Executive Incentives Resit

COURSEWORK TITLE: Executive incentives & performance
MODULE NUMBER: ACC3165
MODULE NAME: Corporate Governance

ACADEMIC YEAR: 2018/19
STUDENT FIRST NAME: Prakrisht
STUDENT LAST NAME Prithipaul
STUDENT ID NUMBER: M00603870
STUDENT'S CAMPUS: MAURITIUS
STUDENT'S EMAIL ID: PP728@live.mdx.ac.uk
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Table of Contents
Abstract..........................................................................................................................3
Introduction....................................................................................................................3
The agency theorem and executive incentives mechanism............................................3
Why were executive incentives required?..................................................................3
Agency theory............................................................................................................4
Economic agency theory and incentives................................................................4
Critics of the Agency theory......................................................................................4
The principal-agent problem..................................................................................4
Examples of managerial errors.......................................................................................5
Waste management Inc Scandal.................................................................................5
Enron Scandal............................................................................................................5
Incentives – Pros & Cons...............................................................................................5
Conclusion......................................................................................................................7
References......................................................................................................................7
2
Executive incentives & Performance
Abstract
The paper addresses the problem of Executive incentives on performance through
empirical research. Using the agency theory, the paper attempts to explain the emergence of
the executive incentives mechanism as a result of the principal-agent problem. The paper
further explores the probability of incentives having an impact on executives in relation to
accounting malpractice. The end result of the research gives a two sided answer to the
question of incentives affecting performance.
Introduction
This paper will discuss the relationship between owners, i.e. shareholders, and
management. Focusing on the agency theory, the report will explain the need of the executive
incentives’ mechanism, the reason for its creation and its role within organisations. The
agency theorem will be used as a layout to show where incentives are placed, how they are
used and the performance of the mechanism.
The agency theorem and executive incentives mechanism
Why were executive incentives required?

Within most companies, the management and owners are two separate entities. This is
mostly due to owners preferring to employ a person more capable of handling the day to day
activities of a company and for taking the right decisions while taking into consideration
shareholder wealth maximisation as the main objective.
Employing a competent management team which does not form part of the
shareholder side is a double-edged sword. Certainly, they will be making the right decisions
for the company, but will slack given the opportunity, from a research, it has been discovered
that humans are naturally lazy beings (Humans wired to be lazy - study. 2015). Another factor
that should never be underestimated is human nature. It is the human nature to seek personal
gain above everything, which therefore give rise to something called managerial temptations.
Managerial temptations are for instance, occasions where managers or the

management as a whole is inclined into manipulating facts and figures in order to cover up a
mistake or situation from the eyes of the owners. For example, the scandal of Waste
Management Inc. in 1998 where the founder and former chairman Dean L. Buntrock and
other top executives inflated earnings to 1.7 billion USD (Tharp, 2002). There is also the
Enron Scandal in 2001 where the company removed huge amounts of debt from the balance
sheet in order to hide losses (Barrionuevo, 2002).
In light of all these scandals and malpractices, new methods had to be put in place in
order to prevent such cases from reoccurring. Therefore, giving rise to executive incentives
within the agency theorem framework.
3
Agency theory
Economic agency theory and incentives
The agency theory was introduced by scholars Stephen Ross and Barry Mitnick. The
theory basically is that the principal (shareholders/owners) delegate work to the agent
(executives/management), where the desirable outcomes of the dealing is viewed from the
principal’s objective (Eisenhardt, 1989). Ross introduced the economic part of the theorem,
the part dealing with incentives and compensation (Mitnick, 2013). Therefore, the executive
incentives mechanism has its underlying roots within the agency theory of Ross and Mitnick.
Focusing on the economic part of the agency theory, an appropriate compensation system was
required for the agents in order to produce proper behaviour (Mitnick, 2013).
The compensation system is akin to incentives. The mechanism was present since the
period of Ross and Mitnick back in the 1980s. But it would seem that the mechanism was not
applied properly or faulty, nevertheless, the end result was certain companies going bankrupt
due to their management.
Critics of the Agency theory

There are two main agency problems to consider about the theory, precontractual
problems that relate to the principal when selecting an agent and post contractual problems
related to what happens after selection of an agent (Gould, Grein and Lerman, 1999). In the
case of this paper, the discussion of agency problem will concentrate on post contractual
situations.
The principal-agent problem
The principal-agent problem arises when separation of ownership and control occur.
Obviously, the problem is non-existent when there is owned-management, that is, the owners
manage their own firms. Accompanying this, is the incentive reserved to the owners which is
using company funds for private expenditure (Thomsen and Conyon, 2012). In the case of
hired professional managers, the incentive is different as they are not managing their own
money and therefore cannot use company funds in a similar way. They tend to spend money
on things they like without keenly considering the costs as their sole objective is to maintain
the job and their salary (Thomsen and Conyon, 2012).
Another complication of the principal-agent problem is the commonly known conflict

of interests. According to perceived wisdom of various businessmen and scholars, the main
aim of a company is to maximise its stock market value and profits. Unfortunately, often
managers prefer to maximise their own interests and somewhat at the expense of the
company itself (Jerzemowska, 2006). This gives rise to agency conflicts as the interests of the
principal do not match with those of the agent, producing agency costs. This scenario is
especially common in public owned companies (Jensen and Meckling, 1976).
Public companies often deal with other companies in other countries through
partnerships and mergers. In this case, theorists have found the agency theory to be
problematic and simplistic as it ignores the complexity of organisations from the perspective
of interorganisational approach (Gould, Grein and Lerman, 1999). Merging and partnerships
have their own benefits and risks, and the principal often tends to push all the risks upon the
agent (Eisenhardt, 1989). With a lack of incentives for the executives, and the risks of such
4
situations being pushed upon them, it is obvious that they will be looking for a way out,
therefore act in their own interests.
Examples of managerial errors
Waste management Inc Scandal

The well-known scandal of 2002, the Waste management Inc inflated its profits by
1.78 billion USD. The accounting malpractice occurred due to pressure upon the management
to meet the earnings figure imposed by the shareholders (Tharp, 2002). The US securities and
Exchange Commission (SEC) accused the CEO the executive of staging a “massive fraud”
for five years (Waste Management Founder, Five Other Former Top Officers Sued for
Massive Fraud. 2002). This is a case of executives looking for their own interest at the
expense of the company and shareholders. From the report of the US SEC, the top executives
enriched themselves and preserved their jobs by producing fake ledger records and
accounting figures, resulting in lawsuits and a fine of 7 million USD on the former CEO
(Waste Management Founder, Five Other Former Top Officers Sued for Massive Fraud.
2002).
Enron Scandal
The Enron scandal was another of accounting malpractice involving the top
executives of the enterprise. From the orders of the CEO, loss figures of hundreds of millions
were bounced from division to division to hide problems from shareholders and used funds
from a security account of the company to inflate earnings to match the targets (Barrionuevo,
2002). The scandal concluded with Kenneth Lay, former CEO and founder of Enron passing
away whilst awaiting his sentence from court and Jeffrey Skillings giving 42 million USD to
compensate the victims of the Enron scandal (Library, 2019). From the detailed SEC report, it
was stated that Skilling and other executives manufactured and manipulated reported
earnings through the improper use of reserves (SEC Charges Jeffrey K. Skilling, Enron's
Former President, Chief Executive Officer and Chief Operating Officer, With Fraud. 2004).
The two scandals have one thing in common, the executives aimed to satisfy their
personal interests at the expense of shareholders and the company. Were the incentives for the
executives not adequate for their tasks? Or is it that the managerial temptations were too big
to not succumb?
Incentives – Pros & Cons

When looking at the position of CEO, chairman and other executive posts wielding
power and influence in an organisation, there comes to mind a saying, “Great power comes
with great responsibility”. Although the source of this saying is vague, it is utterly applicable
to the situation. But mankind is a fragile entity, easily tempted and therefore requires
something to keep it in rein and that are incentives.
5
Incentives can be used for both motivating purposes and to keep executives from
tipping onto the wrong side. But are incentives effective? Do they actually work?
From the work of Laffont, it is understood that the principal often does not want to
give much to the agent in terms of incentives as it represents a loss of some kind (Laffont and
Martimort, 2009). The principal is keen to keep expenses of any kind at the lowest while
maintaining or even increasing gain from the agent. It therefore results in the principal not
giving out enough or proper incentives, therefore proving to be unmotivating to the agent.
Barnard explained that improper incentives can cause the dissolution of management
and operations team or changes of the organisational purpose or failure of cooperation
between agent and principal (Barnard, Barnard and Andrews, 1968).
Therefore, providing the right incentive is crucial to alleviate the principal-agent

problem and to increase performance. Incentives can be separated into two distinct
categories, specific or general (Barnard, Barnard and Andrews, 1968). The specific incentives
can be materialistic that is, increase in salary, bonuses on good performance, a percentage of
shares of the company. It can also be personal non-material objectives, for example vacation
and trips, and desirable physical conditions and benefactions.
The general incentives are associational attractiveness, adaptation of conditions to

habitual methods and attitudes, opportunity of enlarged participation and the condition of
communion (Barnard, Barnard and Andrews, 1968). But the most propagated incentive for
executives remains materialistic in nature.
Materialistic incentives are quite ineffective, quoting the words of Irving Barnard:
“even in purely commercial organization material incentives are so weak as to be almost
negligible except when reinforced by other incentives." (Barnard, Barnard and Andrews,
1968). As such, it is understood that incentives involving bonuses and increases in salary are
ineffective and have to be backed by other incentives in order to work. But that was the case
back in the 1970s, how would these incentives fare now?
During the 1990s, in America, it has been noted that performance bonuses for senior
executives fit perfectly. Performance bonuses has enjoyed a surge in popularity since the in
the age of reduced profitability, it makes executive pay a variable instead of a fixed cost
(Beer and Katz, 1998).
Although there has been much empirical research on the question of performance
bonuses as an incentive to increase company performance, a direct link has not yet been
established (Gomez-Mejia and Wiseman, 1997). It is assumed that bonus pay is justified
through expectancy theory and agency theory in terms that rewards motivate performance
and aligns expectations of the principal and that of the agent.
To answer the question of Gomez on performance bonuses and company

performance, Michael Beer conducted a research involving 205 executives from 30 countries.
The result drawn from his research indicates that bonuses had slight to nearly no impact on
executive decision-making and executive behaviour (Beer and Katz, 1998). Beer has further
discovered that executives do not ponder on incentives when making decisions, thus
completely nullifying the concept that incentives do have an impact on performance.
6
Even though, incentives were said to not having any impact, Beer made an interesting
discovery, a paradox. It would seem that the point of view of executives on incentives is not
streamlined. The executives believe that the incentives have a slight ability to increase
performance but when they face the question as to why their company has instituted such
incentive, their answer is that bourses motivate (Beer and Katz, 1998). Beer therefore
concluded that the incentives were mainly to attract and retain executives and talents.
Conclusion
To conclude, it seems that material incentives on their own do have little to no effect
on performance therefore, the mechanism does not accomplish its actual goal. But, it helps to
attract and maintain employees, executives and talents within the organisation. If the
executive mechanism were to be improved, the materialistic incentives that is so in vogue
have to be backed by other incentives in order to yield satisfactory results.
Countries of east Asia and Europe have embraced performance bonuses as incentive
for executives although their culture regarded the incentive as inappropriate (Beer and Katz,
1998). For incentives to be motivating, it depends on the person viewing the incentive
(Pennings, 1993). Using this statement as the basis of speculation and possible improvement
on the executive incentives mechanism, in order to increase performance of executive team
and that of the organisation as a whole, incentives have to be tailored to the characteristics of
each individual within the organisation. The incentives have to be materialistic supported
with non-materialistic incentives, a mixture of specific and general incentives. Realistically, it
is impossible to realise such feat for every member of a company, but it can be for the
executive team, thus, increasing performance and preventing malpractices.
References
Humans wired to be lazy - study. (2015) Available at: https://www.bbc.com/news/health-
34198916 (Accessed: Apr 28, 2019).
SEC Charges Jeffrey K. Skilling, Enron's Former President, Chief Executive Officer and
Chief Operating Officer, With Fraud. (2004) Available at:
https://www.sec.gov/news/press/2004-18.htm (Accessed: April 30, 2019).
Waste Management Founder, Five Other Former Top Officers Sued for Massive Fraud.
(2002) Available at: https://www.sec.gov/news/headlines/wastemgmt6.htm (Accessed: April
29, 2019).
Barnard, C.I., Barnard, C.I. and Andrews, K.R. (1968) The functions of the executive.
Harvard university press.
Barrionuevo, A. (2002) 'Enron Figures Tell How Results Were Manipulated', The New York
Times, Feb 28, .
Beer, M. and Katz, N. (1998) Do Incentives Work?: The Perceptions of Senior Executives
from Thirty Countries. Division of Research, Harvard Business School.
7
Eisenhardt, K.M. (1989) 'Agency theory: An assessment and review', Academy of
management review, 14(1), pp. 57-74.
Gomez-Mejia, L. and Wiseman, R.M. (1997) 'Reframing execufive compensation: An

assessment and outlook', Journal of Management, 23(3), pp. 291-374.
Gould, S.J., Grein, A.F. and Lerman, D.B. (1999) 'The role of agency-client integration in
integrated marketing communications: A complementary agency theory-interorganizational
perspective', Journal of Current Issues & Research in Advertising, 21(1), pp. 1-12.
Jensen, M.C. and Meckling, W.H. (1976) 'Theory of the firm: Managerial behavior, agency
costs and ownership structure', Journal of Financial Economics, 3(4), pp. 305-360.
Jerzemowska, M. (2006) 'The main agency problems and their consequences', Acta
Oeconomica Pragensia, 14(3), pp. 9-17.
Laffont, J. and Martimort, D. (2009) The theory of incentives: the principal-agent model.
Princeton university press.
Library, C.N.N. (2019) Enron Fast Facts. Available at:

https://www.cnn.com/2013/07/02/us/enron-fast-facts/index.html (Accessed: Apr 30, 2019).
Mitnick, B. (2013) 'Origin of the theory of agency: an account by one of the theory's
originators', .
Pennings, J.M. (1993) 'Executive reward systems: a cross‐national comparison', Journal of

Management Studies, 30(2), pp. 261-280.
Tharp, P. (2002) $1.7B TRASH HEAP – WASTE MANAGEMENT INFLATED PROFITS:

SEC. Available at: https://nypost.com/2002/03/27/1-7b-trash-heap-waste-management-
inflated-profits-sec/ (Accessed: Apr 28, 2019).
Thomsen, S. and Conyon, M. (2012) Corporate Governance Mechanisms And

Systems. Berkshire, UK: McGraw-Hill Education (UK) Limited.
8
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COURSEWORK TITLE: Executive incentives & performance

MODULE NUMBER: ACC3165

MODULE NAME: Corporate Governance

The agency theorem and executive incentives mechanism............................................3

Why were executive incentives required?..................................................................3

Economic agency theory and incentives................................................................4

Critics of the Agency theory......................................................................................4

The principal-agent problem..................................................................................4

Examples of managerial errors.......................................................................................5

Waste management Inc Scandal.................................................................................5

Incentives – Pros & Cons...............................................................................................5

The agency theorem and executive incentives mechanism

Why were executive incentives required?

Managerial temptations are for instance, occasions where managers or the

Critics of the Agency theory

The principal-agent problem

Another complication of the principal-agent problem is the commonly known conflict

Examples of managerial errors

Waste management Inc Scandal

Incentives – Pros & Cons

Therefore, providing the right incentive is crucial to alleviate the principal-agent

The general incentives are associational attractiveness, adaptation of conditions to

To answer the question of Gomez on performance bonuses and company

Gomez-Mejia, L. and Wiseman, R.M. (1997) 'Reframing execufive compensation: An

Library, C.N.N. (2019) Enron Fast Facts. Available at:

Pennings, J.M. (1993) 'Executive reward systems: a cross‐national comparison', Journal of

Tharp, P. (2002) $1.7B TRASH HEAP – WASTE MANAGEMENT INFLATED PROFITS:

Thomsen, S. and Conyon, M. (2012) Corporate Governance&nbsp; Mechanisms And

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