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Yuen Ting Wong

on 13 May 2013

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Principal-agent problems
could not be solved
Before: Take a little risk
After: Take too much risk
Not the expectations of shareholders Example2: WorldCom Scandal Background 1998 Cause 1998-2002 2002 1998 Executives owned shares as compensation

Big gains due to rapid growth Telecommunication industry in U.S. declined

stock price decreased

huge losses incurred Hiding line cost

Faking accounting entries from corporate
unallocated revenue accounts. Methods to mask declining financial condition Increased net profit Consequences Discovered by internal auditors

Reputation tarnished

Civil penalty of $2.25 billion and went bankruptcy Definition Encourage risk-taking behavior to influence share prices

Adverse long-term consequences for shareholder

Illustrated by research by two professors
(W. Gerard Sanders and Donald C. Hambrick, 2007) Analysis - Disadvantage 2 Manipulate financial statements

Example1: Enron Corporation
Fake information
Recorded assets and profit were inflated
Debts and losses were put into 'offshore' entities
Complicated and secret transactions ACCT 2010, Spring 2013 - L13
Group Project Stock-based and option-based executive compensation Group 8 :
Churk Hang Fai, Vincent
Lau Hiu Wai, Natalie
Wong King Hang, Kelvin
Wong Yuen Ting, Chelffie
Wu Wing Ching, Derek Outline Definition
Introduction of our case
Analysis of both pros & cons
Our stance & conclusion
List of References Introduction of our case Share-Based Compensation:

to align the interests of employees, management and shareholders
Sales Profit Analysis - Advantage 1 Stock appreciation
Save cash
Expense on the income statement but
Require cash
Share the risk with key executives Our Stance Thank you! (by Chirantan Basu, Demand Media) An enormous increase in stock-based and option-based executive compensation.

Align upper management incentives with the interests of shareholders.

Motivates managers to engage in earnings management to inflate current share prices at the expense of long-term firm value Positive average relationship between CEO compensation and firm performance
CEOs are motivated to strive for the stock’s best interest Analysis - Other Advantages Analysis - Disadvantage 1

Boost the incentive of employees
Raise the stock price

. . . however, major advantage is likely to be flawed Stock price ≠ real performance

‘Fixing the Game’ by Roger Martin (2011)

Sales up 22%
Profit up 45%
Stock price only increase 2.9% Analysis - Disadvantage 2 (cont) Option-Based Compensation:

The right to exchange options for share
before expiraion dates Definition (Con't) Analysis - Disadvantage 2 (Con't) Induces them to conceal bad news

Lead to earnings management,
misreporting, and outright fraudulent

Severe overvaluation and a subsequent crash in the stock price Analysis - Disadvantage 1 (Con't) Increase stock option based compensation Harm > Benefit Argument Argument (con't) Increase risk-taking investment Extreme performance Nature of Option-based Executive Compensation Probability of big loss > big gain Market price > Exercise price
Execute the option Exercise price > Market price
Execute the option Argument (con't) Risk is inestimable
Take excessive risk Huge loss
Risk > Benefits
Sustainable development Conclusion Increase executives' working incentive

Stock appreciation

Better performance Engage in earnings
management by manipulating
financial statements

Conceal the company losses
/ expenses Take excessive risks

Do not match with the
long-term development of a company
Save cash

Share risks with executives 一致 Stock price ≠
real performance

Principal-agent problems
are still existed For Against Analysis - Advantage 2 CEO performs good Stock price increases Higher incentive for CEO to work harder Research by Jeffrey Liebman CEO do well in performance apprasial Higher stock compensation CEO will be retained Argument (con't) Background
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