Ways Deemed Necessary in Controlling Contracts between Managers and Shareholders - Coursework Example

CONTEMPORARY ISSUE IN ACCOUNTING: REPORT ANALYSIS By Student’s Name Code + Course Name Professor’s Name University Cite, State Date Executive Summary In regards to risk aversion, the paper ascertains that managers would tend to focus their attention on projects that are short-term in nature with low risk and returns and also, early cash inflows at the expense of long-term projects that depict high-level of risks and long-term benefits that is encouraged by shareholders. The paper argues that this aspect can be avoided through tying manager’s compensation to equity and through, bonding and monitoring of their activities. The paper moves ahead to puts up a discussion on horizon problem whereby it is ascertained that it can be eliminated by way of also tying equity to compensation plans. Non-salary components are added to a manager’s compensation plan in order to commit them for a long-period into executing their tasks promptly and with precision. In relation to the voting rights of shareholders to limit the proportion of short-term cash and long-term incentives is based on committing managers into the long-term activities of the firm. Introduction The focus of this paper is on providing a clear report analysis on numerous issues that affect the contemporary accounting. Among the aspects that would be analyzed in the report include; in the first section, the paper puts up a discussion on the risk aversion problem and the ways deemed necessary in controlling contracts between managers and shareholders. Subsequently, the paper evaluates accounting information in regards to contractual terms of bonus plans, the purpose of including non-salary component in executive pay arrangements and also, develops argument in relation to short-term cash over long-term equity bonuses. In the final section, the paper evaluates the voting rights of shareholders in regards to a higher proportionate of pay on short-term bonuses rather than long-term incentives. It is important to realize that different crises arising from accounting nature facilitated the development of principles that was deemed necessary to curtail and protect activities of accounting information in relation to its different users. These principles are formulated by different accounting bodies for regulation purposes. For instance, regulation of issues like social ills that might emanate from laissez-faire policies as well as prevention of economic crashes formed a basis for contemporary accounting policies (Marks, 2014). Risk Aversion It is important to note that the fundamental aim of a company rests with the maximization of its underlying stock market values. The management team of a given company is always tasked with attaining the aforementioned objective. A company’s immediate quality performance is dependent on the managers’ efforts while it is ascertained that shareholders hire managers to operate businesses on their behalf (Bebchuk & Fried, 2003). However, it is noted that the fundamental objective of managers, which was earlier noted to be the maximization of stock market value and shareholders’ wealth for that matter, in most cases fails to conform to the interests of managers given that they strive to maximize their own personal gains at the immediate expense of owners of equity (Bebchuk & Fried, 2003). Subsequently, it must be noted that modern day companies do not recognize conventional owners given that shareholders are mostly dispersed hence they are unable to carry out management functions of a company that they own. This means that they are have to embark on hiring managers who acts as agents in order to their companies on their behalf. For this case, the shareholders are perceived as being more of investors and not traditional owners of the company (Bebchuk & Fried, 2003). It is determined that owners’ main focus rests on business performances while investors are inclined towards the risk and returns of their immediate stock portfolios that are managed by agents. Given that managers are more inclined towards sustaining and protecting their immediate self interests, they tend to averse risk by investing shareholders’ equities in lower risk and returns projects as opposed to engaging in making investments on higher risks and returns projects that are preferred by owners (Williamson, 1988). Significantly, they also averse risks in making investments in projects that possess a relatively shorter payback period with earlier high cash inflows as opposed to investing in long-term cash inflows projects (Bebchuk & Fried, 2003). The contract between managers and shareholders can be vehemently designed in order to reduce possible elements of risk aversion. Some of the notable ways of doing this include; first, it can be reduced through the application of managerial incentives whereby wealth of both executives and shareholders are tied in order to integrate and align the self interests of the two parties. This might involve allowing the executives to own a given amount of stock options as a significant portion of their immediate remuneration package. In this way, they are bound to ensure that they engage in highly profitable ventures for purposes of maximizing their personal wealth while in doing so, they would be maximizing the entire wealth of the company. This means that the managers would rather not averse risk related projects but engage in risk analysis in order to ascertain the long-term benefits of a given project investment. Second, the risk aversion mechanism can be reduced through introduction of a borrowing contract that affects both the bonding and monitoring activities. Bonding would require that the managers refrain from engaging in certain activities or else face heavy penalties in case of breach while monitoring requires them to prepare and disclose audited reports (Prendergast, 2002). Third, covenants aimed at engaging both managers and owners in the selection process of accounting methods should be adopted in order to prevent intentional misrepresentation of accounting information (Prendergast, 2002). Horizon Problems Horizon problem is the immediate temptation that confronts outgoing managers to inflate the present income in order to catapult their earnings that is based on bonus plan within their final years of service (Prendergast, 2002). It is also ascertained that a company’s performance and manager’s immediate discretion over financial variables are integrated making it a challenge to disentangle opportunistic behaviors that arises of managers economic necessity. For purposes of reducing the horizon problem that is fairly developed by managers, equity pay structure is integrated within the managers overall pay (Prendergast, 2002). It is ascertained that the equity compensation structure is used to encourage the adoption of long-term risky projects by way of tying manager’s wealth to the immediate value of the company. Following this line of reasoning, the restrictions put on the sale of the aforementioned equity payments postulates that they are used as a formidable mechanism to tie the managers with the company’s over long horizons (Prendergast, 2002). Consequently, it is established that a management bonus scheme that is adopted in paying bonuses equal to definite percentages of the underlying accounting income might set to promote short-term income hence short-term bonuses at the immediate expense of future incomes of the company at hand (Prendergast, 2002). The incentive for such a myopic focused manager is deemed to be stronger when their respective operational terms are ending and who thus, does not expect any form of accrued benefits from future profits emanating from their present efforts. There are two fundamental mechanisms that are put in place by such mangers in order to boost short-term income at the expense of the long-term incomes. It is established that they focus on cutting down on discretionary expenditures like R&D while increasing the levels of discretionary accruals like in the case of inflating sales figures or in other cases engaging in the understatement of a company’s depreciation expense value (Prendergast, 2002). Both of the aforementioned notions would indeed result to improved performances within the present period at the expense of future profit periods when the executive is no longer in tenure. Purpose Non-Salary Components in Executive Pay Arrangements The principal-agency relationship theory postulates that a company should formulate a contract that aims at yielding optimal level of incentives thus acting as a source of motivation to the chief executive officer to maximize the shareholders’ wealth at any given moment in time (Oyer, 2004). In the course of designing and formulating the pay plan, the owners takes into consideration that CEO’s engage in risk averse related activities. For this reason, the imposition of higher levels of incentives requires more pay to compensate the manager for increased level of risk. Chief executive officers are allowed a substantial amount of equity incentives in order to develop a stronger and increased connection between their wealth and firm’s performances (Oyer, 2004). A financial incentive that is linked to salary and bonuses and also, newer grants of options and restricted level of stocks are allowed to executives for purposes of measuring up to the standard measurement and flow of compensation that they would need to offset personal debt and other aspects altogether. They also are allowed incentives from the alterations in the substantial levels of stock and stock options relating to the company (Oyer, 2004). Significantly the possibility that emanates from these managers being fired due to poor performances gives them a motivation to pursue performance strategies that would lead to maximization of the shareholders’ wealth (Oyer, 2004). In the event that an executive tenure is terminated due to poor performance, they would likely suffer negative reputation as well as human capital devaluation within the top-management labor market (Oyer, 2004). Thus, the fundamental rationale under which executive pay is composed of non-salary items is based in the fact that they motivate them to increase the wealth value of a given firm which conforms to the underlying objective of the shareholders (Murphy, 2002). Short-Term Cash over Long-Term Equity Bonuses Managerial Preference Shareholders of any given firm understand that the principal-agency relationship lead to the managers trying to averse related risks. This means that they would rather engage in making investments in short-term projects investments in order to accrue benefits within the current year of operations (Gibbons, 2005). The accounting income that emanates from their short-term projects is tied to their bonuses compensation plan. On the contrary, in the case of long-term equity bonuses, the agreement ties or rather bonds the managers to the equity performance of the firm and hence, it requires them to engage in activities that would bring in cash inflows for a longer period of time for the shareholders (Gibbons, 2005). Unlike managers, shareholders of a firm require that their wealth be maximized at a greater level hence employ managers to operate their companies on their behalf. Given that managers always act on personal interests rather than on the objective of owners, these owners are forced to connect the managers’ salary plans to equity bonuses in order for them to maximize value of the firm (Gibbons, 2005). This however; does not go well with managers who opt for short-term higher cash inflows projects that would facilitate the increase of their compensation package at the short period of time for which they are employed within the firm (Gibbons, 2005). Voting Rights in Regards to Pay Proportions It is ascertained that the shareholders of a given firm might embark on voting against reports that postulates a higher proportion of pay as short-term cash bonuses as opposed to long-term incentives on the part of the managers (Canyon, 2006). Reports indicating such a disproportionate balance between the two items are an indication that the manager is favored at the expense of company’s immediate value. In real sense, when hiring a manager, the owner expects that them to provide their skilled expertise in the firm for a substantial period of time while maximizing the firm’s market value. Thus, for purposes of taming the manager into committing their expertise into the aforementioned objective, owners designs or rather calls for pay contracts that would keep the managers in the firm for long and also, encourage the formulation of those contracts that would tie these managers into the activities of the firm (Canyon, 2006). Shareholders depict a pay plan that is based on short-term cash basis as being short-term oriented and risk aversive in nature since under the plan, managers’ commitment to the firm at hand is limited while they enjoy a short-term massive accumulation of personal wealth at the expense of future profits of the firm. On the contrary, the long-term incentives plan is encouraged given that it ties managers to the activities of the firm for a long-period and also, it ties their personal wealth to the equity incentives of the firm. Thus, with this plan they are expected to act with dire commitment to ensure that the firm’s market value has been maximized while in doing so, they would also be maximizing shareholders’ wealth (Canyon, 2006). Thus, given the direct benefits of the long-term incentive plan, shareholders are likely to call for it as opposed to short-term cash in order to protect their immediate self interests and wealth for that matter (Murphy, 2002). In conclusion, it can be seen that the relationship between managers and owners is a complicated one given that both of them have different interests to meet. The owners of equity expect the managers to maximize their wealth while the managers on the other hand are focused on maximizing profits at the expense of the market value of the firm. For this reason, contracts are designed to ensure that managers are able to commit their expertise to improving long-term benefits of a firm, which forms the fundamental objective of the shareholders. Voting rights are also exercised in order to ensure that a proportionate balance in pay plan is attained in the course of designing managers’ compensation package. References List Bebchuk, L. & Fried, J. 2003. Executive compensation as an agency problem. Journal of Economic Perspectives, vol.17, no.3: 71–92; Canyon, M, J.2006. Executive compensation and incentives. Academy of Management Perspectives: 25-44. Gibbons, R. 2005. Incentives between firms (and within). Management Science, vol.51: 2–17 Marks, J. 2014. ACCT 3003: Contemporary issues in accounting. Lecture Notes. Murphy, K. 2002. Explaining executive compensation: managerial power versus the perceived cost of stock options. University of Chicago Law Review, vol.69: 847–869 Oyer, P. 2004. Why do firms use incentives that have no incentive effects? The Journal of Finance, vol.59: 1619–1650. Peterson, P. P.1994 Financial Management and Analysis. New York, McGraw-Hill, 1994 Prendergast, C. 2002. The tenuous trade-off between risk and incentives. Journal of Political Economy, vol.110: 1071–1102. Williamson, O. E.1988. Corporate finance and corporate governance, The Journal Of Finance, vol. 43, no. 3: 567–591. Read More