previous year market price







otherwise


DUALCEOit CEO duality, a dummy variable taking value 1 if CEO is also chairman board


LNSALESit Log of net sales


FIRMRSKit Firm risk, standard deviation of monthly stock returns for the fiscal year



95

To control for unobserved heterogeneity and macroeconomic shocks group fixed effects and

time fixed effects are incorporated. Standard errors are adjusted to account for

heteroskedasticity and autocorrelation in error terms.


3.5.5.1 Detecting Earnings Management

In earnings management (EM) research, the detection of EM is crucial. The use of

discretionary accruals as proxy for EM behavior has become a standard approach in EM

research. To detect discretionary accruals, this study uses Jones (1991) model which is

modified first by Dechow et al. (1995) and subsequently by Kothari et al. (2005). However,

for robust checks, results are also obtained using original Jones (1991) model and Dechow et

al. (1995) modification. The general model for detecting discretionary accruals is:

𝐷𝐴𝐶 = 𝑇𝐴𝐶 − 𝑁𝐷𝐴𝐶

Where

DAC Discretionary accruals

TAC Total accruals

NDAC Non-discretionary accruals

Jones (1991) proposes following model to detect discretionary accruals.

𝑇𝐴𝐶𝑖𝑡

𝐴𝑖𝑡−1= 𝛼 + 𝛽1 (

1

𝐴𝑖𝑡−1) + 𝛽2 (

∆𝑅𝐸𝑉𝑖𝑡

𝐴𝑖𝑡−1) + 𝛽3 (

𝑃𝑃𝐸𝑖𝑡

𝐴𝑖𝑡−1) + 𝜀𝑖𝑡

Where

TACit Total accruals, calculated as difference between income before extraordinary

items minus operating cash flow

ΔREVit Change in firm revenues

PPEit Property, plant and equipment for firm i at time t

Ait-1 Lagged total assets

Jones (1991) defines fitted values as non-discretionary accruals. Thus, residuals from this

model represent discretionary accruals.

Dechow et al. (1995) modify Jones (1991) model arguing that some adjustment needs to

be made for discretionary revenue management and deduct change in accounts receivable

from change in revenues as adjustment in the model. Thus, the model becomes:

96


𝐴𝑖𝑡−1= 𝛼 + 𝛽1 (

1

𝐴𝑖𝑡−1) + 𝛽2 (

∆𝑅𝐸𝑉𝑖𝑡 − ∆𝐴𝑅𝑖𝑡

𝐴𝑖𝑡−1) + 𝛽3 (


𝐴𝑖𝑡−1) + 𝜀𝑖𝑡

Where

ΔAR Change in accounts receivable

All other variables are same as above.

Kothari et al. (2005) show that in many research settings, performance-matched

discretionary accrual measures increase the reliability of inferences and suggest adding

performance measure in the model. Thus, modified model becomes:


𝐴𝑖𝑡−1= 𝛼 + 𝛽1 (

1

𝐴𝑖𝑡−1) + 𝛽2 (

∆𝑅𝐸𝑉𝑖𝑡 − ∆𝐴𝑅𝑖𝑡

𝐴𝑖𝑡−1) + 𝛽3 (


𝐴𝑖𝑡−1) + 𝛽4(𝑅𝑂𝐴𝑖𝑡−1) + 𝜀𝑖𝑡

Where

ROAit-1 Lagged performance measure, return on assets

All other variables are same as in above models.

This model is estimated cross-sectionally each year for each industry group as per SBP

classification and residuals of this model represent discretionary accruals – a proxy for

earnings management behavior. Since earnings can be managed in both sides therefore

following earnings management literature absolute value of discretionary accruals (|DAC|) is

used as proxy for earnings management.

3.5.5.2 Regression Model

After estimating discretionary accruals, in line with existing literature (e.g., Ibrahim and

Lloyd, 2011, Ye, 2014), the following model is run to examine the impact of CEO

compensation on Earnings Management (EM) behavior.

|𝐷𝐴𝐶|𝑖𝑡 = 𝛼 + 𝛽1𝐿𝑁𝐶𝑂𝑀𝑃𝑖𝑡 + 𝛽2𝐵𝐷𝑆𝐼𝑍𝐸𝑖𝑡 + 𝛽3𝐵_𝐼𝑁𝐷𝑖𝑡 + 𝛽4𝐹𝐴𝑀𝑂𝑊𝑁𝑖𝑡

+ 𝛽5𝑂𝑊𝑁𝐶𝑂𝑁𝑆𝑖𝑡 + 𝛽6𝐷𝑈𝐴𝐿𝐶𝐸𝑂𝑖𝑡 + 𝛽7𝐹𝐼𝑅𝑀𝑆𝐼𝑍𝐸𝑖𝑡 + 𝛽8𝐿𝐸𝑉𝐸𝑅𝐴𝐺𝐸𝑖𝑡

+ 𝛽9𝐶𝐹𝑂𝑖𝑡 + 𝛽10𝑅𝑂𝐴𝑖𝑡 + 𝛽11𝑀𝑇𝐵𝑖𝑡 + 𝛽12𝐿𝑂𝑆𝑆𝐷𝑈𝑀𝑖𝑡 + 𝛼𝑖 + 𝜔𝑡

+ 𝜀𝑖𝑡 (7)

Where

|DAC|it Absolute discretionary accruals, a proxy of Earnings Management

97







otherwise


DUALCEOit CEO duality, a dummy variable taking value 1 if CEO is also chairman board


FIRMSIZEit Firm size, log of total assets

LEVERAGEit Total debt divided by total assets

CFOit Cash flow from operations

ROAit Return on assets, net income divided by total assets


LOSSDUMit A dummy variable taking value one if the firm is in net loss, and zero

otherwise



Corporate governance variables are included to examine the effects of corporate

governance practices in Pakistan. Weak corporate practices may give room to managers to

manipulate earnings which in turn may depict a camouflaged picture of the firm to the

shareholders.

Other control variables are typically associated with incentives to manage earnings (see

Frankel et al., 2002, Ibrahim and Lloyd, 2011). There is tendency that larger firm would have

larger discretionary accruals. Further, larger firms tend to have more analysts following.

Debts are accompanied with debt covenants which cannot be avoided therefore firms with

higher leverage have more incentives to manage earnings. The firms with better performance

(CFO and ROA) tend to have more accruals and will be more likely to meet or just beat the

analyst expectations, suggesting performance as an important factor that influences earning

management. Similarly, firms having more growth opportunities have greater incentives for

earnings management. Another important factor that can influence the earnings management

is loss because firms with loss have different incentives to manage earnings.

98

To control for unobserved heterogeneity and macroeconomic shocks group fixed effects

and time fixed effects are incorporated. Standard errors are adjusted to account for

heteroskedasticity and autocorrelation in error terms.

99

Chapter 4

CEO Compensation, Firm Performance and Corporate

Governance: Empirical Results and Discussion

100

4.1 Descriptive Statistics

Table 4.1 presents the mean, median and standard deviation of the variables used.

4.1.1 CEO Compensation

Cash compensation includes managerial remuneration (base salary) and bonus while

total compensation includes cash compensation, perquisites and retirement benefits. Over the

sample period, both average total and cash compensations have nearly tripled from Rs4.817

million to Rs13.060 million and Rs3.353 million to Rs9.378 million respectively.

Consistently lower median value than mean value indicates that the distribution of

compensation is positively skewed. Greater number of CEOs is receiving pay that is less than

average compensation. Increased standard deviation over time shows more disperse

distribution of compensation in later years. This may be an indication of firms using their

own criteria to set CEO pay rather than following peer groups or overall market. Figure 4.1

shows overall trend in both cash and total compensation. The increased difference between

cash and total compensation over time indicates that ratio of non-cash to total compensation

has increased. Also, the slop of both the compensations is slightly greater after year 2010.

This might be an indication of revised pay packages after financial crisis and political crunch.

4.1.2 Firm Performance

Return on assets (ROA) is calculated as earnings before interest and taxes divided by

total assets. Mean ROA of Pooled sample is 10.99 percent with standard deviation of 13.39

percent while median is 9.51%. Lower median value than mean indicates that the distribution

of ROA is positively skewed. Average ROA does not seem to vary abnormally across the

years. ROA decreases from 12.52% in year 2006 to 10.17% in year 2007 followed by 9.78%

in year 2008 and 9.26% in year 2009. This downward trend seems to reflect the effects of

financial crisis of 2008. After 2009 recovery takes place and ROA again rises to over 12%

mark followed by a steady decrease again to 10.54% till year 2012.

Total return to shareholders (TRET) is calculated as current year market price plus

dividend divided by previous year market price. Average TRET of Pooled sample stays at

16.74% with standard deviation of 80.04% while median is -0.84%. There exists more

fluctuation in TRET than ROA. In year 2005 average TRET is 27.70% which suddenly

decrease to 3.49% in year 2006 followed by an increase to 24.87% in year 2007. Negative

TRETs (both mean and median) in year 2008 and 2009 are potential indication of financial

crisis. Recovery seems to start after that with positive TRETs ending with mean TRET at

101

86.46% level in year 2012 with standard deviation of 114.89% and median value of 47.84%.

we can see overall downward trend in firm accounting and market performance in 2007 to

2009 reflect effects of unrest due to political issues and general elections, start of energy

crisis in Pakistan and global financial crisis.

4.1.3 Corporate Governance

Board size (BDSIZE) is measured as number of directors on board. Average board size

of pooled sample is slightly above 8 with standard deviation of 1.57. The median board size

in the pooled sample is 7 which is less than mean value, meaning that in more than 50%

observations board size is less than or equal to 8. Recently, similar average board size slightly

above 8 is reported in India however median value is reported exactly as 8 (see, Jameson et

al., 2014). This might be due to resembling institutional setting of India and Pakistan with

concentrated and family ownership structure. However, this average board size is slightly

lower than the board size in US (mean 9.54 and median 9) where firms are known to be

diffusely held and China (mean 9.372 and median 9) where state ownership is common (see,

Conyon, 2014, Huang and Wang, 2015). The average board size seems to have decreased

over time as mean of board size in year 2005 is 8.13 followed by 8.15, 8.08, 8.04 and 8.01 in

year 2006, 2007, 2008 and 2009 respectively and then stays at 8 afterwards. This is perhaps

in line with the developments in corporate governance system in Pakistan emphasizing on

effective boards.

Board independence (B_IND) is measured as ratio of non-executive directors to board

size. Pooled average of B_IND indicates that on average firms keep 63% non-executive

directors on the boards. The median value of pooled sample i.e. 66.67% is greater than mean

value, indicating that more 50% values lie above 63.91% (the mean value). Thus distribution

of B_IND is negatively skewed. Both mean and median of B_IND have moderately

downward trend over time. This might be due to reduction in board size over time as non-

executive directors are more likely to be dropped when board size needs to be reduced. The

ratio of non-executive directors in the board in Pakistan is quite similar to the ratio in India as

reported by Ghosh (2006) but greater than in some European countries and China (Fernandes,

2008, Firth et al., 2007, Ozkan, 2007).

Family ownership (FAMOWN) is a dummy variable taking value 1 if a firm qualifies as

family firm under conditions mentioned in research strategy section and zero otherwise.

Mean of 0.75 shows that 75% observations are coming from family firms. This ratio seems to

be greater than in Europe as Croci et al. (2012) report this to be about 42% in their dataset

102

from continental Europe. Similarly, two studies in Asia, from Korea and Japan, report about

40% and 20% respectively in their datasets (Basu et al., 2007, Kato et al., 2007). The family

firm ratio is stable overtime as family firm in year 2005 is very likely to remain a family firm

in year 2012. Therefore, within firms, no variation is expected over the sample period for this

variable. Thus, to see the impact of family ownership on CEO compensation, variations

between firms should be considered.

Ownership concentration (OWNCONS) represents the number of voting shares held by

the largest shareholder. The average voting shares held by the largest shareholder is 33.67%,

indicating a high concentrated ownership environment – consistent with other studies in

Pakistan (e.g., Awan, 2012, Ibrahim et al., 2010, Javed and Iqbal, 2006, Javid and Iqbal,

2008, Khatab et al., 2011, Nishat and Shaheen, 2006-2007, Yasser et al., 2011). The median

value of 26.66% is less than the mean value, suggesting that less than 50% firms have

OWNCONS more than 33.67% (positively skewed distribution). There is slightly increase in

OWNCONS in later years of 2011 and 2012 with values 34.39% and 35.51% respectively

otherwise OWNCONS is stable around 33% in early years of sample period.

CEO duality (DUALCEO) is a dummy for CEO holding the position of chairman as

well. On average about 34% CEOs also hold the position of chairman board of directors. The

trend of DUALCEO is increasing initially till year 2010 but after that may be due to more

emphasis on strong corporate governance practices, duality has downward trend. This is

similar to the UK and China where emphasis in on separating the post of CEO from the

chairman, and unlike the US where it is usual to combine these two positions (Conyon and

He, 2012).

103

Table 4.1 Descriptive Statistics

Variables Statistic 2005 2006 2007 2008 2009 2010 2011 2012 Pooled Sample

Total Mean 4817 5530 6512 7562 8396 9449 10628 13060 8475 Compensation Median 3156 3384 4153 4553 4999 5459 6060 7519 4800 In Rs.’000 S.D 5854 7030 9094 11028 11278 12519 13493 19935 12538

Cash Mean 3353 3918 4751 5529 6004 6577 7523 9378 6042 Compensation Median 2000 2303 2715 2836 3435 3450 4001 5186 3174 In Rs.‘000 S.D 4626 5840 7786 9268 8867 9690 10460 14766 9733

ROA Mean 11.93 12.52 10.17 9.78 9.26 12.28 11.74 10.54 10.99 %age Median 9.14 9.58 7.86 7.96 9.53 11.20 10.84 10.32 9.51 S.D 11.07 10.67 11.23 11.52 19.31 11.73 12.96 14.80 13.39

TRET Mean 27.70 3.49 24.87 -14.35 -1.73 8.37 -0.47 86.46 16.74 %age Median 18.97 -1.01 7.38 -27.20 -18.04 -6.14 -9.99 47.84 -0.84 S.D 52.18 39.08 71.94 80.74 67.19 62.89 72.12 114.89 80.04

BDSIZE Mean 8.13 8.15 8.08 8.04 8.01 8.00 8.01 8.00 8.05 Median 7.00 7.00 7.00 7.00 7.00 7.00 7.00 7.00 7.00 S.D 1.68 1.68 1.62 1.57 1.53 1.51 1.51 1.51 1.57

B_IND Mean 64.32 64.31 63.90 63.65 62.85 63.23 62.58 63.91 63.54 %age Median 70.00 70.71 70.00 66.67 66.67 66.67 62.50 66.67 66.67 S.D 20.37 20.72 20.71 20.59 20.94 20.64 20.31 19.96 20.49

FAMOWN Mean 0.75 0.75 0.76 0.75 0.74 0.75 0.75 0.74 0.75 Median 1.00 1.00 1.00 1.00 1.00 1.00 1.00 1.00 1.00 S.D 0.44 0.43 0.43 0.43 0.44 0.43 0.43 0.44 0.43

OWNCONS Mean 32.72 33.01 33.07 33.23 33.36 33.61 34.39 35.51 33.67 %age Median 26.46 26.61 26.71 26.25 26.13 26.13 27.45 29.40 26.66 S.D 21.01 21.22 20.78 20.48 20.44 20.30 20.74 21.32 20.74

DUALCEO Mean 0.30 0.33 0.33 0.36 0.36 0.36 0.35 0.33 0.34 Median 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 S.D 0.46 0.47 0.47 0.48 0.48 0.48 0.48 0.47 0.47

TASSETS Mean 7173 8607 9827 10898 11636 12675 14490 17215 11833 Rs in Median 2385 2603 2970 3042 3034 3068 3544 3831 3061 Millions S.D 14281 16821 18677 22158 26033 31098 35893 45860 29092

SALES Mean 8080 10277 11273 12872 13944 15895 18639 21949 14493 Rs in Median 1856 2407 2486 2469 2840 3355 4239 4452 3007 Millions S.D 217689 28719 32536 41939 48335 57547 64179 80479 52015

Net Income Mean 716 771 726 605 576 756 966 1161 790 Rs in Median 88 79 64 53 53 108 138 132 84 Million S.D 2858 4046 4168 5061 4714 4968 5773 8022 5240

FIRMRSK Mean 15.03 12.15 12.70 13.24 24.29 17.88 14.07 15.97 15.88 %age Median 13.54 11.20 12.13 11.66 19.32 13.18 11.15 13.29 13.01 S.D 8.00 8.51 6.63 7.74 23.59 15.63 11.00 11.37 13.59

MTB Mean 1.79 2.35 2.17 1.74 1.56 1.31 1.30 1.84 1.73 Times Median 1.19 0.99 1.13 0.86 0.62 0.52 0.43 0.65 0.75 S.D 2.37 8.17 4.76 4.77 4.81 6.03 4.58 5.62 5.35

FMAGE Mean 31.03 31.84 32.56 32.87 34.01 35.06 36.14 37.50 34.06 Years Median 27.00 28.00 29.00 29.00 30.00 31.00 32.00 33.00 30.00 S.D 16.65 16.75 16.48 16.43 16.61 16.56 16.46 16.59 16.65

104

.

4.1.4 Control Variables

Total assets and net sales are taken as proxies for firm size. Average total assets

(TASSETS) and average net sales (SALES) have increased over time. Larger mean than

median suggests that mean value is driven by large firms. In the pooled sample, average

TASSETS are Rs11,833 million with standard deviation of Rs29,092 million but median is

only Rs3,061 million-nearly four times lower than the mean. This is possibly due to the

reason that family firms in Pakistan are in larger number but they are smaller in term of total

assets than non-family firms like state owned firms. Similarly, average of SALES is also

driven by large firms. The median of SALES in pooled sample is Rs3,007 million while

mean is about five times larger than the median. High standard deviation in TASSETS and

SALES suggests much dispersion in firms in term of size.

Operating cash flows and net income have mean values of Rs926 million and Rs790

million with standard deviations of Rs4,617 million and Rs5,240 million respectively. Note

that there is big difference in mean and median for these two variables. This indicates that

smaller number of firms is making huge profits and distributions of these variables are

positively skewed. Given that textile sector is the biggest sector in Pakistan in term of number

of firms however profits are greater for other sectors like electronic and petroleum sectors

which have smaller number of firms. This possibly leads to positively skewed distribution.

0

2

4

6

8

10

12

14

2005 2006 2007 2008 2009 2010 2011 2012

Rs in Million

Years

Average CEO Compensation Over the Sample Period

Cash Compensation

Total Compensation

Figure 4.1

105

Firm risk (FIRMRSK) is proxied by standard deviation of monthly stock returns in the

fiscal year. Average FIRMRSK is highest (24.29%) in year 2009 while it is lowest (12.15%)

in year 2006 however pooled average is 15.88% with standard deviation of 13.59% while

median stays 13.01% level. The highest FIRMRSK depicts the effects of financial crisis with

higher variations in the stock prices when uncertainty is high in late 2008. It also represents

political situation in Pakistan after the resignation of President of Pakistan during the same

period.

Market to book value (MTB) is used as proxy for firm growth opportunities. Lowest

MTB prevails in year 2010 and 2011 while highest is in year 2006. Being highest in year

2006 MTB gradually decreases to 1.30 in year 2011 then it rises to 1.84 in 2012. This is

perhaps due to political situation in Pakistan. As the economy was booming till 2007 but

recession hits due to energy crisis in 2008.

Average firm age is about 34 years with standard deviation of 16.65 years while median

is 30 years. This shows concentration of mature firms in Pakistan.

4.2 CEO Compensation and Realized Firm Performance

4.2.1 Correlation Analysis

Table 4.2 presents the correlation matrix among compensation, performance and

corporate governance variables. Other control variables are also included in the matrix. Log

transformation is performed for compensation variables and firm size proxies i.e. total assets

and sales. Many significant correlations exist in Table 4.2, for example, high correlation

(0.9722) between cash compensation and total compensation. As evident from Table 3.2, in

Pakistan, not all firms have cash bonuses and retirement benefits plans for CEOs however,

perks are common in the form of house rent, club fee, utilities and others benefits. The perks

are generally linked to the base salaries as some percentage of base salary. Therefore, a

strong correlation is quite expected between cash compensation and total compensation.

Both cash and total compensation have positive correlation with accounting performance

(ROA) with values 0.3088 and 0.3098 respectively but correlation with market performance

(TRET) is not significant although sign is positive. Board structure variables BDSIZE and

B_IND are also positively correlated with compensation, indicating the potential

ineffectiveness of boards in monitoring and reducing CEO entrenchment and hence CEO

compensation.

106

Family firms seem to pay lower compensation to CEO as depicted by negative

correlation between FAMOWN and both cash and total compensation with values -0.3775

and -0.3760 respectively. Ownership concentration is positively correlated with

compensation which is inconsistent with the argument of agency theory that concentrated

ownership provides better incentives to monitor CEOs and mitigates agency problems and

manager’s self-serving behavior. Ownership concentration is also positively and significantly

correlated with BDSIZE and B_IND, indicating that, in Pakistan, concentrated ownership

does not seem to contribute towards board effectiveness.

Surprisingly, CEO duality is negatively correlated with CEO compensation which is

inconsistent with managerial power hypothesis. Apparently, CEO duality looks to reduce the

board independence as correlation between DUALCEO and B_IND is -0.1863, thereby

reducing the board effectiveness. But on the other hand CEO duality has positive effects on

board effectiveness as it has negative correlation with board size with value on -0.2605.

LNASSETS, LNSALES, MTB and FIRMAGE are positively correlated with compensation

as expected. However, CEO compensation reduces as firm risk increases which is

inconsistent with the argument that risky firms need to pay higher compensation to their

CEOs.

4.2.1.1 Addressing Multicollinearity

In regression models, the problem of multicollinearity may lead to higher standard errors

of the coefficients and makes the inference difficult and biased. Therefore, to trace down the

multicollinearity in Model 1 & 2, two widely used techniques 1) correlation matrix and, 2)

variance inflation factor (VIF) and tolerance are used. Table 4.2 shows that none of the

absolute values of correlation coefficients is greater than normally used threshold level of

0.70 for potential serious problem of multicollinearity. To further confirm that no

multicollinearity problem exists, variance inflation factor (VIF) and tolerance are estimated.

Table 4.3 indicates that none of the VIF is greater than generally used threshold level of 10

and mean of VIFs is 1.31 which is not considerably different from one. Similarly, all the

tolerance levels are above the threshold level of 0.10. These diagnostics suggest that problem

of multicollinearity is unlikely to make the regression results unreliable and variables can be

included in one regression model.

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Table 4.2 Correlation Matrix (Variables Used in Model 1,2,3 & 4)

(1) (2) (3) (4) (5) (6) (7) (8) (9) (10) (11) (12) (13) (14) (15)

LNTCOMP (1) 1.0000

LNCASHCOMP (2) 0.9722* 1.0000

ROA (3) 0.3088* 0.3098* 1.0000

TRET (4) 0.0148 0.0225 0.1734* 1.0000

BDSIZE (5) 0.3215* 0.3138* 0.1333* -0.0038 1.0000

B_IND (6) 0.1872* 0.1438* 0.0326 -0.0242 0.3538* 1.0000

FAMOWN (7) -0.3775* -0.3760* -0.2202* 0.0188 -0.4532* -0.2273* 1.0000

OWNCONS (8) 0.3555* 0.3651* 0.2218* 0.0497 0.1007* 0.0638* -0.5435* 1.0000

DUALCEO (9) -0.2944* -0.2777* -0.1671* 0.0108 -0.2605* -0.1863* 0.1730* -0.0841* 1.0000

LNTASSETS (10) 0.5781* 0.5614* 0.1706* -0.0443 0.3795* 0.1320* -0.2750* 0.2495* -0.2164* 1.0000 LNSALES (11) 0.6102* 0.5912* 0.3240* -0.0194 0.3590* 0.1285* -0.3206* 0.2610* -0.2380* 0.8818* 1.0000

FIRMRSK (12) -0.2040* -0.2060* -0.1895* 0.1968* -0.1272* -0.0691* 0.1155* -0.0418 0.1978* -0.2403* -0.2789* 1.0000 MTB (13) 0.0932* 0.1197* 0.1750* 0.0691* 0.0803* -0.1189* -0.1730* 0.2793* -0.0949* 0.0802* 0.1210* -0.0913* 1.0000

FMAGE (14) 0.2469* 0.2380* 0.0670* 0.0354 0.1897* 0.0538* -0.2164* 0.2026* -0.0167 0.1158* 0.1379* -0.0334 0.0389 1.0000 CEOCHNG (15) 0.1359* 0.1178* 0.0290 -0.0013 0.2176* 0.1406* -0.2644* 0.1834* -0.1039* 0.2192* 0.1939* -0.0224 0.0222 0.0621* 1.0000

(*) p-value < 0.05

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Table 4.3 Variance Inflation Factors (Variables Used in Model 1,2,3 & 4)

Variable VIF Tolerance

FAMOWN 1.91 0.52433

OWNCONS 1.67 0.59708

BDSIZE 1.66 0.60337

FIRMSIZE 1.33 0.75329

B_IND 1.21 0.82805

ROA 1.18 0.84446

FIRMRSK 1.18 0.8483

MTB 1.15 0.8683

DUALCEO 1.15 0.86999

CEOCHNG 1.12 0.89144

TRET 1.1 0.90679

FMAGE 1.08 0.92238

Mean VIF 1.31

4.2.2 Regression Results

4.2.2.1 Total Compensation

Table 4.4 describes the empirical results of models 1 and 2 developed in chapter 3 for

total compensation as dependent variable. Columns 1,3 and 5 presents results of Model 1 that

includes current firm performance while columns 2,4 and 6 provide insight of the relationship

between total compensation and lagged firm performance i.e. Model 2. Column 1 and 2

exhibit results of pooled regression. Unobserved heterogeneity is controlled using fixed

effects as described in chapter 3. Columns 3 and 4 report results with industry and time fixed

effects while columns 5 and 6 present results with firm and time fixed effects. Note that R-

Squared has increased when fixed effects are used. F-tests (unreported) indicate that fixed

effects capture significant variation in CEO total compensation thus, endorse the use of fixed

effects.

In Table 4.4, consistent with hypothesis 1, CEO total compensation is positively related

to current firm accounting performance as measured by ROA. The results are consistent

qualitatively over pooled regression (column 1), industry and time fixed effects model

(column 3), and firm and time fixed effects model (column 5). However, coefficient of ROA

in pooled model is the highest with value of 1. 3484 followed by 1.3156 in industry and time

fixed effect model and 0.2460 in firm and time fixed model. The positive association is

consistent with several studies in Asia (e.g., Conyon and He, 2011, Conyon and He, 2012,

Ghosh, 2006, Kato and Kubo, 2006, Mitsudome et al., 2008). However, it is in contrast to the

109

findings of Shah et al. (2009) and Kashif and Mustafa (2012) study in Pakistan which find no

relationship between CEO compensation and ROA. This might be due to difference in data

period and sample used or methodological difficulties in these studies. In addition Shah et al.

(2009) and Kashif and Mustafa (2012) use only pooled regression models which might not

have captured the true picture.

Current total returns to shareholder do not significantly contribute to pay setting process

as none of the models in columns 1, 3 and 5 reports coefficient for TRET that is different

from zero significantly. Since CEO compensation in Pakistan rarely includes any restricted

stocks, stock options and other stock based bonuses, therefore weak link between CEO total

compensation and market performance is expected. Complement to that, like many other

emerging markets, Pakistani bourses are considered to be highly volatile (Sheikh and Riaz,

2012), therefore using market performance as benchmark for setting CEO compensation may

not be a good choice for board of directors, leading to an insignificant relationship between

CEO total compensation and firm market performance. This is consistent with the findings of

(Aggarwal and Samwick, 1999b) that pay to stock performance link is weak when stock

volatility is high and vice versa. The insignificant coefficients of TRET are also consistent

with studies in China and Japan (see, e.g., Basu et al., 2007, Conyon and He, 2012) where use

of stock base compensation is not very prominent.

With regard to influence of lagged firm performance on current CEO total compensation,

columns 2, 4 & 6 show that previous year ROA also significantly influences CEO total

compensation in positive direction. The coefficient is highest with value 1.6911 in pooled

regression followed 1.5490 and 0.2575 in other two models that incorporate industry and firm

fixed effect along with time fixed effects respectively. The previous year ROA seems to

influence more than the current year ROA as coefficients of previous year ROA is greater in

all models. Similar findings are reported in India where Ghosh (2006) find that lagged ROA

has larger impact than current ROA. Thus, past firm performance has more contribution in

pay setting process in Indian subcontinent.

Surprisingly, previous year total return to shareholders (market performance) has

negative relationship with current CEO total compensation in column 2 and 4. But in column

6 the relationship becomes insignificant with positive sign. One possible reason for negative

relationship may be that since Pakistani markets are highly volatile and it is difficult to base

compensation on market performance. Thus, during the period of bad market performance,

next year compensation may have increased due to positive accounting performance, leading

to negative relationship between current compensation and previous year market

110

performance. In addition, in times of good market performance, increase in current

compensation may not correspond to extra ordinary good market performance in last year,

leading to weak positive or negative relationship between current compensation and previous

year market performance. Therefore, it is presumed that this negative association is by

chance.

Overall, the results suggest that the first hypothesis that firm performance influences

CEO compensation is accepted for firm accounting performance only as both current and

previous year ROA positively contributes towards CEO pay setting process. This implies that

the boards of directors in Pakistan reward CEOs against accounting performance only and do

not give weight to market performance due to opaque nature of Pakistani stock markets. This

is consistent with studies in China and India where too only accounting performance affect

CEO compensation decisions. The positive impact of firm performance on CEO

compensation in a family ownership environment in Pakistan suggests that family ownership

contributes towards alignment of shareholder-manager interests. Existing evidence, however,

on family ownership environment from Asia indicates expropriation view of family

ownership as Kato et al. (2007) find in Korea that accounting performance (ROA) does not

have any impact on CEO compensation in family firms. This may imply that behavior of

family firms in Pakistan is different.

Ownership concentration seems to have positive impact on CEO total compensation

which is inconsistent with agency theory argument that concentrated ownership has better

incentives to monitor and curb managerial opportunism, leading to lower CEO total

compensation. The coefficients of OWNCONS are significantly positive in column 1 through

4. Interestingly, within firm estimation (column 5 & 6) does not depict significant

relationship between CEO total compensation and ownership concentration. This might be

due to the fact that less variation exists for ownership concentration within the firms, leading

to insignificant coefficients. Overall these results reject hypothesis 2 that concentrated

ownership has a negative effect on CEO compensation. The positive impact of ownership

concentration on CEO compensation supports the view that large shareholders expropriate

minority interests by paying excessive compensation to CEOs. Controlling shareholders seem

to be colluding with management to get personal benefits at the expense of minority

shareholders thus overlooking CEO compensation. This finding is consistent with an earlier

study, Shah et al. (2009), in Pakistan but inconsistent with studies in US (Core et al., 1999),

Canada (Amoako-Adu et al., 2011), Europe (Croci et al., 2012, Ozkan, 2007, Ozkan, 2011)

except Denmark (Banghoj et al., 2010) and a few instances in Asia (Conyon and He, 2011).

111

Thus, in term of CEO compensation, concentrated ownership in Pakistan generally behaves

differently as compared to North American and European countries.

In pooled regression, CEOs seem to receive lower total compensation in family firms.

This is inconsistent with Basu et al. (2007) in Japan which finds higher executive

compensation in family firms. However, when industry and time fixed effects are introduced

in the model, coefficients of FAMOWN do not appear to be significant and sign of the

coefficients changes from negative to positive (see column 3 & 4). In addition, introduction

of firm fixed effects along with time fixed effect makes the results significant with positive

sign. These results may be interpreted as CEOs receive less total compensation in family

firms as compared to non-family firms but within firm if family takes over it revises

compensation contracts upward. However, estimates of FAMOWN must carefully be

interpreted in the presence of firm fixed effects. When firm fixed effects are used there must

be reasonable variations within the firm for FAMOWN. However, this is unlikely as family

firm in 2005 is very likely to remain a family firm throughout the sample period of 8 years.

Within industry CEOs in family and non-family firms seem to receive equal compensation on

average. Overall, the third hypothesis that family firms pay less CEO compensation finds

weak support from the results.

Board size is normally used as proxy for board effectiveness. Larger boards beyond

certain size limits become ineffective. Such larger boards can easily be influenced by CEOs,

leading to excessive CEO compensation and hence positive association between CEO pay

and board size. The results do not support this argument as coefficient of board size is

consistently insignificant in all models. These results suggest that board size does not

influence CEO total compensation in either side positive or negative. Thus, hypothesis 4 that

board size is positively associated with CEO compensation is rejected. This implies that

board size is irrelevant in Pakistan. This finding contradicts with the finding of several

studies (e.g., Basu et al., 2007, Conyon, 2014, Conyon and He, 2012, Core et al., 1999,

Fernandes et al., 2013, Shah et al., 2009) however, it corresponds with the institutional

context of Pakistan discussed earlier. Groups or family firms use proxy directors who are

obligated to controlling groups or families only. These proxy directors don’t have any say or

they support the decisions coming from controlling group or family. This makes board size

irrelevant. Similarly, state owned firms and foreign owned firms bypass boards in taking

major decisions which also leads to no influence of board size on CEO compensation

decisions.

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The insignificant coefficients for B_IND in all models indicate no effect of board

independence in CEO pay process. Thus, hypothesis 5 that board independence contributes

effectively to reduce managerial opportunism and hence reduce CEO compensation is

rejected. The results seem to support the managerial power approach that independent

directors can be under influence of CEO as they wish to be re-nominated and re-appointed

and may engage in secret contracts with CEOs, which in turn may lead to overlooking of

CEO compensation contracts or approving excessive CEO compensation contracts. The

finding implies that non-executive directors are neutral in CEO compensation decisions. They

do not give their inputs. This is due to the reason that non-executive directors are generally

hired from within controlling families and cannot go against the family decisions. Further it

implies that CEO compensation decisions are not made within the board. The boards just

approve CEO pay decisions which have been taken elsewhere14.

While this finding is consistent with Kashif and Mustafa (2012) in Pakistan and some

other studies outside Pakistan (e.g., Guthrie et al., 2012, Ozkan, 2011) however, it is in

contrast with Basu et al. (2007) in Japan and Shah et al. (2009) in Pakistan which find

negative relationship between CEO total compensation and board independence. This

contradicting finding from Shah et al. (2009) in Pakistan may be due to difference in data

period and sample size used. However as discussed earlier Shah et al. (2009) also suffers

from methodological difficulties which might be another reason for contradicting results.

CEO duality appears to be significantly negatively related to CEO total compensation.

The coefficients of DUALCEO are consistently negative and significant in column 1 through

4. However, with firm fixed effects they lose their significance but sign remains negative.

Again within firms, there might not be reasonable variations in CEO duality over sample

period which might have led to insignificant coefficients when firm fixed effect models are

used. Nevertheless, overall, hypothesis 6 that CEO duality leads to ineffective corporate

governance and results in higher CEO compensation is rejected. Thus, the argument that

more concentrated power in one person lead to expropriation resulting in higher CEO

compensation is not supported. This finding is inconsistent with most of the studies inside

and outside Pakistan (e.g., Chen et al., 2011, Conyon and He, 2012, Core et al., 1999, Kashif

14 One can argue that principle component analysis (PCA) should be warranted as insignificant coefficients of board size and board independence may be due to potential multicollinearity issues in board structure variables. However, correlation matrices and VIFs suggest that there is no issue of multicollinearity in the studied variables. In addition, the primary objective of the study is to examine the individual influences of corporate governance variables on CEO compensation. If PCA is performed, much of the information in the variables would be lost as PCA would reduce the number of variables to one or two components which are themselves difficult to interpret (see, Jolliffe, 2002). Therefore, PCA should not be warranted in this case.

113

and Mustafa, 2012, Shah et al., 2009). This is an unexpected finding which implies that

Pakistani firms behave differently from rest of the world in that when CEO also holds the

position of chairman, he/she agrees upon receiving lower compensation. One reason for this

finding might be that since family ownership is common in Pakistan and the position of CEO

or chairman is generally held by founding father or elder sibling therefore being steward of

the family and holding all the powers single handedly, he might not give weight to higher

compensation against power he enjoys or his social stature, resulting in lower compensation

(see, e.g., Gomez-Mejia et al., 2003). A split sample analysis (unreported) confirms that

negative impact of CEO duality on CEO compensation is driven by family firms. Similarly,

mean comparison of CEO compensation shows that family firms and firms with CEO duality

have lower average CEO compensation. Overall, this finding warrants investigation on the

impact of internal family issues and conflicts on CEO compensation as mentioned by

Bertrand and Schoar (2006). However, this is beyond the scope of this study. In addition, the

dataset used in this study does not allow to investigate effects of internal family issues on

CEO compensation.

Firm size (FIRMSIZE) as measured by log of total assets is appeared to be significantly

positively related to CEO total compensation in all models which implies that large firms pay

higher compensation to their CEOs. This supports the argument that larger firms are complex

and difficult to run and hence require quality CEOs with higher compensations. Firm risk

(FIRMRSK) is negatively associated with CEO total compensation however coefficient is

significant only in the models with firm fixed effects. Negative association indicate that risky

firms pay less to their CEOs which is inconsistent with existing studies (e.g., Brick et al.,

2006, Conyon and He, 2011, Core et al., 1999, Lippert and Moore, 1994, Lippert and Porter,

1997). MTB appears to have no significant relationship with CEO total compensation. Thus,

it can be assumed that MTB does not influence CEO total compensation in Pakistan. Aged

and matured firms seem to pay higher compensation to their CEOs as most of the coefficients

of FMAGE are positive and significant.

4.2.2.2 Cash Compensation

Table 4.5 describes the empirical results of models 1 and 2 developed in chapter 3 for

cash compensation as dependent variable. Similar to Table 4.4, columns 1,3 and 5 presents

the results of Model 1 that includes current firm performance while columns 2,4 and 6

provide insight of the relationship between cash compensation and lagged firm performance

i.e. Model 2. Column 1 and 2 exhibit results of pooled regression. Unobserved heterogeneity

114

is controlled using fixed effects as described in chapter 3. Columns 3 and 4 report results with

industry and time fixed effects while columns 5 and 6 present results with firm and time fixed

effects.

In Table 4.5, again, consistent with the main hypothesis, CEO cash compensation also

seems to be positively related to current firm accounting performance as measured by ROA.

The results are consistent qualitatively over pooled regression (column 1), industry and time

fixed effects model (column 3) but not over firm and time fixed effects model (column 5).

The coefficient of ROA in pooled model is the highest with value 1. 3644 followed by 1.3315

in industry and time fixed effect model and 0.2497 in firm and time fixed model. The

closeness of coefficients of the models with cash compensation and total compensation

indicates high correlation between cash compensation and total compensation in Pakistan.

The positive association of cash compensation and firm accounting performance is consistent

with other studies in Asia (e.g., Ghosh, 2006, Kato and Kubo, 2006, Kato and Long, 2006)

Current total returns to shareholder do not significantly contribute to cash compensation

as none of the models in columns 1, 3 and 5 reports coefficient for TRET that is significantly

different from zero in both tables. This indicates that firms in Pakistan do not link base salary

and cash bonuses to market performance. The reason might be existence of high volatility in

stock markets of Pakistan which may drive away the attention of directors to use market

performance as benchmark for setting CEO cash compensation (Shaw and Zhang, 2010).

With regard to influence of lagged firm performance on current CEO cash compensation,

columns 2, 4 & 6 show that previous year ROA also significantly influences CEO cash

compensation in positive direction. The coefficient is highest with value 1.7678 in pooled

regression followed 1.6122 and 0.3101 in other two models that incorporate industry and firm

fixed effect along with time fixed effects respectively. The previous year ROA seems to

influence more than the current year ROA as coefficients of previous year ROA are greater in

all models. Surprisingly, previous year total return to shareholders (market performance) has

negative relationship with current CEO cash compensation in column 2 and 4. But in column

6 the relationship becomes insignificant with positive sign. This is similar situation as in case

of total compensation as dependent variable in Table 4.4. The possible reasons for this

finding are the same as discussed earlier

Ownership concentration seems to have positive impact on CEO cash compensation also

like on total compensation which is inconsistent with agency theory arguments. This might

again be an indication of expropriation of minority interests by controlling shareholders.

115

Thus, hypothesis 2 that concentrated ownership is negatively related CEO compensation is

rejected for cash compensation also.

Like in case of total compensation, influence of family ownership on CEO cash

compensation seems inconclusive. However, since within firm variation in FAMOWN

variable is not expected therefore ignoring firm fixed effect model, the hypothesis that family

firms pay less to their CEO is partially accepted with a need to explore it further by

incorporating variables related to family characteristics such as family CEO, number of

family members on board etc.

The coefficients of BDSIZE and B_IND stay insignificant in all models. Thus, Board

size and board independence has no impact on setting CEO cash pay. These results reject

hypotheses 4 and 5 and seem to support the managerial power approach.

Similar to CEO total compensation, CEO duality appears to be significantly negatively

related to CEO cash compensation also. The results are quite similar to as in case of total

compensation. Thus, hypothesis 6 that CEO duality leads to ineffective corporate governance

and results in higher CEO compensation is also rejected for cash compensation.

All other control variables such as FIRMSIZE, FIRMRSK, MTB and FMAGE have

same relationship with CEO cash compensation as they have with CEO total compensation.

FIRMSIZE and FMAGE have positive, FIRMRSK has negative while MTB has no

relationship with CEO cash compensation with similar possible reasons as described earlier.

This is mainly due to high correlation between the two measures of CEO compensation.

116

Table 4.4

Total Compensation and Firm Performance Dependent variable is log of total compensation as measured by sum of all pay components, ROA = return on assets measured

by earnings before interest and taxes divided by total assets, TRET = total return to shareholders as measured by current market

price plus dividend divided by previous year market price minus one, OWNCONS = concentrated ownership as measured by

voting shares held by the largest shareholder, FAMOWN = a dummy variable taking value one for family firms and zero

otherwise, BDSIZE = board size as measured by number of sitting directors on board, B_IND = board independence as

measured by ratio of non-executive directors to board size, DUALCEO = CEO duality a dummy variable taking value one if

CEO is also chairman board of directors, FIRMSIZE = firm size as measured by log of total assets, FIRMRSK = firm risk as

measured by standard deviation of monthly stock returns over the fiscal year, MTB = market to book ratio as measured by

market value divided by book value per share, FMAGE = firm age as mentioned in annual reports, CEOCHNG = Interaction

term of a dummy variable taking value 1 if CEO is replaced during the year and number of CEOs drawing remuneration during

the year

Log of Total Compensation

(1) (2) (3) (4) (5) (6)

VARIABLES Pooled Pooled Fixed Effects

(Industry and

Time)

Fixed Effects

(Industry and

Time)

Fixed Effects

(Firm and

Time)

Fixed Effects

(Firm and

Time)

ROAit 1.3484*** 1.3156*** 0.2460*

(0.3927) (0.3429) (0.1268)

TRETit 0.0132 -0.0406 0.0053

(0.0262) (0.0246) (0.0189)

ROAit-1 1.6911*** 1.5490*** 0.2575**

(0.3965) (0.3296) (0.1289)

TRETit-1 -0.0849*** -0.0576** 0.0137

(0.0316) (0.0262) (0.0162)

OWNCONSit 0.7634** 0.7818** 0.5726* 0.5797** 0.0384 0.1224

(0.3298) (0.3247) (0.2937) (0.2910) (0.4862) (0.4174)

FAMOWNit -0.2767* -0.2640* 0.0137 0.0095 0.5938*** 0.4843***

(0.1486) (0.1494) (0.1465) (0.1461) (0.0488) (0.0482)

BDSIZEit 0.0016 0.0133 0.0029 0.0083 -0.0145 0.0056

(0.0425) (0.0418) (0.0382) (0.0379) (0.0351) (0.0393)

B_INDit 0.3561 0.2843 0.2463 0.2020 0.2489 0.2712

(0.2844) (0.2862) (0.2536) (0.2562) (0.2291) (0.1954)

DUALCEOit -0.3416*** -0.3489*** -0.2217** -0.2156* -0.0483 -0.0587

(0.1217) (0.1221) (0.1095) (0.1105) (0.1156) (0.1262)

FIRMSIZEit 0.3546*** 0.3396*** 0.3503*** 0.3450*** 0.2255*** 0.2967***

(0.0353) (0.0356) (0.0363) (0.0359) (0.0622) (0.0708)

FIRMRSKit -0.1918 0.0228 -0.0783 0.0749 -0.2950** -0.2913**

(0.2106) (0.2151) (0.2110) (0.2103) (0.1339) (0.1432)

MTBit -0.0080 -0.0087 -0.0075 -0.0082 -0.0005 0.0009

(0.0086) (0.0086) (0.0092) (0.0088) (0.0040) (0.0031)

FMAGEit 0.0097** 0.0090** 0.0072** 0.0071** -0.0218 -0.0716

(0.0037) (0.0037) (0.0032) (0.0030) (0.0468) (0.0524)

CEOCHNGit -0.1296 -0.1395* -0.1196* -0.1288* 0.0389 0.0296

(0.0805) (0.0815) (0.0711) (0.0732) (0.0366) (0.0406)

Observations 1,508 1,277 1,508 1,277 1,508 1,277

R-squared 0.4686 0.4863 0.6060 0.6120 0.9301 0.9377

Industry FE NO NO YES YES NO NO

Firm FE NO NO NO NO YES YES

Time FE NO NO YES YES YES YES

Robust standard errors in parentheses

*** p<0.01, ** p<0.05, * p<0.1

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Table 4.5

Cash Compensation and Firm Performance Dependent variable is log of cash compensation as measured by sum of basic salary and cash bonuses, ROA = return on assets

measured by earnings before interest and taxes divided by total assets, TRET = total return to shareholders as measured by

current market price plus dividend divided by previous year market price minus one, OWNCONS = concentrated ownership as

measured by voting shares held by the largest shareholder, FAMOWN = a dummy variable taking value one for family firms

and zero otherwise, BDSIZE = board size as measured by number of sitting directors on board, B_IND = board independence

as measured by ratio of non-executive directors to board size, DUALCEO = CEO duality a dummy variable taking value one if

CEO is also chairman board of directors, FIRMSIZE = firm size as measured by log of total assets, FIRMRSK = firm risk as

measured by standard deviation of monthly stock returns over the fiscal year, MTB = market to book ratio as measured by

market value divided by book value per share, FMAGE = firm age as mentioned in annual reports, CEOCHNG = Interaction

term of a dummy variable taking value 1 if CEO is replaced during the year and number of CEOs drawing remuneration during

the year

Log of Cash Compensation

(1) (2) (3) (4) (5) (6)

VARIABLES Pooled Pooled Fixed Effects

(Industry and

Time)

Fixed Effects

(Industry and

Time)

Fixed Effects

(Firm and

Time)

Fixed Effects

(Firm and

Time)

ROAit 1.3644*** 1.3315*** 0.2497

(0.4029) (0.3611) (0.1572)

TRETit 0.0244 -0.0304 0.0066

(0.0267) (0.0258) (0.0224)

ROAit-1 1.7678*** 1.6122*** 0.3101**

(0.4083) (0.3513) (0.1502)

TRETit-1 -0.0872** -0.0594** 0.0115

(0.0336) (0.0277) (0.0180)

OWNCONSit 0.8819*** 0.9131*** 0.7061** 0.7242** 0.0172 0.0938

(0.3363) (0.3318) (0.3114) (0.3095) (0.5338) (0.4787)

FAMOWNit -0.2915* -0.2765 -0.0421 -0.0428 0.6186*** 0.4294***

(0.1657) (0.1705) (0.1649) (0.1658) (0.0566) (0.0578)

BDSIZEit 0.0160 0.0291 0.0253 0.0317 -0.0127 0.0054

(0.0485) (0.0490) (0.0437) (0.0445) (0.0391) (0.0395)

B_INDit 0.1132 0.0403 0.0292 -0.0175 0.2313 0.3415

(0.2965) (0.3032) (0.2725) (0.2801) (0.2475) (0.2265)

DUALCEOit -0.3210** -0.3297** -0.2191* -0.2121* -0.0040 0.0089

(0.1269) (0.1279) (0.1150) (0.1167) (0.1254) (0.1421)

FIRMSIZEit 0.3530*** 0.3390*** 0.3532*** 0.3490*** 0.2712*** 0.3298***

(0.0368) (0.0371) (0.0385) (0.0381) (0.0679) (0.0753)

FIRMRSKit -0.2886 -0.0559 -0.1914 -0.0144 -0.2849** -0.2640*

(0.2126) (0.2215) (0.2044) (0.2059) (0.1365) (0.1437)

MTBit -0.0040 -0.0049 -0.0052 -0.0062 -0.0002 0.0000

(0.0081) (0.0081) (0.0088) (0.0084) (0.0036) (0.0028)

FMAGEit 0.0092** 0.0085** 0.0062* 0.0062* -0.0116 -0.0571*

(0.0040) (0.0040) (0.0034) (0.0033) (0.0249) (0.0330)

CEOCHNGit -0.1733** -0.1898** -0.1583** -0.1757** 0.0127 -0.0086

(0.0858) (0.0854) (0.0767) (0.0775) (0.0391) (0.0411)

Observations 1,508 1,277 1,508 1,277 1,508 1,277

R-squared 0.4474 0.4666 0.5707 0.5779 0.9135 0.9226

Industry FE NO NO YES YES NO NO

Firm FE NO NO NO NO YES YES

Time FE NO NO YES YES YES YES


*** p<0.01, ** p<0.05, * p<0.1

118

4.2.2.3 Regression on Lagged Explanatory Variables

To control for potential problem of endogeneity, CEO compensation is regressed on

lagged values of explanatory variables as discussed in chapter 3. Table 4.6 reports the results

for Model 3 in chapter 3 for both cash and total compensation.

Firms accounting performance as measure by ROA appears to influence both CEO cash

and total compensation even after controlling for endogeneity. The coefficients of ROA are

significant across pooled and fixed effects models. However, market performance as

measured by total return to shareholders, surprisingly, seems to be negatively related to both

cash and total compensation. The reason for this negative association is assumed to

preference of board to not using highly volatile market performance as a benchmark for pay

setting process as discussed earlier. Thus, in Pakistan, the only firm performance that matters

in setting CEO compensation is accounting performance.

Concentrated ownership appears to positively affect both CEO cash and total

compensation in pooled and industry fixed effect models. Thus, it can fairly be assumed that

concentrated ownership positively influence CEO compensation and large shareholders

oblige CEOs by setting CEO compensation high. Given the Pakistani context, this is mainly

due to get personal benefits. Influence of family ownership on CEO compensation is again

mixed. Again comparison between firms without considering industry (pooled regression)

shows that CEO in family firms receive less pay than their counterparts but within firm

change of family ownership status from non-family to family positively influence CEO

compensation.

BDSIZE and B_IND do not appear to influence CEO compensation as indicated by

insignificant coefficients for these variables. CEOs who are also chairman board of directors

appear to receive less compensation than their counterparts as coefficients of DUALCEO are

negative and significant except in column 3 and 6. This indicates that within firm change of

status from separate chairman to CEO as chairman does not seem to affect CEO

compensation on average.

Coefficients of FIRMSIZE are highly significant with positive sign in all models for cash

and total compensation, indicating that firm size is perhaps one the most important factors

that contributes towards CEO compensation. FIRMRSK and MTB do not appear to have

convincing contribution towards devising CEO compensation packages. FMAGE does have

some positive influence on CEO compensation.

Overall, regression on lagged explanatory variables confirms the previous results.

119

Table 4.6

CEO Compensation and Firm Performance, controlling for Endogeneity (Regression on lagged explanatory

variables) Dependent variables are log of compensation, ROA = return on assets measured by earnings before interest and taxes divided by

total assets, TRET = total return to shareholders as measured by current market price plus dividend divided by previous year

market price minus one, OWNCONS = concentrated ownership as measured by voting shares held by the largest shareholder,

FAMOWN = a dummy variable taking value one for family firms and zero otherwise, BDSIZE = board size as measured by

number of sitting directors on board, B_IND = board independence as measured by ratio of non-executive directors to board size,

DUALCEO = CEO duality a dummy variable taking value one if CEO is also chairman board of directors, FIRMSIZE = firm

size as measured by log of total assets, FIRMRSK = firm risk as measured by standard deviation of monthly stock returns over

the fiscal year, MTB = market to book ratio as measured by market value divided by book value per share, FMAGE = firm age as

mentioned in annual reports, CEOCHNG = Interaction term of a dummy variable taking value 1 if CEO is replaced during the

year and number of CEOs drawing remuneration during the year

Cash Compensation Total Compensation

(1) (2) (3) (4) (5) (6)

VARIABLES Pooled Fixed Effects

(Industry and

Time)

Fixed Effects

(Firm and

Time)

Pooled Fixed Effects

(Industry and

Time)

Fixed Effects

(Firm and

Time)

ROAit-1 1.8433*** 1.6888*** 0.4430*** 1.7596*** 1.6158*** 0.3792***

(0.4097) (0.3522) (0.1338) (0.4006) (0.3325) (0.1245)

TRETit-1 -0.0752** -0.0556* 0.0120 -0.0773** -0.0573** 0.0158

(0.0335) (0.0288) (0.0166) (0.0317) (0.0275) (0.0150)

OWNCONS it-1 0.9074*** 0.7132** 0.3700 0.7796** 0.5749* 0.4696

(0.3462) (0.3213) (0.4289) (0.3380) (0.3011) (0.3959)

FAMOWNit-1 -0.2700 -0.0448 0.3306*** -0.2530* 0.0133 0.3422***

(0.1717) (0.1679) (0.0535) (0.1511) (0.1483) (0.0513)

BDSIZEit-1 0.0322 0.0305 -0.0258 0.0160 0.0072 -0.0110

(0.0496) (0.0447) (0.0451) (0.0428) (0.0385) (0.0455)

B_INDit-1 0.0312 -0.0228 0.1582 0.2701 0.1902 0.0826

(0.2954) (0.2760) (0.1926) (0.2804) (0.2543) (0.1795)

DUALCEOit-1 -0.3234** -0.2168* 0.0725 -0.3580*** -0.2329** -0.0232

(0.1298) (0.1180) (0.0995) (0.1244) (0.1123) (0.0899)

FIRMSIZEtt-1 0.3439*** 0.3529*** 0.2735*** 0.3451*** 0.3490*** 0.2601***

(0.0373) (0.0386) (0.0830) (0.0357) (0.0361) (0.0815)

FIRMRSKit-1 -0.0665 0.0075 0.0833 0.0468 0.1100 0.0584

(0.2231) (0.2129) (0.0985) (0.2191) (0.2191) (0.0913)

MTBit-1 -0.0055 -0.0071 -0.0036 -0.0093 -0.0090 -0.0022

(0.0083) (0.0088) (0.0037) (0.0089) (0.0093) (0.0043)

FMAGEit 0.0084** 0.0062* -0.0661* 0.0089** 0.0071** -0.0798

(0.0040) (0.0033) (0.0380) (0.0037) (0.0031) (0.0577)

CEOCHNGit -0.1809** -0.1674** -0.0043 -0.1252 -0.1165 0.0354

(0.0853) (0.0774) (0.0406) (0.0803) (0.0722) (0.0404)

Observations 1,277 1,277 1,277 1,277 1,277 1,277

R-squared 0.4645 0.5765 0.9211 0.4856 0.6119 0.9362

Industry FE NO YES NO NO YES NO

Firm FE NO NO YES NO NO YES

Time FE NO YES YES NO YES YES


*** p<0.01, ** p<0.05, * p<0.1

120

4.2.2.4 Dynamic Panel Model – GMM Estimation

Table 4.7 exhibits the results of dynamic panel model (Model 4 in chapter 3) estimated

using GMM approach. As described in chapter 3 the model is estimated using three GMM

techniques. Column 1 & 4 present results of the model estimated using of GMM-Diff for cash

compensation and total compensation respectively. Similarly, columns 2 & 4 report results of

GMM-Orthogonal technique and column 3 & 6 show results of GMM-System technique for

cash compensation and total compensation respectively. Arellano-Bond serial correlation

tests m1 & m2 and instrument over-identification tests are also reported at the bottom of the

table. Arellano-Bond test for second order (m2) validates the use second and earlier lags of

dependent variables as instruments in all the columns. None of the values of m2 rejects the

hypothesis of no second order correlation in error terms. Similarly, over-identification tests

Sargan test and Hansen J test show that the instruments used in the GMM estimation

techniques are jointly valid. All the values of Sargan test statistic and Hansen J test statistic

are insignificant thus, accepting the hypothesis of joint validity of the instruments used. Note

that GMM models’ results are within firm estimation and comparable to firm fixed and time

fixed effect models only which are discussed earlier.

The GMM estimation confirms the finding of positive relationship between both

measures of CEO compensation and firm accounting performance. However, although signs

of the coefficients of TRET are negative but they remain insignificant in all three techniques

for both measures of CEO compensation, confirming no influence of market performance on

CEO compensation. Thus, it is confirmed that only firm accounting performance contribute

towards CEO pay setting process in Pakistan. The boards of director ignore market

performance while setting CEO compensation. This is believed to be due to highly volatile

and opaque Pakistani stock markets.

With regard to corporate governance variables, there is little evidence that concentrated

ownership has impact on total CEO compensation (see column 6) as compared to firm fixed

effect models where such evidence does not exist (see Table 4.4). Thus, dynamic panel model

that controls for endogeneity problem along with unobserved heterogeneity and serial

correlation seems to confirm that large shareholders support setting CEO compensation high

as they are in direct relation with CEOs to get personal benefits.

Family ownership appears to be related to lower CEO cash compensation as the

coefficient of FAMOWN is negative and significant in GMM-Orthogonal technique (see

column 1 to 3). On the other side, FAMOWN appears to have positive influence on CEO

total compensation in GMM-DIFF technique. As cash compensation includes only base

121

salary and cash bonuses while total compensation includes all the components therefore,

these results indicate that CEOs in family firms receive lower base salary and cash bonuses

but higher perks and retirement benefits.

The coefficients of BDSIZE and B_IND are consistently insignificant which is consistent

with fixed effect models. Thus, dynamic panel model confirms that board size and number of

non-executive directors in the board in Pakistan are irrelevant in CEO compensation

decisions. DUALCEO appears to have significantly negative relationship with both CEO

cash and total compensations. This confirms that after controlling endogeneity, CEOs who

are also chairman board of directors receive lower cash as well as total compensation.

Overall, the results of corporate governance have improved using GMM approach. This is

due to better control for endogenous nature of corporate governance variables.

The coefficients of FIRMSIZE are consistently positive and significant across all three

techniques for both cash and total compensation. FIRMRSK does not have any significant

coefficient in any of three techniques used. Earlier FIEMRSK shows negative effect on both

cash and total CEO compensation in firm fixed effect models (see Table 4.4 & 4.5). MTB

does not seem to have any convincing relationship with CEO total compensation however

there is some sign of positive effect on cash compensation in GMM-Orthogonal approach.

FMAGE appears to have decreasing effect on both CEO cash compensation and CEO total

compensation as GMM-DIFF and GMM Orthogonal approaches report significantly negative

coefficients for FMAGE (see columns 1, 2, 4 and 5).

One important feature of dynamic panel model is that it considers the dynamic

adjustment of CEO pay towards the target levels. Conyon and He (2012) argue that the

boards of directors have incomplete information about CEOs’ capabilities and this

information has to be updated over time. Thus, boards of directors adjust CEO compensation

to target levels as they learn more about CEO capabilities over time. However, the boards

cannot adjust CEO pay quickly to the target levels rather they try to smooth the adjustments

process, leading to serial correlation in CEO compensation.

Consistent with the above arguments coefficients of lagged CEO pay are positive and

significant in all three techniques for both cash and total compensation, indicating that CEO

pay is highly persistent and takes time to adjust to its long-term equilibrium level. This is an

important finding of this study as most of the literature on CEO compensation (see, e.g.,

Croci et al., 2012, Devers et al., 2007, Kashif and Mustafa, 2012, Ozkan, 2007, Shah et al.,

2009) ignores the dynamic nature of CEO compensation and estimate static pay models

122

considering that pay is in equilibrium, thus, ignoring the CEO pay adjustment to long run

equilibrium.

It is important to note here that very few studies have adopted dynamic panel model

estimation while analyzing CEO compensation. Conyon and He (2012) is the only study in

Asian context of which results are directly comparable to this study. Consistent with this

study, Conyon and He (2012) also find in China that the boards of directors pay more

attention to firm accounting performance than to firm market performance while setting CEO

compensation. This may be because of the fact that stock based CEO compensation is rare in

both countries which may eliminate the option of making market performance as benchmark

for CEO compensation. Further, Conyon and He (2012) also find that CEO compensation is

highly persistent and dynamically adjusted towards target equilibrium level. However,

inconsistent with this study, ownership and board structure variables (board size, board

independence and CEO duality) do not have significant impact on CEO pay process in their

study after controlling for pay persistence, unobserved heterogeneity and endogeneity. In

Pakistan, as results suggest, ownership concentration and CEO duality have important

contribution towards pay setting process even after controlling for pay persistence,

unobserved heterogeneity and endogeneity. The differences in results of corporate

governance variables of both studies are presumably due to differences in institutional

contexts of China and Pakistan.

4.2.3 Robustness Checks

Although results presented are robust across different model specifications however, to

further reconfirm, three robustness checks are conducted. First, all the continuous variables

are winsorized using 1% level at both tails to eliminate potential outliers and all models are

re-estimated. But, the results do not change qualitatively therefore it is decided to report the

original data results. Second, alternative measures of firm accounting performance, firm size

and ownership concentration as log of net sales, EPS and voting shares held by three largest

shareholders respectively, are incorporated. Again, the results remain qualitatively similar to

as reported above. Third, median regression is estimated using STATA but that also does not

lead to change the inferences.

Fourth, ownership concentration and family ownership variables are incorporated in

separate models as they may shadow each other. However, the results remain qualitatively

similar to as reported. Fifth, two dummy variables are constructed to account for

effectiveness of board size and board independence in another way. One, considering board

123

size between 8 and 10 as optimum board size, a dummy variable is constructed taking value 1

if board size is between 8 and 10, and zero otherwise. The other, considering one of the

requirements of the Code 2002 that the ratio of the number of executive directors to board

size should not exceed 75%, a dummy variable is constructed taking value 1 if this ratio is

less than or equal to 75%, and zero otherwise to see if a company meets the requirement.

These variables are incorporated in the model instead of original variables of board size and

board independence. However, both dummy variables appear to have no impact on CEO

compensation in any direction. Thus, this confirms the original results that board size and the

presence of non-executive directors in the board do not contribute towards CEO

compensation decisions. Thus, findings of this study are robust to different model

specifications and alternative measures of important variables.

124

Table 4.7

CEO Compensation and Firm Performance, Dynamic Panel Model (GMM Estimation) Dependent variables are log of compensation, ROA = return on assets measured by earnings before interest and taxes

divided by total assets, TRET = total return to shareholders as measured by current market price plus dividend divided by

previous year market price minus one, OWNCONS = concentrated ownership as measured by voting shares held by the

largest shareholder, FAMOWN = a dummy variable taking value one for family firms and zero otherwise, BDSIZE = board

size as measured by number of sitting directors on board, B_IND = board independence as measured by ratio of non-

executive directors to board size, DUALCEO = CEO duality a dummy variable taking value one if CEO is also chairman

board of directors, FIRMSIZE = firm size as measured by log of total assets, FIRMRSK = firm risk as measured by

standard deviation of monthly stock returns over the fiscal year, MTB = market to book ratio as measured by market value

divided by book value per share, FMAGE = firm age as mentioned in annual reports, CEOCHNG = Interaction term of a

dummy variable taking value 1 if CEO is replaced during the year and number of CEOs drawing remuneration during the

year

Cash Compensation Total Compensation

(1) (2) (3) (4) (5) (6)

VARIABLES GMM

Differenced

GMM

Orthogonal

GMM

System

GMM

Differenced

GMM

Orthogonal

GMM

System

LNCOMPt-1 0.4281*** 0.3732*** 0.8995*** 0.3547*** 0.3908*** 0.8037***

(0.1356) (0.1215) (0.0413) (0.1185) (0.1286) (0.0577)

ROAit 0.2723* 0.4127*** 0.4194*** 0.2687* 0.3765*** 0.5282***

(0.1528) (0.1506) (0.1404) (0.1480) (0.1228) (0.1567)

TRETit -0.0480 -0.0507 -0.0275 -0.0289 -0.0302 -0.0447

(0.0397) (0.0429) (0.0465) (0.0343) (0.0404) (0.0615)

OWNCONSit -0.0541 0.2543 0.1173 -0.3847 0.0807 0.1486*

(0.6606) (0.3469) (0.0910) (0.4114) (0.2765) (0.0831)

FAMOWNit 0.0322 -1.1709*** -0.0163 0.1859** -0.2949 -0.0339

(0.0856) (0.4462) (0.0432) (0.0754) (0.6523) (0.0380)

BDSIZEit -0.0168 0.0031 0.0069 0.0045 0.0142 0.0087

(0.0387) (0.0286) (0.0114) (0.0249) (0.0304) (0.0093)

B_INDit 0.0982 0.2273 0.0160 0.2362 0.1820 0.0300

(0.1735) (0.1478) (0.0612) (0.3773) (0.1341) (0.0707)

DUALCEOit -0.2422* -0.0427 -0.0651* -0.2400* -0.1257* -0.0750*

(0.1471) (0.0866) (0.0353) (0.1278) (0.0738) (0.0386)

FIRMSIZEit 0.1785*** 0.2548*** 0.0365** 0.1721*** 0.2023*** 0.0664***

(0.0590) (0.0600) (0.0146) (0.0550) (0.0549) (0.0204)

FIRMRSKit 0.1119 0.0136 0.0493 0.0067 -0.0520 -0.0763

(0.1908) (0.2300) (0.1222) (0.1493) (0.2155) (0.1580)

MTBit 0.0034 0.0027* -0.0004 0.0024 0.0022 0.0010

(0.0023) (0.0014) (0.0035) (0.0029) (0.0019) (0.0032)

FMAGEit -0.0585*** -0.0507** -0.0004 -0.0799*** -0.0612* 0.0008

(0.0157) (0.0254) (0.0008) (0.0223) (0.0313) (0.0008)

CEOCHNGit 0.0229 0.0263 0.0186 0.0595* 0.0487 0.0292

(0.0387) (0.0372) (0.0419) (0.0335) (0.0340) (0.0382)

Observations 1,051 1,057 1,277 1,051 1,057 1,277

Number of firms 215 215 220 215 215 220

Arellano-Bond

AR(1) in Diff. (m1) -2.90*** -2.82*** -4.44*** -3.32*** -3.36*** -5.67***

AR(2) in Diff. (m2) -1.37 -1.33 -0.99 -0.95 -0.84 -0.33

Over identification tests

Sargan test 61.43 54.49 93.99 91.14 57.05 63.43

Hansen J test 64.48 61.98 86.42 70.83 56.72 42.38

(df) (60) (60) (79) (80) (60) (52)

Windmeijer-corrected Standard errors in parentheses

*** p<0.01, ** p<0.05, * p<0.1

125

4.3 CEO Compensation and Future Firm Performance


Table 4.8 presents the correlation matrix of the variables used in Model 6 developed in

research strategy section. Current firm performance seems to be positively correlated with

future firm performance with correlation coefficient of 0.5697. This seems to indicate that

currently well performing firms are also likely to perform well in future. Both cash and total

compensations (LNCASHCOMP and LNTCOMP) also appear to have positive correlation

with ROAt+1 and coefficients are significant with values of 0.2720 and 0.2738 respectively.

This indicates some motivation aspects of CEO compensation to perform good in future.

Current total returns to shareholders also seems to have significant positive correlation with

ROAt+1 (coefficient is 0.1707). With regard corporate governance variables, ownership

concentration (OWNCONS) and board size (BDSIZE) are positively correlated with future

firm performance with correlation coefficients of 0.2144 and 0.1155 respectively while

family ownership (FAMOWN) and CEO duality are negatively correlated with future

performance with coefficients of -0.2064 and -0.1607. However, board independence does

not seem to have any significant relationship with future firm performance as indicated by its

insignificant correlation coefficient with ROAt+1. As far as firm specific variables are

concerned, LNSALES and MTB have significant positive correlation while FIRMRSK is

significantly negatively correlated with future firm performance.


The correlation matrix (see Table 4.8) shows that none of the absolute values of

correlation coefficients is greater than normally used threshold level of 0.70 for potential

serious problem of multicollinearity. To further confirm that no multicollinearity problem

exists, variance inflation factor (VIF) and tolerance are estimated. Table 4.9 indicates that

none of the VIF is greater than generally used threshold level of 10 and mean of VIFs is 1.45

which is not considerably different from one. Similarly, all the tolerance levels are above the

threshold level of 0.10. Thus, the tests suggest that variables of Model 6 can be used

simultaneously in one regression model without the fear of multicollinearity problem.

126

Table 4.8 Correlation Matrix (Variables used in Model 6)

Variables

(1) (2) (3) (4) (5) (6) (7) (8) (9) (10) (11) (12) (13)

ROAt+1 (1) 1.0000 ROA (2) 0.5697* 1.0000

TRET (3) 0.1707* 0.2096* 1.0000 LNTCOMP (4) 0.2720* 0.3264* -0.0511 1.0000

LNCASHCOMP (5) 0.2738* 0.3261* -0.0452 0.9721* 1.0000 OWNCONS (6) 0.2144* 0.2339* 0.0482 0.3693* 0.3802* 1.0000

FAMOWN (7) -0.2064* -0.2269* -0.0001 -0.3852* -0.3861* -0.5578* 1.0000 BDSIZE (8) 0.1155* 0.1393* 0.0233 0.3205* 0.3134* 0.1107* -0.4468* 1.0000

B_IND (9) 0.0240 0.0356 -0.0320 0.1762* 0.1330* 0.0588* -0.2278* 0.3578* 1.0000 DUALCEO (10) -0.1607* -0.1670* 0.0044 -0.3048* -0.2859* -0.0823* 0.1690* -0.2594* -0.1807* 1.0000

LNSALES (11) 0.2704* 0.3313* -0.0340* 0.6130* 0.5926* 0.2748* -0.3240* 0.3560* 0.1231* -0.2328* 1.0000 MTB (12) 0.1625* 0.1560* 0.0853* 0.1031* 0.1289* 0.2814* -0.1717* 0.0836* -0.1050* -0.0971* 0.1196* 1.0000

FIRMRSK (13) -0.1236* -0.1777* 0.1742* -0.1956* -0.1989* -0.0335 0.1213* -0.1289* -0.0462 0.1877* -0.2591* -0.0905* 1.0000

(*) p-value < 0.05

127

Table 4.9 Variance Inflation Factor (Variables used in Model 6)


FAMOWN 1.90 0.525556

LNTCOMP 1.88 0.530793

LNSALES 1.78 0.561353

OWNCONS 1.72 0.582379

BDSIZE 1.57 0.63807

ROA 1.28 0.779931

B_IND 1.20 0.830764

DUALCEO 1.18 0.848947

FIRMRSK 1.16 0.862592

MTB 1.14 0.874929

TRET 1.12 0.890896

Mean VIF 1.45

4.3.2 Regression Results: Compensation and Future Firm Performance

Table 4.10 reports the results of Model 6 for future firm performance as dependent

variable and current CEO compensation and corporate governance variables as explanatory

variables. The standard errors are adjusted for heteroskedasticity and serial correlation in

error terms.

There seems to be no evidence that CEO compensation has any influence on future firm

performance as coefficients of compensation are insignificant consistently in all models. So,

it can confidently be assumed that CEO compensation unexplained by current observable

firm performance has no influence on observable future firm performance. However, it may

also be inferred that CEOs in Pakistan are compensated only against realized firm

performance but not against current unobservable performance. The results are inconsistent

with other studies ((e.g., Adithipyangkul et al., 2011, Balafas and Florackis, 2014, Hayes and

Schaefer, 2000). These inconsistent results might be due to higher unpredictability of future

performance in Pakistan given the political and economic situation. Nevertheless, the results

do not support hypothesis 7 that CEO compensation is positively related to future firm

performance, leading to rejection of hypothesis 7. This implies that CEO pay packages are

not designed to compensate for unobservable future firm performance. The boards of

directors in Pakistan reward CEOs for realized firm accounting performance only.

Ownership concentration does not influence future firm performance as measured by

ROA. Similar finding is reported by Balafas and Florackis (2014) in UK. However, there is

weak evidence that family ownership has some negative influence on future firm

128

performance as indicated by significant negative coefficients in column 3 & 6. Board size and

board independence do not seem to have any influence on future ROA however, CEO duality

does seem to have weak negative relationship with future ROA in pooled regression in both

tables. In a similar study in UK context, Balafas and Florackis (2014) find strong negative

effect of board size, moderate negative effect of ratio of non-executive director to board size

and no effect of CEO duality on future performance as measured by ROA. Overall the current

study finds that corporate governance variables seem to have very little influence on future

ROA.

Other control variables such as LNSALES and MTB do not seem to have convincing

relationship with future ROA however negative relationship is found between FIRMRSK and

future ROA in industry fixed model.


Although results presented are robust across different model specifications however, to

further reconfirm, certain robustness checks are conducted. First, all the continuous variables

are winsorized using 1% level at both tails to eliminate potential outliers and all models are

re-estimated. But, the results do not change qualitatively therefore it is decided to report the

original data results. Second, alternative measures of firm size and ownership concentration

as log of net sales and voting shares held by three largest shareholders respectively, are

incorporated. Again, the results remain qualitatively similar to as reported above.

129

Table 4.10

CEO Compensation and Future Firm Performance Dependent variables is one year forward ROA as measured by earnings before interest and taxes divided by total assets,

LNCASHCOMP = log of cash compensation as measured by sum basic salary and cash bonuses, LNTCOMP = log of total

compensation as measured by sum of all the pay components, TRET = total return to shareholders as measured by current

market price plus dividend divided by previous year market price minus one, OWNCONS = concentrated ownership as

measured by voting shares held by the largest shareholder, FAMOWN = a dummy variable taking value one for family firms

and zero otherwise, BDSIZE = board size as measured by number of sitting directors on board, B_IND = board independence

as measured by ratio of non-executive directors to board size, DUALCEO = CEO duality a dummy variable taking value one if

CEO is also chairman board of directors, LNSALES = log of net sales, MTB = market to book ratio as measured by market

value divided by book value per share, FIRMRSK = firm risk as measured by standard deviation of monthly stock returns over

the fiscal year

One-year forward Return on Assets (ROA)

(1) (2) (3) (4) (5) (6)

VARIABLES Pooled Fixed effect

Industry and

Time

Fixed effect

Firm and

Time

Pooled Fixed effect

Industry and

Time

Fixed effect

Firm and

Time

LNCSHCOMPit 0.0052 0.0067 -0.0022

(0.0056) (0.0064) (0.0127)

LNTCOMPit 0.0053 0.0073 -0.0033

(0.0058) (0.0069) (0.0127)

ROAit 0.5138*** 0.4952*** 0.0244 0.5140*** 0.4949*** 0.0245

(0.1332) (0.1328) (0.1487) (0.1329) (0.1326) (0.1487)

TRETit 0.0137 0.0141 0.0215** 0.0138 0.0142 0.0215**

(0.0102) (0.0101) (0.0103) (0.0102) (0.0101) (0.0103)

OWNCONSit 0.0178 0.0246 0.1930 0.0183 0.0250 0.1934

(0.0244) (0.0249) (0.1989) (0.0244) (0.0249) (0.1976)

FAMOWNit -0.0124 -0.0119 -0.1136*** -0.0125 -0.0123 -0.1129***

(0.0098) (0.0119) (0.0160) (0.0098) (0.0120) (0.0154)

BDSIZEit -0.0019 -0.0001 0.0131 -0.0018 -0.0000 0.0131

(0.0030) (0.0030) (0.0094) (0.0029) (0.0030) (0.0094)

B_INDit -0.0068 -0.0006 -0.0373 -0.0081 -0.0022 -0.0370

(0.0164) (0.0166) (0.0383) (0.0166) (0.0168) (0.0382)

DUALCEOit -0.0130* -0.0107 -0.0043 -0.0129* -0.0106 -0.0046

(0.0076) (0.0076) (0.0170) (0.0076) (0.0077) (0.0171)

LNSALESit 0.0044 0.0045 0.0162 0.0043 0.0043 0.0164

(0.0037) (0.0044) (0.0131) (0.0037) (0.0045) (0.0132)

MTBit 0.0013 0.0015 0.0006 0.0013 0.0015* 0.0006

(0.0010) (0.0009) (0.0005) (0.0010) (0.0009) (0.0005)

FIRMRSKit -0.0101 -0.0423* 0.0310 -0.0107 -0.0432* 0.0308

(0.0207) (0.0228) (0.0460) (0.0207) (0.0228) (0.0458)

Observations 1,277 1,277 1,277 1,277 1,277 1,277

R-squared 0.3475 0.3660 0.5638 0.3473 0.3660 0.5639





*** p<0.01, ** p<0.05, * p<0.1

130

Chapter 5

CEO Compensation and Earnings Management: Empirical

Results and Discussion

131

5.1 CEO Compensation and Earnings Management

5.1.1 Descriptive Statistics

Table 5.1 presents the descriptive statistics of variables used in Model 7. Pooled average

of absolute discretionary accruals (|DAC|) is 7.93 percent with standard deviation of 12.19.

Average |DAC| reaches to its maximum level in year 2008 with value of 11.55 percent and

standard deviation of 28.10 percent. This is possibly because of three reasons: 1) effects of

financial crisis, 2) unrest due to political issues and general elections and 3) start of energy

crisis in Pakistan, leading to more camouflaged earnings. Apart from that, overall trend is

mixed over the sample period.

Both average total and cash compensation have gradually increased and nearly tripled

over the sample period. Total compensation has increased from Rs4.817 million in 2005 to

Rs13.060 in 2012 while cash compensation has increased from Rs3.353 million in 2005 from

Rs.9.378 million in 2012. Consistently lower median value than mean value indicates that the

distribution of compensation is positively skewed meaning that greater number of CEOs is

receiving pay that is less than overall average pays.

Average board size of pooled sample is slightly above 8 with standard deviation of 1.57.

Recently, similar average board size of 8 is reported for Indian firms (see, Jameson et al.,

2014). This is possibly due to resemblance in institutional setting in India and Pakistan which

is characterized by concentrated and family ownership structure. The average board size in

Pakistan is lower than the board size recently reported for US (mean 9.54 and median 9) and

China (mean 9.372 and median 9) where ownership is either widely held or state has the

major stake in the firms (see, Conyon, 2014, Huang and Wang, 2015). On average, firms

seem to keep 63% non-executive directors on the boards. However, B_IND has slightly

downward trend over time. This is seemingly due to decrease in board size over time. The

non-executive directors are more likely to be an easy target when board size needs to be

reduced.

In our sample, about 75% observations are from family firms and, quite expectedly, this ratio

is stable overtime as family firm in year 2005 is very likely to remain a family firm in year

2012. In addition, more than 30% average voting shares held by the largest shareholder

indicates a highly concentrated ownership environment. Interestingly, OWNCONS has

slightly increasing trend over time which could have implications for earnings management

behavior. On average about 34% CEOs also hold the position of chairman board of directors.

Interestingly, DUALCEO shows maximum value i.e. 36% in 2008, 2009 and 2010, the time

132

characterized by financial crisis, energy crisis and political change. However, recent

downward trend in 2011 and 2012 is consistent with more emphasis on strong corporate

governance practices in Pakistan. This is similar to the UK and China where emphasis in on

separating the post of CEO from the chairman, and unlike the US where it is usual to

combine these two positions (Conyon and He, 2012).


Table 5.2 shows the correlation matrix for the variables included in Model 7 in chapter 3.

The correlation between absolute total accruals (|TAC|) and absolute discretionary accruals

(|DAC|) is positive with value of 0.8266. Only firm size as measured by log of total assets

and leverage as measured by debt to total assets ratio have some significant correlation with

both |TAC| and |DAC|. FIRMSIZE is negatively correlated with |TAC| and |DAC| with

coefficient values of -0.0712 and -0.0895 respectively, indicating that larger firms are more

likely to not engage in earnings management activities. LEVERAGE has some significantly

positive correlation with proxies of earnings management with values of 0.0701 and 0.0557

for |TAC| and |DAC| respectively. This gives the impression that higher debt firms have more

incentives to manage earnings to show better picture of the company to debt financers who

require companies to achieve certain landmarks.

Surprisingly, all other variables including log of cash compensation and log of total

compensation do not appear to have any significant correlation with absolute total accruals or

absolute discretionary accruals.


The correlation matrix in Table 5.2 shows that none of the absolute values of correlation

coefficients is greater than normally used threshold level of 0.70 for potential serious problem

of multicollinearity. To further confirm that no multicollinearity problem exists, variance

inflation factor (VIF) and tolerance are estimated. Table 5.3 indicates that none of the VIF is

greater than generally used threshold level of 10 and mean of VIFs is 1.51 which is less than

2. Similarly, all the tolerance levels are above the threshold level of 0.10. These diagnostics

suggest that Model 7 can be estimated without worrying about problem of multicollinearity.

133

Table 5.1 Descriptive Statistics (Earnings Management and other variables)

Variables Statistic 2005 2006 2007 2008 2009 2010 2011 2012 Overall

|DAC| Mean N/A 7.16 7.36 11.55 7.47 7.22 7.75 7.52 7.93

%age Median N/A 5.28 5.66 6.45 4.99 5.20 5.87 5.20 5.49

S.D N/A 6.13 8.44 28.10 8.58 6.29 7.48 8.43 12.19

Total Compensation Mean 4817 5530 6512 7562 8396 9449 10628 13060 8475

In Rs.’000 Median 3156 3384 4153 4553 4999 5459 6060 7519 4800

S.D 5854 7030 9094 11028 11278 12519 13493 19935 12538

Cash Compensation Mean 3353 3918 4751 5529 6004 6577 7523 9378 6042

In Rs.‘000 Median 2000 2303 2715 2836 3435 3450 4001 5186 3174

S.D 4626 5840 7786 9268 8867 9690 10460 14766 9733

BDSIZE Mean 8.13 8.15 8.08 8.04 8.01 8.00 8.01 8.00 8.05

Median 7.00 7.00 7.00 7.00 7.00 7.00 7.00 7.00 7.00

S.D 1.68 1.68 1.62 1.57 1.53 1.51 1.51 1.51 1.57

B_IND Mean 64.32 64.31 63.90 63.65 62.85 63.23 62.58 63.91 63.54

%age Median 70.00 70.71 70.00 66.67 66.67 66.67 62.50 66.67 66.67

S.D 20.37 20.72 20.71 20.59 20.94 20.64 20.31 19.96 20.49

FAMOWN Mean 0.75 0.75 0.76 0.75 0.74 0.75 0.75 0.74 0.75

Median 1.00 1.00 1.00 1.00 1.00 1.00 1.00 1.00 1.00

S.D 0.44 0.43 0.43 0.43 0.44 0.43 0.43 0.44 0.43

OWNCONS Mean 32.72 33.01 33.07 33.23 33.36 33.61 34.39 35.51 33.67

%age Median 26.46 26.61 26.71 26.25 26.13 26.13 27.45 29.40 26.66

S.D 21.01 21.22 20.78 20.48 20.44 20.30 20.74 21.32 20.74

DUALCEO Mean 0.30 0.33 0.33 0.36 0.36 0.36 0.35 0.33 0.34

Median 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00

S.D 0.46 0.47 0.47 0.48 0.48 0.48 0.48 0.47 0.47

TASSETS Mean 7173 8607 9827 10898 11636 12675 14490 17215 11833

In Rs. Millions Median 2385 2603 2970 3042 3034 3068 3544 3831 3061

S.D 14281 16821 18677 22158 26033 31098 35893 45860 29092

LEVERAGE Mean 0.63 0.60 0.64 0.65 0.66 0.63 0.62 0.57 0.62

Times Median 0.63 0.64 0.63 0.64 0.64 0.62 0.60 0.56 0.62

S.D 0.31 0.38 0.44 0.39 0.35 0.32 0.31 0.42 0.37

CFO Mean 911 799 721 632 1024 1266 941 1020 926

Rs in Median 73 154 108 31 144 175 81 182 113

Millions S.D 3434 3982 3417 4951 4668 5057 5522 4932 4617

ROA Mean 6.96 6.36 4.42 4.01 2.29 5.76 5.18 4.42 4.84

%age Median 5.12 4.46 2.96 2.79 1.93 4.97 4.75 4.38 3.80

S.D 8.52 8.61 9.31 9.09 18.26 9.23 11.22 13.25 11.64

MTB Mean 1.79 2.35 2.17 1.74 1.56 1.31 1.30 1.84 1.73

Times Median 1.19 0.99 1.13 0.86 0.62 0.52 0.43 0.65 0.75

S.D 2.37 8.17 4.76 4.77 4.81 6.03 4.58 5.62 5.35

LOSSDUM Mean 0.11 0.16 0.23 0.27 0.31 0.21 0.23 0.24 0.22

Median 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00

S.D 0.31 0.37 0.42 0.45 0.46 0.41 0.42 0.43 0.42

134

Table 5.2 Correlation Matrix (Variables used in Model 7)

Variables (1) (2) (3) (4) (5) (6) (7) (8) (9) (10) (11) (12) (13) (14)

|TAC| (1) 1.0000

|DAC| (2) 0.8266* 1.0000

LNCASHCOMP (3) -0.0209 -0.0258 1.0000

LNTCOMP (4) -0.033 -0.0409 0.9722* 1.0000

OWNCONS (5) 0.0223 -0.0255 0.3651* 0.3555* 1.0000

FAMOWN (6) -0.0252 0.0087 -0.3760* -0.3775* -0.5435* 1.0000

BDSIZE (7) 0.0211 0.0186 0.3138* 0.3215* 0.1007* -0.4532* 1.0000

B_IND (8) 0.0161 -0.0002 0.1438* 0.1872* 0.0638* -0.2273* 0.3538* 1.0000

DUALCEO (9) -0.0459 -0.0279 -0.2777* -0.2944* -0.0841* 0.1730* -0.2605* -0.1863* 1.0000

FIRMSIZE (10) -0.0712* -0.0895* 0.5614* 0.5781* 0.2495* -0.2750* 0.3795* 0.1320* -0.2164 1.0000

LEVERAGE (11) 0.0701* 0.0557* -0.1944* -0.1912* -0.0873* 0.0889* -0.0435 -0.0205 0.1877* -0.1164* 1.0000

CFO (12) -0.0402 -0.0534 0.1331* 0.1499* 0.2235* -0.1975* 0.2435* 0.1382* -0.0983* 0.3226* -0.1184* 1.0000

ROA (13) -0.0455 -0.0438 0.2893* 0.2886* 0.1948* -0.1996* 0.1304* 0.0346 -0.1816* 0.1578* -0.2351* 0.2838* 1.0000

MTB (14) 0.0061 0.0083 0.1197* 0.0932* 0.2793* -0.1730* 0.0803* -0.1189* -0.0949* 0.0802* -0.0436 0.0452 0.1613* 1.0000

135

Table 5.3 Variance Inflation Factor (Variables used in Model 7)


LNTCOMP 1.87 0.5335

OWNCONS 1.71 0.5831

FAMOWN 1.88 0.532

BDSIZE 1.65 0.6056

B_IND 1.22 0.8217

DUALCEO 1.19 0.843

FIRMSIZE 1.75 0.5727

LEVERAGE 1.15 0.872

CFO 1.28 0.7793

NROA 1.74 0.5763

MTB 1.15 0.8729

LOSSDUM 1.57 0.6355

Mean VIF 1.51

5.1.3 Regression Results: Compensation and Earnings Management

Table 4.13 exhibits the results for compensation driven earnings management (EM)

behavior taking absolute discretionary accruals as proxy for EM estimated by Jones (1991)

Model modified by Dechow et al. (1995) first and then Kothari et al. (2005). The results of

pooled and fixed effect models are reported using Huber-White heteroskedasticity consistent

standard errors clustered by firms.

There seems to be no evidence that earnings management is driven by CEO cash or total

compensation. The coefficients of LNCASHCOMP and LNTCOMP are insignificant in all

six columns. Thus, the results do not seem to support the hypothesis 8 developed in chapter 3

that CEO compensation is positively related to earnings management behavior, resulting in

rejection of hypothesis 8. These results are inconsistent with other studies on the relationship

between executive pay and earnings management such as Healy (1985), Holthausen et al.

(1995), Guidry et al. (1999), Balsam (1998) and Ye (2014). One possible reason for this

might be the less use of cash bonuses in compensation contracts. In Table 3.2, only 24.80%

observations have cash bonuses as part of CEO compensation plan. Therefore, earnings

management does not seem to provide extra pecuniary benefits to CEOs in term of extra

bonuses presumably based on earnings.

Although the results in previous chapter suggest that CEO compensation is tied to firm

accounting performance however, despite that, this study does not find any evidence of

136

higher compensation as a motive to manage earnings in either direction (upward or

downward).

With regard to corporate governance variables, Ownership concentration, family

ownership and board independence do not seem to have any influence on earnings

management behavior. This finding is consistent over all six columns as coefficients of

OWNCONS, FAMOWN and B_IND are consistently insignificant. This means that large

shareholders or family owners are not significantly engaged in earnings management

activities in Pakistan. Kamran and Shah (2014) find similar results in Pakistan for

OWNCONS using different proxy for ownership concentration. Insignificant impact of

concentrated/family ownership seems to be contradicting with existing evidence in Asian

context. For example, Fan and Wong (2002) find that ownership concentration is related to

low earnings informativeness in 7 east Asian countries while Ye (2014) find increased

earnings management with the increase in ownership concentration.

Board size has some positive influence on earnings management. Firms with larger

boards seem to be engaged in earnings management more than their counterparts. This might

be indicating ineffectiveness of larger boards. DUALCEO has some significant coefficients

with negative sign for both cash and total CEO pay when industry and time fixed effects are

used. This means CEO duality reduces earnings management behavior. The negative

association between CEO duality and EM is more pronounced (unreported) when

discretionary accruals are estimated using Dechow et al. (1995) modification of Jones model.

The results of BDSIZE and DUALCEO are inconsistent with Kamran and Shah (2014) as

they find no relationship of these variables with discretionary accruals. This might be due to

different sample size and data period used15.

Larger firms appear to have less earnings management activities as coefficients of

FIRMSIZE are significant with negative sign in all models except when industry fixed effects

are used. This is consistent with the argument that larger firms are more visible and more

people follow them, therefore engage in less earnings management as compared to small

firms (see, Kamran and Shah, 2014). LEVERAGE has some positive association with EM in

pooled regression for both cash and total compensation, indicating some evidence of debt

covenant driven EM. All other variables such as CFO, ROA, MTB and LOSSDUM do not

have significant influence on EM behavior.

15 Kamran and Shah (2014) use 986 firm-year observations for period from 2003 to 2010.

137

To get more insight of the relationship between CEO compensation and earnings

management, absolute discretionary accruals are divided into two components, income

increasing and income decreasing discretionary accruals, on the basis of the sign of estimated

discretionary accruals. Then regression models are run taking income increasing and income

decreasing discretionary accruals as dependent variables separately. Table 5.5 reports the

results for income increasing discretionary accruals while Table 5.6 shows the results for

income decreasing discretionary accruals.

5.1.3.1 Income Increasing Discretionary Accruals

In Table 5.5, higher LNTCOMP appears to be negatively related to income increasing

discretionary accruals, indicating that CEOs with higher total compensation avoid costly

decision of exaggerating the firm performance. However, coefficients are significant at 10%

level of significance, showing moderate level of relationship. LNCASHCOMP appears to

have no relationship with income increasing EM behavior in any model. Again the results are

inconsistent with existing studies (e.g., Balsam, 1998, Holthausen et al., 1995, Ye, 2014).

This might be an indication that costs are higher than the benefits associated to higher income

increasing discretionary accruals for the firm, leading to negative impact on executive

compensations16.

With regard to corporate governance variables, only DUALCEO seem to have some

relationship with income increasing EM behavior with negative sign, meaning that CEO

duality leads to lower exaggerated earnings. This is seemingly contradicting with managerial

power approach. No other corporate governance variable has significant impact on income

increasing EM.

Higher amount of debt leads to higher reported earnings as indicated by strong positive

relationship between LEVERAGE and income increasing discretionary accruals. This is an

indication of debt convents driven earnings management. Larger firms do not appear to

report exaggerated earnings as coefficients of FIRMSIZE are insignificant in all models.

Higher amount of debt leads to higher reported earnings as indicated by strong positive

relationship between LEVERAGE and income increasing discretionary accruals. This is an

indication of debt convents driven earnings management. Larger firms do not appear to

report exaggerated earnings as coefficients of FIRMSIZE are insignificant in all models.

16 The costs may include inability to set aside reserves due to maximizing reported income, tax costs and higher future targets due higher current performance (Balsam, 1998)

138

5.1.3.2 Income Decreasing Discretionary Accruals

In Table 5.6, firms with higher cash compensation seem to have greater income

decreasing discretionary accruals, inconsistent with Ye (2014) for independent directors. The

coefficients LNCASHCOMP are statistically significant in pooled and industry fixed effect

models. The significant positive relationship between income decreasing accruals and total

compensation can also be seen but the coefficient of LNTCOMP is significant only in pooled

regression. This might be an indication of more conservative accounting in firms with highly

paid CEOs. Another possible reason for this relationship can be deduct from contextual

setting of Pakistan. Given the concentrated family ownership environment in Pakistan, the

possibility of conflicts between controlling family and non-family shareholders is high.

Therefore, highly paid executives, being under family obligation, may engage in

manipulating earnings through income decreasing discretionary accruals in order to meet

long-term family expectations instead of achieving short-term objectives.

Family owned firms and firms with larger boards appear to have more income decreasing

discretionary accruals, consistent with Ali et al. (2007) in the US context. However, the

coefficients of FAMOWN are significant only in pooled regression. Ali et al. (2007) find

more negative (income decreasing) discretionary accruals for family firms in US. The family

firms may be motivated to increase income decreasing discretionary accruals by their desire

to minimize taxes or reduce political cost (Ali et al., 2007). Firms with larger boards also

appear to have more income decreasing accruals as the coefficients of BDSIZE are

significant in the pooled and industry fixed effect models. Other variables of corporate

governance have no impact on income decreasing discretionary accruals.

The coefficients of FIRMSIZE are significantly negative across all models, indicating

that larger firms do not encourage income decreasing accruals. LEVERAGE also does have

some significantly negative coefficients, suggesting that high debt leads to higher reported

income, leading to lower income decreasing discretional accruals. This is consistent with the

finding in case of income increasing discretionary accruals where LEVERAGE is

significantly positive.


Certain robustness checks are conducted to further confirm the results. First, all the

continuous variables are winsorized using 1% level at both tails to eliminate potential outliers

and all models are re-estimated. But, the results do not change qualitatively therefore it is

decided to report the original data results. Second, discretionary accruals are also estimated

139

using original Jones (1991) model and modification of Jones Model by Dechow et al. (1995).

However, the results remain qualitatively similar to the results reported above except that the

negative relationship between CEO duality and absolute discretionary accruals is more

pronounced. This relatively more pronounced result has been discussed earlier as well.

Table 5.4

CEO Compensation and Earnings Management Dependent variables is absolute discretionary accruals estimated using Kothari et al. (2005) modification of Jones Model,

LNCASHCOMP = log of cash compensation as measured by sum basic salary and cash bonuses, LNTCOMP = log of total

compensation as measured by sum of all the pay components, OWNCONS = concentrated ownership as measured by voting

shares held by the largest shareholder, FAMOWN = a dummy variable taking value one for family firms and zero otherwise,

BDSIZE = board size as measured by number of sitting directors on board, B_IND = board independence as measured by ratio

of non-executive directors to board size, DUALCEO = CEO duality a dummy variable taking value one if CEO is also

chairman board of directors, FIRMSIZE = firm size as measured by log of total assets, LEVERAGE = leverage as measured by

debt to total asset ratio, CFO = operating cash flows taken from cash flow statements, ROA = return on assets as measured by

net income divided by total assets, MTB = market to book ratio as measured by market value divided by book value per share,

LOSSDUM = a dummy variable taking value one if company is in loss.

Absolute Discretionary Accruals

(1) (2) (3) (4) (5) (6)


Industry and

Time

Fixed effect

Firm and

Time

Pooled Fixed effect

Industry and

Time

Fixed effect

Firm and

Time

LNCSHCOMPit 0.00421 0.000715 0.00440

(0.00317) (0.00285) (0.0114)

LNTCOMPit 0.00173 -0.00217 -0.00150

(0.00359) (0.00360) (0.0117)

OWNCONSit -0.00319 0.00257 0.0137 0.000279 0.00551 0.0146

(0.0230) (0.0182) (0.0600) (0.0214) (0.0169) (0.0602)

FAMOWNit 0.00316 0.000637 0.0197 0.00257 0.000560 0.0227

(0.00983) (0.00928) (0.0169) (0.00981) (0.00931) (0.0169)

BDSIZEit 0.00472* 0.00519** -0.00705 0.00488* 0.00528** -0.00699

(0.00257) (0.00225) (0.0103) (0.00262) (0.00227) (0.0102)

B_INDit -0.00773 0.00116 -0.0476 -0.00789 0.00174 -0.0453

(0.0150) (0.0138) (0.0439) (0.0148) (0.0139) (0.0433)

DUALCEOit -0.0128 -0.0147* -0.0117 -0.0133 -0.0151* -0.0120

(0.00868) (0.00811) (0.00803) (0.00903) (0.00829) (0.00828)

FIRMSIZEit -0.0100*** -0.00370 -0.0345* -0.00908*** -0.00262 -0.0326*

(0.00322) (0.00289) (0.0190) (0.00313) (0.00291) (0.0185)

LEVERAGEit 0.0164** 0.00431 0.00746 0.0156** 0.00368 0.00704

(0.00670) (0.00613) (0.00792) (0.00693) (0.00653) (0.00784)

CFOit -4.16e-10 -3.12e-10 -1.79e-09 -5.30e-10 -4.02e-10 -1.78e-09

(8.14e-10) (8.12e-10) (1.72e-09) (8.03e-10) (8.03e-10) (1.71e-09)

ROAit -0.0410 -0.0694 -0.0627 -0.0364 -0.0653 -0.0615

(0.0731) (0.0623) (0.0962) (0.0742) (0.0631) (0.0959)

MTBit 0.000323 -0.000121 0.00117 0.000320 -0.000155 0.00120

(0.000959) (0.000506) (0.00153) (0.000966) (0.000494) (0.00156)

LOSSDUMit -0.00166 0.000298 -0.00324 -0.00167 0.000209 -0.00336

(0.0176) (0.0161) (0.0174) (0.0177) (0.0160) (0.0172)

Observations 1,247 1,247 1,247 1,247 1,247 1,247

R-squared 0.018 0.090 0.252 0.018 0.090 0.252





*** p<0.01, ** p<0.05, * p<0.1

140

Table 5.5

CEO Compensation and Income Increasing Discretionary Accruals Dependent variables is absolute income increasing discretionary accruals estimated using Kothari et al. (2005) modification of

Jones Model, LNCASHCOMP = log of cash compensation as measured by sum basic salary and cash bonuses, LNTCOMP =

log of total compensation as measured by sum of all the pay components, OWNCONS = concentrated ownership as measured

by voting shares held by the largest shareholder, FAMOWN = a dummy variable taking value one for family firms and zero

otherwise, BDSIZE = board size as measured by number of sitting directors on board, B_IND = board independence as

measured by ratio of non-executive directors to board size, DUALCEO = CEO duality a dummy variable taking value one if

CEO is also chairman board of directors, FIRMSIZE = firm size as measured by log of total assets, LEVERAGE = leverage as

measured by debt to total asset ratio, CFO = operating cash flows taken from cash flow statements, ROA = return on assets as

measured by net income divided by total assets, MTB = market to book ratio as measured by market value divided by book

value per share, LOSSDUM = a dummy variable taking value one if company is in loss.

Absolute Income Increasing Discretionary Accruals

(1) (2) (3) (4) (5) (6)


Industry and

Time

Fixed effect

Firm and

Time

Pooled Fixed effect

Industry and

Time

Fixed effect

Firm and

Time

LNCSHCOMPit -0.00648 -0.00737 -0.00839

(0.00436) (0.00471) (0.0133)

LNTCOMPit -0.00864* -0.00912* -0.0152

(0.00471) (0.00471) (0.0165)

OWNCONSit -0.0159 -0.00119 0.0601 -0.0147 -0.000993 0.0628

(0.0222) (0.0211) (0.0804) (0.0219) (0.0207) (0.0819)

FAMOWNit -0.00592 -0.00403 -0.0154 -0.00675 -0.00403 -0.0341

(0.0138) (0.0145) (0.0617) (0.0137) (0.0144) (0.0683)

BDSIZEit 0.00423 0.00383 -0.0117 0.00417 0.00370 -0.0116

(0.00303) (0.00299) (0.0114) (0.00300) (0.00299) (0.0114)

B_INDit -0.0182 -0.0102 -0.0214 -0.0152 -0.00753 -0.0196

(0.0180) (0.0175) (0.0426) (0.0179) (0.0174) (0.0426)

DUALCEOit -0.0145* -0.0170** -0.0117 -0.0152** -0.0174** -0.0140

(0.00751) (0.00787) (0.0211) (0.00752) (0.00782) (0.0220)

FIRMSIZEit -0.00263 0.00191 0.0132 -0.00180 0.00259 0.0144

(0.00374) (0.00418) (0.0261) (0.00377) (0.00417) (0.0265)

LEVERAGEit 0.0372*** 0.0278*** 0.0372* 0.0369*** 0.0279*** 0.0375*

(0.00716) (0.00678) (0.0202) (0.00713) (0.00675) (0.0203)

CFOit -6.07e-09** -5.87e-09** -9.81e-09* -6.12e-09** -5.91e-09** -9.74e-09*

(2.53e-09) (2.46e-09) (5.67e-09) (2.52e-09) (2.45e-09) (5.63e-09)

ROAit 0.302*** 0.262*** 0.423*** 0.309*** 0.266*** 0.421***

(0.0701) (0.0725) (0.0905) (0.0694) (0.0720) (0.0895)

MTBit -0.00137*** -0.00192*** 0.000720 -0.00142*** -0.00195*** 0.000827

(0.000503) (0.000707) (0.00263) (0.000512) (0.000689) (0.00270)

LOSSDUMit 0.00593 0.00603 0.00516 0.00651 0.00642 0.00550

(0.0119) (0.0119) (0.0167) (0.0119) (0.0118) (0.0166)

Observations 617 617 617 617 617 617

R-squared 0.140 0.235 0.552 0.142 0.237 0.553





*** p<0.01, ** p<0.05, * p<0.1

141

Table 5.6

CEO Compensation and Income Decreasing Earnings Management

Dependent variables is absolute income decreasing discretionary accruals estimated using Kothari et al. (2005)

modification of Jones Model, LNCASHCOMP = log of cash compensation as measured by sum basic salary and

cash bonuses, LNTCOMP = log of total compensation as measured by sum of all the pay components,

OWNCONS = concentrated ownership as measured by voting shares held by the largest shareholder, FAMOWN =

a dummy variable taking value one for family firms and zero otherwise, BDSIZE = board size as measured by

number of sitting directors on board, B_IND = board independence as measured by ratio of non-executive

directors to board size, DUALCEO = CEO duality a dummy variable taking value one if CEO is also chairman

board of directors, FIRMSIZE = firm size as measured by log of total assets, LEVERAGE = leverage as measured

by debt to total asset ratio, CFO = operating cash flows taken from cash flow statements, ROA = return on assets

as measured by net income divided by total assets, MTB = market to book ratio as measured by market value

divided by book value per share, LOSSDUM = a dummy variable taking value one if company is in loss.

Absolute Income Decreasing Discretionary Accruals

(1) (2) (3) (4) (5) (6)


Industry and

Time

Fixed effect

Firm and

Time

Pooled Fixed effect

Industry and

Time

Fixed effect

Firm and

Time

LNCSHCOMPit 0.0122*** 0.00651* 0.0321

(0.00334) (0.00351) (0.0246)

LNTCOMPit 0.00834** 0.000604 0.0221

(0.00406) (0.00670) (0.0182)

OWNCONSit 0.0207 0.0176 0.148 0.0273 0.0253 0.149

(0.0338) (0.0297) (0.119) (0.0301) (0.0258) (0.117)

FAMOWNit 0.0192* 0.0113 -0.0183 0.0178* 0.0104 -0.0152

(0.0104) (0.00900) (0.0434) (0.0100) (0.00917) (0.0410)

BDSIZEit 0.00502* 0.00687** -0.00334 0.00553* 0.00728*** -0.00254

(0.00280) (0.00276) (0.00849) (0.00288) (0.00276) (0.00845)

B_INDit -0.000201 0.0115 -0.0379 -0.00142 0.0116 -0.0337

(0.0169) (0.0162) (0.0463) (0.0167) (0.0165) (0.0452)

DUALCEOit -0.0165 -0.0200 -0.0247 -0.0170 -0.0209 -0.0250*

(0.0144) (0.0158) (0.0159) (0.0151) (0.0164) (0.0151)

FIRMSIZEit -0.0172*** -0.00908*** -0.0440*** -0.0158*** -0.00697* -0.0418**

(0.00356) (0.00327) (0.0167) (0.00323) (0.00394) (0.0167)

LEVERAGEit -0.0120 -0.0255** -0.00312 -0.0136* -0.0272** -0.00465

(0.00735) (0.0124) (0.00949) (0.00772) (0.0131) (0.0103)

CFOit 1.95e-09*** 2.04e-09*** 6.34e-09** 1.69e-09** 1.78e-09*** 6.21e-09**

(7.20e-10) (6.23e-10) (2.60e-09) (6.93e-10) (6.17e-10) (2.75e-09)

ROAit -0.172*** -0.189*** -0.237*** -0.166*** -0.183*** -0.233***

(0.0509) (0.0441) (0.0621) (0.0535) (0.0463) (0.0648)

MTBit 0.000992 0.000630 0.00107 0.000999 0.000547 0.00105

(0.00135) (0.000520) (0.00201) (0.00134) (0.000533) (0.00200)

LOSSDUMit 0.0116 0.0173 0.0252 0.0117 0.0171 0.0258

(0.0278) (0.0280) (0.0322) (0.0278) (0.0277) (0.0324)

Observations 628 628 628 628 628 628

R-squared 0.045 0.103 0.405 0.042 0.101 0.403





*** p<0.01, ** p<0.05, * p<0.1

142

Chapter 6

Conclusions and Policy Implications

143

6.1 Conclusions

Family and concentrated ownerships are common in Pakistan and corporate governance

systems are weak but evolving. Given that there are chances of expropriation of minority

shareholders’ interest and a number of steps have been taken to reform the corporate

governance environment in Pakistan, it is important to examine how executives are rewarded

and incentivized. CEO compensation literature focused in developed economies may not

have implications for emerging economies due to differences in institutional contexts and

corporate governance practices.

Given the Pakistani context, the primary objective of the study is to examine the

relationship between CEO compensation and firm performance. In addition, the study also

explores how concentrated/ family ownership and board structure variables influence CEO

compensation, and how CEO compensation affect future firm performance. Moreover, the

relationship between CEO compensation and earnings management is also examined.

In Pakistan, long term incentive plans, stock options and restricted stocks are virtually

absent. CEO pay can be identified to have four forms: base salary, cash bonuses, perks and

benefits and post-employment benefits. Consistent with existing literature, this study uses

two measures of CEO compensation i.e., cash compensation and total compensation. Cash

compensation includes managerial remuneration and bonuses while total compensation is the

sum of all the components. Two measures of firm performance are used; one represents

accounting performance i.e. ROA and other represents market performance i.e. total return to

shareholders. Corporate governance variables include board size, board independence, CEO

duality, ownership concentration and family ownership. Other main control variables include

firm size, firm growth opportunities and firm risk.

The study uses an unbalanced panel data consisting of 1508 year-observations from 225

listed firms in KSE for period 2005 to 2012. Multiple regression models with fixed-effects

which account for unobserved heterogeneity are used. In addition, standards errors are

adjusted to account for heteroskedasticity and serial correlation in error terms. Moreover,

endogeneity is controlled by regressing CEO compensation on lagged explanatory variables

and by estimating a dynamic panel model using GMM techniques.

The study finds that current and past firm accounting performance as measured by ROA

positively contributes towards CEO compensation. This finding is consistent over different

model specifications and estimation techniques including a dynamic panel model estimated

using GMM. This is the main finding of this study. However, market performance as

144

measured by total return to shareholder does not have any effect on CEO pay setting process.

Although, there is some evidence that past market returns have some decreasing effect on

CEO compensation however, it is presumed that this negative association is by chance due to

high returns volatility and occasionally extra ordinary bearing and bullish trends in capital

markets of Pakistan. Overall, results suggest that firm accounting performance is an

important determinant of CEO pay process in Pakistan. Thus, despite the institutional context

characterized by powerful CEOs, expropriation of interests of minority shareholders by large

shareholders and weak legal environment, the boards of directors do account for accounting

performance while devising CEO compensation contracts.

Although CEOs in Pakistan are rewarded for current and past accounting performance

however this study does not find any conclusive evidence that CEOs are rewarded for

unobserved future firm performance. This implies that future expected firm performance does

not have any impact on CEO compensation until that future performance is realized. This is

believed to be the result influenced by higher unpredictability of future performance in

Pakistan because of prolonged volatile political and economic conditions.

Similarly, although CEO compensation is positively related to current firm accounting

performance however, the study does not find any convincing evidence that earnings

management is driven by any measure of CEO compensation. Thus, CEOs in Pakistan do not

manipulate earnings to have impact on their compensation.

An important by-product finding of this study is that boards of directors adjust CEO

compensation to target levels as they learn more about CEO actions over time. In dynamic

panel model estimation, CEO pay appears to be highly persistent and takes time to adjust to

its long-term equilibrium level. Most of the literature on CEO compensation ignores the

dynamic nature of CEO compensation and estimate static pay models considering that pay is

in equilibrium, thus, ignoring the CEO pay adjustment to long run equilibrium.

Pertaining to the influence of concentrated/family ownership on CEO compensation,

there is evidence that the largest shareholders have positive impact on CEO compensation.

This is an indication of some collusion between the largest shareholders and the executives to

get personal benefits at the expense of minority shareholders. CEOs in family firms seem to

receive lower compensation as compared to their counterparts. However, this finding is not

fully supported by all model specifications used in this study.

With regard to the board structure which is the primary focus in the Code of corporate

governance in Pakistan, this study finds that board size and board independence do not have

any impact on CEO compensation. This is consistent with Pakistani corporate governance

145

environment in that non-executive directors are generally hired from within family or they

are gray directors who do not have any influence on major corporate decisions. As the

number of non-executive director increases, board size increases, since non-executive

directors have no influence therefore board size remains ineffective.

Contrary to the expectations, this study finds that when CEOs also hold the position of

chairman, they agree upon receiving lower compensation. This is contrary to theoretical as

well as empirical literature in the area. Both agency theory and managerial power hypothesis

view that CEO duality should lead to higher CEO compensation. As these theories assume

that managers are self-interested therefore when managers gain power they behave

opportunistically and set their own pay higher. Nevertheless, this finding is considered to be

due to high family ownership in Pakistan. In family owned firms, the joint position of

chairman/CEO is generally held by founding father or the eldest sibling in the family because

they are considered to be the most respectful persons in the family. In return, being the eldest

and considered to be the most respectful person within the family, CEO acts as steward of the

family and works on collective basis while holding all the powers single handedly. Therefore,

it is against his social stature to negotiate for higher compensation or he might not give

weight to higher compensation against the power he enjoys. A split sample analysis confirms

that negative impact of CEO duality on CEO compensation is driven by family firms.

Firm size appears to be an important determinant of CEO compensation in Pakistan. This

supports the view that larger firms are complex and difficult to run and hence require quality

CEOs with higher compensations. The results of other control variables are not consistent

over different models and estimation techniques. At some instances, coefficients of these

variables change their signs and in other instances they lose their statistical significance.

Regarding corporate governance and future firm performance, ownership concentration,

board size and board independence do not have influence over future firm performance

however, there is weak evidence that family ownership and CEO duality have some negative

effect on future firm performance.

Concerning corporate governance and earnings management, ownership concentration,

family ownership and board independence do not have any influence on earnings

management behavior. However, firms with larger boards are more likely to engage in

earnings management which is an indication of ineffectiveness of larger boards. CEO duality

does appear to have influence in resisting earnings management behavior. Larger firms

appear to have less earnings management activities than their counterparts.

146

6.2 Policy Implications

Given the results, the study provides some important policy and practical implications.

First the study documents that base salary and perquisites are the most common forms in

which the CEOs are being paid in Pakistan. This indicates lack of incentive base

compensation in Pakistan. Internationally, CEO compensation is being shifted to take the

form of an optimal mix of base salary and incentive based remuneration. Short term

incentives include bonuses and other performance based benefits while long term incentives

include equity compensation in the form of stocks and stock options. There is evidence that

some firms are paying bonuses to CEO however equity compensation is virtually absent in

Pakistan. Equity compensation in the form of stocks and stock options is an important

incentive mechanism to align shareholder-manager interests in Western economies. Some of

the Asian countries have also become part of the global shift towards equity compensation as

a mechanism of reward and motivation. Regulators and policy makers in Pakistan may

consider the global shift as they develop optimal pay policies for CEOs. The introduction of

bonus plans and equity compensation is more likely to induce managers to perform better in

future as many studies report that after incentive based compensation are offered to

managers, the future firm performance increases.

Second, the negative relationship between CEO duality and CEO compensation is quite

unexpected in the Pakistani context. Considering that CEO duality is an inappropriate

corporate governance practice, recently, the Code of corporate governance has made

separation of two positions (chairman board of directors and CEO) mandatory in Pakistan.

However, the finding of this study indicates that CEO duality is consistent with protection of

minority shareholders’ interests in that it leads to less expropriation through excessive CEO

compensation. Therefore, this study suggests that policy makers and regulatory authorities

should consider conducting complete cost-benefit analysis of mandatory separation of the

two positions in revised Code of corporate governance in Pakistani context.

Third, the study finds that the number of non-executive directors and board size do not

have any influence on CEO compensation decisions. Given the Pakistani context, these

findings are quite expected as most of the non-executive directors are from within the

controlling family or they are gray directors having no influence on major corporate

decisions. Therefore, this study supports the recent steps taken by the regulatory authorities

emphasizing and making it mandatory to have more independent directors on the boards who

fulfill the recently issued definition of independent director. The mandatory board

147

independence would help reduce CEO entrenchment and probability of excessive executive

compensation.

Fourth, the study finds potential indications of expropriation of minority shareholders’

interests by the largest shareholders. Although recent reforms in corporate governance

environment of Pakistan are aimed at reducing all kinds of expropriations by the large

shareholders however this study suggests that besides ensuring best corporate governance

practices in the firms, the policy makers should also notice the decision making process

within the boards and the factors that influence decision making process including the largest

shareholders and family directors. This would help devise effective policies to reduce CEO

entrenchment, align mutual interests of large and small shareholders and reduce potential

expropriation by controlling shareholders.

Finally, the study finds that CEO pay is related to past pay levels and takes time to adjust

because of learning about CEO actions. In practice, boards should take into account the

incomplete information about CEO abilities/actions and adjustment costs along with firm

performance while designing CEO pay plans.

6.3 Limitations and Scope of Future Research

The study is conducted systematically with continuous review process contributed by

qualified and specialized supervisor. However, it is acknowledged that there are potential

theoretical and methodological limitations of the study which need to be recognized while

interpreting the findings.

Theoretically, there are many diverse and contrasting theories, hypotheses and

approaches (see, e.g., Otten, 2008) that explain executive pay process. However, it is not

possible to comprehend all the theories and hypotheses in a single study. Therefore, this study

develops its hypotheses mainly within the framework of most dominant approaches (optimal

contracting and managerial power) derived from agency theory. The reader may find

conflicts in the hypotheses developed in this study and the hypotheses presented by other

competing theories. For example, CEO duality is assumed to be a symptom of ineffective

internal corporate governance system in agency theory but at the same time, it is encouraged

in stewardship theory because of better control of CEO over the system to act in the best

interests of the shareholders without any hindrance in decision making. Nevertheless, the

empirical results will remain same regardless of competing theoretical arguments.

Methodologically, because of unavailability of data, the sample of firms used in this

study does not include unlisted, defaulted, delisted and merged/demerged firms. Thus, this

148

study might be prone to sampling and survivorship biases and warrant careful interpretation

when generalizing. In addition, including only listed firms in sample may lead to firm size

bias as only firms with certain size can be listed in the stock exchange. Furthermore,

investment and financial firms are not part of the sample due to difference in regulations,

accounting practices and performance parameters, leading to problem of generalizing the

results to these sectors. Moreover, although, this study controls for firm related unobserved

heterogeneity however it neither controls for CEO related unobserved heterogeneity such as

CEO ability nor it controls for CEO characteristics such as age, education and experience etc.

due to difficulty in operationalizing and unavailability of data.

Although this study provides evidence on how CEO compensation is related to firm

performance, important corporate governance variables and earnings management, however,

many questions remain unanswered. Since research on executive compensation in Pakistan

has not flourished therefore there are plenty of unanswered questions which can be addressed

in future research. Given the limitations of the study, future research may be aimed at

examining the implications of theories other than agency theory. The impact of a bundle of

other corporate governance variables that are not examined in this sturdy can be explored

once data availability increases. The impact of CEO’s characteristics on his compensation is

another avenue that needs to be focused in future research. The research could also be aimed

at how family characteristics interact with CEO compensation within family firms since most

of the companies in Pakistan are family owned. In Pakistan type of concentrated ownership is

considered to be more important than concentrated ownership, therefore further research may

be directed to how types of ownership interact with CEO compensation. Many firms in

Pakistan have some foreign directors in their boards. Influence of these foreign directors on

executive compensation decisions is another interesting area to explore in Pakistan.

Interaction of CEO compensation with capital structure decisions, dividend policy decisions,

investment decisions and asset management decisions are some broader areas on which future

research can be aimed at.

An important extension to CEO compensation research would be qualitative research

based on structured interviews for in depth analysis of the subject matter. Because most of the

research in CEO compensation relies of quantitative analysis, thus supplementing empirical

findings with elite interviews would be a valuable contribution towards understanding

executive pay setting mechanisms.

149

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Executive Compensation, Firm Performance and Corporate ...prr.hec.gov.pk/.../1/Muhammad_Fayyaz_Manag_Sciences... · I Muhammad Fayyaz CIIT/FA11-PMS-004/ISB hereby state that my PhD