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When business activities expand immensely with time
the ownership of the firm is distributed among number of investors to collect
required funds for the expansion. All these investors as the new owners of the company
cannot involve in the monitoring and controlling activities due to many reasons.
Involving with managing activities is not possible to all the owners and if
they involved it consumes time and ultimately it effects to the performance. The
much more important and possible option is to appointing an effective board of

There for they appoint a board of directors to evade
this inability and carry on managing and controlling activities more
effectively rather than the owners resulting a separation of ownership from the
firm. Corporate governance is about how these board members monitor the
managers in the company and how they become accountable to shareholders in
return. In brief corporate governance is a result of complex corporate
organizations and globalization.

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The terms “governance” and “management” are not the
same even they consider to be similar. Corporate management is preferred to the
typical procedure which involves in making decisions within the company. The
pool of rules and practices which ensure the extent that all the stakeholders
are served properly is defined as corporate governance. 14

Members of the board are acting on behalf of the all
shareholders, the real owners. These principals to agent relationship raise
some issues when carrying out better governance on the company.

Further 14 states that agency approach describes the
contractual interpretation of a firm related to the shareholders (Principals)
and company’s directors (Agents).

Agency theory is criticized when directors are acting
for self-interest than owners’ interest. Therefor interests of the directors
need to be line up towards the interests of owners and unless agency costs and
inefficiencies within the firm may arise. Corporate governance mechanisms are
used to ensure the behavior of directors aligned towards owners’ interest.
According to 14 such corporate governance mechanisms are effective board
structure, compensation contracts, active monitoring of executives and market
for corporate control.

According to 49, corporate governance is a
countrywide system in a formal structure to gain advantages from corporate
organizations where agency costs are reduced in a stable fashion with the
society’s history, legal, political and social traditions. Corporate behavior
is built up by the link of economic incentives and disincentives created by
corporate governance system.

When the board consist a considerable proportion of
owners, it can eliminate most of the agency problems. But observations have concluded
that large number of block holders cause to ineffective governance and increase
the influence on CEOs. 05

Because of the conflicts arise in an agency,
remuneration to directors is debatable. As stated in 45, there are four
corporate governance mechanisms and executive compensation is one of them.
Further executive compensation is defined as a mechanism aligning the interests
of managers and shareholders. Even most of the studies have identified a
positive relationship between executive pay and performance in US, Germany and
Japan. 45

After examining the firm performance and CEO
compensation components, there is a positive association between changes in
compensation and changes in firm performance. Due to the changes in market
returns, bonuses paid to the CEOs are changing as well. (04)

CEO compensation largely depends on a firm’s
accounting performance than on stock market performance. It is proved when firm
performance is measured using ROA. And even the leading shareholders are having
a less impact on the compensation made to CEOs. 05

However agency theory indicates that the
compensation to directors is positively correlated to corporate performance.
Therefor firms tend to prepare more attractive compensation packages to
motivate directors providing expected incentives. 45

According to 01, after studying the relationship of
pay and performance findings have revealed a significant pay and performance
relationship among sample firms. Further they have not identified pay
performance relationship based on market based measures and argued that the
executive compensation is determined depending on accounting based measures
rather than market based measures.

In 02, have carried out their research to examine
the relationship of firm performance measures and cash compensation with new
and old CEOs to investigate the relationship in two models. The results have
indicated that both accounting and market based performance measures are
related to the cash compensation of new CEOs showing positive correlation.
Conversely they have identified negative and insignificant relation between
performance measures and cash compensation of CEOs about to retire.

In Sri Lankan context many corporate governance
practices are adopted by British practices which are established through
voluntary codes giving freedom to companies to have their own preferences in
executing. As Sri Lankan companies are having family or concentrated ownership,
the corporate governance practices created for disseminated ownership
environment create disputes in the efficiency of governance systems in Sri
Lanka. 14

In Sri Lanka social, cultural and economic
conditions are very much differ from western countries. In that case referring
to the studies conducted in western context or applying the findings to Sri
Lankan context is limited.

One of the major characteristics of a firm is
separation of ownership and the control. In that case there must be a proper
corporate governance system that meets the requirements of shareholders as well
as the firm.

According to a survey steered by Association of
Chartered Certified Accountants have find out an increasing awareness in the
South East Asian countries on employing corporate governance systems for the
success. 14

In this research it is expected to find out how
directors compensation act as a corporate governance mechanism to achieve
desired performance of the firm. And make recommendations on how to use
compensation contracts to attract and retain skillful directors in the company.

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