C30Hx : Accounting Theory : Assessment Answers

1 Making managerial pay contingent on measures of managerial and/or firm performance motivates them to deliver good performance for shareholders. However, it also burdens them with greater risks than they may like. How do organisations balance these two considerations when choosing managerial pay and performance measures? 

2 Obtain the remuneration report for a publicly listed company. Examine the compensation contract for the chief executive officer (CEO). Prepare a report which summarises your findings relating to the following issues: at What amount is short-term in nature (salary and cash bonus) and what is based on long-term firm or managerial performance? (5) What proportion of the CEO's pay is performance based, and what proportion is not? to What measures of accounting performance are used to determine the CEO's bonus? on Given the accounting firm performance measures in the contract, what accounting decisions could the CEO might make in order to maximise their bonus? to Can agency theory provide an explanation for the various remuneration components? Justify your answer.

3 Bonus plans are used to reduce agency problems that exist between managers and shareholders. Discuss two (2) of these problems specific to the relationship between shareholders and managers and identify how bonus plans can be used to reduce the agency problems you have identified. In your answer you should provide examples of specific components that should be added to a bonus contract to address the issues identified.

4 You have recently been appointed as a lending officer in the commercial division of a major bank. The bank is concerned about lending in the current economic environment, where there has been an economic downturn. You have been asked by your supervisor to provide a report indicating how you can safeguard the bank against the risks of lending. In your report you should outline how covenants in debt agreements can be used to reduce the risks, what agency problems the bank should be concerned with, and how accounting information can be used to assist in this process.

Answer:

1.Contigent Pay Measures for Managerial Motivation

The contingent pay designed for managers refers to the compensation paid to them on the basis of performance for motivating them to contribute their best towards improving the organisational outcomes. The compensation provided to the managers or executives is dependent on the company performance and thus they make their best efforts in increasing the performance of the company leading to its higher growth and development. The remuneration committee designed for structuring the compensation package of the senior executives and mangers within a company need to include contingent pay as an important component of the overall package to drive the manager behaviour towards achieving increased returns for the shareholders. The contingent pay measures generally includes short and long-term incentive compensation for maximising the managerial performance and as a result driving company’s profits. Short-term incentive compensation includes the annual incentives that are provided to the managers on the basis of achievement of certain desired targets. On the other hand, the long-term compensation refers to the options or bonuses stock provided to the managers. The major difference between the two is that stock option does not provide any compensation to the managers if there is no increase in the stock prices after the date of grant whereas bonus stock is free stock that guarantees compensation to the executives even in the condition of fall in stock prices after the grant date (Stabile, 2002).

On the other hand, there are also perceived risk associated with the use of contingent pay measures for driving the company performance through increased motivation of managers or executives. This is because managers or executives tend to adopt the use of unethical practices for driving the company performance in order to attain the desired results and gaining high compensation. There are also evident cases where large corporations such as Enron and Worldcom business managers have implemented the use of false accounting practices to disclose higher financial performance. This is largely done by the mangers for achieving higher contingent pay by driving the increase in the stock prices through disclosure of false information (Azim and Ahmmod, 2014).

Therefore, it can be said that there is both risks and benefits associated with the use of contingent pay measures and it is essential on the part of a business corporation to achieve a balance between the two considerations for enabling the sustained growth in its performance. In this context, the Board is highly responsible for structuring the compensation package in a manner that motivates executives but also limits the amount of compensation that can be provided to them on the basis of company performance. Also, the internal audit committee should be appointed by the board members for reviewing the compensation structure to identify the risks of it driving nay unethical behaviour within the managers or executives (Bloom and Milkovich, 2005).

2. Remuneration Report for Telstra Corporation Limited

(a) Short and long-term amount paid to CEO as managerial performance

As stated in the remuneration report of Telstra, an ASX listed telecommunication giant in Australia, the company provides both short and long-term contingent pay to the senior executives on the basis of their performance. The short-term incentives provides rewards to the CEO and senior executives on the basis of attaining the specified annual business objectives. The rewards are provided in the form of cash and also they are entitled to receive rights to Telstra shares. The long-term incentive is designed for rewarding the employees for creation of sustainable shareholder returns over the period of 3-5 years the form of equity instrument of options and restricted shares.

(b)Proportion of CEO Pay for Performance Based

The maximum achievable short-term incentives is 180% of fixed remuneration whereas long-term incentives is 120% of fixed remuneration for the CEO in Telstra Corporation Limited .

(c) Measures of Accounting Performance Used for Determination of Bonuses for CEO’s

Telstra Corporation Limited adopts the use of ROI (Return on Investment) as an accounting measure for determining the executive’s share options. It helps in determining the returns realised by the company on both its debt and equity instruments and therefore determining the compensation provided to the CEO on the basis of achievement of company targets (Telstra Corporation Limited and controlled entities, 2017).

(d)Accounting Decisions taken by CEO for Maximising its Bonuses

The CEO of the company can select the use of income-increasing accounting procedures for maximising the bonuses paid. CEO can adopt the use of debt and equity instruments on the basis of determined targets of ROI to be achieved for maximising the bonuses received (Azim and Ahmmod, 2014).

(e) Use of Agency Theory to Provide Explanation for Various Remuneration Components

As per the agency theory, the managers or senior executives are the agents that are acting as per the interests of the owners of a corporation, i.e. shareholders. Therefore, compensation structure should consists of fixed and contingent pay to resolve the conflict of interest that can occur between the shareholders and the managers. This is possible as contingent pay provides motivates to managers for performing bests in achieving the determined targets and goals. Also, it provides a tool to the owners for monitoring the performance of the managers and determining whether they are acting in the interests of the owners. Thus, contingent compensation seeks to reduce the agency costs by proving to be advantageous for both the executives and shareholders (Stabile, 2002).

3.Use of Bonus Plans for Reducing Agency Problems

The major agency problems specific to the relationship between shareholders and managers and use of bonus plans for reducing the problems identified are discussed as follows:

Dividend Retention Problem: There can occur conflict of interest between the shareholders and managers regarding the dividend paid to the shareholders from the company earnings. Managers prefers to pay less of the earnings as dividend to shareholders and this can lead to the occurrence of conflict between the managers and the shareholders. The bonus plans can help in overcoming this agency problem by linking the remuneration paid to the divided pay out ratios. Thus, managers will receive specific bonus only if they are able to provide specific dividend to the shareholders. The specific component that need to be added to bonus contract for addressing this issue is linking the bonuses to the dividend payout ratios. This will help in resolving the agency problem related to the dividend retention and seeks to align the interest of both the managers and shareholders (Chakraborty, 2010).

Short vs Long-term Interest: Managers tend to have only short-term interest in the cash flows impacting the remuneration within the period they remain within the company. However, shareholders are interested in the long-term growth and development of the company and therefore need to promote the long-tern cash inflows by use of sustainable growth strategies. This can lead to the occurrence of conflict of interest between the managers and shareholders leading to the rise of agency problem. This agency problem can be resolved by the sue of bonus plans by linking remuneration paid to the managers on the basis of long-term incentives. The long-term incentives provides bonuses to the managers on the basis of determined targets set to be achieved over 3-4 years period of time (Gomez-Mejia and Werner, 2008).

4.Safegurding the Bank Against the Lending Risk

Lending or credit risk in reference to banking institutions refers to the situation where a bank borrower is not able to meet its financial obligations as stated in the loan agreement. Banks are involved in lending of money to individuals or businesses on daily basis and therefore are subjected to face lending risk frequently. The economic downturn in the economy can negatively impact the income level of an individual or financial performance of a business corporation leading to the possibility of occurrence of default on their part to meet the credit obligations due to the bank. Banks need to adopt the use of loan covenants for reducing the risk of possibility of default (How banks can reduce the risks of bad loans, 2003).

The covenants are used for placing debt restrictions on the borrower by the lender to carry out certain specific cations that can lead the rise in lending risk for the banks that are mentioned in the loan agreement such as necessary terms and conditions for borrower to lend further. The agency problem that ac occur at the bank relates to the conflict of interest that can occur between the ownership and control of the banking operations (Carmichael and Graham, 2012). The reserve bank maintained control over the banking operations and places restrictions on the lending capacity of the banks which can lead to conflict of interest between the banking executives for increasing the amount of lending to promote the growth and development of the banking institution. The accounting information disclosed by a business corporation by its financial statements helps in assessing the credit risk related with lending money to it. Also, the past and current accounting information related to an individual helps in identification of the risk of occurrence of default. Therefore, accounting information proves to be of substantial help to minimise the lending risk for the bank (Rugger, 2018).

References:

Azim, M. and Ahmmod, M. 2014. Executive Remuneration, Financial Crisis and ‘Say on Pay’ Rule. Journal of International Business and Economics 2 (4), pp. 71-99.

Bloom, M. C. and Milkovich, G. T. 2005. The relationship between risk, performance-based pay, and organizational performance. School of Industrial and Labor Relations.

Carmichael, D.R. and Graham, L. 2012. Accountants' Handbook, Financial Accounting and General Topics. John Wiley & Sons.

Chakraborty, I. 2010. Agency Problems In Corporate Finance. Publicly Accessible Penn Dissertation.

Gomez-Mejia, L. and Werner, S. 2008. Global Compensation: Foundations and Perspectives. Routledge.

How banks can reduce the risks of bad loans. 2003. [Online]. Available at: https://www.iflr.com/Article/2026910/How-banks-can-reduce-the-risks-of-bad-loans.html [Accessed on: 2 June 2018].

Rugger, D. 2018. The Bank Lending Process. International Journal of Business and Management 13(2), pp. 53-64.

Stabile, S.J. 2002. Motivating executives: does performance-based compensation positively affect managerial performance? Journal of Labor And Employment Law 2(2), pp. 227-285.

Telstra Corporation Limited and controlled entities. 2017. Remuneration Report. [Online]. Available at: https://www.telstra.com.au/content/dam/tcom/about-us/investors/pdf%20C/remuneration-report.pdf [Accessed on: 2 June 2018].