SINCE China opened up to the world with its sweeping economic reforms in the late 1970s, and especially in the past decade as private-sector enterprises have mushroomed, the model of executive compensation in the country has increasingly mirrored ones in the United States and Europe.

How is it, then, that Chinese executives are paid only a fraction of the compensation earned by their American counterparts in companies of equal size in the same industries? Or are they?

In China, executive compensation above tens of millions of yuan would be seen as astronomical and would cause an uproar.

In 2007, the latest year studied, China Stone Management Consulting Group used compensation disclosures in companies' annual reports to analyze data on executive compensation at China's 200 largest public companies by market capitalization. They found that 64.8 percent of executives received compensation ranging from 100,000 to 500,000 yuan (around US$16,000-US$80,000), and 19.5 percent between 500,000 and one million yuan.

On the other hand, executive compensation in China has always been shrouded in mystery. The majority of Chinese public companies - those listed in Shanghai and Shenzhen - disclose only the individual executive's aggregate compensation.

This number does not usually reflect actual aggregate compensation because it omits such things as hidden payments and extra bonuses. As such, it can represent just the tip of the compensation iceberg.

Are the figures disclosed in the annual reports of public companies in China accurate? What is the true picture of executive compensation in China?

The main source of income for top executives in China is not the disclosed annual compensation or bonuses and dividends, but hidden payments.

A typical executive in a state-owned enterprise can easily receive hidden income because the on-duty expense level has high elasticity.

According to one executive interviewed by China Knowledge@Wharton, the cost of a normal business meal can range from a thousand yuan to tens of thousands of yuan.

For overseas business trips, benefits can be obtained and transferred through flexible allocations and use of consumption rights, such as office expenses, travel expenses, entertainment expenses, communication expenses, overseas training fees, expenses of the board of directors and conference fees.

Using "administrative expenses," as disclosed in annual reports, Gao Minghua, director of the Research Center for Corporate Governance and Enterprise Development at the Beijing Normal University, compared on-duty consumption and annual revenue, and listed the top 100 public companies in China in 2010 in terms of on-duty consumption as a percentage of annual revenue for the year. In 10 of the companies, the on-duty expenses exceeded the revenues.

On-duty consumption

A study conducted in 2011 by professor Yang Rong of East China Normal University showed that the average on-duty consumption of all individual companies in the dataset - the research was based on 1,320 listed companies examined between 2002 and 2009 - exceeded average executive compensation by two to 50 times, and has been growing over the years.

Analyses by a number of researchers, including professor Chen Donghua in the business school at Nanjing University, show that such covert on-duty consumption has no correlation with company earnings, or has a negative correlation.

In state-owned enterprises, on-duty consumption has a significant negative correlation with company earnings.

Besides on-duty consumption, under-the-table bonuses can sometimes be a major source of income for top executives as well.

One interviewee noted that a securities company in China distributed 300 million yuan in cash as bonuses at the end of 2008.

The main beneficiaries were those in senior management. Such generous bonuses usually undergo special accounting treatment so that the public is unaware of them.

US model

In terms of stock option incentives, Chinese companies are rapidly adopting the US model. Among 1,725 public companies in China, nearly 250 offer stock option incentives, with close to half of them beginning to do so in the past two years.

Offering such incentives had achieved positive effects, including revenue growth or earnings growth for some companies.

At high-tech companies, stock options are a common form of incentive and have become an important part of executive compensation.

In the case of Shandong Sun Paper Industry Joint Stock Co, a public company in the private sector, the average annual compensation of its top three executives was raised from approximately 250,000 yuan to more than four million yuan with the implementation of stock option incentives, bringing its executive compensation in line with its earnings.

Sun Paper implemented its stock option plan starting in 2008. The earnings growth rate in 2009 was 52.97 percent; in 2010, it was 112.93 percent. At most private enterprises that are going public, stock options have become the norm.

However, stock option incentives still are not widespread in China.

In 2010, they were offered at only about 15 percent of the 1,725 public companies in the sample. Nor do they generally carry much weight, given that the average ratio of fixed salary to earnings-at-risk is 3:1, with fixed salary and earnings-at-risk accounting for 75.29 percent and 24.71 percent of total compensation respectively.

Distortions

Gao acknowledges that stock options are not common in China and believes that they should remain so. Generally speaking, he says, the meaning of "incentives" is lost when it comes to stock options because of the serious distortions in their use.

Indeed, stock options are morphing into a welfare system arrangement. In many Chinese companies, the beneficiaries of stock options cover a wide spectrum.

The strike prices of stock options at public companies in China are generally lower than their prevailing market rates.

The strike prices of restricted stock options in the announced plans of 91 companies in 2010 were mostly lower than prices in the secondary market, with the strike prices of 70 percent of these companies at only 50 percent of the prevailing prices of their stocks (on the announcement dates). Some were even less than 30 percent.

It meant that top executives could easily pocket high premiums by the exercise deadlines - a significant departure from the intended purpose of stock option incentives.

Exercise periods are necessary for stock options to act as long-term incentives.

Top executives are unable to sell the stocks they hold before the expiration of the exercise periods as a way to prevent any short-term actions on their part.

However, in the past two years, many public companies in China have seen the departures of top executives soon after their companies went public so that the executives could sidestep the exercise period and quickly cash in their holdings.

Adapted from China Knowledge@Wharton, http://www.knowledgeatwharton.com.cn. To read the original, please visit: http://bit.ly/KRGWJa