FDs come under pressure as bonus schemes face scrutiny

The row over banker bonuses could effect finance directors far outside the Square Mile.

As companies face growing pressure to make their bonus schemes fairer and more transparent FDs will play a key role in agreeing any changes and justifying the board’s decision to sceptical shareholders and journalists.

Currently, many bonus schemes are based on performance measures such as earnings per share (EPS), pretax profit and shareholder value compared to a company’s peers.

And bonus schemes have been attacked for using a narrow set of financial measures which reward past performance and encourage short-termism, for example,encouraging some bank employees to behave recklessly in order to hit targets, critics have claimed.

Andrew Likierman, dean and professor of management practice in accounting at London Business School and recently appointed chairman of the National Audit Office board, has called for a significant proportion of senior executives’ annual bonus – between 25% and 50% – be based on criteria linked to the ability of the organisation to deliver sustainable performance in the future.

The criteria used should tie individual executive bonuses to the company’s strategy through a combination of non-financial measures, such as improved innovation or market share, and judgments, such as diversification of strategy or ‘talent management’, Likierman wrote last month in The Times in his London Business School role.

One way to improve confidence in the fairness and transparency of company bonus schemes could be to use independent market research companies to verify non-financial bonus targets, according to Richard Mallett, director of technical development at the Chartered Institute of Management Accountants. ‘If you move to more non-financial measures, investors may need that assurance over transparency of calculation, over whether it’s the customer satisfaction programme being done by an independent market research company.’

But amid the recession, companies are expected to base bonus schemes on narrow financial measures.

‘There is an element of back to basics in [bonus schemes] at the moment,’ said Sophie Black, director in performance and reward at Ernst & Young.

Gilad Livne, senior lecturer in accounting and finance at Cass Business School, added: ‘There is lip service to customer satisfaction and other non-financial performance measures. What you see in reality – and this is backed up by research – is most British firms’ bonus schemes simply use EPS [to decide payouts].’

Bonuses based around EPS – earnings divided by the number of shares – can give a ‘distorted’ view of corporate performance, said Livne, as companies can boost their EPS by buying back shares, rather than through an improvement in revenue or profit.

Even if companies decide not to broaden the yardsticks for bonuses they are likely to face pressure to make schemes longer-term, experts believe.

Bonuses could be paid every three years, rather than annually, in an effort to encourage more sustainable growth and long-term planning. In addition, a greater proportion of each bonus could be paid through shares rather than cash.

Such reforms could create some financial challenges for FDs who will need to forecast likely bonus payments over three years and set aside enough cash to cover payouts. Forecasts will have to include variables, such as staff turnover.