Group Assignment: How bonus plan hypothesis influences agency problem and

share prices/profits of a company.

Name

ID

Arafat ZahinHoque

S00191665

Julia Nancy Kibuga

S00192230

Navjot Kaur

S00179875

Mahfuzur Rahman
Tahreerur Rahman

S00191714

Anika Shan Azam

S00192019

Unit name: Accounting and Accountability

Unit code: ACCT602

Course: Master of Professional Accounting

Lecturer: Dr. Mark St Leon

Submission Date: 13.05.2016

Submitted on: 13.05.2016

Answer to question no 1:

The research topic here is: How bonus plan hypothesis influences
agency problem and share prices/profits of a company. Bonus plan
hypothesis clearly explains how managers tend to increase their
bonuses by boosting profits. As explained earlier, when management
bonuses is tied to company profits, the managers tend to inflate profits in the
current year in order to increase their bonuses. They overlook interests of the
shareholders in order to pursue their own and thus create the agency
problem. There are lots of ways managers use accounting methods to boost
profits. Managers, out of self interest are inclined to select accounting
procedures which shift the reported earnings from future periods to the
current period(Setyorini & Ishak,2012,pg.3). This in turn elevates the
share price of the company in the short run. The company may look good in
the short run but it might have an adverse affect on the profit in the long run.
The positive accounting theory has an efficiency and opportunistic
perspective. This research topic is very fascinating because it can be related
to some of the reasons behind the major financial crisis that has taken place.
The agency problem that comes with this topic can never be eliminated but
can be reduced significantly under certain circumstances. The bonus plan
hypothesis can also be related to several theories like Stakeholder theory,
Legitimacy theory, Agency theory and efficient market theory which are
explained in more detail later in this paper.

Answer to question no 2:
The three research questions that have been identified are as follows:

a) Giving examples, explain bonus plan hypothesis?

Answer: Bonus plan hypothesis states that managers who work for
companies that have bonus schemes in place are more drawn towards using
accounting methods that will increase their overall profits so that they can
get huge bonuses in the short run but which might have a greater bad effect
on the company in the long run. They achieve this by shifting the earning of
future periods to the current period therefore increasing the current incomes
figure (Watts, R. and J. Zimmerman 1986). The example is described in
answer number 4.
b) How bonus plan hypothesis explains agency problem?3.In terms of bonus
plan hypothesis,how managers use accounting methods to boost profits
Answer: Information asymmetries and inefficiencies give rise to agency
problems (Deegan. 2007 pg. 123). The managers sometimes hide information
about risks from their shareholders to earn immediate gains in their variable
compensation.
c) In terms of bonus plan hypothesis, how managers use accounting methods to
boost the profit?
Answer: The managers, out of self-interest, can use accounting methods to
boost profits in many ways. Several methods are used to falsely shrink the
expenses and cost of goods sold. There by inflating the profit.

Answer to question no 3:
Relevance of journal articles with area of research:
At first, the concept of bonus plan hypothesis was discussed with the help of
the journal Corporate Social and Environmental Disclosure: A Positive

Accounting Theory View Point by Christina Tri Setyorini and ZuainiIshak.

According to the article,bonus plan hypothesis states that manager who work
for companies that have bonus schemes in place are more draw towards
using accounting methods that will increase their overall profits so that they
can get huge bonuses. They achieve this by shifting the earning of future
periods to the current period therefore increasing the current incomes figure.
(Watts, R. and J. Zimmerman 1986) .This article is important because it
discusses the opportunistic perspective of positive accounting theory.It
explains that when managers bonus is tied to accounting profits, they tend
to use accounting methods which boost up current profits. That is why this
article is relevant to our research.The article emphasizes on corporate and
social disclosures.Stakeholders tend to have a positive response to firms that
are actively involved in corporate social responsibility activities so what the
executives would do is have more disclosures in their financial reports of
these activities leading to better performance and greater rewards. (Setyorini
C. &Ishak Z. 2012 Pg.154).This provides a recommendation of how managers
might be prevented from using accounting methods to boost profits in order
to achieve bonuses tied to profits.
In order to understand the effect of bonus plan hypothesis on share prices,an
academic journal used in this research is The Development of Earnings
Management Research by SubhrendruRath and Lan Sun.This article also
talks about the opportunistic driven earnings management(Rath& Sun
2008,pg.268).When managers tend to use accounting methods which boost
profits in the current period, this might give the market an impression that

the company is doing well and thus investors would be willing to buy the
companys shares.This might increase the share prices of the company.
An article which explains how bonus plan hypothesis can create agency
problems is Bonus regulation: aligning reward with risk in the
banking sector by MarilenaAngeli and ShahzadGitay.Agency problems arise
when managers interests are not aligned with shareholders interests.This
article explains that bonus plans for managers working in banks of England
encourage excessive risk taking. Bonuses and long-term incentive plans
(LTIPs) combinations consists of variable remuneration.In 2006, insurance
industry and finance industry of the total remuneration the variable
remuneration moved a crest of 34%(Angeli& Gitay,2015,pg.324).These type
of bonus plan leads to agency problem.Onbehalf of shareholders(principals),
executive directors (agents) are carrying out firms activities by making
decisions. The assumption of agency theory is conflict of interest between the
executive directors and a firms shareholders. To maximize shareholder
wealth the agents acting as executives are hired to make decisions.
Nevertheless, to maximize their own wealth the agents are tempted. For
immediate gains (high bonuses) they take higher risks than the shareholders.
Conversely, they arent ready to take any responsibility if shareholders
sustain loss and will not be responsible for any costs or firms loss. Hence,
shareholders wishes to monitor the executive directors to reduce agency
cost but reality is relentless monitoring is unfeasible and costly(Angeli&
Gitay,2015,pg.324).
Another article which was useful in explaining how bonus plan
hypothesiscreates agency problems is Motivation and Executive

Compensation by A S Agarwal.According to this academic journal,one of

the important component of Corporate Governance is executive
compensation, where there are three type of incentives or bonus plan. One is
short-term incentives, long-term incentives and perquisites and benefits.
These are founded on agency theory and which leads to agency problem. The
statics of last seven years shows, The Economist ( 2007) reported about
CEO compensation to be sky-rocketing. The CEO compensation has increased
up to 40 times from 1960s employees and 600 times in 2002.These
adventitious rewards results to agency problem because these come at the
cost of shareholders. (Agarwal 2010, pg28-30)
To increase the return on asset over time and simultaneously increasing their
bonus the executives uses straight line depreciation method. When prices
falls the depreciation expense will fall accordingly, which will result in an
overstated of asset value and reported income. Therefore, agency problem
becomes more profound. Moreover, the practice of not spending in Research
and development by managers is very prominent. They keep doing cost
cutting in different departments, for the companies to keep their bonuses
increasing. However, investing in those departments will have future benefit
for the company to have more sustainable business.
A book used in this research,that describes bonus plan hypothesis and
addresses the agency problems between managers and shareholders is
Professional Accounting Essays and Assignments by MiracelGriff.In this
book ,it is explained that when management bonuses are tied to
shares,managers tend to boost up companys reported profits so that market
reacts to the insider information and the share prices of the company go up

as a result(Griff 2014,n.p). Managers often take high risks in order to increase

reported earnings which enables them to earn short term bonuses.It also
argues that managers would be less motivated to work in the interests of
shareholders when trying to shift future profits in the current reporting
period.This creates conflicts of interest leading to agency problem.
An article which was used to address how managers use accounting methods
to boost profits in terms of bonus plan hypothesis is Earnings
Management from the Bottom Up: An Analysis of Managerial
Incentives Below the CEO.This article explains measures of earnings
management such as discretionary accruals.For example firms might include
credit sales in current reported earnings for which they are to receive money
in future(Oberholzer-gee &Wulf 2012,pg.11).This is consistent with managers
gearing future profits to current times.Moreover Generally Accepted
Accounting Principles(GAAP) allow managers to recognize some current
expenses in the future and this helps inflate profits for the current reporting
period.So this article is important in explaining how managers use accounting
methods to boost profits in terms of bonus plan hypothesis.
In general, managers can use accounting methods to boost profits in many
ways. For example they might cut expenditure on research and development
to boost profits. This would prove detrimental in the long run especially for
businesses selling technological products. Moreover they might use
absorption costing improperly to lower cost of good sold(Segarra,2012).An
example of how absorption costing was used by managers to reduce cost of
goods sold in the current year was explained in the article Why the Big Three
Put Too Many Cars on the Lotby Marielle Segarra.This article talks about the

big three automobile manufacturing companies such as Ford,Chrysler and

General Motors who used absorption costing to decrease cost of goods
sold.They produced above market demand as they had excess production
capacity and this showed that cost per product unit was less in accordance
with absorption costing where fixed costs are considered as part of cost of
goods sold(Segarra,2012,pg1-2).So this article helps in explaining how
managers use accounting methods to lower expenses and thus boost profits.
Another academic journal which discusses management motivations
regarding boosting up bonuses is Techniques,Motives and Controls of
Earnings Management by Md. Musfiqur Rahman, Mohammad
Moniruzzaman and Md. Jamil Sharif.This article states that managers often
decrease research and development costs in the final year of their tenure in
order to increase profits and thus their payout when they leave the
company(Rahman et al.2013,pg.9-10).So this journal is relevant to our
research in explaining how managers use accounting methods to boost
profits.

Answer to question no 4:
In response to the research questions, the following results have been found:
a) Firms have different methods they use when awarding bonuses to their
executives. The compensation package of an executive in a company has five
main components which are the base pay, the annual bonus, stock options,
stock grants and long-term incentive plans. According to research, tying

bonuses to payment through stock options and grants presents the biggest
problem because the top executives who have a huge number of shares will
work to ensure that the stock price goes high guaranteeing them a higher
payout. This takes managers focus from shareholder wealth maximization to
their own self-interest. (Sun L. 2012 pg. 119)
b) Information asymmetries and inefficiencies give rise to agency problems
(Deegan. 2007 pg. 123). The managers sometimes hide information about
risks from their shareholders to earn immediate gains in their variable
compensation. In the end they dont take the responsibility and leave
shareholders suffer the long-term loss. So there is the conflict of interest
between the manager and the shareholders. According to agency theorist,
the agency cost is unavoidable. (Motivation and Executive Compensation, A S
Agarwal, Jan-Apr 2010, 28). Its extremely difficult to eradicate the agency
problem but it can be reduced significantly under a well balanced
compensation package. It is also assumed that managers will be driven by
self-interest. Reducing share based payments to executives will stop the
overpayment to the executives in terms of bonuses.
c) The managers, out of self-interest, can use accounting methods to boost
profits in many ways. For example they might cut expenditure on research
and development to boost profits. This would prove detrimental in the long
run especially for businesses selling technological products. Moreover, they
might use depreciation method and absorption costing improperly to lower
the expenses and cost of goods sold respectively (Segarra,2012).

Answer to question no 5:

There are few accounting theories that can further explain the research questions.
The theories and their relevance are explained as follows:
a) Stakeholder theory: The theory addresses the business practices of moral
values in managing the organization (R. Edward Freeman, 1994). The
hypothesis does affect the morals and values in managing the company. The
managers selfish practices to increase their own wealth adversely affect the
minor and major shareholders, the organizations creditors, banks and
customers etc. the stakeholders have the right to know the information of the
organization they are affected by. So the managers should disclose enough
information to the stakeholders to avoid any adverse effect.
b) Legitimacy theory: The hypothesis affects the public at large. Managers
selfish practices do have a negative long term impact on the profit of the
company which in turn has similar affect on the share price. This causes small
investors loose lot of money. So the organizations must disclose proper
information in their annual report (general purpose financial report) for the
public. Its the publics right too.
c) Agency theory: There is goal congruence between the manager and the
shareholders. To maintain the goal congruence between the agent and the
principal different accounting methods and compensation plans should be
implemented. The manager is driven by self interest. The conflict of interest
between the manager and shareholders cannot be eliminated completely, but
it can be reduced significantly by maintaining and minimizing the agency
costs (Bonding, monitoring and residual loss). This in-turn increases the
performance.
d) Efficient market hypothesis theory: It states that market reacts in an efficient
and unbiased manner to publically available information. But under the bonus

plan hypothesis, the market is not efficient and unbiased. Managers tend to
manipulate the share price by hiding information. Insider trading is being
carried out in the market. The information is not always reflected in the share
prices. Integrity of the manager is at stake. There has to be proper disclosure
of related information for share price movement in the annual report.

References:
Agarwal, A.S. (2010) Motivation and executive compensation by A.S. Agarwal:
SSRN, The IUP Journal of Corporate Governance, vol.9, no.(1 & 2), pp. 2746,
viewed 11th May 2016; <http://papers.ssrn.com/sol3/papers.cfm?
abstract_id=1540325>
Angeli, M. and Gitay, S. (2015) Bonus regulation: aligning reward with risk in the
banking sector, Cross-Sectoral Policy Division, vol.4, no.1, pp. 322333;
<http://www.bankofengland.co.uk/publications/Documents/quarterlybulletin/2015/q
401.pdf>
Griff, M. (2014) Professional accounting essays and assignments. 1st edn. United
Kingdom: Lulu.com.

Oberholzer-gee &amp; Wulf (2012), Earnings Management from the Bottom Up: An
Analysis of Managerial Incentives Below the CEO,Harvard Business Review, vol.12,
no.56, pp. 1-37, viewed 10th May 2016; <http://www.hbs.edu/faculty/Publication
%20Files/12-056_d272d220- d6ad-4681- a5cd-239d1f4eb952.pdf&gt>
Rahman, M., Moniruzzaman, M. and Sharif, J. (2013) Techniques, Motives and
Controls of Earnings Management, International Journal of Information Technology
and Business Management, 11(1), pp. 2234. viewed 11th May 2016; <
http://www.jitbm.com/11th%20Volume/rehman.pdf>
Rath, S. and Sun, L. (2008) The Development of Earnings Management Research,
International Review of Business Research Papers, vol.4, no.2, pp. 265277, viewed
10th May 2016;
<http://www.irbrp.com/static/documents/March/2008/1423379256.pdf>
Segarra, M. and Parkinson, J. (2012) Why the big Three put too many cars on the lot.
viewed 12th May 2016; <http://ww2.cfo.com/managementaccounting/2012/02/why-the-big-three-put-too-many-cars-on-the-lot/>
Setyorini &amp; Ishak (2012), Corporate Social and Environmental Disclosure:A
Positive Accounting Theory Viewpoint,International Journal of Business and Social
Science, vol.3, no.9, pp. 1-3, viewed 10th May 2016;
<http://ijbssnet.com/journals/Vol_3_No_9_May_2012/17.pdf&gt>

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