Positive Accounting Theory - Contracting Theory - Assignment Example

Positive Accounting Theory-Contracting Theory By Student’s Name Course + Course Name Professor’s Name University Name City, State Date Positive Accounting Theory-Contracting Theory Introduction Compensation of companies’ Chief Executive Officers based on both the composition and amount has received significant attention during the past few years. Most of the arguments have centred typically on the compensation arrangements or exorbitant pay levels. However, it has been argued that such pay levels are not indeed exorbitant and when compared to the pay levels of the CEOs during the 1930’s, the current CEOs may be underpaid. They therefore argue that regardless of the amount that the CEOs are paid, how they are paid remains very vital. It has indeed been established there is a weak link between the pay that is paid to the CEOs pay and performance and therefore the composition of numerous compensation package requires further attention. There seems to be a wide gap between theory and practice in the provision of incentives for top-management. Contracting theory is known to define the firm as being a legal nexus comprising of contractual relationships which organize economic activities in order to minimize contracting costs. An agency relationship emerges from a contract in which one party (the Principal) deals or engages another party or the agent on their behalf. A good example of an agency relationship is one between the Shareholders and the Managers in which control and the separation of ownership implies that managers, being the shareholders’ agents are capable of acting in their own interests which may at times not be in the best interests of their shareholders. There are various problems which can result in differences between the managers and shareholders incentives about the incentives adopted by company policies which include the horizon problem and the risk aversion problem. In addition to that, there may also exist conflicting economic incentives between the agent and the principal. Question 1 The Risk Aversion Problem The risk aversion problem refers to a situation in which the investor when challenged with two similar expected return investments having different risks will instead prefer or choose one having a lower risk. In essence, risk aversion refs to a phenomenon in which an investor or an individual becomes reluctant in accepting losses when there is indeed a greater possibility of receiving such a loss. It therefore emerges to what an individual can perceive as being a gain and a loss as well (Chiu, 2012). An investor who is risk averse therefore dislikes risks and thus will prefer staying away from making an additional high risk investment or stocks to their portfolio and will instead lose out on the higher rates of return. On the other hand, investors searching for safer investments will prefer to stick to government bonds and index funds that have lower returns. The risk aversion problem has known to greatly affect the shareholder or Manager Agency relationships which the pay contracts are assigned. According to most the studies that have been conducted, it has been ascertained that most individuals would never stomach losses and as a result, they will instead prefer giving up the possibility of achieving a gain so as to ensure that they don’t suffer any possible loss despite the fact that the risk of such a loss is less as opposed to the chance of getting a gain. How to Reduce Risk Aversion between Managers and Shareholders Risk aversion between the Manager and shareholders can be reduced by increasing the use of stock based incentives and through using risk attitude. This is because risk attitude helps one to prioritize and rank a company’s risks so as to develop a comprehensive risk management plan. In most circumstances, a risk management plan will normally depend upon the risk attitude of the organization and its stakeholders. If an organization’s stakeholders are risk tolerant or risk averse, then it is quite probable that one will get a fewer number of the risks which have less priority. However, in circumstances where the stakeholders in an organization are risk seekers, then one will definitely get lots of risks having high priorities. Managers should therefore make a fine balance between the two extremes so as to emerge as risk neutral individuals (Elton, 2009). The contract between the shareholders and the managers can be designed with an aim of reducing risk aversion by better understanding the expected value. In both theory and statistics, the expected value is normally the weighted values which are derived from all the possible outcomes. For instance, if a stock value which is valued at $100 for each share has a 50 per cent of rising up to a total of $150 during the course of a particular year, then such a stock has really an expected value of approximately $115 by the end of the year. This is achieved through the process of having $150X50% + $80 X 50%=$115 One of the greatest ways of avoiding risk aversion is having a chance to understand it. Despite the fact the fact it is the inclination of each and everyone to avoid losses and that no investor will want to lose money, it is however important to note that many of the people’s fears are not based on actuality and science. At most times, it is just the fear of incurring a loss that keeps most people away from significant earnings and getting more money through other opportunities. Loss aversion can keep individuals away from earning more in their lives and therefore it is through comprehending the human psyche that one can avoid risk version not only in investments but also in one’s life. Question 2 How Equity as a Pay Component works to reduce the Horizon Problem In the accounting Literature, the horizon problem has been debated extensively and it refers to the temptation faced by the Outgoing Chief Executive Officers of inflating income so as to enhance their earning-based bonuses during their final years on work. In order to mitigate the horizon problem, CEOs should be automatically rewarded in their current pay so as to offer compensation in their subsequent years. It has also been ascertained that indeed, a management bonus scheme which pays bonuses that are equal to a full percentage of the accounting income may indeed encourage a company’s management to reduce short term income and thus short term bonuses at the income of future expenses (Frezatti, 2014). Pay as a component is greatly beneficial in ensuring that the horizon problem is reduced or minimized because there is clear evidence that managers who are nearing their retirement may actually resort to taking actions which may inhibit or prevent a firm’s profitability through cutting the R&D expenditures. It has therefore been reported that a decrease in R&D is not linked a company’s poor performance and thus it is most serious when such turnover is planned. It has also been ascertained that indeed, opportunistic behaviour has been known to be higher during the terminal year. Evidence also points out the fact that pay compensation was significantly and also positively linked to the line earnings especially if such earnings are positive and not when they are negative. How Accounting Information Reduces the Horizon Problem Accounting information plays a vital role in the reduction of the accounting information because it aids in the creation of implicit long term contracts with the stable shareholders. It is through accounting information that it can be ascertained that indeed, firm managers are known to use smoother earnings in order to maintain a very long tern association or relationship with their company’s stakeholders which is actually consistent or true with the argument that the smoothing earnings are capable of playing an informational role through serving as an effective form of communication about the private beliefs of the managers about a company’s future earnings. In addition to that, accounting information is capable of playing a vital role especially in implicit contracting since managing of the accruals towards smooth earnings leads to the lowering of the perceived variance of the shareholders regarding a company’s underlying performance (Prodhan, 2013). Accounting information provides the setters in accounting standards to choose the most suitable accounting policies out of a range of alternatives and in circumstances where there is no apparent accounting standard or the standard is capable of allowing choice, and then the preparers of the financial statements must select a policy which is most appropriate. Good accounting information should be able to give an organization’s top management accounting policies which can lead to reliable and relevant financial information. Question 3 The Purpose of including non-salary components in Executive Pay arrangements Non-salary components are normally included in the pay arrangements for executives because they help in not only attracting and retaining the CEOs but they also help in motivating them. The inclusion of non-salary components in the executive’s pay arrangements is also aimed at avoiding tax and the annoyance associated with having to categorize the expenditures which are based at the corporate levels. However, it should be noted that the non-salary benefits normally vary widely and they are also greatly influenced by numerous factors; for instance, inter-country differences in healthcare and also differences in the legislative requirements (Hooper, 2009). The use of non-salary components in the executives’ pay arrangements is to actually present them with competitive remuneration and thus attracting and retaining them in areas of the recruitment pressure. Organizations can therefore include different remuneration packages like research support, housing subsidies, housing loans, flexible work programmes, personnel development chances, reduced interest and outside earnings as a form of non-salary benefits so as to retain and motivate them (Altbach, 2012). Question 4 Why managers Prefer Short Term Cash as opposed to Long Term Equity Bonuses At most times, the compensation system of a given employee is normally designed with an aim of providing both competitive wage and reward systems for employees who exhibit behaviours and accomplish the set objectives or goals which benefit the organization. As a result, when the salaries and bonuses for the managers are annually adjusted and reviewed, such an annual programme encourages such managers to make and take actions which establish measurable results in a period of less than one year. However, most of the stakeholders are against the short term cash and advocate for the long term equity bonuses because they believe that the senior executives actually need to create longer term strategic decisions and therefore the reward for such managers should be based on the results obtained from three and even more years in future (Thomas, 2009). Most of the shareholders will always prefer the use of long-term incentives because they strongly believe that the senior executives of the company may indeed have no effect on the operations of the current year or worse still, they may have a negative impact on the operations of the company yet they may also have a longer term positive impact on the firm. In addition to that, the stakeholders also strongly that if such compensation was paid based on the annual plan, then it is quite definite that there will be a disincentive of making the correct long term decision for the firm since it can negatively have an impact on the current year’s compensation for the executive. It is therefore due to such reasons that most compensation plans for the executives in the company will at times comprise of a long term incentive component instead of the short term cash. Long-term incentives reward for the managers are always preferred by the stakeholders as opposed to the managers because the executives are rewarded for the achievement of the set performance goals and targets in future so as to encourage them to make decisions which are in the organization’s long term best interests. Long term incentives also help in the retention of the executive in the firm because one automatically looses the long term incentives when leaving the company before the stipulated period. Typically, most of the compensation packages have both long-term and short term components. Most of the short term plans are normally based on some form of annual earnings while the long term plans are either based on the accounting measures or on the firm’s performance stock. However, most of the Managers prefer the short term cash as opposed to the long term equity bonuses despite the fact that this does not fully align with the interests of the shareholders. This is because unlike the long term equity bonuses which takes about 3 to five years and lengthens the executive’s decision horizon, the short term cash is not all that involving and therefore managers will prefer to have it. The CEO compensation, if expertly employed can a powerful device or tool through which the company boards are capable of aligning the shareholders’ and management’s financial interests. It has been ascertained that CEOs who are heavily compensated with the performance based stock can be made to behave like the real owners of the companies or the firms which they manage to the full benefit of all the relevant stakeholders in such firms (Durkin, 2011). Question Five Why Shareholders might opt to vote against Reports having a high proportion of pay as short term cash bonuses as opposed to long term incentives In Australia, most of the shareholders of the Australian entities actually have the ability of voting so as to show either their dissatisfaction or support with the remuneration reports of the companies. And despite the fact that such actions are in most circumstances never binding on the Board, they are however obliged to take into consideration the views of such stakeholders. Shareholders may opt to vote against reports having high proportions of pay as being short term cash bonuses instead of the long-term incentives because this will help in raising accountability of many executives, who despite of being paid handsomely still go ahead and produce a shoddy performance. It can correctly be ascertained that having a mandatory say on the pay system will greatly enhance both the structure and the size of the pay package. Apart from that, most of the Australian shareholders will prefer to have a strong alignment to exist between the pay of the executives and their performance. As a result, such shareholders will actually favour executive pays which adjusts in accordance with the performance. It has also been ascertained based on the long term “performance metrics” that long term compensation packages are normally structured in a precise manner and they therefore eliminate any misalignments between the interests of the shareholders and the executives’ incentives (Maiden, 2014). The shareholders have a strong feeling that indeed, the CEOs of their companies should suffer along with them especially in circumstances when the stocks of the company underperform. This can therefore only be achieved through the use of the long-term incentives since if the option and equity grants are substantial and are given over a window period of 3 to five years, based upon the performance of the long-term metrics, then it is quite obvious that the company executives will behave in a manner of more like the owners of such an organization. As a result, they will definitely establish a long term “risk appetite” which will be more in line with the desires of the shareholders. This is unlike in the short term cash bonuses whereby the executives are only keen in pocketing the bonuses without performing to ensure that the company becomes successful (Michaela, 2012). Reference List Altbach, P2012, Paying the Professoriate: A Global Comparison of Compensation and Contracts, New York, Taylor & Francis Canyon, M2003, Executive Compensation and Incentives, New York, University of Pennsylvania Chiu, C2012, Risk Analysis in Stochastic Supply Chains: A Mean-Risk Approach, New York, Springer. Durkin, P2011, Pay backlash Prompts Shift to Bonuses, New York, The Australian Financial Review. Elton, E2009, Modern Portfolio Theory and Investment Analysis, New York, John Wiley & Sons Frezatti, F 2014, Accounting In Latin America, New York, Emerald Group Publishing Hooper, G2009, Australian Master Superannuation Guide2010/11, New York, CCH Australia Limited. Maiden, M2014, Pay for Australian CEOs is down, but it’s still too high, Retrieved on 30th September 2014 from http://www.smh.com.au/business/comment-and-analysis/pay-for-australian-ceos-is-down-but-its-still-too-high-20140917-10i2p9.html. Michaela, R2012, Contemporary Issues in Accounting, New York, John Wiley & Sons. Prodhan, B2013, Multinational Accounting: Segment Disclosure and Risk, New York, Routledge. Thomas, L2009, Consumer Credit Models: Pricing, Profit and Portfolios...New York, Oxford University Press. Read More