Financial Scandals of Enron and WorldCom in the US - Literature review Example

Abstract Company stakeholders have used several ways to motivate their managers to attain company objectives. These incentives otherwise known as bonuses are an addition in excess of their salaries and in most cases comprise of deferred salary payments, insurance plans, performance plans, bonus plans, and issuing stocks in various forms such as non-qualified stock options, restricted stocks, and stock appreciation rights. At the same time, different companies have used different ways to determine which manager is performing well as to be awarded these bonuses. To be able to know which manager is under performing or performing well, company owners have in most cases set up bench marks through which they can appropriately judge the performance of these managers. These bench marks are normally set in accordance with the company’s goals such as how much the managers are able to raise for them in the form of dividends. But the greatest problem here is that, this had led to managers deriving their own ways of producing accounting information that should come up with the required results that can make them have some bonuses at the end of the financial year. Introduction The recent financial crisis has raised a lot of eye brows as to how top management and executives have been managing their entities. This has further fuelled speculation as to how these top managers carry out their accounting procedures as to be able to meet with their bonuses plans. This has pushed academics and researchers into trying to analysing why some managers should be more performant while others are not. Following the financial scandals of Enron and WorldCom in the US that shocked the financial community and markets in the late 1980’s and the UK financial market turmoil scandals such as Polly and Peck, BCCI and Maxwell the rocked investor confidence, the accounting profession and London Stock Exchange created a task force headed by Sir Adrian Cadbury to review what had transpired and the committee came up with one of the first Code of Practices, known as the Cadbury Code, published on December 1, 1992. This committee thoroughly reviewed the financial reporting and accountability of corporate governance, the role of the board, financial reporting and financial practices, pension governance, auditing and the firm’s relationships with the owners or shareholders and came up with a “comply or explain” approach that was subsequently adopted by the London Stock Exchange (LSE). According to Söhnke M. and Idlan Zakaria (2008a, pp 4 – 12), this code (Cadbury Code) became impetus to similar codes in Europe and around the world. According to Sönhke M. and Idlan Z. (2008b, pp 4 – 12), similar to the Cadbury Code, there was the Greenbury Report of 1995 that proposed a code of best practices, similar to the “comply or explain” approach of the Cadbury Report of 1992. Unlike the Cadbury Report, the Greenbury Report laid strong emphasis on two main areas: Improved disclosure, and linking pay to performance. The Greenbury Report saw that the levels of disclosures were opaque and therefore called for a total overhaul of the remuneration reporting system that was in place. This request was based on the fact that the existing Company Act of 1985 that required companies to make disclosures of remuneration to the chairman and the highest paid directors only in aggregate terms. Thus, the Greenbury Report of 1995 called for a full disclosure of all elements of remuneration paid to each individual director, including the base salary, benefits, bonuses and other incentive scheme plus pension. According to Paul Healy (1984a, pp 85 - 107; as stated in Fox (1980)), ninety percent of the one thousand largest US manufacturing corporations in the 1980’s based their remuneration for their managers on a bonus plan based solely on accounting earnings, whereas twenty five percent based remuneration of their managers on performance plan and further stated that bonus awards constituted the highest proportion of top executives compensation than performance payments. On the other hand, Healy recognised that a good number of companies operated both the bonus and performance plans simultaneously, making it difficult to make a distinction between earnings definitions and target horizons of these two plans difficult to identify and come out with a clear cut combined effect on managers accounting decisions as to which accounting procedure the manager used to be able to produce the so required results that could give a good bonus or compensation. Thus this makes the formulae and variables used in defining these bonus schemes to vary considerably between firms and even more within the same firm over time. Despite all these shortcomings, the question that still remained unanswered is, what should be the best formula, variables or definition to use in calculating the bonus scheme that companies should use to remunerate the directors and managers for their jobs? Critics had criticised the Cadbury and Greenbury Codes as being so radical and termed it as being codes for preventive abuse especially as these codes came out after the financial scandals. We all agree that: Through bonus schemes, companies, with their managers can place more focus on areas and investments that allow the company to maximise performance and increase profitability for the company. A good scheme may allow the company to create that incentive to recruit new staff, motivate the existing staff and management to work hard towards achieving company goals, and create that possibility for the company to retain staff and management. Can raise management awareness to support important company objectives that can promote good team work and effectiveness in management They can make management more involved in the business ideas and cover more costs. According to Healy (1984c), in 1980, Standard Oil Company defined its bonus scheme as “the annual fund from which awards may be made is two percent of the amount by which the company’s annual income for the award year exceeds six percent of its annual capital invested for such year”. In this case, there is this school of thought led by Sir Ronald Hampel, that came up with the Hampel Report in 1998, requesting that the idea of management bonuses should be left with the board of directors to determine how much they should pay management as bonuses. According to Brummer (1995)1, the Board of Directors of British Gas, despite accepting the Cadbury report, instead went forward to pay their managers high bonuses using their own company remuneration policies. According to John Knopf and John Teall (2008, pp 37 – 42), till date, executive compensation bonus packets in the US still remain comparatively high than that of their counterparts in Europe. This difference according to them is as a result of a more incentive-based pay in the US coupled with large bonus and stock-based compensation and smaller proportions derived from fringe benefits these managers get compared to their European counterparts. Apart from this, they conclude that, in most cases, the size of the benefits accrued to managers in the form of bonuses depends on the size of the economy and the number of firms operating in that particular economy. Thus according to them, in such economies, when shareholders create these firms, they sell shares to investors, who in turn determine the kind of managers who will manage their investments. Thereby, in the struggle to determine who should be that best manager to manage their investment, they do so by creating what kind of package the manager should receive. This means, in an economy where they are more managers than the firms to manage, they are bound to compete for managerial positions and thereby will realise that their pay packages will be smaller as the investors will be ready to hire a manager with the best smaller pay demands so as to maximise their wealth. At the same time, they agree that the worth of a manager and what that particular manager can offer to a firm, no matter the size, can determine how much compensation that manager gets. Thus, a small firm may decide to hire a more qualified manager that they think will create them value at a much more high compensation package. But according to Healy (1984d) as stated in Watts (1977) and Watts and Zimmerman (1978) postulate that managers can still create value for their bonus package by selecting an accounting procedure. They say by using accruals accounting methods, a manager can increase the value of their bonus award. To be able to do this a manager may observe cash flows from operations and non-discretionary accruals at the end of the financial year and by selecting a discretionary accruals accounting method that can maximise whatever bonus the manager may get at the end of the year. The choice of the accruals accounting method used affects the bonus award to get at the end of the year, but does not affect the firm’s production or investment decisions as these cash effects are financed by stock issues or repurchases. Healy (1984e) goes further to try an explanation as to why managers often have that upper hand to determine how much they may get as bonus by the end of the year by making known that, since boards often set goals some three or four months into the new financial year, this gives managers that opportunity to may be set a threshold as target. In such a situation, they use the ideas of shareholders of wanting to base their judgement on earnings to set up their accounting procedures, in this case, accruals accounting, that they think can help them meet these shareholder target earnings. Healy (1984f, pp 86) defines accrual accounting as the difference between reported earnings and cash flow from operations. Thus as Healy (1984g, pp 106) continues, manager’s therefore use accrual accounting to boost their income-reporting incentives as on their contracts. In such cases therefore, manager’s are more likely to choose decreasing income-decreasing accrual accounting methods especially when they realise that their upper or lower bounds set for earnings they have to generate are binding. And in the case where they realise that the earnings forecast bounds of either upper or lower targets are not binding, they resort to using an income-increasing accruals accounting methods. Thus he goes further to state that, in most companies where there is no upper bound as to manager’s bonus contracts, there is always that possibility that managers will not use accruals accounting methods in presenting their financial results. Interestingly, one can note from Healy’s conclusion that, there is that high probability that manager’s will change accounting procedures in companies that either make changes to their bonus plans yearly, and that hardly will manager’s use accounting procedures that will decrease earnings for the company when they are upper and lower bounds on their bonus plans. This is for the simple reason that, their bonuses at the end off the year depends on how much earnings the manager’s make. So by applying accounting procedures that will lead to a decrease in earnings, means their take home amount in form of bonuses will obviously be reduced. Conclusion Using earnings as the bench mark by which management’s compensation can be judged is seen as the best way. This is because, earnings show prove that management has been able to meet its obligations and has generated enough money to pay shareholders. But care should be taken for management can concentrate on creating earnings at the expense of investments. This means, if thresholds are used for which management bonuses can be calculated, thresholds also should be used as to level on investments the manager’s have been able to create, for future earnings depends on investments. Bibliography Brummer (1995): Greenburg greeted with humbug display. The Guardian, July 18 John Knopf and John Teall (2008): European integration and executive compensation structures: Results of Bargaining and Merger activity. International Business and Management, Vol. 24, pp 64 - 68: Markets and Compensation for executives in Europe. Emerald Group Publishing Ltd Paul M. Healy (1984): The effects of bonus schemes on accounting decisions: Journal of Accounting and Economics. Vol 7, pp 85 – 107 Söhnke M. Bartram and Idland Zakaria (2008): International Business and Management, Vol. 24: Markets and Compensation for executives in Europe. Emerald Group Publishing Ltd Read More