Contemporary Issue in Accounting - Term Paper Example

CONTEMPORARY ISSUES IN ACCOUNTING   By of the of the School This paper looks at agency problems that result from the relationships between shareholders (principals) and managers (agents). Agency relationships results to conflicts due to the conflict of interests between the two parties. Recently, there has been a quick rise in the executives pay which has sparked a strong debate regarding the nature of the pay-setting process. The high level of executive compensation is a product of powerful executives setting their pay. Additionally, it is as a result of optimal contracting for the managerial talent particularly in the competitive markets. Managers in their terminal years tend to manipulate the corporation’s earnings in order to enhance earnings based compensations. The paper discusses how equity as a pay component works to reduce the horizon problem by exploring the relationship between executives’ compensation and firm performance in a bid to maximize the value to the shareholders. Risk taking shareholders should motivate their managers to choose appropriate projects and work hard to ensure that they implement them. The paper then discusses the purpose of including non-salary component of executive pay arrangements. We find that it acts as motivation thus increasing individual productivity, teamwork, loyalty to the organization and total job satisfaction. The report then concludes by presenting the reasons why managers prefer short term cash over long term equity bonuses. In addition, it discusses why shareholders may vote against the remuneration reports that have a high proportion of short-term bonuses. Table of content Abstract……………………………………………………………………………………………2 1.0 Introduction……………………………………………………………………………………4 2.0 Risk aversion problem………………………………………………………………………...4 2.1 Reducing risk aversion problem……………………………………………………………....5 3.0 How equity as a pay component works to reduce the horizon problem……………………6 3.1 Role of accounting information……………………………………………………………….8 4.0 Purpose of non-salary component of executive pay arrangements……………………………8 5.0 Why managers prefer short-term cash over long-term equity bonuses……………………...11 Conclusion……………………………………………………………………………………….12 References……………………………………………………………………………………13-14 Introduction Agency theory helps in explaining the relationship between managers and shareholders. Managers or agents are, usually, hired by shareholders (principals) to perform work in their best interest, however that rarely takes place as the parties normally have a conflict of interest (Solomon, 22). When decision-making authority is delegated several problems may arise for instance, loss of efficiency and increased agency costs. Efficiency is lost because managers may not work as hard as shareholders would have because executives do not directly in the results of the company. Therefore, this may lead to agency problems as this theory entails aligning the interests of the two parties and the cost of resolving the conflicts. Positive accounting theory is, therefore, the agency problems that are brought about when decision-making authority is delegated. There are several problems that can cause disparity in managers’ and shareholders’ incentives concerning the policies of the company such as risk aversion and horizon problem. Particular contractual arrangements should be put in place so as to minimize agency costs linked with the problems (Mathis, 221). Risk aversion problem Risk aversion problem is brought about by the relationship between return and risk. In investing, risk aversion is the avoidance of risks. Any given investment has some level of risk hence it is upon the investors to establish their amount of risk tolerance. Investors that carry high level of risk tolerance tend to invest in companies or industries that have a greater possibility of failure because such investments promise a higher rate of return on the invested money as a compensation for the greater inherent risk. On the other hand, risk averse investors tend to go for those investments that are not likely to fail, for instance, government securities. Such investors mitigate such risks by diversifying their investment portfolio (Solomon, 24). Managers and shareholders of a company have different levels of risk tolerance. Shareholders are mostly risk takers. They prefer investments that have greater risks because they promise higher returns. Shareholders, usually, follow the general convention that the higher the risk of the project; the greater is its potential return. On the contrary, managers are risk averse hence go for less risky investments. Managers are prepared to take a smaller amount of the risk of the industry or company since that is typically their primary source of income. In case the managers continue to go for the less risky projects, the company would have low return or profits which are in contrary to the shareholders’ expectation. Therefore, this leads to the agency problem known as risk aversion. Risk aversion problem occurs when the behaviors of the managers are not value maximizing because they are risk averse (Kaufman, 167). Reducing risk aversion problem In designing the contract between shareholders and managers, there is a need to accentuate the link between executive pay and performance. Risk aversion problem can be narrowed by designing the contract in such a way that remuneration packages (bonus incentives) are linked to accounting revenues so that the managers can be obliged to go for higher risk investments for them to achieve those bonuses (Shavell, 259). Managers normally play a vital role in the selection and implementation of projects. They should, therefore, be motivated to select those projects that are appropriate among the many available alternatives that may maximize the value to the shareholders. With regards to selection of projects, the contract should be formulated in a way that offers a compensation scheme increases with increase in profits so that it creates managerial incentives that are greatly aligned with those of the shareholders. Additionally, compensation contracts should be designed in such a way that effective project selection is motivated. For instance, an endogenously selected compensation schemes are capable of giving top executives performance-based compensations such as phantom stock plans, stock appreciation rights, incentive stock options and performance share or unit plans in order to encourage any risk tolerance level that is desired (Shavell, 258). Practically, incentive compensation can be extensively used. The curvature of the compensation contract of managers is mostly used because it is a function of profit and thus capable of affecting their attitude towards project risk. The optimal curvature should be established by looking at the trade-off between the motivating effort and controlling project risk in order for the managers to work hard to implement the chosen projects and also to ensure their success (Kaufman, 169). How equity as a pay component works to reduce the horizon problem Horizon problem occurs when managers anticipate staying with the corporation for a short period. While managing the company, the managers tend to take a short-term view because after their departure they will not have interest in the company, for instance, they tend to under-invest. They favor lower investment and higher profit payouts rather than high level of reinvestment as it will not benefit them. To avoid horizon problem, managers’ bonuses should be tied to share prices or compensation in the form of shares so that they can take a longer-term view (Pandey, 215). Equity as pay component can be manipulated in different ways to help lower the horizon problem. In the recent times, there is an escalating agreement that the equity-based compensation that is given to the top level managers of public corporations should be attached or linked to long-term results because bonuses for short-term gains prove to be illusory hence producing significant distortions in the decision making of the managers. In addition, top-level executives should be inhibited from cashing out their equity incentives or compensations for a given period after investing in order to provide them with stronger inducements to focus on the long run instead of short run (Froeb & Mccann, 279). On the other hand, however, corporations should shun “hold-till retirement” requirements because they are capable of distorting the executives’ decision to retire. Also, they can undermine the top executive’s incentive to focus on the long-term while they near retirement. In addition, awards that are equity-based should, on unwinding, be subject to grant-based limitations (Pandey, 217). Placing restriction on the unwinding of the equity incentives or grants awarded to a top executive ensures that they take a longer-term perspective as they only unload an increasing quantity of the equity as time lapses from the vesting time of a specific equity grant. Equity as a pay requires that executives be averted from using derivative and hedging transactions for it to produce the intended benefits. If the use of financial instruments is not restricted, the incentive effects of the equity-based instruments can be weakened or eliminated hence resulting to the horizon problem (Froeb & Mccann, 277). Role of accounting information in specifying contractual terms of bonus plans designed to reduce horizon problem Accounting information plays a vital role in bonus plans. Use of accounting information in setting these contractual terms ensures effectiveness of the governance process thus preventing deviation from the set goals and objectives. Managers are able to perform their duties in line with the shareholders’ interests because of the set control mechanisms. Such contracts, usually, include clearly stipulated financial accounting measures that define the boundaries of the executives’ authority (Ogden et al. 123). At the time of contracting, accounting information and numbers are often used in determining the contract’s parameters such bonus rates in compensation. Managers will, therefore, be obliged to work along that line so that they may achieve the desired results for them to get the bonuses. Accounting information, therefore, aids in setting the end results and the compensation associated with the achievement of such result. Accounting information also aligns the managers’ objectives with the interests of the shareholders thus reducing horizon problem because the two groups work towards a common goal (Tirole, 998). Purpose of non-salary component of executive pay arrangements Top level executives such as company presidents, chief executive officers, chief financial officers and other upper-level managers are, usually, compensated in a number of ways. These numerous components of executive compensations play different purposes. Non-pay incentives aim at rewarding the performance of the top executives. These rewards are, usually, linked to particular long-term goals and objectives of the organization. They, therefore, help to change the perspective of the managers from short term to long term (Balsam, 185). The most frequently used long-term non-pay incentive is the stock option. This incentive allows the executives to buy the stocks of the company at a reduced price. Upon acquiring stock options, the managers will be tied to the organization. They will be obliged to improve the financial status of the company by undertaking high level of reinvestment so that their stocks can become more valuable in the long run which in turn maximizes the shareholders’ value. The ownership of stocks, therefore, motivates the executives to make the company more profitable. Including the non-salary component in the executives’ compensation arrangements, therefore, rewards managers for improved commitment thus encouraging and motivating them to improve performance (Bebchuk & Fried, 102). Non-salary compensation is of great importance to executives in their total job satisfaction. Executive perks such as company paid membership clubs, car service, special parking, executive dining rooms and other such amenities serves to improve the managers’ ability to do their jobs. In addition, non-salary compensations bring with them some level of status thus motivating the executives to fully commit themselves to the organization. These compensations act as inducements to the executives to deliver upon the promises they made to the company. Non-salary compensation ensures a more relaxed and conducive and happier workplace. Also, they reward good work thus creating an incentive to reduce costs because managers are encouraged to think and discharge their duties from the viewpoint of the shareholders (Balsam, 183). Some non-salary compensations such as group insurance plans help in retaining valuable executives. Most companies have delayed vesting in a pension plan to encourage executives to remain with the company for a little longer period until the contributions remitted by the company can become irrevocably the executives’ property. The vesting period ought to be long enough to retain the executives for a significant period. However, it should not be so long to discourage them. Non-salary compensation should, therefore, be included in the executive pay arrangement because it reduces the problem of employee turnover because it helps the company to retain its valuable executives (Bebchuk & Fried, 118). The company, therefore, saves money and time that would have been used in recruiting and hiring new people. By offering good non-salary compensation, the corporation is also able to attract more well-qualified executives. In addition, non-salary encourages team work among executives. The managers are, therefore, able to strengthen their bonds because they pull together for a common goal. A unified workforce ensures pleasant and a more efficient work environment for all. It also enhances regular work relationships between them resulting in increased productivity. This gives the employees a clear message of the priorities of the organization as it helps in reducing misunderstanding and conflicts among the employees. Such employees tend to be loyal to their company because they have higher organizational commitment (Organization for Economic Co-Operation and Development, 89). Why managers prefer short-term cash over long-term equity bonuses Top executives often prefer short-term cash over long term-tern equity bonuses for numerous reasons. Firstly, most managers tend to have a short-term perspective, and they need not wait long to get their bonuses. Long-term equity bonuses result to unhappy executives as they have to meet the demanding performance hurdles for them to get the options. Secondly, they prefer short-term cash because it places little constraint on them. Such compensations are also not tied to their performance level (Gross, 59). Finally, the vesting period for long-term equity bonuses may be very long enough thus discouraging them to perform their duties. Short term cash bonuses do not align with the interests of the principals who have a long term perspective. They choose to vote against it because it does not maximize their value. Such shareholders prefer long term equity bonuses rather than cash. They argue that by increasing the manger’s ownership share in the corporation encourages them to make decisions that favor company’s long-term growth rather than short-term gains. Long-term equity bonuses also work as retention tool for the top executive talent because they are normally paid in the future and managers may not be willing to forfeit them by leaving before the time (Khan & Jain, 6-24). Shareholders may also choose to vote against reports with too high a proportion of pay as short-term cash bonuses rather than long-term incentives because short-term cash bonuses have a substantial negative long-term impact on the corporation. For example, if the manager’s compensation is paid in annual basis, they will not have an incentive to make appropriate and right long-term decisions for the company as it negatively affect their current year compensation. With regards to this, shareholders prefer long-term incentives since they encourage managers to make decisions that are often in the best long-term interest of the company because such incentives rewards managers for achieving performance goals and targets in future years (Upadhyay, 222). Conclusion Managers and shareholders of a company often have conflict of interest because of their different incentives regarding the policies of the company. Managers prefer riskless investments because their guarantees earnings, however, shareholders prefer risky investments because they have higher returns that help in maximizing their value. This situation is referred to as risk aversion problem which can be reduced by motivating executives to select risky process by designing contracts in such a way that remuneration packages are linked to accounting revenues. Equity as a pay component should be linked to long-term results so that managers are encouraged to take long-term perspectives in order to reduce horizon problem. In specifying contractual terms for bonus plans used in reducing the horizon problem accounting, information should be used in setting the end results and the compensation associated with the achievement of such results. Non-salary component should be included in the executives’ compensation arrangements because it rewards managers for improved commitment thus encouraging and motivating them to improve performance. Managers prefer short-term cash bonuses because they place less demanding performance hurdles on them, and they do not wait for long to get them. However, shareholders prefer long term equity bonuses because they make managers make decisions that favor company’s long-term growth. References Balsam, S. (2002). An introduction to executive compensation. San Diego, Calif. [u.a.], Academic Press. Bebchuk, L. 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