In order to fix that, Choudhury and Sampler (1997) offered their idea in the article “Information specificity and environmental scanning: An economic perspective” that as there are always information lacking for principals, and thus they do not know clearly about whether the contracts between them and the agents have been constraining or carried out by the agents, thus under such problem, principals could only offer a high enough compensations to be the appropriate incentives in order to make agents act in the way that principals wish them to.
Austin (2001) takes contracts between agents and principals as a same way of releasing employment contract (actually in some of the large companies, CEOs are hired by board of the direction, the former one are called “air force”). However, there are also various compensation mechanisms such as share options, bonuses, profit sharing, efficiency wages, deferred compensation, and etc.
On considering the above theories, there are lots of other researchers consider the following conflicts between executive compensation and the goal of maximizing shareholder wealth.
1) Short-term performance & Long-term sustainability
Short-term performance is chased by the executive team, also marked as agent, while the sustainability is good for the shareholders’ wealth. Hawkins et al. (2006) in their book Delegation and Agency in International Organizations has mentioned about this issue, they assume that both the principal and the agent are rational, that agent is smart enough to know his compensation is largely connected with his annually performance and what is more important, the employment contracts for agents will usually evaluate performance of agents with the concern about current data such as stock price, current cash balance, and annual income, etc., thus decisions will be made all depending on that condition (Green & Stokey, 1983). But for the intelligent principals, they also know that their enterprises should be sustainable in order to stably increase their wealth, and long-term development should be taken consideration of the agent (Flyvbjerg et al., 2004). This conflict can hardly resolved as the compensations for agents must be related to the shareholders’ returns, thus agents will try hard to raise the shareholders’ wealth through all means, although sometimes those means could be very harmful for companies long-term development (IEA, 2007). For example, if there is a business opportunity in which the early investments are huge and returns shall be slow in the first a few years, but in foreseeable future the returns will be overwhelming. For the shareholders they would certainly take the opportunity and invest large amount of money in this project, but for management executives it will be hard to make that decision as in the future several years they could have to leave the companies due to the bad performance without large amount returns.
2) Accounting Fraud
According to Eisenhardt (1985) and Rosen (1986), a high percentage of the agents have the potential to cheat the principals for their own sake. Accounting frauds should also be kept an eye on as the compensations and performances are connected (Sappington & David, 1991). Under the global financial crisis, nearly all the agents are living in high pressures, and most of the pressures are from their principals, who are asking for business growth and increase of their wealth. However, winning money from the current marketing environment is not that easy, thus agents will have to face the situation of dissatisfying their principals. Accounting frauds thus are appearing in the aim of getting continuous trust and investments from shareholders in order to make sure the compensations will not be declined or eliminate by the principals. There are various accounting frauds exist in the current world, all of which can hardly be found and are taking the use of the accounting regulations. The most commonly seen accounting fraud is false net income annually (Murtishaw & Sathaye, 2006). Every year, the principals will predetermine a certain set of targets for the agents to achieve in the following year, mostly the targets will take the sales quantities, sales revenues, and net incomes included. However, among which the net income target is the most important, as it is positively related to the principals’ wealth (Nikkinen et al., 2004). Agents could make fraud information on the net income, for example, the original target for 2007’s net income is about 2 million for one company, and actually the number of 2007’s net income is 4 million. CEO would possibly consider hide 1 million net income with some financial mechanisms, and the reporting of 3-million-net-income is still far beyond the principals’ expectations. However, the principals will design a target of 3.5 million for 2008’s net income. In 2008, financial crisis takes lots of capitals from that company and the actual net income is just 2.8 million, but CEO still have 1 million net income hidden, therefore the net income reported to broad of direction is 3.8 million, which is also beyond the principals’ expectation. In making this accounting fraud activity, the CEO gets stable compensation but shareholders are not getting clear overview about their businesses thus decisions cannot be very rational and accordingly.
3) Higher Agency Costs
There still researchers having research on the agency costs due to the unstable principal-agent relationships (Alchian & Demsetz, 1972; Bahli & Rivard, 2003). In order to safely release the compensation to the agents as well as testify the reported information is worth believing, the principals usually hire third-party accounting firms to have auditing work on the companies’ operation results. Besides, some agents are also willing to set a auditing department or similar position in their companies to show their principals that they are trustworthy and paying efforts on gaining more wealth for them. Nevertheless, no matter the external auditing or the internal auditing, they could all cost a lot of money especially when the company is large and having branches in different areas under various accounting principles.
Minimizing Conflicts between Principals & Agents
According to the previous research and analysis, the author has worked out some of the recommendations with which the principals and agents conflict of interest may be minimized.
1) Complete Evaluation & Appraisal System
In tackling the problems aroused by conflicts in both counterparties’ interests, a complete and successful evaluation & appraisal system for the agents should be established with which it can take consideration of different attitude with risks and other related differences between both counterparties. The following findings could be useful in designing the system.
- Stock price cannot be valued as the only criteria in evaluating agents’ performance. The change of stock prices sometimes cannot present the changes of companies’ performance, thus if stock price is deployed as the main evaluation benchmark for agents’ performance, agents will possibly make decisions on how to raise the stock price for companies other than raise the actual performance.
- The system shall not be too complicated so that agents will focus on their jobs, but not deviate from the direction of achieving better business performance.
- The system should take consideration of long-term growth, such as three to five years’ incomes, so that agents could be less risk-averse when the long-term business opportunity has arrived.
2) Make the Financial Statements more Trustworthy
In order to know clearly about the financial status of the companies and thus to make more precise evaluation for agents’ performance, the administration bureaus and principals are better taking the following suggestions:
- Build complete internal auditing system and deploy advancing financial information systems. This can to some extent eliminate most of the chances for accounting frauds, and besides it can make the principals know clearly about the income and expenses statements in-timely.
- Make punishments of accounting frauds more severely for agents. Most accounting frauds are made due to the thought that results cannot be too serious. Deployment of more severe punishments for accounting frauds will eliminate this thought.
- Establish a random checking system with the principals. Principals, especially for those who own large shares of the companies’ stocks, shall be offered with the rights to have random check in the financial status of the agents, this can be a warning for agents.
3) Mix of Principals and Agents
Agents will link their compensation with their personal wealth only if they can also be one of the shareholders. Although has its disadvantages, but make highest executive get into board of direction would possibly be the best way of minimizing the conflict of interests, after all, they themselves are principals and agents.
Besides, allow members in board of direction take part in managerial activities of the companies are also effective on tackle the problem of interest conflicts. However, this will also generate other problems such as over-interference of the management or etc.
Conclusion
This article is a studying of agency theory and the conflicts between executive compensation and the goal of maximizing shareholder wealth. With the help of literatures, the author is able to find several ways in which the conflicts happened and find according suggestions in minimizing those conflicts.
Reference
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