Reasons Of Principal Agent Problem Accounting Essay

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On December 02, 2001, Enron Corporation filed for bankruptcy. Stockholders of Enron lost tens of billions of dollars as the share price fell to almost zero. The Enron collapse shows that how information asymmetry and opportunistic behavior of agents of the firm (executives, auditors) and the inability of the principals (owners and stockholders) to control it, resulted in one of the biggest bankruptcy.

Principal-Agent problem:

Theoretically, interest of the owners of the firm or shareholders (principals) and managers (agents) are the same, but in practicality this is not the case. Agency problem arises when the shareholders (principals) hire executives or managers (agents) to make decisions that are in the best interests of the shareholders, but agents pursued the activities for their self-interest and these activities or decisions reduces the shareholders' value. Managerial interest can be risk diversification, power, status, prestige and the personal gain from the stock options etc.

To overcome with the agency problem, shareholders attempt to align the interest of management with that of their own, by designing attractive compensation packages for the top executives of the firm. Bonuses, pay-raises, promotion, profit sharing, stock options and the threat of firing are some ways to solve the agency problem.

Reasons of Principal-Agent Problem:

Information asymmetry: Agents have more information about the firm than that of principals and agents use this information for their personal interests which is not in favor of principals.

Differing risk preference: Risk preference of the agent and principal are different. Principals are risk neutral but the agents are risk averse and this difference creates an effect on the firms' profitability.

Company Introduction:

Enron was one of the world's leading companies dealing in electricity, natural gas, communication, and pulp and paper industry. It was founded in 1985 and based in Texas. Company claimed that it generated nearly $101 billion revenue in 2000. [1]It was named "America's most innovative company" for six consecutive years by the Fortune magazine. In October2001, company declared an accounting fraud and revised the financial statements and later in December 2001, filed for bankruptcy. Enron shares dropped from over US$90.00 in the summer of 2000 to just pennies. Stockholders lost around $11 billion because of misconduct of the executives at Enron. So we are analyzing who were actually responsible for this loss. The information asymmetry and opportunistic behavior of agents (executives and managers) and the inability of the principals (stockholders) to control it, made the Enron collapse catastrophic. Our group will mainly focus on the 3 top executives and their compensation packages and these executives are: Kenneth Lay (Chairman, CEO), Jeffrey Skilling (President, COO) and Andrew Fastow (CFO).

Philosophy behind executive compensation at Enron:

Enron executives' compensations were primarily composed of salary, bonus and stock options.

A significant portion of compensation was tied to the performance of business unit and that of Enron.

Bonus of the executives was based on the stock price of Enron.

[4]

Cause of the problem & Supporting Evidences:

The executives were paid generous bonus if the share price of Enron crosses a particular mark. So the executives' only objective was to increase the share price anyhow. They were also rewarded by lucrative stock options, which were also going up with the share price. In the year 2000, the total compensation of K.Lay and Jeff Skilling was $132 million and $69 million respectively and more that 90% of it came from selling the stock options. [5]

To increase the share price, executives started taking high risks, expanding in many fields whether relevant or irrelevant and manipulating the accounts and statements.

In the last 3 years before Enron collapsed, 3 main executives sold their major portion of the stock options. Andrew Fastow (CFO) sold $34 million, Kenneth Lay (Chairman, CEO) sold $184 million and rewarded bonus payment of $14.1 million and Jeffrey Skilling (COO) sold $71 million and got bonus payment of $10.8 million.[7]

From mid 1999 to 2001, Enron executives sold shares of $1.1 billion, which shows that they all want to make quick money from the stock options by increasing the share price in short term. [6] To meet the expectations of the analysts, executives started manipulating accounts, inflating profit figures and hiding the liabilities of the company. Andrew Fastow (CFO) created so many SPE's (Special purpose entities) to transfer the liabilities of the Enron and thus reducing debt obligations of Enron on papers. Moreover, in some of the SPE's he was the promoter, which was a clear conflict of interest, but the board of directors approved all these deals. Skilling (President) backed all the deals done by the Fastow and produced false documents to the auditors to inflate the revenue and profit. Lay (Chairman, CEO) neglected all the wrong-doings of the executives. Enron executives used the shares of Enron as the collateral for making the deals and if the share price fell below a certain limit, they had to put more shares or cash. This was also one of the reasons of keeping the share price high in the market.

All the top executives encouraged everybody to buy Enron shares but they were selling their shares in the market as they know the actual financials of the company. Below graph shows the shares sold by Skilling and the share price, which clearly shows that whenever the stock price made an intermediate high, he sold a major portion of his holding.

[3]

Conclusion:

Agency problem can be solved by proper monitoring of the actions of the agents. Since it is very difficult for the principals to monitor the agents, they link the compensation of the executives with the firm's performance. But at Enron the only criteria to measure the company performance was the share price, which based on the false results. The executives made a fortune by selling their stock options in the market due to the high share price. So the solution to the agency problem was not working at Enron or not implemented properly.

The executives should be rewarded based on the long term performance of the company and there must be multiple criteria to measure the firm's performance. For example contracts should limit the amount of profit that bonuses will be paid on to reduce short-term profitable decisions over long term profitability by agents. We also have some recommendations, which firms should consider to avoid such incidents.

While making the contract firm should explicitly mention

The activities that firm wants to encourage

The activities that the firm wants to discourage

Stock options should be granted only on the basis of sustainable profits.

Principal should closely monitor the activities of agents.

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