Agency Theory Is Used to Explain Executive Pay Essay

This situation can lead to negative consequences for a business when its executives or management direct the organization to act in the best interest of themselves instead of the best interest of its owners or shareholders. Stockholders of the enterprise can keep this problem from arises by attempting to align the interest of management with that of themselves. This normally occurs through incentive pay, stock compensation, or other similar incentive packages that now cause the managers financial success to be tied to that of the company (Garcia, Rodriguez-Sanchez, & Fdez-Valdivia, 2015; Cui, Zhao, & Tang, 2007; Bruhl, 2003; Carols & Nicholas,

2.Shareholders want high long-term profits. Managers want job security and wonderful perks and amenities. Since risk and return tend to be positively related, managers may wish to avoid risks that shareholders want the managers to undertake. To encourage managers to take on risks, compensation committees can place a greater weight of their compensation on long-term incentives such as stock, options to buy stock, and bonus based on surpassing the performance of comparable firms over several years. When all

However, there have been many cases where the CEO and executive officers receive outrageous compensation even when the companies suffer. Overall, there is a wide disconnect between the incentive of the executives and the financial performance of their company, which needs to be fixed. By passing regulations and rules such as the Dodd-Frank Act, there is hope of shedding light on the connection between the company’s performance and the executives pay. Although it will provide a clear insight, it will not be able to set a strict regulated compensation or define what an executive should earn. Instead regulations will allow for more transparency for the shareholders regarding corporate governance issues such as executive pay. Along with that, it will force companies to take accountability for their actions. If they do poorly, then the executives should be paid less, and vice versa. Overall, there should be a direct alignment between executive pay and the company’s

Generally, under-performing companies are the prime targets of hostile takeovers, so it makes sense that aligning shareholder and executive goals is a major way to avoid that. One popular way of aligning these goals is through the use of elaborate, structured compensation plans for executives which directly tie an executive’s salary to the performance of the company, usually and specifically its stock price (Megginson & Smart, 2009). These compensation plans have become the norm for American corporations, and their effectiveness in solving the agency problem is debatable. On one hand, it should drive an executive to strive to maximize the shareholder wealth, and it also helps companies to attract and retain the best available managers. On the other hand, it serves to sometimes wildly inflate the compensation paid to these executives, either by corporations trying to stay competitive for the best talent, or through easily achievable goals and uncapped maximums. The structured plans, if done correctly, are an effective way to help insure the goal of wealth maximization, but they are also by definition agency costs. Hence, agency problems are inherent to our American corporate system.

Directors have awarded compensation packages that go well beyond what is required to attract and hold on to executives and have rewarded even poorly performing executives. These executive pay excesses come at the expense of shareholders as well as the company and its employees. Furthermore, a poorly designed executive compensation package can reward decisions that are not in the long-term interests of a company. Excessive CEO pay is essentially a corporate governance problem. When CEOs have too much power in the boardroom, they are able to extract what economists' call "economic rents" from shareholders (Economic rent is distinct from economic profit, which is the difference between a firm's revenues and the opportunity cost of its inputs). The board of directors is supposed to protect shareholder interests and minimize these costs. At approximately two-thirds of US companies, the CEO sits as the board's chair. When one single person serves as both chair and CEO, it is impossible to objectively monitor and evaluate his or her own performance.

An agent is hired by the principal to perform some duty that benefits the needs of the principal. The agency problem is an issue that occurs when the agents use their authority to make decisions in their own interest at the expense of the principals. For example, company managers (agents) were put in place to make decisions that maximize the wealth of the shareholders (principals) but may instead engage in empire-building or may make inefficient company decisions for job security. In order to mitigate these potential agency problems, several mechanisms have evolved. These include directly tying the compensation of managers to the success of the firm; oversight and influence by the board of directors as well as outsiders such as security analysts, creditors, or large institutional investors; the threat of a proxy contest by unhappy shareholders to replace the current management team; or the threat of takeover by another firm. However, most of these mechanisms have a low chance of success or can create other problems. The best mechanism that prevents agency problems is the threat of takeover by another firm. If the

There are a multitude of mechanisms that should be put in place to better align managers with the interests of shareholders, and the government plays a big part of that puzzle. Agency problems arise when the management of a public company pursues its own economic self-interest ahead of shareowners’ and secondary stakeholder’s interests’ and portrays disregard for the respect for others and does not reflect at atmosphere of corporate citizenship. This behavior may manifest itself in the form of golden parachutes, long-term employment contracts, corporate jets, and other perquisites. Managers are susceptible to human nature and may pursue their own economic agendas without any concern for maximizing the wealth of the shareowners (Anson, White, McGrew, Butler, 2004). Nortel investors complained that even in its downward spiral, the executives received bonuses and issued excessively optimistic projections. Soon there would not be much left other than the lawsuits alleging issuance of misleading financial statements and blatant insider trading

The components of executive pay are base pay, bonuses, and long-term incentive plans. Several hypotheses on pay justification were derived from James B. Wade at the University of Illinois. Generally, the greater the shareholder involvement, the more market performance is emphasized; the greater the incentive bonuses are, the more accounting performance is emphasized.

The evaluation of a large firm leads to a principle agent problems when the agent has the tendency to act in his own best interests instead of the interests of the principal. It can prove to be difficult to supervise the agent in a direct manner. For instance, if the compensation of the agent is connected directly to the sales revenues of an organization, the agent may attempt to increase sales revenues even if the profits of the company are reduced. There are problems when there is a conflict of interest between shareholders and management and the principle agent.

The relationship between executive compensation and firm performance is a topic of major concern amongst academics, professionals, and regulators. In an effort to identify a relationship between executive pay and firm performance, scholars have conducted research since 1925 and have established that compensation packages are the primary means of incentivizing managers to achieve certain financial targets or goals. These goals include certain performance measures that can be broken down into three main categories: accounting based, measures, market based measures, and non-financial based measures. Additionally, compensation packages have become an increasingly researched topic due to the surge in levels of compensation in

Agency theory is concerned with the agency relationships. The two parties have an agency relationship when they cooperate and engage in association wherein one party the principal delegates decisions and /or work to another an agent to act on its behalf (Tan & Lee, 2015). The important assumptions underlying agency theory is that potential goal conflicts exists between principals and agents; each party acts in its own self-interest; information asymmetry frequently exists between principals and agents; agents are more risk averse than the principal; and efficiency is the effectiveness criterion (Miller & Sardais, 2011; Kingston & Haijie, 2014). Two potential problems stemming from this assumption may arise in agency relationships: an agency problem and a risk sharing problem. An agency problem appears when agents’ goal differs from the principals’ and it is difficult or expensive to verify whether agents have appropriately performed the delegated work.

Executive compensation packages have been used both successfully and unsuccessfully to solve the principal-agent problem facing corporations these days. In this study, we focus on a specific element of an executive compensation package, stock options. The use of stock options as a form of senior executive compensation has been studied extensively to be a testament to the success of it’s ability to realign executive with shareholder interests. However, as the study reveals, prior to the Sarbanes-Oxley Act of 2002, there were many problems with the usage of stock options within corporations that had a weak corporate governance structure. Problems included executive’s incentives to focus on short run profit, take on risky business strategies, and manipulations (legal and illegal) to fulfill executive self-interests. While it is difficult to measure the true effect of stock option’s influence on executive performance and behaviors, we see that the problems with stock option usage far outweigh the benefits of stock options prior to the implementation of the Sarbanes-Oxley Act.

Executive compensation is a form of financial compensation that is determined by the compensation committee. The compensation committee sets the package so it correlates with factors that have an effect on the company. According to an economic theory known as the “Optimal Contracting Theory.”, top executives and shareholders negotiate through the board of directors to maximize their respective interests (Managerial). A principal/agent problem arises because shareholders need to get the

The notion of executive compensation is a contentious issue, particularly during times of economic slowdown. According to Business Dictionary, executive compensation is “the financial payments and non monetary benefits provided to high level management in exchange for their work on behalf of an organization.” Examples of high level management include presidents of the corporation, chief executive officers (CEOs), chief financial officers (CFOs), vice presidents, managing directors and other senior executives (Business Dictionary). It is understood that these individuals are of special interest, because their decisions influence the strategic direction of the company. Over the last 20 years, academic

The principals (the shareholders) have to find ways of ensuring that their agents (the managers) act in their interests.