Performance Management and Executive Compensation Essay

Introduction In the history of modern economies, from the late 1800s to today businesses have faced ethical challenges regarding compensation for executives and its relation to job performance. In response to major economic crises during the 20th century, the United States enacted broad-based legislation measures as attempts to prevent what were seen as ethical challenges and agency conflicts surrounding both performance management and executive compensation. To understand the current issues facing businesses and regulators, it is important to look at three of most significant legislative acts Congress has passed. The Securities Exchange Acts of 1933 and 1934, as well as the Sarbanes–Oxley Act of 2002 represent legislative interventions regarding corporate financial accounting toward the goal of curtailing the ethical challenges and the conflict of agency problems that can arise from performance management and executive compensation. Yet even after these laws were enacted, ethical conflicts can and still do arise when it comes to the compensation for employers and executives. Securities Act of 1933 The Securities Act of 1933 was born in response to the stock market crash of 1929. Just as it was then, companies who issue securities to raise money for funding new investments or to expand operations have an inherent incentive to present their company and its plans in the rosiest light possible to investors (Sarkar, 2013). The Securities Act of 1933 serves the dual purpose of ensuring that issuers of securities to the public disclose material information to investors as well as ensuring that any securities transactions are not based on fraudulent information or practices (Sarkar, 2013). The Securities Act of 1933 affects public disclosures through a mandatory registration process for sellers and brokers and applies to the sale or trade of any regulated security type (Sarkar, 2013). Securities Act of 1934 (a.k.a. the Exchange Act) The Exchange Act primarily regulates transactions of securities that take place after its initial offering by a company (Sarkar, 2013). These transactions often take place between parties other than the issuer, such as through trades that retail investors execute via brokerage firms (Sarkar, 2013). The biggest effect of The Exchange Act was the creation of the Securities and Exchange Commission (SEC), a federal agency responsible for regulating the securities markets (Sarkar, 2013). Since 1934, the SEC has taken on the role of mitigating fraud, abuse, and other ethical issues in the financial reporting of publicly traded entities. Sarbanes-Oxley Act of 2002 The Sarbanes-Oxley (SOX) Act of 2002 was the most significant legislation passed since the 1930s and came in the aftermath of the corporate scandals at companies such as Enron, WorldCom, and Arthur Andersen (Amadeo, 2013). Sarbanes-Oxley created the Public Company Accounting Oversight Board (PCAOB), a new organization whose purpose is to help oversee the accounting industry (Amadeo, 2013). To prevent the sort of conflicts of interest that had led to the Enron fraud, SOX established new prohibitions for auditors when engaging in consultation work for their auditing clients. It also banned company loans to executives and gave increased job protections to whistleblowers (Amadeo, 2013). Performance Management and Executive Compensation Even after the passing of the Securities and Exchanges Acts of 1933 and 1934 and the Sarbanes-Oxley Act of 2002, there are reasons to be concerned about ethical violations in financial accounting. Two areas where there still exist possibilities for unethical activity which could harm the supply of reliable information to investors are the performance management within a company and the compensation packages of executives. Current Ethical Challenges When evaluating situations to support ethical decision-making, one must first identify the ethical problems as they arise (Eldenburg, 2005). Performance measurements are most often measured in terms of time or financial figures – â€Å"how long† or â€Å"how much.† When selecting a new CEO, the board of directors is required to offer a financial package that is both lucrative enough to attract the most qualified individual and yet also appears fair to other ranking executives of the company. Such financial packages need to be approved by the major shareholders when the salary will impact the company’s financial reports. During an economic recession, firms may significantly downsize their workforce as well as benefits and labor rates employees receive, yet often find themselves contractually obligated to hand-out large bonuses and increasing salaries for their executives. This is potentially a major ethical issue for a company and its executives, with the fibers of the company being reduced while executives are earning more and more – even though the firm is struggling. â€Å"CEOs at the country’s 200 largest companies earned an average of 20 percent more last year than in 2009, according to recent corporate filings. By comparison, average pay for workers in the private sector rose just 2.1 percent last year—nearly the smallest increase in decades† (Harkinson, 2011). It is also not unheard of for CEOs to be forced to step down while still receiving their lucrative compensation packages only to also be given a generous â€Å"golden parachute† as they leave. Excesses like this can have detrimental effects on employee morale as the majority of the company often consists of those earning the least. Boards of directors should take into consideration the financial standing of the firm before they offer an over-the-top compensation package to a CEO. As an illustration of the contrary, Steve Jobs volunteered to work at Apple for a salary of only $1 per year: â€Å"A regulatory filing shows Apple CEO Steve Jobs’ compensation package remained the usual $1 in fiscal 2010†¦ as is customary, Jobs got no bonus or perk† (â€Å"Steve Jobs,† n.d.). In terms of ethical challenges and executive compensation, Jobs proved by his example that it is possible to put the company first – even if that meant earning a salary of $1. CEOs do not often have to settle for such low salaries to show leadership and camaraderie; however, accepting less exorbitant amounts can help avoid accusations of greed and impropriety altogether. Current Agency Issues â€Å"Principals hire agents to make decisions for them and to act in their behalf† (Eldenburg, & Wolcott, 2005, pp. 591). Often, agents may go on to hire agents of their own, delegating authority and establishing sub-units known as responsibility centers which can decentralize decision-making and accountability. A particularly special case of the principal-agent relationship involves the executives of companies who are effectively agents of the shareholders selected to run the company. â€Å"Four common types of responsibility centers are cost centers, revenue centers, profit centers, and investment centers.† (Eldenburg & Wolcott, 2005, pp. 595) Those agents who possess decision-making authority over a responsibility center use demographic financial data provided by the accountants for budgets and reviews of sales, profits/losses, value appraisals, and costs. Accountant and audit provided information is used to evaluate and measure performance, monitor the effectiveness of managers, reward performance, and influence decisions. (Eldenburg & Wolcot, 2005) The audit information accountants prepare and present is vital to the principal/agent relationship and performance measurement, but also has its costs. The primary challenge presented by the principal/agent relationship concerns the high level of pressure to perform that an agent can experience in the form of the agent’s compensation. Money, as well as other forms of compensation such as bonuses and stock options, increased authority, and ownership expectations are direct motivators of challenges to the ethical foundation of agent performance. When principals evaluate the performance of agents, their decisions are likely to be based on the same accounting information their agents also used. This common use provides a potential incentive for an agent to alter, falsify, or otherwise misrepresent certain data that principals receive. As decision-making authority is granted from a principle to an agent, the agent’s performance is evaluated to some degree from each authority level. Evaluating the effectiveness of the decisions made in each agency level or responsibility center is the core of measuring, monitoring, and motivating performance. Poor performance leads to a loss of decision-making authority, responsibilities, compensation, and other benefits within the entire principal-agent structure. Conversely, outstanding performance has the opposite effect and benefits everyone up the principal-agent ladder. Conclusion The Securities Exchange Acts of 1933 and 1934 are essential because of their transparency as spelled out in their objectives, and for providing prospective investors detailed information about investment decisions. Their main purpose was to protect shareholders from misrepresentation and scam in the selling of security. The Acts mandated that securities sold to the public within the United States of America must be listed with the Securities and Exchange Commission. Later, the Sarbanes-Oxley Act of 2002 (SOX) was established to make sure that CFOs and CEOs authenticate and approve the financial reporting of their companies. Despite these monumental pieces of regulation, which resulted in the creation of two separate oversight agencies, there are still situations susceptible to ethical challenges and agency issues; particularly concerning performance management and executive compensation. References Amadeo, K; 2013. Sarbanes-Oxley Act of 2002. Retrieved from http://useconomy.about.com/od/themarkets/p/sarbanes-oxley.htm Eldenburg, L. & Wolcott, S. (2005). Cost management: Measuring, monitoring, and motivating performance, (1st ed). Hoboken, NJ: John Wiley & Sons. Harkinson, J. (2011). America’s 10 Most Overpaid CEOs. Retrieved from http://www.motherjones.com/politics/2011/04/10-most-ridiculously-overpaid-ceos McConnell, C., & Brue, S. (2005). Economics: principles, problems and policies (16th ed.). New York: McGraw-Hill. Sarkar, D; 2013. Securities Act. Retrieved from http://www.law.cornell.edu/wex/securities_act_of_1933 Steve Jobs again earned $1 for work. (n.d.). Retrieved from http://www.timesleader.com/stories/Steve-Jobs-again-earned-1-for-work-at-A,115771