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PERM BRANCH OF FEDERAL STATE

AUTONOMOUS EDUCATIONAL INSTITUTION

FOR HIGHER EDUCATION

«NATIONAL RESEARCH UNIVERSITY

«HIGHER SCHOOL OF ECONOMICS»

Faculty of Economics, Management and Business Informatics

Graduate qualification thesis

Relationship between CEO compensation and firm performance in european companies

On program track 38.03.01 Economics

Education program «Economics»

Smirnova Aleksandra Sergeevna

Reviewer

PhD Felix J. Lopez Iturriaga

Advisor

Candidate of Science

Marina A. Zavertyaeva

Perm 2016

Abstract

According to the agency theory, CEO compensation is one of the pivotal instruments, which serve to align managers' and shareholders' interests. The problem is the discrepancy between theory and reality observed in empirical literature on executive pay. In this study, we seek to examine, whether CEO remuneration is performance-sensitive and whether companies that pay their CEOs more perform better. Our analysis, in which we treat both compensation and firm performance as endogenous, is based on the sample of approximately 350 European firms for the period from 2009 to 2013. The findings suggest that CEO compensation is positively associated with corporate performance either market- or accounting-based. Nevertheless, simultaneous estimation of compensation and performance equations revealed that CEO pay positively influences only corporate operational results and has insignificant impact on stock efficiency. Overall, our findings are partially consistent with real practices since most companies design compensation contracts as a function of accounting-based results.

Key words: CEO Compensation, Firm Performance, Simultaneous Estimation, Sharpe Index.

Аннотация

Согласно теории агента, вознаграждение генерального директора является ключевым инструментом, позволяющим уравнять интересы менеджеров и акционеров. Проблема заключается в несостоятельности теории на практике, что демонстрирует эмпирическая литература на тему вознаграждения. Данная работа нацелена на исследование взаимовлияния между компенсацией генерального исполнительного директора и результатами деятельности компании. В рамках анализа, основанном на выборке из порядка 350 европейских компаний за период с 2009-2013 гг., и результаты деятельности, и вознаграждение были заданы как эндогенные параметры. Полученные результаты показывают, что вознаграждение генерального директора положительно связано с корпоративной эффективность, будь то рыночной или бухгалтерской. Тем не менее, совместная оценка уравнений для вознаграждения и для результатов компании выявило, что выплаты генеральному директору положительно влияют лишь на операционные показатели деятельности и оказывают незначительное влияние на рыночную эффективность. В целом, достигнутые в работе результаты частично согласуются с реальной практикой, поскольку, действительно, многие компании назначают вознаграждение в зависимости от бухгалтерских результатов.

Ключевые слова: вознаграждение генерального директора, результаты деятельности компании, совместное оценивание, коэффициент Шарпа.

Сontents

Abstract

Introduction

1. Literature review

1.1 Agency theory

1.2 CEO compensation structure

1.3 Interdependence between CEO pay and company performance

2. Research question formulation and hypothesizing

3. Methodology and preliminary data analysis

4. Empirical results

Conclusion

References

Appendix

Introduction

Agency theory is a paramount framework for understanding the relationship between boards of directors, who represent interests of owners, and chief executive officers (CEOs). Stated differently, it is an attempt to explain the agency relationships in which one party, called principal, delegates authority to another one - an agent (Young and Buchholtz, 2002). When a principal and an agent discord with goals, interests or risk preferences, so-called agency conflict occurs. Trying to neutralize this conflict a company, in turn, incurs notable expenses. Scholars claim that executive compensation is one of the key instruments to minimize agency costs (Walsh and Seward, 1990).

For a long time, CEO compensation has been hotly discussed in spheres of finance, management and accounting. According to the agency theory, compensation committees engaged in remuneration system formation must closely tie pay levels to company results (Matsumura and Shin, 2005). A considerable amount of research has been conducted in order to confirm this statement empirically (Kang et al, 2002; Coles et al, 2006; Cambini et al, 2015).

The problem is that the agency theory concepts do not find support in empirical literature. Some papers evidence the absence of any relationship between executive compensation and company performance (Gomez-Mejia et al, 1999; Firth, 2006; Parthasarathy et al, 2006), while others indicate the presence of negative association, what we can describe as an unexpected result (Malmendier and Tate, 2009; Balafas and Florackis, 2013; Cooper et al, 2013). The variety of indicators evaluating performance and compensation, as well as methods providing a solution, has caused significant differentiation across empirical outcomes.

Besides multivalued results obtained previously, we get interested in this topic because in prior studies scholars typically did not address the issue of interrelation. In other words, the previous papers mostly investigate the influence of CEO compensation on firm performance or vice versa. We intend to combine these two types of studies. Accordingly, the present research paper is aimed to examine the relationship between CEO compensation and firm performance. Specifically, we try to answer two questions simultaneously: whether companies tie CEO remuneration to particular financial indicators and how effective in firm performance this pay level is.

The goal achievement requires a number of tasks:

- to explore prior studies that examine the association between CEO compensation and corporate results;

- to determine a research model, in particular, it is necessary to formulate a research question, then to put forward respective hypotheses and, as the results, to propose an appropriate methodology for answering the question;

- to accomplish data collection required for empirical analysis along with data treatment in order to adjust it to the research;

- using data generated to conduct an econometric analysis of the relationship between CEO pay and company performance followed by results interpretation and hypotheses verification.

The empirical part of the study is based on a regression analysis, in particular, on Ordinary Least Squares (OLS) and Two-Stage Least Squares (2SLS) methods. The research is carried out with the use of actual data collected by International Laboratory of Intangible-driven Economy (IDlab) in 2014-2016 with author's participation. Thus, the object of the inquiry is presented as European joint-stock companies. Whereas, the research subject is the relationship between CEO compensation and firm performance.

To recapitulate, this study potentially may not only satisfy the author's research interest, but also make some notable contribution to the literature on the studied question. In addition, the findings of the current research may be of considerable practical value for shareholders as well as for CEOs and boards of directors. Each company has certain targets and shareholders being capital owners are interested in the achievement of these goals as well as in general company efficiency. The results of the current paper helps to understand whether compensation stimulates CEOs for pursuing corporate objectives. As for the executives, they are also interested in their salary determinants. If a CEO is aware that the level of money he/she can receive depends on his/her decisions, his/her actions will be more reasonable. Moreover, CEOs receive relatively high payments. In turn, a board of directors, which charge CEO compensation level, wants this high level to be justified.

The tasks posed above allow tracing the structure of the current paper, which is represented as four sections, introduction and conclusion. The first section provides a brief literature review of the agency theory that helps to understand even more about the research problem, and emphasizes relevance of the chosen topic. One paragraph is devoted to CEO compensation and its components. As a rule, researchers are not ready to stop only on the theoretical analysis, therefore, they move to the verification of practical applicability of the agency theory. Thus, in the last paragraph we analyze three types of empirical studies. The first investigates whether CEO remuneration is performance-sensitive. The second examines the compensation influence on firm performance. The last part of papers combines two previous ones and focuses on the interrelationship between CEO pay and corporate results. The analysis of existing empirical studies on the topic allows to identify potential research sphere and to determine possible place of the current research in the scientific literature.

In the second section, we formulate the main research question and put forward appropriate hypotheses based on the literature review. Along with proposed conjectures, we define economic models for CEO compensation and firm performance through determination of the main factors. Moreover, here we make some suggestions about methods that can serve for hypotheses testing.

The third section sheds light on the main steps of empirical research. In the section, we precisely describe the choice of compensation and performance measures. Based on hypotheses and economic models, we determine the set of control variables for both compensation and performance equations. The section provides a depiction of research database and methodology. Lastly, here we conduct a preliminary data analysis in order to improve the sample and identify potential problems associated with data features that can affect estimation results of the study.

The last section is dedicated to the presentation of the results on the relationship between CEO compensation and corporate performance. On a par with the correlation analysis we have conduct several stages of the regression analysis. Here we discuss hypotheses' verification and compare obtained results with that of previous researchers. The practical applicability of the findings, limitations of the study and further research perspectives are discussed in the conclusion.

1. Literature review

1.1 Agency theory

A distinctive feature of large enterprise contemporary shareholder capital structures is dispersed share ownership, a degree of which varies across countries and industries. However, the dispersed capital among owners has a pronounced advantage - an opportunity to raise relatively large-sized capital. Furthermore, a rule of thumb states that joint stock companies can carry out complicated projects requiring such a technology level that is not available for other corporation types. In order to put this advantage into practice, shareholders transfer rights of daily operational control over assets to an outside agent called manager. This company authority transmission is accompanied by a certain risk studied in the framework of agency theory, which was proposed by Jensen and Meckling (1976).

According to this theory, agency relationships imply relations between two parties, a principal and an agent. From the economic theory perspective, the «principal-agent» relationship is studied in the framework of an employer and an employee. When information is asymmetric, an agent is prone to opportunistic behavior, and a principal is obliged to take into account this fact proposing incentive mechanisms, which may include restrictions, punishment and a reward system.

In financial management the «principal-agent» relations emergence refers to the situation where shareholders being the capital owners delegate investment and financial decision-making authority to managers, or agents. Agents are rewarded for achieving principals' objectives, while shareholders and management interests may be different.

In our study, we treat a CEO as a manager or an agent. Agency theory states that boards of directors can be considered as a mechanism through which owners, or shareholders, control and compensate CEOs for actions. CEOs may deviate from optimal behavior that is consistent with shareholders' interests in different ways. For instance, they may neglect their operational duties in favor of having a rest (Jensen and Meckling, 1976) or, what is more, abuse privileges such as corporate planes (Jensen, 1988). Moreover, with respect to anticipated experience in companies CEOs may focus on short-term perspective instead of long-term horizon, which is better for firms. Usually, CEOs trying to save their job positions avoid risky investments. The reason is that many CEOs are highly specialized. In this case, sometimes their skills and abilities can be useful and appreciated only in the company, where they have had some experience. Shareholders at the lowest cost can diversify their investments among many firms, thereby making each investment of a low risk. CEOs, on the other hand, simply cannot diversify risks, as they are closely connected with their companies. Since the director usually can work for only one firm, he/she is unlikely to be neutral to the risk connected with his/her job (Young and Buchholtz, 2002).

An owner and a manager discord with interests, as they have different company perceptions. For the owner a company is an investment object. He ventures invested capital and has limited impact on the company performance. While the manager consider the company as a source of income in salaries and bonuses terms. The manager acts under uncertainty because there are spheres, which are not subject to him/her, and there are risks for which he cannot influence, in particular, systematic risk.

Defending the income source and maximizing benefits the manager is inclined to pursue their own goals in decision-making to the detriment of the owners. In this case, agency conflict occurs. It is worth noting that the agency conflict does not always occur in an agency relationship. In a situation when there is no uncertainty, i.e. the agent always knows what strategy to follow, and the principal can always evaluate agent efforts, the conflict does not arise. If the principal detects poor-quality work of the agent, he just either lays him off or makes him deprived of remuneration. When the uncertainty exists and the agent is not risk-averse, he can take whole risk and, at the same time, be satisfied with pay for performance. In this case, the conflict of interests does not also occur. Thus, two factors determine the agency conflict: uncertainty, or information incompleteness, and risk aversion (Teplova, 2000).

The way to resolve this conflict is to create an incentive system. When transferring management functions of assets and investments to managers the task of the owner is to find such a scheme of incentives that will be the most stimulated. Therefore, compensation is one the instruments that can serve for conflict resolution and control over manager's activities. In this case, the manager is compensated with the income that he/she has fairly earned. Nevertheless, it is not all as easy as it sounds. The problem is how to assess executive performance and, consequently, how much compensation to appoint. In addition, it is necessary to understand how effective this incentives system is. Stated differently, whether charged compensation aligns managers' and shareholders' interests. These questions have caused a number of research papers that we will discuss in our paper later.

1.2 CEO compensation structure

A company board of directors is responsible for the representing owners' interests and for the interest conflict resolution between managers and shareholders. Typically, a compensation committee (a board of directors sub-committee) charges an executive pay level. The committee has to report annually on the compensation policy for the CEO and the next four highest paid executives over the previous financial year. A company has to justify a remuneration level and its relationship with corporate results, such as income or earnings per share (Matsumura and Shin, 2005).

Although differences may occur across firms or industries, most executive compensation packages consist of four major components: base fixed salary, annual bonus, stock options or restricted stock grants and long-term incentive plan (Murphy, 1999). Furthermore, there is an «other» category of compensation that can be generalized as benefits. Speaking more generally, we can identify two types of remuneration. The first is fixed pay or guaranteed compensation, which includes base salary and benefits. The second one is variable pay, also known as incentive pay, which includes annual bonuses, stock options and components of long-term incentive plan.

Executive base salaries are generally determined by comparison with salaries of similar companies in the same industry. Usually the amount of base salary is fixed. Additionally to this remuneration, CEOs may receive some benefits. There are different benefits types, which can be fixed or variable, monetary or non-monetary. Some examples of optional benefits are funding of education, severance payments, daycare, tax and tuition reimbursements, health insurance, signing bonuses, retirement benefits, sick leave, paid vacation, along with flexible and alternative labor routine. In our study, we are more interested in monetary benefits. Base salary and benefits are so called guaranteed components of compensation and typically paid on a monthly basis (Bussin and Blair, 2015).

Annual bonus is a reward paid at the end of the year that is why sometimes we may meet it as «year-end bonus». The annual bonus is usually based on annual accounting performance indicators, such as earnings per share or return on equity (Murphy, 1999). This type of remuneration is variable and has motivational nature. Compensation committees use annual bonuses to reward CEOs for performing their responsibilities and for achieving superior results. Bonus goals and their associated outputs reflect a range of anticipated levels of performance (Dwight Ueda, 2013). As a rule, these bonuses are referred to short-term incentive pay.

Finally, in contrast to the annual bonus, which rewards 12-month-period performance, many companies offer equity and sometimes cash based awards: stock options and long-term incentive plans. These options give executives the right to buy company shares at a pre-determined price, and that could be implemented within a pre-specified period. Sometimes companies provide CEOs with restricted options, which may lose its power due to certain circumstances (Coleman and Fortier, 2002). Long-term incentive plans reward CEOs for reaching results over a long measurement period and based on a moving average of three- or five-year cumulative performance (Matsumura and Shin, 2005).

1.3 Interdependence between CEO pay and company performance

The relationship between CEO compensation and firm performance has been at the heart of numerous discussions within a scientific and public context. Indeed, according to the agency theory, the association exists and must be empirically confirmed. However, it is not all easy, as it seems at the first sight, studies on the subject show that the question remains uncertain.

The first problem is that mutual influence of CEO compensation and company results within the same and different periods exists. In other words, lagged effect may occur. Thus, there are two approaches to analyze executive remuneration. The first one assumes identification of CEO pay determinants, while the second suggests investigation of compensation influence on firm performance. The possibility of mutual influence has caused additional research trend, within which scholars have raised the question of the necessity to overcome endogeneity problem associated with this interrelation. Subsequently, we will consider the empirical studies concerning all these approaches.

The second problem is that research results vary depending on what compensation and performance measures have been taken as a basis. Hence, there is an ambiguity in the results. Certainly, according to different study in most cases association between compensation and corporate results exists. Nevertheless, some researches disprove the statement. For example, Firth, Fung and Rui (2006) trying to identify the presence of the relationship in question among Chinese companies have found that when a major company shareholder is a State agency the link between CEO compensation and firm performance is absent, otherwise - association exists, but is too weak.

Before proceeding to the analysis of studies on the topic, it is necessary to make a remark about such an indicator as firm performance. Surely, the term is quite broad and multiform, so it requires some specification. Generally, companies use two types of basic indicators that can be potentially tied to executive remuneration. The first type includes accounting measures, specifically, measures that can be obtained from balance sheets. These are profitability ratios - ROA, ROE, ROS, etc. (Adjaoud et al, 2007), the relative revenues and expenses that estimated with respect to industry corporate leaders (Sun et al, 2013), growth rates (revenue growth, earnings growth, etc.), economic value added (Adjaoud et al, 2007) and many other possible accounting parameters. The second type includes market measures such as market capitalization, market value-added indicators (Adjaoud et al, 2007), stock returns (Dee et al, 2005) or volatility (Core et al, 1999), market-to-book ratios (Cadman et el, 2010) and so on. However, these two groups of indicators are incomplete set of corporate performance measures. Sometimes researchers take a more specific performance indicators, which, for example, assess company innovativeness, investment opportunities and sometimes even information disclosure (Balkin, 2000; Cheng, 2004; Sheikh, 2012). Moreover, sometimes researchers treat company risk as performance measure as well putting appropriate hypothesis concerning what risk type is good for firms and what is harmful (Gray and Cannella, 1997; Miller et al, 2002; Chourou et al, 2008).

Firm performance influence on CEO pay

As we have mentioned previously, there are different approaches to analyze CEO compensation. The first part of studies, which we will consider, bears upon the topic of company results effect on CEO compensation. The consensus among scholars on the topic is absent. The agency theory states that compensation is an incentive, which is designed to be tied to performance. Indeed, some scholars found that executive remuneration is positively related to firm performance. For instance, Griner (1996) evaluating the relationship between CEO compensation and corporate performance, measured by return on equity (ROE) and shareholder return, confirmed the hypothesis that executive officer pay is positively correlated with the company results. Later, other researchers would have confirmed Griner's results (Coles et al, 2006; Cambini et al, 2015).

Typically, result differentiation is caused by the use of different firm performance measures. For example, Firth, Tam and Tang (1999) took two types of returns as variables that evaluate company performance. The first one is an accounting measure, return on shareholders' equity (ROSE), while the second one is a market annual stock return. Similarly, conducting a new research Firth with other co-authors (2006) determined company performance as an accounting measure through return on sales (ROS), which was estimated as operating income normalized by sales. Surprisingly, in the first research Firth and co-authors obtained both performance measures as statistically significant in CEO compensation variance explanation, while in the second research they got insignificant coefficients for financial factors. In the research literature scope, we can find a number of studies that also declare a weak company results effect on CEO pay (Gomez-Mejia et al, 1999; Gregg et al, 2005; Parthasarathy et al, 2006).

The same problem faced Core, Holthausen and Larcker (1999). Investigating CEO compensation determinants they found that return on assets (ROA) is not significant, while stock return positively and significantly influences executive pay. Whereas Angelis and Grinstein (2014) analyzing compensation policies of S&P 500 firms revealed that companies tie a CEO pay level largely to accounting measures, which are more informative of executive performance. The authors noted that companies «put heavier weights on income measures, sales, and accounting returns».

In this group of studies researchers have also tried to take into account multi-year relationship between CEO pay and company results. Specifically, these papers are aimed at investigation how past firm performance influences current CEO remuneration. Ahn (Ahn, 2015) revealed the positive effect of prior company results on CEO compensation. It might mean that compensation committees pay attention not only to present company situation but on the past experience as well. Here we can remember about long-term incentive plan which is based on the cumulative performance of some years., Nevertheless, Banker et el (2013) came to confused results since they found that past performance plays different roles as a CEO pay determinant. The authors indicated that prior-year ROE and stock return both positively influence CEO salary, while bonus is inversely associated with previous-year ROE. What is more, considering salary and bonus together they found that total compensation is unrelated to past performance.

The topic concerning company innovativeness influence on CEO compensation has attracted many researchers since high-tech companies have to produce a steady stream of innovation to survive in conditions of strong competition in the technology market. In this field of literature, we do not observe such strong results differentiation, authors on a large scale found that CEO pay is subject to a positive impact from investment in R&D, the number of patents and citations but under certain conditions. For instance, Balkin, Markman and Gomez-Mejia (2000) have made some notable contribution to the literature on the studied question. Conducting the research on two samples depending on the technology level, the authors revealed that in high-technology companies innovation significantly and positively influences CEO compensation, while in low-technology firms it does not affect either short- or long-term CEO pay. Moreover, they found the lack of relationship between CEO pay and firm performance measured through ROA for the high-technology sample. Trying to explain the phenomenon, researchers suggest that in high-technology industries CEO are likely to be rewarded for activities associated with innovation such as R&D projects and patents rather than for financial results. Another example is of Cheng (2004) who identified significantly positive association between R&D spending and CEO pay under two conditions simultaneously: a CEO is close to retirement and a company faces small losses.

CEO pay influence on firm performance

The second type of studies we will analyze focus on compensation influence on company performance. Scholars who conducted research on this theme have not arrived at a common view. Prior paper findings are quite different. According to the agency theory and common sense, the higher CEO compensation the higher his/her productivity and, consequently, the better corporate performance. Thus, the positive effect of different compensation types on the company financial measures has been empirically confirmed in the article by Kang, Karim and Rutledge (2002). Researchers indicated that short-term CEO compensation has a stronger impact on the firm performance estimated through the relative excess value ratio, in comparison with the long-term one. The positive influence of pay on company results are also confirmed in several studies (Hanlon et al, 2003; Conyon and Freeman, 2004).

Adjaoud, Zeghal and Andaleeb (2007) in their work investigated the impact of board of directors quality, including the compensation level, on company outcomes. The important point is that the authors divided performance measures into traditional balance sheet measures (ROI, ROE, EPS) and more modern based on the value creation indicators (EVA, MVA). At the same time, according to the results of empirical research, it was found that the effect of board of directors quality on accounting measures is statistically insignificant, whereas, the same effect on value added indicators was not only statistically significant but also positive.

However, at the same time a considerable amount of studies (Malmendier and Tate, 2009; Cooper et al, 2013) evidences a negative relationship between CEO compensation and firm performance. It can be approved through closer examination of a recent interesting paper. According to Balafas and Florackis (2013), the consequences of the last financial crisis have revealed severe flaws in corporate compensation policies, for example, the weak link between CEO remuneration and corporate performance, which resulted in an intense debate about whether the cross-sectional variations in executive pay can be fully justified by economic fundamentals. In other words, the authors urge scholars to take into account annual effects. Therefore, the researchers have tried to incorporate this factor by submitting the following research question: whether companies that pay their CEOs excessive fees generate superior future returns and better operating performance. The study indicates a strong negative relationship between CEO incentive payments and subsequent shareholders returns. Firms that pay their CEO relatively high remuneration earn significantly lower returns. Moreover, CEO incentive pay is inversely associated with future operating performance.

Mutual influence of CEO pay and firm performance

Based on two groups of papers considered previously, we can say corporate performance may influence CEO compensation that may affect firm performance as well. In an empirical analysis based on econometric tools this potential mutual influence of parameters may cause endogeneity problem. In this case, the correlation between variables and regression residuals may leads to estimates empirically obtained to be biased and inconsistent. Some scholars being interested in the relationship between CEO remuneration and firm performance have conducted researches taking into account the possible simultaneity problem. Theoretically, the endogeneity problem can be solved by running simultaneous equations through Two- or Three-Stage Least Squares analysis (2SLS and 3SLS).

Although Ozdemir, Kizildag and Upneja (2013) examining a relationship between CEO pay and systematic risk were forced to estimate simultaneous equations treating compensation and performance measures (ROA and stock return) as endogenous. The authors found that cash compensation positively and significantly influences ROA, while equity compensation effects stock return. Moreover, CEO compensation is positively associated with both performance measures.

Huang and Chen (2010) obtained the similar results for banking industry. The interesting feature of this paper is authors hypothesized that in equilibrium where a compensation contract is optimally formed to reflect corporate contracting environment, there should be no association between CEO remuneration and company performance. According to their 2SLS regression results, executive compensation is sensitive to accounting measure ROE, while it is not sensitive to market performance determined as stock return. Whereby, it was found that CEO compensation enhances both market and accounting performance measures. Thus, the authors partially confirmed disequilibrium hypothesis that CEO pay lowers agency costs and enhances corporate outcomes. The reason is that broads of directors design «less-than-optimal» compensation contracts (Jensen and Murphy, 1990) what can be explained by weak corporate governance, CEOs' risk aversion, public opinion and financial constraints (Huang and Chen, 2010).

As we discussed above, many scholars who are interested in executive compensation analyze company innovativeness. For example, Holthausen, Larcker and Sloan (1995) examined both whether the structure of CEO pay influences future firm innovation activity and whether remuneration is affected by expected innovation opportunity. The results of 2SLS estimation are mixed. It was found that compensation has the modest positive effect on subsequent firm innovation, while expected company innovation set relation with executive compensation is insignificant. Following Holthausen and co-authors, Rajgopal and Shevlin (200) investigated whether executive stock options provide managers with incentives to invest in risky projects. They took incentives risk of stock options and exploration risk as endogenous variables. Using lagged effect as well, the researchers found that risk incentives of stock options has a positive association with future exploration risk taking. More recent paper of Sheikh (2012) related to interdependence between compensation and firm innovation measures indicates that CEO portfolio incentives pay-performance sensitivity is positively associated with investment in R&D expenditures. Sheikh also used lagged parameter of innovation.

Stated briefly, the present literature review has some essential implications. According to studies considered above, the question of the relationship between CEO compensation and firm performance is of great interest. The first implication concerns methodology. The approaches to compensation investigation are rather different as they vary across papers. Previously researchers followed, on general, one of two approaches when dealing with remuneration: remuneration influence on corporate performance and vice versa. However, focusing narrowly on one type of influence can only partially explain the nature of CEO compensation. Moreover, the potential interdependence may lead to the endogeneity problem. Therefore, the current research paper bears upon an additional type of studies that attempt to combine these approaches and take into account the endogeneity problem.

The second implication is of results. The findings of previous research papers are quite multivalued. Despite the fact that many studies confirm the presence of association between CEO compensation and company performance level, there is a great number of papers in which authors were unable to prove this phenomenon, since corporate outcomes were not only statistically insignificant but had negative coefficient signs. Indeed, the agency theory states that a company minimizing agency costs ties executive compensation to corporate performance. In reality, however, firstly, not all firms follow this requirement; secondly, they tie it to various parameters. Perhaps, these factors explain result variation. Nevertheless, because a clear judgment about the presence of the relationship between CEO remuneration and corporate performance does not exist, what the literature review supports, this theme is a potential area for further research.

2. Research question formulation and hypothesizing

Joint-stock type corporations have to annually disclose information about their compensation policies for management groups. In this regard, companies can establish a certain link between company financial results and remuneration level. Moreover, charging a high pay level, boards of directors expect CEOs to perform better. Unfortunately, companies not always follow these regulations and compensation contracts sometimes can be inefficient. That is why the theme of relationship between compensation and company performance has been the subject of many research studies. manager shareholder geo

The literature review presented in the previous section has made some notable contribution to understanding the studied topic. Firstly, we have found that authors of prior papers have been mostly interested in corporate performance influences on compensation level. Whereas some researchers have confirmed the presence of compensation influence on company results. Based on these facts, we can say that the simultaneity problem exists. In other words, both CEO pay and company results may influence each other. In this case, some researchers focusing, for example, only on performance effect on CEO compensation have been forced to deal with simultaneity problem and run a system of equations (Ozdemir et al, 2013). Other researchers have been interested in the topic of interrelation and automatically have overcome the problem. However, generally such studies deals with company innovativeness rather than with financial measures. Secondly, the uncertainty of the results that can be observed in the literature on the topic in consideration indicates the potential research sphere.

The agency theory states that CEO compensation being performance sensitive can serve to enhance company results. According to the literature reviewed, sometimes the theory cannot be practically confirmed. Therefore, we have been interested in understanding the applicability of the agency theory in practice. Specifically, in this paper, we seek to examine whether CEO compensation is paid for performance and whether companies that pay their CEOs more perform better. With respect to research questions stated, we put forward the first hypothesis:

Hypothesis 1: In order to align managers' and shareholders' interests, a CEO compensation package is designed to be a function of current corporate performance. The hypothesis is based not only on the agency theory as it is known that companies usually reward its directors for efficient activity, but also on results of previous studies, which on general evidence positive relationship between compensation and company performance (Griner, 1996; Core et al, 1999; Coles et al, 2006; Sun et al, 2013; Cambini et al, 2015).

Based upon the literature review above, it was found that executive compensation level may depend on company characteristics (), in particular, financial measures and on CEO personal qualitative features () that may affect his/her performance and integrity level within the company. Under firm factors, we understand company size and some other indicators that can influence CEO pay apart from performance measures, for example, dummies for industry. Certainly, researchers can capture only part of potential qualitative factors, information for which is available outside. The CEO qualitative characteristics may include gender (Adams et al, 2007; Tian and Yang, 2014), education (Wade et al, 2006), duality (Dorata et al, 2008), tenure (Zheng, 2010) and so on. According to the literature review and the hypotheses, we assume that CEO compensation is characterized by the following functional form:

(1)

The topic of corporate performance and its determinants seems to have always been at the heart of numerous discussion. For many years, researchers and practitioners all over the world have sought to identify firm performance drivers in order to boost company welfare. One of the decisive factors of firm performance is CEO performance. Within the current research paper, we try to understand can a board of directors influence CEO efficiency through remuneration. We derive the second hypothesis as:

Hypothesis 2: CEO compensation is an incentive that enhances company performance. We base the hypothesis on the agency theory concepts, that compensation is one of the instruments that align interests of executives and shareholders. In addition, a number of prior researches has revealed positive influence of remuneration on company results (Kang et al, 2002; Hanlon et al, 2003; Conyon and Freeman, 2004).

Based on the literature review and the hypotheses, we assume that the following functional form characterizes firm performance:

(2)

By we mean some external factors that do not depend on company actions, but can influence its performance. We will take these factors into account in order to avoid endogeneity problem. With this regard, researchers usually consider industry and year effects (Huang and Chen, 2010; Sheikh, 2012).

Previously, we consider both CEO compensation and corporate performance as endogenous variables. When dependent and independent variables are mutually influences each other simultaneity problem occurs, which subsequently distorts the results. We can overcome this problem by estimating system of equations with both variables to be endogenous. In order to conduct an analysis of these parameters simultaneously, we construct system of equations and put forward the last hypothesis:

Hypothesis 3: CEO compensation is tied to corporate results and influences firm performance simultaneously. The hypothesis combines two previous ones and is also based on the agency theory statements. Furthermore, it is consistent with results of Ozdemir, Kizildag and Upneja (2013) and partially with that of Huang and Chen (2010).

It is necessary to mention that our analysis of firm performance and CEO compensation equations has not examined an apparent optimization model that explains precise drivers of performance or the nature of compensation contract formation. Our models are, to a certain extent, heuristic depictions that represent some of the important factors of performance and compensation. Furthermore, our analysis is partially consistent with the previous empirical literature, which has considered performance and compensation as endogenous parameters (Holthausen et al, 1995; Huang and Chen, 2010; Sheikh, 2012).

There are two important aspects of the equation system. The first is that we allow both firm performance and CEO compensation to be endogenous parameters. The second is that firm characteristics and market factors in the performance equation do not directly influence CEO compensation, but these variables have an indirect effect on compensation through their impact on corporate performance. Having a database with companies and indicators the system of equations can be solved with the help of regression analysis, in particular by using the Two- Stage Least Squares method (2SLS), which will be implemented in the present paper.

3. Methodology and preliminary data analysis

This part of the proposal explains methods used in carrying out the study and describes the choice of measures of CEO compensation and firm performance. There is a great variety of approaches for investigating the CEO compensation nature and purpose. As for the topic on relationship between executive pay and firm performance, scholars of this field tend to use econometric methods. This paper is not an exception. The empirical part of the current research provides an estimation of an econometric model based on the actual data.

On the first stage, it is necessary to draw special attention to measurement of the main endogenous variables. The dependent variable in the functional form (1) is CEO compensation. As mentioned earlier, most of compensation packages consist of several components. Usually these are basic salary, annual bonus, stock options and benefits. Depending on research objectives and relevant data availability, scholars have differently calculated compensation. Some authors have analyzed only cash remuneration (Sun, 2013; Shaw and Zhang, 2010), others only compensation in the form of stock options (Griner, 1996), and still others have tried to combine both measures through, for instance, a particular ratio (Chourou et al, 2008). In this paper, we will examine total amount of remuneration (Total Pay), that is, the sum of salary (Salary), annual bonus (Bonus), benefits (Benefits), and then disentangle the effects from the constituent parts of the compensation.

The dependent variable in the functional form (2) represents corporate performance. There is a great variety of indicators, which researchers used to consider as company performance measures. According to the literature review, on general firm performance can be determined through either an accounting indicator or a market measure. In that respect, we employ two different measurements of corporate performance. The first is an accounting-based measure that is determined as a ratio of net income to the book value of total assets (ROA). The choice is based on the prior papers (Ozdemir et al, 2013; Sun et al, 2013; Cambini et al, 2015).

The second performance benchmark is a market-based ratio that is defined as a Sharpe Index (SI). The choice of such performance measure can be justified by some reasons. Firstly, prior papers shows that researchers usually determined market performance as stock share return (Dee et al, 2005; Cadman et al, 2010; Banker et al, 2013; Cambini et al, 2015; Sur et al, 2015). Secondly, there are studies where authors have provided evidence that risk is an important determinant of CEO compensation (Gray and Cannella, 1997; Miller et al, 2002; Chourou et al, 2008). Due to these reasons other authors take into account both market return and risk when analyzing the relationship between CEO pay and firm performance (Huang and Chen, 2010; Ozdemir et al, 2013; Tian and Yang, 2014). In this case, the consideration of these indicators independently from each other may result in unexplained variance of dependent variables what make regression residuals higher. The Sharpe Index is a one of the instruments that weight return by risk and, hence, demonstrates the assets or, in our case, share efficiency. The Sharpe Index is calculated as difference between average annual stock return and risk-free rate weighted by annual stock volatility. The higher the Sharpe Index, the more stable and more efficient a share is.

More arguments why we employ accounting- and market-based measures are as follow. Firstly, market return might be determined by not only CEOs' performance but by general market conditions. Secondly, Huang and Chen (2010) noted that market-based return is «forward looking» since it demonstrates current and expected performance, while accounting-based measure is «backward looking». In addition, we will include the performance measures in the compensation equation separately since we suggest that ROA may influence the market-based ratio. The correlation between independent variables may lead to multicollinearity, which can significantly distort the regression estimates.

The Hypothesis 1 predicts that CEO remuneration is a function of firm performance. In order to identify the dependence of compensation on corporate results, research requires involving a number of control variables. In fact, CEO compensation cannot be explained only by financial firm results, because it depends on many other factors. Certainly, it seems impossible to list all factors that affect executive pay, so, each researcher selects a set of control variables in his/her sole discretion, often on the basis of common sense and the previous studies results. As mentioned in the Section 2, CEO remuneration may depend on factors that can be divided into two groups: CEO qualitative characteristics and company performance metrics, including financial measures. Within the current research paper we include such control variables related to CEO features as MBA degree being a measure of education (Wade et al, 2006) and working experience in the company (Coles et al, 2006; Ozkan, 2011; Cambini et al 2015) that is squared (Adams at el, 2007). In addition to corporate performance, we assume that compensation also depends on such financial indicators as book value of total assets being a measure of size taken by natural logarithm (Ryan et al, 2001; Chourou et al, 2008; Huang and Chen, 2010) and firm age (Angelis and Grinstein, 2015), which is squared. We suggest that company age (Firm Age is an important determinant of CEO pay since sometimes young companies being small on the start but having satisfactory performance and favorable development trend cannot afford to pay their CEO large amounts of compensation. Additionally we include industry (Adams et al, 2007) and year (Dee et al, 2005; Wade et al, 2006; Ahn, 2015) effects. Thus, the compensation equation looks as follows:

,(3)

where: ;

;

- company number;

- CEO number;

- year.

At the first stage, for the purposes of Hypothesis 1 verification, we will conduct the estimation of the compensation equation from Formula 4 with the use of OLS method. It is worth noting, OLS is one of the generally accepted methods that allow to estimate a linear regression. Moreover, most of statistical packages include this calculation method. In order to analyze the effect of different company results on different remuneration types, we will run eight different compensation equations.

With respect to Hypothesis 2, we expect CEO compensation to be one of the factors that explain company performance variance. Obviously, not only CEO compensation can influence it. Since we employ two different performance measures, some control variables will be the same and others will be different. We will control ROA-based performance equation for liquidity ratio, sales growth (Huang and Chen, 2010; Ozdemir et al, 2013), financial leverage (Dee et al, 2005; Ozdemir et al, 2013) and size that is presented as natural logarithm of total assets book value (Adjaoud et al, 2007; Huang and Chen, 2010). The liquidity ratio (Liquidity Ratio measures company ability to pay for short-term obligations. It is calculated as all cash and other liquid assets divided by short-term borrowings and current liabilities. Thus, the ratio shows how many times short-term debts are covered by available liquidity. We suggest that the liquidity ratio may explain ROA variance as it is one the indicators of corporate climate and ability to survive during turn down. The financial leverage (Leverage) is a ratio between raised and equity funds. It may also influence ROA being an indicator of company sources to perform. We also include industry dummies to account for industry specific conditions that may affect company welfare. Formula 5 represents the ROA-based performance equation.