Executive Compensations to Address Agency Problems and the Income Strategy Impact

Executive Compensations to Address Agency Problems and the Income Strategy Impact

The general acceptance of the agency theory and the parallel research on executive compensation began in the early 1980s.

It was the evolution of the modern corporation with ownership separation and control that undermined the agency theory. Early studies in this area focused on documenting the relation between CEO pay and firm performance. The discussion of executive compensation must proceed with the fundamental agency problem afflicting management decision-making as background. According to Jensen and Murphy (1990), there is an optimal contracting approach, which is when boards use design compensation schemes to maximize shareholder value with efficient incentives (Jensen and Murphy 1990). To connect the agency problem and the executive compensation, the authors use the managerial power approach when this connection is seen as an integral part of the agency problems. It is important to remember that the principal-agent problems treat the difficulties that arise under conditions where information is incomplete and asymmetric whenever a principal hires an agent (Murphy, 1999, Eisenhardt (1989); Bebchuk and Fried (2003)). Furthermore, the agency theory aims at solving two problems that can occur in agency relationships. The first is the desires or goals of the principal and agent conflict and it is difficult or expensive for the principal to verify what the agent is actually doing. The problem is that the principal is unable to check if the agent has behaved correctly. Secondly, it is the problem of risk sharing facing the different attitudes toward risk, because the principal and the agent have different actions according to different risk preferences (Eisenhardt 1989).

Hall and Liebman (1998) argue that the solution to the agency problem is aligning the incentives of executives with the interests of shareholders by granting (or selling) stock and stock options to the CEOs. The CEOs have the correct incentives on every margin, including effort, perquisites and project choice, and support that the optimal contract is a one-to-one correspondence between firm value and CEO pay (Hall and Liebman 1998). In their work, Hall and Liebman (1998) conclude that the relationship between pay and performance is much larger than has previously been recognized, and that this includes both gains and losses in CEO wealth. The salary and bonus vary so little because corporate board members are often reluctant to reduce CEO pay, even in response to poor performance and that may attract unwanted media attention. Using salary and bonuses to reward and penalize CEOs may only be possible to create high-powered incentives that align CEO pay with shareholder objectives (Hall and Liebman, 1998). A large part of the executive pay literature argues that compensation and managerial interests should be aligned with shareholder interests in order to solve agency problems (see, for example, the surveys by Murphy and by Core et al. (2003a). Equity-based compensation is widely documented in the research examining pay versus performance. Jensen and Meckling (1976), Murphy (2003) and Jensen (2004) state that the increase in stock options pay is the result of the boards’ inability to evaluate the true cost of this form of compensation. The use of equity-based compensation is encouraged by all stakeholders, such as investors, regulators and academics. The controversy over CEO compensation reflects a perception that CEOs effectively set their own pay levels. In most companies, the last decisions over executive pay are made by members outside the board of directors who are keenly aware of the conflicts of interest between managers and shareholders over the level of pay. However, the CEOs and other top managers exert at least some influence on the level and on the structure of their pay (Murphy 1999). In recent years, the use of restricted stocks in compensation executives has increased and has been widely criticized when these executives received dividend equivalents on restricted stocks before the vesting period. Agency cost benefits of dividend equivalent rights argue that this practice helps executives focus on the business, and rewards them for managing the business to produce cash. Therefore, this is encouraged because it is a way of distributing dividends by shareholders (Akpotaire 2011).

The SFAS 123 (R) is a change in accounting policy and represents an exogenous shock to the accounting benefits, and restricts the choice of accounting principles by managers (Zmijewski and Hagerman 1981). There are economic incentives to determine and motivate the managers’ concern with a set of accounting principal utilized to generate the firms’ financial statements. Under economic factors which influence the decision, managers will attempt to archive the optimal reported net income over time and will choose a set of income policies according to theirs goals. There are many variables that induce managers to use deflating policies while other variables encourage managers to choose income inflating solutions. That infers a conservative or liberal firm income strategy. This trade-off means that any combination of Generally Accepted Accounting Practice (GAAP) variables may be optimal for each firm. However, the SAF 123(R) prevents this income strategy by the imposing and restricting some variables as accounting treatment of stock-options compensation and the fair-value report. In their study, Zmijewski and Hagerman (1981) suggest that individual accounting choice decisions are part of an overall firm strategy and applicable in larger firms and in more concentrated industries. In this sense, Matsunaga (1995) suggests that some change in the financial reporting of treatment of stock options, as proposed by the FASB, is likely to reduce the use of the employees’ stock option for some firms (Matsunaga 1995).

From “CEO Compensation in High-Tech Firms and Changes in the SFAS No 123 (R)” by Paula Faria, Francisco Vitorino Martins and Elísio Brandão


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