18 Agency theory, Incentives and Payment Systems

Question 1

What is agency theory

Answer 1

• Firms are regarded as a set of contracting relationships among individuals (i.e. the principal and the agent) wishing to maximize their interests
• An agency relationship exists when one person, the principal, contracts with another, the agent, to act on their behalf.
• Involves the delegation of decision making authority from the principal to the agent

Question 2

What are the issues with agency theory

Answer 2

• Both agent and principal are economically rational
  o i.e. they seek to maximise their utility
  o Not saying CEOs are corrupt they are the same as the shareholders in wanting to maximise their wealth
• Given the agent is a utility maximiser there is a good chance that the agent may not act always in the best interests of the principal
  o It is difficult to ensure that they act in the principles best interest
• To limit the divergences between the agents best interests and those of the principal, incentives are used in the employment contract
  o Concerned with how contracts of employment and incentives can be designed to motivate self interested agents to achieve goal congruence
  o Attempts to specify the main factors which should be considered in employment contracts to optimise the utility of agents and principals
• Must use incentives to ensure alignment

Question 3

What are the interactions of agency theory and accountability

Answer 3

• Whenever a principal engages an agent and trusts them to work in the principal’s best interests the agent will become accountable to the principal
• Accountability requires
  o A duty on the part of the agent to give an account of his/her performance to the principal
  o The form of the account given can vary (account does not mean the same as in the context of accounting)
  o An audit, possibly by the principal, of the account

Question 4

What are some of the problems in agency theory

Answer 4

• The principal and the agent might have diverging interest and differing attitudes toward risk.
• The agent (e.g. CEO) motivated by greed and self interest
  o The agent might take actions that promote her/his own utility but detracts from that of the principal.
  o The agent has no incentive to work to maximise the interests of the principal
• The principal cannot observe the agent’s efforts but can measure the outcome that affect her/his interest.
  o Principal cannot know for certain that the agent is working in the principal’s best interests

Question 5

What are the risk preferences of agents VS principles

Answer 5

• Agents unable to spread risks like shareholders
• Agents tend to be more risk averse than principals
• Agents (managers) less likely to want to risk everything, job etc
• More managers are tied to the success of a firm the more risk averse they become, resulting in a tendency to refuse some investment alternatives that shareholders may favour

Question 6

What is informational asymmetry

Answer 6

• The inability of the principal to directly monitor the actions taken by the agent
• The agent has more information, e.g. private information)
• Adverse selection
• Moral hazard where the agent misrepresents information to the principal

Question 7

What is adverse selection

Answer 7

• Adverse selection occurs when the principal does not have full information about the agent’s preferences, ability and which of the actions will maximise the interest of the principal (Hidden information)
  o The agent might be “shirking” given the existence of information asymmetries.

Question 8

What is the moral hazard

Answer 8

• Moral hazard might happen as the agent strives to protect his/her own interest and chooses not to act in the best interest of the principal (Hiddentaction)
  o The agent might take action to maximise his/her own interest at the principal’s expense.
  o E.g. Nissan ex chairman Carlos Ghson (see

Question 9

What are some of the costs of agency theory

Answer 9

Monitoring expenditures by the principal
* The principal can limit divergences from his interest by establishing appropriate incentives for the agent and by incurring monitoring costs designed to limit the aberrant activities, of the agent.
Bonding costs
* The principal may also pay the agent to guarantee that he will not take certain actions which would harm the principal.
Residual loss
* The value placed on the reduction in welfare experienced by the principal due to any divergences between the agent’s decisions and those decisions which would maximize the welfare of the principal
* All other costs, so if you increase monitoring it is likely to reduce residual loss

Question 10

How can you align the interests of the agent and the principle

Answer 10

• Need to create bonuses that align interests
  o Increase goal congruence
• Pay manager a fixed salary
• Incorporate incentive into the remuneration package
  o Incentive is necessary where the principal cannot easily monitor the actions of the agent
  o Incentives encourage the agent to work in the interests of the business because these will also be in their best interests

Question 11

How does agency theory relate to management accounting

Answer 11

• Agency theory is concerned with the application of incentive schemes by incorporating performance measures which reflect the interests of the principal and the agent.
• The most important measures of their performance are financial measures captured by accounting procedures
• Much of the performance information originates from the management accounting function
  o Thus, management accountants should understand how managers are incentivized to influence performance measures and the attributes of good performance measures

Question 12

Implications of Assumptions of Agency Theory for Accounting

Answer 12

• In the presence of a self interested agent the principal will carry any defects of an accounting system which is inefficient
• A poor accounting system will allow the agent’s actions to go undetected or to be evaluated wrongly.
• A good accounting system will allow “noise” in the system to be recognised ie. factors which are relevant to the performance of an agent but over which they have no control (e.g. inflation)

Question 13

What is incentive compensation

Answer 13

Incentive compensation reward systems:
* Provide monetary (extrinsic) rewards based on measured results
* Pay-for-performance systems
* Base rewards on achieving or exceeding some measured performance
* Require performance measurement systems that gather relevant and reliable performance information
* Based on
o Absolute performance,
o Relative performance to some plan or some comparable group

Question 14

What are some measures of absolute performance

Answer 14

Measures of absolute performance include:
* The number of units sold
o A commission based system
* The organization’s results
o Profit levels or an organization’s balanced scorecard measures of customer or employee satisfaction, quality, and rate of successful new product introductions
* The organization’s share price performance
o A stock option plan

Question 15

What are some measures of relative performance

Answer 15

Examples of rewards based on relative performance are those tied to the following:
* The ability to exceed a performance target level
o Paying a manager for accomplishing his or her goals under budget, or paying a production group a bonus for beating a benchmark performance level
* The degree to which performance exceeds the average performance level of a comparable group

Question 16

What is needed for effective performance management

Answer 16

Six attributes must be in place for a measurement system to work and motivate desired performance so that employees accept it
1. Employees must understand their jobs and the reward system and believe that it measures what they control and contribute to the organization
* Employees’ incentive compensation should reflect the nature of their responsibilities in the organization
2. Designers of the performance measurement system must make a careful choice about whether it measures employees’ inputs or outputs
– The choices and decisions for these two comprise one of the most difficult tasks in the design of performance measurement and compensation systems
3. The elements of performance that the performance measurement system monitors and rewards should reflect the organization’s critical success factors
4. The reward system must set clear standards for performance that employees accept
5. The measurement system must be calibrated so that it can accurately assess performance
6. When it is critical that employees coordinate decision making and other activities with other employees, the reward system should reward group, rather than individual, performance

Question 17

What conditions favour incentive compensation

Answer 17

• Not all organizations are suited to incentive compensation systems
• Incentive compensation systems work best in organizations in which employees have the skill and authority to react to conditions and make decisions (i.e. a decentralized organization)
• When the organization has empowered its employees to make decisions, it can use incentive compensation systems to motivate appropriate decision-making behavior

Question 18

What are some performance criteria for incentive plans

Answer 18

• Financial criteria:
  o Contribution margin
  o Business unit profit
  o Controllable business unit profit
  o Income before taxes
  o Net income
  o ROI (Return on Investment)
  o RI (Residual income)
• Non financial criteria:
  o Sales growth
  o Market share
  o Customer satisfaction
  o Quality
  o New product development
  o Personnel development

Question 19

What are some examples of incentives

Answer 19

• Financial incentives
  o Salary
  o Bonuses
  o Perquisites
• Psychological and social:
  o Promotion
  o Increased responsibilities
  o Increased autonomy
  o Recognition e.g. better office, expense account, car, travel

Question 20

What are some forms of bonus payments

Answer 20

• Short term:
  o Cash
  o Stock
• Long term:
  o Stock options
  o Phantom shares
  o Performance shares
  o Stock appreciation rights

Question 21

What is a cash bonus (short term incentive)

Answer 21

• A cash bonus plan pays cash based on some measured performance
  o Such a bonus is a one-time award that does not become part of the employee’s base pay in subsequent years
• Cash bonuses can be:
  o Fixed in amount (triggered when measured performance exceeds the target) or proportional to the level of performance relative to the target
  o Based on individual or group performance
  o Paid to individuals or groups
• Most common for cash bonus to be based on profit

Question 22

What is profit sharing

Answer 22

• A group incentive compensation plan focused on short-term performance
• A cash bonus calculated as a percentage of an organization unit’s reported profit
• All profit-sharing plans define:
  o What portion of the organization’s reported profits is available for sharing
  o The sharing formula
  o The employees who are eligible to participate in the plan
  o The formula for each employee’s share

Question 23

What are stock option plans

Answer 23

• A stock option is the right to purchase a unit of the organizations stock at a specified price, called the option price
  o Judging by the published remarks of compensation experts, stock options are the most widely known, misused, and maligned approach to incentive compensation
• A common approach to option pricing is to set the option price at about 105% of the stock’s market price at the time the organization issues the stock option

Question 24

What are some other non stock related plans

Answer 24

• Organizations use many other forms of stock-related incentive compensation plans:
  o Performance shares stock, stock appreciation rights, participation units, and employee stock ownership plans (ESOPs)
• They are designed to motivate employees to act in the long-term interests of the organization by acting so as to increase its market (stock) value
  o All these plans assume that stock markets will recognize exceptional behavior with increased stock prices

Question 25

How can you manage incentive plans

Answer 25

• Some studies show a positive correlation between executive compensation and shareholder wealth, others a negative correlation.
• Considerable evidence indicates that organizations have mismanaged incentive compensation plans, particularly those for senior executives
• Many have argued that executives have been paid excessively for mediocre performance
• Many investors argued that the amounts are excessive and reflect high status rather than performance
  o Rising opposition to CEO pay tied to ‘questionable practices’ (Reuters 22 Feb, 2022)
  o More companies facing shareholders rebellion over CEO pay (e.g. Shell, M&S, Ocado)
• The issue of fairness has also surfaced. According to Hight Pay Centre:
  o Median CEO pay 109 times that of the median UK full-time worker in 2021, compared to 79 times in 2020 and 107 times in 2019.
  o FTSE 100 firms spent £720.21m on the pay of 224 executives

Question 26

How is dysfunctional executive pay being managed

Answer 26

• In 2002 in the UK it became law that firms release details of executive pay. The 2006 Company Act also gave shareholders to an advisory (that is non-legally binding) vote on director pay
• No general approach across nations to capping pay

Question 27

What are the World Financial Crisis and the G20 Guidelines (2009) for executive compensation

Answer 27

Agreement on the following
* Avoiding multi-year guaranteed bonuses
* A significant proportion of compensation to be deferred and tied to performance with clawback
* Ensuring compensation aligns with performance
* Making compensation policies transparent through disclosure
* Compensation committees are independent