Accounting for Management Control - Literature review Example

Institution : xxxxxxxxxxx Title : xxxxxxxxxxx Tutor : xxxxxxxxxxx Course : xxxxxxxxxxx @2012 Introduction The issue of reward packages offered to executives in financial institutions has brought about a great deal of contention essentially in the wake of the latest economic downturn. The debate has resulted to the need for government intervention. A case in point is the mounting pressure by the government on the Royal Bank of Scotland’s Board to declare that the chief executive Stephen Hester should get a significant reduction on his bonus. In despite of the mounting pressure ,the board argues that the bonus given to Mr Hester is justified due to his contribution in lowering the risks taken by the bank and also reducing its susceptibility to external shocks . Traditionally the basis for developing a reward system for executives was one that involved alignment of the incentives given to executives with those of the shareholders. However, it has been noted that a lot of changes do exist; currently executive rewards essentially in the financial industry are directly linked to performance. Although there is no adequate evidence to back the fact that the bonus packages offered to executives during the crisis, impacted on the performance of financial institutions, an interesting question that arises after the evaluation of the 2007/2008 financial downturn is the notion of that the reward structures in pre-crisis financial institutions were short termist and encouraged risk taking behavior. This particular paper seeks to evaluate the statement that; the reward Structures in pre-crisis financial institutions were short termist and encouraged risk taking behaviour. The scope of the analysis will be grounded on the evaluation of the statement in relations to what is happening in the financial industry. In addition the paper will provide applicable recommendations for a new and improved reward structure for financial institutions. In evaluating the notion; ‘’ the reward Structures in pre-crisis financial institutions were short termist and encouraged risk taking behaviour,’ it is essential to evaluate the basic reasons why bonuses are paid to executive in the financial industry. Harney (2010) highlights that bonus are paid to executives as a motivation strategy as propagated by the employee motivation theory. This is because they work hard and for long hours as a result there is need for motivation. On an interview with the BBC Stephen Hester, admits that people working the financial service industry deserve good reward packages he states; ‘’Those people are doing a good job. I think they deserve recognition. If they do a good job, it is our task to make sure that there is a connection between the job people are doing and how they get treated" (BBC, 2012). Harney (2010) further highlights that the executives’ perspective is that bonuses improve their performance. In addition people working in the financial industry are well educated and they handle complex financial numbers as a result their abilities should be rewarded through good bonuses. A study conducted by Beer and Katz (2003) to evaluate whether incentives for management works, however proposes that care should be take in the endeavor to design a system for rewarding executives. This is because the contingent approach of designing incentives on the basis of the unit of performance is sometimes misguided, and raises debates. One such debate is raised by Creg et al (2011). According to Creg et al (2011), the typical pay structures for executives in the financial industry before the crisis exposes some sort problematic practices. The reward structure for U.K executives in the pre-financial institutions substantially increased between the years 1994-2006, making the reward structure for executives in the financial industry higher than in other sectors. Creg et al (2011) highlight that following the implementation of a series of reforms in corporate governance throughout the nineties, there were great expectations that the elasticity of pay performance would increase over time, based on the fact that one of the widespread themes of adopting these reforms was to link executive pay to their performance. However according to the study by Creg et al (2011); there is little evidence to prove that there was an upward tendency towards pay-performance sensitivity. The study identified that there was an asymmetric relationship in the elasticity of pay performance, in the sense that the elasticity of pay performance was high when the returns on stock were high, on the other hand the pay was not as much sensitive to performance in the context where returns on stock were low. This therefore resulted to a scenario whereby executives were given a base remuneration that was not related to their performance; in addition the bonuses they received were only average to their performance. Creg et al (2011) highlights that; this sort of one sided risk model develops an asymmetry in the link between pay and performance which further promotes termist and risk taking behavior in financial institutions. There are various incentive structures that influence excessive short termist and risk taking behavior. It has been recognized that tournament incentives and option contracts may promote risk taking. For instance when reward contracts are short term, they may influence myopic quest for short term profits (Eriksen and Ola, 2011). Eriksen and Ola (2011) highlight that there is a widespread notion that incentive structures in financial institutions elicit myopia or narrow framing and risk taking behavior. Eriksen and Ola (2011) therefore undertook a study to investigate the aspect of myopia and risk taking behavior in tournaments or scenarios when executive bonus is high, and their return on investments is frequently evaluated. The study involved adopting the tournament reward approach where subjects are issued rewards on the basis of their performance. The subjects were exposed to nine scenarios in which they could put their investments on risky lottery. The results of the study were quite striking; the findings revealed that the average investments made on risky lottery were much higher in the frequent treatment as opposed to the infrequent treatment. According to Eriksen and Ola (2011) this implies that when the subjects were exposed to a high reward system, they would become prone to taking more risk and more often when their return on investment was evaluated. Eriksen and Ola (2011) explained their findings through the use of mental accounting and the prospect theory, when the subjects are myopic or use narrow framing, then selecting a higher risk is more attractive in the short –term period as opposed to the long term period. Eriksen and Ola (2011) highlight that; the findings of the study can be linked to what happened in financial institutions prior to the financial crisis. Reward structures that were poorly structured (rewards linked to performance that is based on frequent evaluation of the return on investment), encouraged short term quest for profits and risk taking behavior. Executives were frequently rewarded on the grounds of short term profits which further encouraged the get involved in extreme risks that actually paid off in the short run however in the long –run, the organizations experienced huge losses. Eriksen and Ola (2011) highlights that many factors existed that caused the financial crisis however one of the contributory factors was the high bonuses given to executives in the financial industry. As a result great implications were later experienced. For instance as highlighted earlier in the year 2010,the bonuses given to executives by the Royal Bank of Scotland exceeded by £1 million yet in the same year the bank accounted for a 1.1 billion loss (Royal Bank of Scotland website, 2010). The notion that the reward Structures in pre-crisis financial institutions were short termist and encouraged risk taking behaviour is directed to the greater issue of corporate governance. Corporate governance can be described as a system through which organizations are controlled and directed. According to Colley (2000) corporate governance concerns the development of credibility. In addition it also entails enhancing accountability and transparency as well upholding an efficient channel of disclosure that can foster good financial performance and decision making. It’s basically all about sustaining confidence and building trust among the interest groups that exist in the organization. In a scenario whereby the reward structure for executive’s results to the adoption of risky and short termist behavior then it can be argued that good corporate governance does not exit within a particular industry. In addition the agency problem does arise, in the sense that the agents (executives) maximize their own wealth as opposed to maximizing the wealth of the shareholders who have the principle ownership (Anthony and Vijay (2006) .Anthony and Vijay (2006) highlights that the agency problem is one of the most critical problems in the design of control systems. This results due to the fact that human beings are usually naturally inclined to maximizing their own interests. As propagated by the agency theory the agents are usually much more informed than the principles. In this case executives are usually more informed than the stakeholders as a result Coles, et al (2001) argue that without establishing an effective mechanism of monitoring the firm there is an impending risk whereby the management of the firm can maximize their own interests as opposed to the interests of the shareholders. Good corporate governance therefore exists if a firm is properly aligned, whereby the system should be able to satisfy the interests of both parties (the shareholders and executives), in addition good corporate governance should improve both the shorter and long-term performance of the organization. If the interests of one party are maximized excessively at the expense of other stakeholders then the agency problem is bound to occur (Coles, et al 2001). The statement pre-crisis financial institutions were short termist and encouraged risk taking behaviour can also be linked to the moral hazard theory which describes the tendency of a particular individual or group in taking undue risk due to the fact that the costs that are associated to the risk will not be felt by the party taking the risk. Such a tendency may affect the status of the party when transaction takes place. When executives get involved in short termist and risk taking behaviour, their behaviour can be described as that of taking undue risks in order for their performance to be linked to their bonuses. However the costs inquired will be channelled to the shareholders who bare the future burdens caused by short term profits which may result to losses in the long run ( Dembe et al, 2000). In most cases executives usually follow the random walk theory whereby they believe that it is not possible to outperform or function effectively in the market without undertaking additional risk. However critics of the random walk theory highlight that outperforming the market does not necessary require the taking of additional risks but rather there is a possibility of functioning effectively in the market by using care in the selection of exit and entry points for investments in equity (Cheng, 2009,). In addition as propagated by the report by Mr Haldane and Lord May on how to maintain and rebuild the financial system, there is need to adopt systematic diversity, whereby more focus should be given to the regulatory community as opposed to stakeholders within the industry such as executives. Mr Haldane and Lord May propose that the notion that banks have a hidden hand that gives them protection through much action and not regulation should be eliminated (Ghosh, 2011). Although various arguments have been raised to back the notion that the reward Structures in pre-crisis financial institutions were short termist and encouraged risk taking behaviour. Prosser, (2009) seems to disagree with this notion. Prosser, (2009) highlights that prior to the crisis, various approaches were used in order to regulate the bonuses that chief executives received, which further eliminated the practice of short termist and risk taking behaviour. Prosser,(2009) asserts that despite of the fact that the mechanisms of regulating executives pay were frequently very tentative , and that the approaches did not exist within the international level, the methods used to regulate executive pay prior to the crisis are worth taking note of , especially when describing the development of polices that govern financial institutions . Prosser,(2009 ) highlights that the first regulatory approach that was used was the ‘softer ‘ approach. Prosser,(2009 ) defines the softer approach as a mechanism in which policies did not legally regulate the bonus rates for executives but rather other techniques such as salary disclosure and ‘naming and shaming’ for the purpose of encouraging moderation in the bonuses given to executives were used. Some of the regulations that were adopted include in 2002, it was made statutory for organizations to disclose all details of their pay in the annual accounts. Also the company Act was passed in 2006 in the U.K. The act provided shareholders with a non –legally binding right of voting on the pay of directors. The passing of such a regulation gave shareholders teeth to control the bonuses given to executives in financial institutions. Prosser, (2009) further also argues that there is no sufficient evidence that can relate executive bonuses and risk taking. Prosser, (2009) takes a point of reference from a study conducted by Houston and James (1995) in 1995. Houston and James (1995) conducted a study to investigate the relationship between CEO rewards and bank risk through analyzing whether bonuses in the banking industry are structured to encourage risk taking. The findings of the study indicated that, regularly the CEO of a bank gets less rewarding in the form of cash. In addition the CEO is less likely to take part in the stock option plan, they also hold less stock option and they get a lesser percentage of their total compensation in the form of stock and options. Due to these aspects the findings of the study indicated that the hypothesis that reward structures promote risk taking within the banking sector was inconsistent. In the verge of controversy there is however need for devising a new reward structure for the financial industry. A New Improved Reward Structure for Financial Institutions The question of resolving the contention concerning the reward structure for executives, entails developing a prolific reward system that can result in making effective managerial accounting decisions. As highlighted by Hopper et al (2007) there is need for developing strategic managerial accounting. According to Hopper et al (2007) strategic managerial accounting SMA uses both the current and traditional methods of managerial accounting in the understanding and acquisition of financial information, in order develop informed business plans that can facilitate the improvement of the performance of the organization at a strategic level. A good reward system should therefore eliminate short termist and risk taking behaviour in financial institutions. Wim Van der Stede (2008) provides a good example of elements that should exist in a good reward system. One of the elements to put into consideration is the aspect of the strength of the incentive. According to Wim Van der Stede (2008), incentives have always been centered on directing the minds of employees towards what is to be rewarded. As a result there mind set has always been ‘’ what you measure is basically what you get’’. Wim Van der Stede (2008) argues that this particular notion does not work as required at all times. A good incentive structure is one that follows the principle of; what is rewarded and what is measured should be related to what the organization really wants. As a result the measured performance should capture what is required for improvement. Wim Van der Stede (2008) suggests that the strength of the incentive should be reduced, in addition it is essential to address the problem of incomplete measurements and also the incentives should be balanced for the purpose of considering the performance evaluations of the subject. Another element that should be constituted in the new reward structure is the aspect of the incentive type. Wim Van der Stede(2008), proposes that when the performance evaluation of the subjects is used, all or part of the bonus is usually based on subjective judgments concerning the performance. It is therefore essential to have a reward system that allows for rebalancing of incentives. The type of incentive should be designed in a manner that can alleviate myopia and encourage employees to develop long-term focus on what they want and what the organization wants. The incentives should balance their concern for the long-term profitability of the organization and also the short term profitability. For instance as propagated by Sir John Vickers’s report, bonuses should be structured in manner that is grounded on the actual results as opposed to fantasy accounting. In addition they should be transparently and genuinely earned, and thus they should be related to the actual financial status of the bank that is paying them. Consequently, a bank that is recording losses in terms of billions of pounds should not be paying more billions in bonuses (Treanor, 2012). The third essential aspect to be integrated in reward structure is the aspect of the incentive horizon (scope). Wim Van der Stede (2008) highlights that one of the challenges of the reward system was demonstrated by the recent financial downturn whereby incentives were linked to short term performance, especially at the level of top executives. However when it turned out to be apparent that in some situations, the profits that were attained in the short-run were actually not sustainable in the long-run, the bonuses had already been paid. The incentive horizon(scope) should therefore be devised in a manner to ensure that profits are estimated in the long run, as result employees will not only focus on increasing the quarterly, annual and monthly profits , but beyond this levels. For instance the UBS incentive plan may be appropriate. The plan proposes that incentive should stop focusing on the short-term earning but rather on the long-term through rolling forward adjustables on a down or up basis. For example cash payouts will be limited to the executives earned bonuses in any particular year. The remaining two-thirds will be integrated into the executives’ bonuses which will depend on the performance of the coming year. This will reduce the excessive focus of employee on the existing years in despite of the decisions may impact on the coming year (Wim Van der Stede, 2008). Another appropriate example developing an appropriate horizon in the reward structure is through subjecting bonuses to the Keynesian economy whereby the bonus spending of top executives should increase the earning of other people in society. However this can not be fully attained if the bonuses are not lowered. For instance there is no need for Mr. Hester who is working for one of the biggest state owned financial institutions to receive very high bonuses yet other employees in the same sector or even in other sectors, who perform exceptional jobs do not get any sort of bonuses. . As a result as propagated by the Project Merlin bank deal, (2011) the bonuses given to executives such as Stephen Hester should be re-adjusted to lower levels. Conclusion From the above analysis of the statement; the reward Structures in pre-crisis financial institutions were short termist and encouraged risk taking behaviour, what is evident is that the current reward structure in the financial industry is quite controversial. The discussion above has presented facts to back the statement through studies that highlight the correlation between short –termist and risk taking behaviour, which might have influenced the economic crisis, in the long run. However the discussion has also presented the fact that the statement may actually not be viable based on the fact that policies that govern managerial decision making do exist and have existed ever since. As a result the notion that the reward structure contributed to short termist and risk taking behaviour prior to the crisis may be incontinent. The discussion has provided a new reward system that focuses on effective managerial decision making and also effective performance related rewards. References Anthony,R and Vijay , G,2006, Management Control Systems, McGraw-Hill/Irwin Beer, M and Katz, N, 2003, Do Incentives Work? The Perceptions of a Worldwide Sample of Senior Executives, Human Resource Planning, 26, 2003 Cheng, H, 2009, Yesterday’s Heroes: Compensation and Creative Risk-Taking, University of Michigan (Ross) Colley , J, 2005, What Is Corporate Governance? McGraw-Hill Professional. . Cayon, M,J, Fernandes, M, A, Ferreira,P, Matos and Murphy, K,j,2010, The Executives Compensation controversy, A Transatlantic Analysis ,Redraft of Annual FRDB Conference paper. Coles, J, McWilliams, B and N. Sen, 2001. An examination of the relationship of governance mechanisms to performance. 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Wim Van der Stede, 2008, Designing Effective Reward Systems . Read More