Evidence Of Managerial Power View Accounting Essay


Nowadays, agency problem becomes more and more serious caused by the separation of ownership and management. Based on agency theory (Jensen and Meckling 1976): 'a contract under which one or more (principals) engage another person (the agent) to perform some services on their behalf which involves delegating some decision-making authority to the agent', conflict may rise between the owners of the firm (principal) and the managers (agents). The remuneration of managers has become a most important key solution to reduce the conflict. Basically, there are two main issues about remuneration:

(i) Do the hardest working and most successful managers receive the most remuneration?

(ii) How can remuneration be used to align the interests of shareholders and managers?

1 Theories and cases of manager's remuneration and performance

1.1 Hudson Bay Company case

For the early period, the remuneration of managers used to be basically fixed. For example (from Carlos and Nicholas 1990, Jour Econ Hist.), the Hudson Bay Company (HBC), which is one of the oldest Canada company, has been in the furs trading industry between England and Canada since 1670. HBC's managers and employees were located in Canada but its owners were in England. In the old times, telephone had not been invented and it took several weeks for people travel between Canada and England. So one serious problem was casted out: those managers in Canada could trade on their own accounts, act opportunistically and get lazy at work, but the owners would know little of this for months. Obviously the owners of HBC did not want to pay for the inefficient managers and they adopted bonding and monitoring mechanisms to overcome this problem. One significant mechanism was that the owners of HBC paid the managers well and linked the managers' remuneration to their performance. This helped them to reduce the conflict of interests between the principals (HBC owners) and agents (HBC managers), thus to fix the agency problem.

Lady using a tablet
Lady using a tablet


Essay Writers

Lady Using Tablet

Get your grade
or your money back

using our Essay Writing Service!

Essay Writing Service

1.2 Basic relationship between performance and remuneration

Fama and Jensen(1983) pointed out that, the firm is a nexus of contracts where contracts are made between firm participants both to describe their mutual relationships and reduce the impact of conflicting interests. In the consideration of the agency problem, shareholders always tie manager's remuneration to firm performance to maintain efficiency, let managers undertake activities in the best interests on shareholders' behalf (goal congruence).

Since the remuneration is linked to performance, the topic that whether the hardest working and most successful managers receive the most remuneration has already been discussed by thousands of scholars in the field of accounting, financing, management and psychology. Galbraith once said that the salary of the chief executive of the large corporation is not a market award for achievement, it is frequently in the nature of a warm personal gesture by the individual to himself. It is people's common sense to believe that managers always get what they deserve, which means hard working and successful ones get well paid when the remuneration is tied to performance, but the compensation arrangements have become the subject of a large literature.

1.3 Two dominating views

There are two key dominating views of executive compensation in the literature:

1.3.1 Theory part of optimal contracting view

The optimal contracting view: it sees executive pay arrangements as a product of arm's length contracting between boards and executives, which leads to contracts that provide efficient incentives for reducing agency problems as much as possible (Holmstrom 1979). Bebchuk and Grinstein(2005) stated that in the optimal contracting view, compensation arrangements were the product of arm's length transacting between executives providing managerial services and directors looking for the best deal for their shareholders. The price of will rise up if:

(i) The value to companies of executives' services goes up (demand side),

(ii) Executives' reservation value (resulting in part from executives' outside options) goes up (supply side), or

(iii) The job nature or requirements become more demanding or costly for executives.

It can be referred that within the arm's length bargaining perspective, manager's remuneration depends on 3 aspects: demand side, supply side and job nature. Manager's hard work and successfulness can only be the demand side, it may not fully affect the price (remuneration). Furthermore, Himmelberg and Hubbard (2000) and Hubbard (2005) suggested that, the demand for executives rises up and companies have to pay more in order to retain and hire executives, which means the turnover of executives can also change the 'price'.

Lady using a tablet
Lady using a tablet


Writing Services

Lady Using Tablet

Always on Time

Marked to Standard

Order Now

1.3.2 Evidence of optimal contracting view

Bebchuk and Grinstein (2005) collected compensation information in public US firms from the standard ExecuComp database. The set of data included the S&P 500, Mid-Cap 400 and Small-Cap 600 firms (known as S&P 1500), which represented more than 80% of the total market capitalization of US listed firms. The table below is for the period 1993 to 2003.

From the data above, it is obvious to see that, for the year from 1993 to 2003, the average compensation for executives from S&P 500 is higher than those from Mid-Cap 400, and the group in Small-Cap 600 gets the lowest. Top five executives get higher remuneration than the industry's average because they are 'Top five' with better managerial services to provide. It seems that the remuneration difference can be fully explained by those three factors in optimal contracting view (demand side, supply side, and job nature), but the problem is, even the average remuneration of executives from S&P 500 is higher than the average remunerations of top five executives in Small-Cap 600. To some extents, the words 'Top five' managers mean they are 'hard working' and 'successful',and of course they are far better than the average level that manager market can provide for the S&P 500. It is not too hard to find out that the hardest working and most successful managers get paid well, but those demand side factors do not ensure the best remuneration. The significance influence of supply side and job nature on remuneration must be taken into consideration in the optimal contracting view.

1.3.3 Theory part of managerial power view

The managerial power view: it questions whether pay arrangements are the product of arm's length contracting and see pay arrangements as part of agency problem itself rather than a solution to it (Bebchuk and Fried 2003, 2004). Bebchuck and Grinstein (2005) believed that directors would rather to go along with compensation arrangements more favorable to executives. The extent executives and directors will stray from shareholders' interests will decided by the market penalties and social costs that they will have to respond when adopting arrangements favorable to executives. It is in contrast with optimal contracting view, the managerial power view allows for the possibility that pay arrangements will be structured sub-optimally in ways that lead to diluted or even perverse incentives. Jensen and Murphy (1990) argued that, because of external social pressures, pay is insufficiently tied to firm performance. The managerial power view suggests that the sub-optimal pay-performance sensitivity could be a result of executive influence itself.

1.3.4 Evidence of managerial power view

Jack Welch ran GE for 20 years retiring in 2001 after keep bringing consecutive profits growth. His share option was estimated to be between 0.75 to 1 billion US dollars. GE used to be a firm focused on quality, took first place at engineering innovation and research with a tradition of progressive management and profits growth. But Welch initiated profit maximization progamme followed with a policy of cost reduction. Around 100,000 staffs were made redundant under this profit directing programme, they slashed the budgets for research, suspended their employee pensions contributions, stretched those accounting regulations. About 30 billion dollars of shares were bought back to rise up the share price thus to make share options more valuable, which should be used to invest in company.

Merkl-Davies and Brennan (2011) pointed out that, within the positive accounting theory, one opportunistic perspective for managers to engage in impression management is to increase their managerial compensation for self-interested utility maximization. In such case, Jack Welch applied strategies and policies deviate far from corporate culture and the appropriate way (shareholder's favor). He did get a huge amount of compensation through short-term financial goals and impression management, but the wealth of company shareholders was seriously hurt and they will suffer more losses in the future.

Jensen and Murphy (1990) studied about 2,000 CEOs in three data sets spanning 50 years to analyse the relationship between performance and remuneration of managers. They examined the incentives generated by cash compensation, stock options, inside stock ownership and threat of dismissal. The empirical evidence they presented was consistent with the implication that: changes in manager's remuneration were positively and statistically significantly related to the changes of firm owner's value, and manager's turnover probabilities were negatively and significantly related to changes in owner's value.

Lady using a tablet
Lady using a tablet

This Essay is

a Student's Work

Lady Using Tablet

This essay has been submitted by a student. This is not an example of the work written by our professional essay writers.

Examples of our work

But they found out that the magnitude seems so small in terms of the implied incentives despite the estimated pay-performance sensitivity is statistically significant, there must be some other perspectives to affect pay-performance relationship, such as risk and psychological incentives. Nonmonetary rewards will affect the level of remuneration to retain and attract more experienced and skillful managers to the company, such as 'power', 'fame' or 'honor'. It is easy to understand that the best managers (hard working and successful) do not only look for the most remuneration, they desire something beyond monetary compensation. Therefore the most remuneration can not perfectly explained by the words 'hardest working' and 'most successful'. The top ten earner in the US came from firms with less than strong performance, for example, Reuben Mark of Colgate got about 148 million dollars, Michael Esiner of Disney, which was called one of the worst performing bosses, earned 121 million dollars.

2 Remuneration arrangement

2.1 Regular payment forms

Another major issue extracted by the agency problem is that: how to align the interests of shareholders and managers by setting the remuneration properly. Firstly, here are some acceptable payment forms in UK:

Approved profit Sharing (APS): Firm makes tax deductible payments to a trust, which will buy shares in the firm and passes them to the employees of the scheme.

Save As You Earn Scheme (SAYE): Employees of the company enter a three or five year saving contract to save fixed monthly sum of between £5 and £250. When the contract expires, it is usually for a tax free bonus to be added ad proceeds from the savings contract to be used buy stock options.

Company Share Option Plan (CSOP): This plan was introduced under the Finance Act (1984) to encourage employee retention. Within the plan, an employee is granted a 'option', which is a right to buy a fixed amount of shares, at a fixed price, in a arranged period of time. The price of option is fixed at the time of grant, it can not be lower than the market value of the shares, is valid for 10 years from the date of grant and can not be exercised in the begging 3years.

Long Term Incentive Plan (LTIP): The Greenbury report (1995) on corporate governance indicated Long Term Incentive Plan should be used in preference to executive share options (ESOs). This plan includes grants of cash, shares or options with performance conditions and conditional Executive Share Options with zero exercise prices. It has become an increasingly important component of executive remuneration packages but there are some problems for the LTIPs. First, managers can manipulate the key part of this plan to achieve personal advantage. Because the performance is set relative to comparator companies, managers could select peer groups to provide executive friendly (easier to achieve) standard (Porac et al 1999). Second, it is complex to choose the performance hurdle, holding period and others for the plan, Buck et al (2003) suggests that ratios such as Earnings Per Share (EPS) other than share price are often used. Third, both of good and lucky executives exist. It is hard to find out that whether the increased value of the company is caused by good one's strong management or lucky one's free ride on good industrial performance and macro economics.

Deferred Share Schemes: Deferred share scheme is a alternative method of the LTIP scheme. Deferred bonuses require a participant to set aside a mount of annual cash bonuses to purchase the shares. If the performance of targets is subsequently met over a specified period of time the company will match those purchased shares with a specified number of free shares.

2.2 Share options

Share Options are most widely used to link manager's remuneration to the performance of firm, to align the interests of shareholders and managers. The wealth of shareholders (company's share price) and the remuneration of managers (share option's value) are linked together. Managers get more monetary feed back via the share option when company's share price goes up above a specific point, otherwise the share option has no value.

Denis and McConnell (2003) emphasized that, the research survey of US done by Murphy (1999) and Core, Guay, and Larcker (2003) supported two conclusions about share option. First, the sensitivity of pay-performance has increased over time and the vast majority of this growth was contributed by manager ownership of common stock and share options. Second, share options are the quickest growing component of manager compensation in US. These two results help to demonstrate that share options linked the remuneration with firm performance for US companies in past years.

But some doubts were cast out by scholars to against the share option, some problems could be critical. If only key variables such as share prices are focused, shareholder's dividends may be decreased and manager may adopt inappropriate strategy or policy to achieve the goal. Also the managers have incentives to engage in impression management to manipulate key figures for a higher exercise price of the option. In some extreme circumstances, share option is totally useless if the share prices fall far below the strike (grant) price.

Bebchuk and Grinstein (2005) analyzed the average US S&P1500 companies CEO remuneration from 1993 to 2003, they discovered the fact that: The fraction of equity-based compensation (share option) in total compensation increased largely from year 1993 to 2001 and declined a little bit in year 2002 to 2003. Despite the rise in equity based compensation, cash payments did not decline over this period. But changes in firm performance could explain only 40 percent rise in CEO's compensation, about 60 percent remained unexplained. This indicates that share options did not align the performance and remuneration perfectly.

Murphy (2002) and Hall and Murphy (2003) argued that the increasing use of options, which led to the higher level of remuneration, was due to the director's misperceiving the true costs to owners of remuneration based on share option. But the argument was not that strong because the independent members of compensation committees could not continually make systematical failure to recognize the 'true cost' of share option.

Bebchuk and Fried (2004) claimed that, within the managerial-power perspective, executives and directors could use outsider's enthusiasm to raise share option based remuneration in ways that would appear in favor of outsiders. Under their statement, managers were capable of taking advantage of outsider's enthusiasm for incentive-based compensation in several ways: First, they could get large amount of extra share option payment without taking any responsibility for downward adjustment in cash compensation. Second, executives took advantage of their position to arrange the details of share option plans in favor of themselves.

Jensen and murphy (1990) pointed out that the largest CEO performance incentives came from ownership of their company's share, but such holding were small and declining. They also mentioned that nonpecuniary rewards associated with success and accomplishment and nonpecuniary punishment associated with failure could also help to align the interest of shareholders and managers.

3 Conclusion

The literature on manager's performance, remuneration and remuneration arrangements drew the conclusion that:

(i) The levels of payment under most acceptable payment forms seem to be justified. The remuneration of managers can be explained by the factors 'hard working' and 'successful', but the relationship is not perfect. There are still many other important perspectives that should be taken into consideration.

(ii) Many methods of payment are designed to encourage alignment between managers and the shareholder, they all seem to work well but everyone has its shortcomings. Share option (equity based instrument) is the most widely adopted method, and it causes the most discussions. But it is undeniable that share option contributes the most to solve agency problem and it is the most acceptable compensation method so far.