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.