CHAPTER TWO

LITERATURE REVIEW

2.1 Introduction
This chapter discusses the theoretical and empirical literature on the relationship between executive
compensation and firm performance. This chapter will further elaborate on the already stated
variables of the conceptual framework while attempting to respond to the what and how aspects of
the research objectives. Objectives are also looked into in detail in this chapter as well as the
theoretical framework.

2.2 Conceptual Framework

DEPENDENT
INDEPENDENT VARIABLES VARIABLES

Firm performance
Executive compensation
Salaries, allowances and bonus
Board Composition

Figure 1: Conceptual framework

The diagram above shows the conceptual framework adopted in the study. The independent
variables will be executive pay and board composition and the dependent variable was firm
performance. The researcher hypothesize that executive pay and board composition positively affect
firm performance.
According to Arnold (2020), executive compensation is an independent variable which means,
salaries, allowances bonuses does not depend on firm performance. Firm performance is the only
variable that is depending on the executive compensation. This means there is a positive
relationship between the executive compensation and firm performance. Huang (2020) also
supported the above by suggesting that there is a strong relationship between the executive
compensation and firm performance as shown on the above diagram.
2.3 Theoretical Framework
The theoretical understanding of the determinants of executive pay is still fragmented (Frydman &
Jenter, 2010, p.23; Murphy, 2012, p.156). However, “Executive pay has provided fertile ground for
much conceptual research originating in different disciplines and academic traditions” (Gomez-
Mejia, Berronne & Franco-Santos, 2010, p.140). The lack of consensus is most visible between
scholars in economics and finance, who advocate for the primacy of market-based explanations, and
scholars outside of these two disciplines, who have challenged these explanations and some of their
underlying assumptions, by highlighting the importance of the power of social-psychological
processes and the institutional environment in the creation of compensation practices (Diprete,
Eirich & Pittinsky, 2010).

However, schools of thought can be contradictory and complementary at the same time. This seems
to be especially true for theories used in the field of executive compensation. While most of the
previous research on executive compensation uses economic perspectives such as agency theory,
research that aims at examining the issue of executive compensation along the same economic
theoretical tracks and using the same methodology appears to be incapable of explaining the human
element as an important determinant through its social interaction, which is deeply embedded in the
sociocultural and political contextual setting.

closer look at the conceptualization and theoretical perspectives that characterize the assumptions
often implicit in empirical research on executive compensation. It is only through conceptualization
and a clear theoretical stance that an empirical framework can be developed. While such a
conceptual framework cannot include every dimension of executive compensation which is
mentioned in the literature (because of the broad range of disciplines represented), it nevertheless
attempts to offer an integrated approach to executive compensation. Despite the many
(fundamental) differences between the theories, the schools of thought reviewed in this paper are
not necessarily contradictory, but represent different ways of examining executive compensation.
One inference from these efforts is that executive pay is a very complex phenomenon that cannot be
easily captured in any single model or school of thought.

2.3.1 Schools of Thought on Executive Compensation

The different schools of thought that serve as a framework for executive compensation often list
different factors, criteria and elements when conceptualizing the determinants of executive
compensation. The different schools of thought in executive compensation are discussed below.

2.3.1.1 Cognitive theory

Proponents of cognitive theory view the process of determining executive compensation as a
psychological process or force which affects motivation and the basic needs of individual
executives. According to Robbins and Judge (2011), cognitive theory is concerned with peoples’
perception of their working environment and the ways in which they interpret and understand it. For
those who are focusing on the cognitive aspect on executive compensation, the term ‘cognition has
a wide meaning which goes beyond rational calculation. It denotes a broad range of mental activity,
including
proprioception, perception, sense- making, categorization, inference, value judgement, and
emotions. According to Robbins and Judge (2011), cognitive theory is a broad theory that includes,
amongst others, theories from the psychological perspective, as well as equity (equity theory) and
social comparison theory.

2.3.1.2 Equity theory

Boivie, Bednar and Barker (2012) posit that what is most desirable about equity theory in terms of
explaining executive compensation is that equity theory has been applied at both the individual and
team levels of analysis. Equity theory offers predictions about how individuals react to over-reward
and under-reward situations. Gomez-Mejia et al., (2010) confirmed that equity theory has played a
predominant role in traditional compensation theory and practice. Equity theory, which is part of
motivational theory, posits that an individual’s motivation is affected by how he or she perceives
the ratio of inputs (i.e., work performance) to outcomes (i.e., rewards) in relation to people who
perform the same job. According to equity theory, individuals make subjective assessments of the
ratio of their inputs (e.g., effort) and outcomes (e.g., compensation) to those of referent others, and
experience dissonance when their perceived ratio is unequal to that of others. Gerakos, Ittner and
Moers (2012) assert that employees seek to maintain equity between the inputs they provide and the
outputs they receive in comparison to the perceived inputs and outputs of others (Adams, 1966;
Vroom, 1964).

2.4 Empirical Literature

2.4.1 Board Composition
According to Kakanda et al., (2016), board composition is the number of non-executive directors
serving under a board of a company. It is the proportion of non-executive directors to total directors
(Marn & Romuald, 2012). Rahman (2018) argued that non-executive directors’ representation on
the board contributes to more transparency and disclosure practices of the firms. Based on the
agency's theory, corporate boards bigger proportions of by non-executive directors to executive
directors are in better positions to serve in the best interest of the shareholders and enhance the
firm's performance through a high degree of skepticism. Likewise, as an assumption of resource
dependence theory, companies that engage powerful community members into their boards acquire
key resources from the external environment which may lead to performance increase. Related
studies on this notion found a positive relationship between board composition and firm
performance. Harvey et al. (2015) investigates the association between corporate governance
mechanisms and performance of firms in South Africa and the result shows that composition of
board of directors (non-executive directors) is positively related with firm performance. Some
studies that belong to this group include; Abdurrouf (2011); Agrawal and Knoeber (1996) and Ali
and Nasir (2014). Others have found a negative relationship (for instance, (Marn & Romuald, 2012;
Narwal & Jindal, 2015)). Hence, this study hypothesized that:
H2. There is a positive relationship between board composition and financial performance

2.4.2 The Concept of Executive Compensation

In modern corporate governance, executive compensation is a commonly used incentive method.
The executive market releases information related to executive compensation plan formulated by
the board of directors or compensation committee for executives. Qualified professional managers
can sniff this information, join in the development and operation of enterprises, create value for
shareholders, and make a long-term development for enterprises (Wang,2019). There are two
different views on the effect of executive compensation on enterprise development. The first view is
that there is a reverse relationship between executive compensation and the development of the
enterprise. The higher the executive compensation, the more likely the executive will violate the
moral constraints and deviate from the value orientation of the enterprise itself, which is extremely
unfavorable for the sustainable development of the enterprise (Tohama,2019).
 In Lucian Boccek and Jesse Friede’s book “getting paid for nothing examining the executive
compensation system in the United States”, they put forward solutions to alleviate this harmful
impact. They think that through the reform of the management system, directors can bear more
responsibilities for shareholders so that when making compensation arrangements, they can avoid
the distortion of compensation plans to a certain extent Condition. The second view is that there is a
positive correlation between executive compensation and enterprise development. Under the
incentive of executive compensation, the management will be loyal to the interests and values of
shareholders. In the book executive compensation, Ella T. Kay and Steven van Putten analyzed the
listed companies in the United States and thought that executive compensation matched with their
contribution to the company, and the incentive for executives was conducive to the effective
development of the whole market.

Compared with mature markets such as the United States, the executive compensation of Chinese-
listed companies is not only the same but also different (William,2019). There is both the
phenomenon of rapid growth of executive pay and the emergence of sky-high pay. And “zero
compensation” is a unique phenomenon of Chinese listed companies. The issue of executive
compensation is not only related to the governance and development of the enterprise itself, but also
related to social equity, corruption and other social hot spots of national economy and people’s
livelihood. Every year, the relevant media will analyze, compare and rank the executive
compensation of listed companies, and deeply analyze its development trend, change causes, etc.
This has further stimulated the public’s enthusiasm and interest in the issue of executive
compensation. In recent years, the issue of executive compensation has become the focus of
academic and practical circles (Wu etal,2018).

2.4.3 The link Between Executive Compensation and Firm Performance

By the 1980s, the corporate ideology that the professional managerial class should replace
paternalistic management was well-established in organizations. Therefore, in order to align
executives’ interests to theirs and ensure profitability, shareholders opted to develop complex
executive financial incentives organized around company performance indicators (Abowd &
Kaplan, 1999). Particularly, optimal pay contracts are commonly viewed as the mean to address the
principal agent problem that emerge with separation of ownership and control of the company
(Jensen & Meckling, 1976; Hall, 2003, Bebchuk & Fried, 2004). De facto, some studies have
evidenced the positive response from markets following the implementation of incentives for
executives (Tehranian & Waegelein, 1985). In South Africa, the relationship between executive
pays and company performance is advocated by the King III Code and Report on Governance.

Optimal contracting implies that incentives are linked to performance so that executives bear the
costs and rewards of their decisions, and executives and shareholders’ interests are aligned.
Remuneration committees that might involve the Board of Directors are tasked to design executive
packages (Jensen & Murphy, 1990; Bizjak, Lemmon, & Naveen, 2008; Cho, Huang, &
Padmanabhan, 2014). As suggested by optimal contracting theory, these committees rely on
benchmarking and consultants’ advice in order to attract and retain talented executives (Baker et al.,
1988; Bebchuk & Grinstein, 2005; Bizjak, Lemmon, & Nguyen, 2011; Shin, 2013). This “market”
approach has been criticized, as it results in executive’s bargaining power influencing executive pay
(O’Reilly & Main, 2010; Bivens & Mishel, 2013). First, labor markets impose constraints to pay
levels that can be negotiated between executives and the Board of Directors (Bebchuk & Fried,
2004). According to managerial contract theory, executives are able to exert influence on the Board
of Directors or the remuneration committee in order to benefit from favorable pay packages
(Anabtawi, 2005). To that end, CEOs and executives use four types of power: structural power,
ownership power, expert power and prestige power (Finkelstein, 1992). In addition, benchmarking
might result in compensation packages that are not related to the firm performance (Bebchuk &
Fried, 2003). Additionally, Bebchuk and Grinstein (2005) found that stakeholders’ dissatisfaction
with executive pay levels had an influence on executive pay levels. Therefore, critics view
executives’ pay design as a characteristic of failure of corporate governance in organizations.
Following these developments, restricted shares rather than options are now incorporated in equity-
based pay in order to mitigate motivation and loyalty to the company.

Company characteristics are indicated as having an influence on executive pay settings (Frydman &
Jenter, 2010). Large companies allocate a higher proportion of equity-based pay in executive total
pay (Benston, 1985). The stability of pay-size elasticity in some sectors also indicates an executive
pay designed on sales growth rather than the fluctuations of the market performance (Coughlan &
Schmidt, 1985). Lastly, the size and life cycle of the company are found to have an influence on
executive pay. For instance, equity-based pay is generally designed in companies during their
growth stage. In contrast, companies at a maturing stage favor fixed pay (Balkin & Gomez-Mejia,
1987).

A significant amount of research has been devoted to the relationship between executive pay and
firm performance, particularly following the corporate scandals in the 2000s that were preceded
with soaring levels of executive pay (Bebchuk et al., 2003). Early economic researchers assume that
pay is critical in performance, as both variables are associated and markets react positively to
incentive pay contracts (Raviv, 1985). Although contested, a large part of literature proposes a
small positive association between executive pay and firm performance (Frydman & Saks, 2010;
Pepper & Gore, 2014; Bussin and Modau, 2015). In addition to the mixed results, there is no
consensus on the adapted methodology which varies from regressions, fixed effects, first difference
to lagged dependent variable, nor model specifications for measuring the relationship between the
firm performance and executive pay (Allison, 1994). Some cross-sectional studies indicate that 10%
increase in market performance is associated with executive pay increases comprised between 2.2%
and 4.8% (Hall & Murphy, 2002). However, Bruce, Skovoroda, Fattorusso, and Buck (2007) find a
lack of significance of the pay-performance relationship among 350 FTSE companies for the period
2002–2003, and rather suggest the influence of managerial power on executive pay. The results
from these cross-sectional studies have consistently indicated a pay-size elasticity range between
0.2 to 0.4 across time and business sectors (Baker et al., 1988; Frydman & Saks, 2010). Size is also
found to be an important factor in explaining pay levels (Murphy, 2012). However, the restriction of
cross-sectional models to the current firm performance results in a systemic bias as pay contracts
are often tied to long-term incentives (Frydman & Jenter, 2010). Fixed effects models are dynamic
and based on panel data manipulation and variation of some of the control variables, besides time
and company size. Time series models use lagged performance in order to eliminate the effect of
pay on performance (Bebchuk & Grinstein, 2005). Overall, these models that relate current pay to
lagged performance seem to indicate a weak pay-performance relationship, but a strong influence of
current performance on current executive pay. Hall and Liebmann (1998) argue that salary is not
strongly linked to performance as compared to bonus pay. They conclude that relative performance
is not the basis for executives’ pay.

Comparing industries, Chhaochharia and Grinstein (2009) find that Return on Assets (ROA) does
not impact equity-based pay. In addition, the study found that tenure has no significant impact on
equity-based pay. Bertrand and Mullainathan (2001) conclude that executives of oil companies are
paid for luck and that pay for luck is higher in organizations dotted with weak corporate governance
structures. Gabaix, Landier, and Sauvagnat (2014) find that the increase in executive pay is
explained by size growth in the largest companies of the top US 1000. They argue that executive
compensation is determined by the value put by shareholders on their companies. The inclusion of
company size results in a stronger pay-performance relationship.
Murphy’s (1985) study indicates that a 10% increase in returns increases executive pay by 11%.
Time-series models, based on linear estimators, find that executive pay is associated with market
and accounting indicators. However, critics have argued that fixed effects models result in biased
estimates when control variables that are correlated to the independent or dependent variables are
omitted (Liker et al., 1985). In addition, the need to control for several variables in fixed effects
models poses analytical challenges at various levels (Allison, 1994).

H2. There is a positive relationship between board composition and financial performance

2.4.4 Reasons why executives perform badly regardless of being highly paid
Executive are at the core of organizational success and if any changes are done in the organization
which is not in their favor, they may be forced to underperform which concurs with what Durak
(2019), postulates that management have in them the chameleon behavior that makes them change
counts times depending on the circumstance and current situation. During the past two decades,
many studies have been conducted and have been interested in organizational change and the
mechanisms that promote that process smoothly (Benford & Snow, 2000; Bouckenooghe, 2010;
Caldwell et al., 2009; Pettigrew et al., 2001). Despite that wide interest in the process of
organizational change, these studies reported negative results, as most of those efforts ended with an
unsuccessful implementation of the process of organizational change and ultimately failure due to
executive behaviour (Beer & Nohria, 2000; Meaney and Pung, 2008; Hussain et al., 2018). This is
because the focus was on many secondary variables and ignored the most important factor of
individual and executive reactions towards organizational change in those studies (Oreg et al., 2011;
Penava and Scenic, 2014). Herold et al., 2008; Holten and Brenner, 2015; Oreg & Berson, 2011;
Alnoor et al., 2021).

A reaction towards a change is a cognitive and behavioral response based on an adaptation and a
comprehensive understanding of how to react towards a change (AL-Abrrow et al., 2019b; Peng et
al, 2020). This largely depends on how managers introduce a change and on the extent to which
others respond. Usually, a negative reaction towards change happens when it is expected to result
into more workload, uncertainty, and fatigue, especially when change is rapid and spans the whole
organization or large parts of it (Beare, 2020; Liet, 2017). Individuals’ reactions towards
organizational change are expected to be dependent on the individual’s perception and assessment
of the change effects on the individual. This suggests that a reaction towards a change is developed
through the interactions between attitudes, beliefs, and feelings of an individual towards a change.
A successful implementation of a change depends on how individuals interact with organizational
change (Oreg et al, 2011; Shura et al., 2017).

Participation in the change process is closely related with reactions towards a change. Practitioners
are likely to be able to effectively diagnose and improve the willingness to change when they
understand the need for change (Albrecht et al., 2020). Besides, people are more inclined to commit
to a change if they perceive the change in alignment with their expectations and the resistance to
change would be minimal (Helpap, 2016). A positive reaction allows individuals to be more job
focused and hence less resistance to change can be expected (Gardner et al., 1987). Similarly, a
negative reaction towards change often generates a strong resistance to change. This happens if
change is perceived as harming. Moreover, individuals’ resort to negative reactions when work
relationships are threatened because of a change in a way that causes them to quit their job (Michela
& Vena, 2012). This is so practical in case of executives when their power and authority is in a way
threated. However, some individuals are indecisive in their reactions towards a change, especially
when future outcomes are unpredictable. This results into disruption and anxiety for both
organizations and individuals, and thus reactions serve as the method aimed at dealing and engaging
with change (Blom, 2018).

These considerations suggest that individuals react differently towards organizational change,
depending on their respective perceptions. This invites a comprehensive study to understand the
differences in reactions and to explain the main role that reactions play towards organizational
change. Based on a systematic literature review, we provide a comprehensive framework that can
help get an in-depth understanding of the reactions on organizational change. Earlier studies on
precedents and consequences of change have been more concerned about reactions to organizational
change (Akhtar et al., 2016). Despite the need of organizational change, many change initiatives fail
(Beer & Nohria, 2000), mainly because of differences in individuals’ interactions in the change
process (Oreg, 2011).

Rafferty et al., (2013), developed a model to study individual level willingness to change. It was
found that change based on interactions, homogeneous attitudes, and feelings are successful, and
vice versa. Still, there is need to present a broader and more comprehensive theoretical framework
based on earlier studies to better understand reactions towards change at different levels. Although
many researchers have contributed to conducting many studies to try to analyze the nature of
cognitive and behavioral responses, for example, job satisfaction, individual performance,
emotional intelligence, readiness for organizational creativity, and leadership abilities of all kinds
(Malik and Masood, 2015; Malik and Masood, 2015). There are rare studies that dealt with
reactions to organizational change at all levels, micro and macro (Khan et al., 2018). Thus, the
number of studies that investigated reactions to change has increased, but the different types of
study cases are still unknown to allocate the most critical determinants that contribute to positive
and negative reactions to change. Hence, further investigation is needed. This systematic analysis
seeks to provide useful insights into contexts of change reactions and to assist the authors in
identifying current options and gaps in this type of study.

2.4.5 Motivating Strategies to Enhance Executive Performance

Motivation in general referred as the reasons for acting or behaving in a particular way. It gives the
reason for people's actions, desires, and needs. Motivation can also be defined as one's direction to
behavior or what causes a person to want to repeat a behavior and vice versa. A motive is what
prompts the person to act in a certain way, or at least develop an inclination for specific behavior.
According to Maher and Meyer, “Motivation is a word that is parts of the popular culture as few
other psychological concepts. Managing motivation is therefore a critical element of success in any
business; with an increase in productivity, an organization can achieve higher levels of output.

Llopis (2012) draws attention to the increasing relevance of the work-life balance problem for
modern employees and stresses its negative impact on the level of employee motivation.
Specifically, Llopis (2012) reasons that unless employees achieve an adequate level of work-life
balance in personal level, management investment on the level of employee motivation can be
wasted. This viewpoint is based on the Hierarchy of Needs theoretical framework proposed by
Abraham Maslow (1943). According to him there is a certain hierarchy for individual needs, and
more basic human needs need to be satisfied in order for the next level needs to serve as motivators.
Motivated employees will retain a high level of innovation while producing higher-quality work
more efficiently. There is no downside that is the opportunity cost of motivating employees is
essentially zero, assuming it does not require additional capital to coach managers to act as effective
motivators.

Leaders motivate people to follow a participative design of work in which they are responsible and
get it together, which make them responsible for their performance. Aguinis (2013) stated that
monetary rewards can be a very powerful determinant of employee motivation and achievement
which, in turn, can advance to important returns in terms of firm level performance. Vuori and
Okkonen (2012) stated that motivation helps to share knowledge through an intra-organizational
social media platform which can help the organization to reach its goals
and objectives. Den and Verburg (2004) found the impact of high performing work systems, also
called human resource practices, on perceptual measures of firm performance.

2.5 Chapter Summary

The chapter analyzed theoretical contributions by various scholars who researched about the link
between the executive compensation and firm performance. Included in this chapter are causes of
poor performance in organizations that highly pay their executives and factors that motivates
executives to perform well at work place and the relationship between the executive compensation
and firm performance. The following chapter will probe into how, what, when, and where the
researcher intends to collect data about the variables under study.