Compensation and Motivation of Management Based on Accounting Theory Research Paper

Introduction

Compensation has conventionally been associated with an exacting job description. The broad spectrum scheme is that the more responsibility the manager has performed the more compensation he would earn. Often the jobs are interrelated by a job evaluation method that measures the variables such as the figure of subordinates, level of organizational hierarchy, and the complication and significance of the job function. In this conventional approach the senior organizational executives have a propensity to be paid very higher. Motivation is a psychological feature that uplifts a person’s extent of commitment. It takes account of the aspects like reason, conduit, and sustainable performance in a fastidious committed direction. Motivating is the course of action of the management to influencing people’s performance pedestal on this knowledge and experience.

Motivation compatible with the objective of the company should produce better performance. Measurement of performance should indicate the range of compensation. There is a long been conflict between compensation and motivation. The fundamental conflict is the interests of investors in opposition to the interests of managers. Others conflicts are among the manager and Manager, manager and lender, manager and government. To overcome these conflicts, the managers would essentially act in accordance with accounting standards that are designed to afford the most constructive information for investors as well as to minimize the conflict between employees and management. Game theory and agency theory is the tools that suggest impending conflicts resolution and recommend choosing appropriate accounting policies with the concerns of investors as well as management.

Understanding the Game Theory

Oligopolies’ performance has the uniqueness of certain games of strategies like the bridge, chess, and poker. The most excellent way to play such games depends on the understanding of the opponent‘s strategy. Players must model their actions in accordance with the proceedings and the predictable reactions of rivals. Game theory entails the study of how people conduct themselves in a strategic situation. In other words, game theory investigates the way two or more players chosen strategies those are jointly affect each other. A Hungarian mathematical mastermind Neumann, J. V. (1903 – 1957) has developed this theory and is widely used by economists, union-management disputes, country’s trade policies, global environmental concord, reputations, as well as conflict resolution. It offers on way for policies, welfare, and everyday life as well. Thus, for compensation and motivation purposes the theory has a most important implication. To understand it would be needed to move for the further analysis of accounting theory.

Compensation setting under game theory

Let’s begin by analyzing the dynamics of compensation settings. It has been assumed that there are two managers named as Manager-A and Manager-B and both are working a managers of the UK producing athletic shoes.

Here, the vertical rust arrows show Manager-A’s compensation cuts; the horizontal rust arrows show Manager-B’s matching each price cut. By tracing through the pattern of reaction and counter-reaction, it would be seen that this kind of rivalry will end in mutual ruin at 0 compensation. Why? Because the only compensation compatible with both satisfies is compensation of 0 to 90%. Finally, it dawns on the two managers when one manager increases managers its compensation, the other manager would match the compensation rise. Only if the managers are shortsighted will they think that they can undercut each other for long. So, they will think that- ‘What will my rival do if I cut my compensation or raise my compensation?

Alternative Strategies

The new elements of game theory are analyzing not only the individual actions but also the interaction between a manager’s goals and moves of the competitors. But while trying to get the better of the opponent, it should be kept in mind that the opponent is trying to outwit him. The principle viewpoint of the game theory is to pick one’s strategy by asking what makes the most sense for his assuming that his opponents are investigating his strategy and doing what is best for them. Note that the two managers have the highest joint compensation in outcome A, each manager earns £12 when both follow a standard or high compensation strategy. At the other extreme in the compensation war, each cuts its compensation and runs a big loss. The game theory produces those interesting strategies where only one manager would be engaged in the compensation war.

In outcome C, for example, manager-A follows a high price strategy while manager-B takes most of the market share but losses a great deal of money because it is selling underneath costs, manager-A is better off selling at a normal price rather than responding. So, here manager-B’s low compensation acquires £15 million while manager- A would earn only £ 6 million.

Several strategies used in Game Theory

• Dominant Strategy: – In considering possible strategies, the simplest case is the dominant strategy. This situation arises when one player has a single best strategy no matter what strategy the other player follows. If manager-A conducts business as usual with a high price, manager-B will get £6 million of profit if it plays the high compensation and would lose £15 and it declares economic war. On the other hand, if manager-A starts a war, Starship will lose £6 if it follows a high performance but will lose even more if it also engages in economic warfare. We can see that the same reasoning holds for Manager-A. Therefore, no matter what strategy the manager follows, each manager’s best strategy is to have a high price. Charging the high compensation is a dominant strategy for both managers in this particular price war game and here cell A is the dominant equilibrium as it arises from a situation where both managers are playing their dominant strategies.
• Nash equilibrium: – When we call the rivalry game, each manager considers whether to charge its high price or to raise its price toward the monopoly price and try to earn monopoly profit. The managers can raise their prices in the hopes of earning monopoly profits. The other situation considering the reactions of opposition is described in cells B and C. So, Nash equilibrium is a solution in which no player can improve his or her payoff given the other player’s strategy. This concept has been named after mathematician John Nash. It is also sometimes called the non-cooperative equilibrium because each party chooses the strategy which is best for itself- without collusion or cooperation and regard for the welfare of the society or any other party.

Important issues of Game Theory

Regarding the accounting professionals’ viewpoint, the game theory has a great value for the specific industry that is specially characterized as an example of an oligopoly situation. So, before starting the discussion, it needs to have a specific idea of oligopoly competition. In terms of competitiveness, the spectrum of market structures reaches from pure competition to monopolistic competition, to oligopoly to pure monopoly among them oligopoly market is dominated by a few large producers of a homogeneous or differentiated product. Because of their fewness, oligopolies have considerable control over their prices, but each must consider the possible reaction of rivals to its pricing, output, and advertising decision.

• To collude or not to collude: – One of the important lessons regarding game theory is that the non-co-operative equilibrium can be inefficient for the players. Thus the Nash equilibrium in cell D brings in less total profit for the duopolies than any of the other outcomes. The best joint situation is A, in which each duopolistic are charging a higher price and earning a joint profit of 24 million. The worst is the non-cooperative equilibrium with total profits of 16 million.

Consider the co-operative equilibrium which occurs when the players act in union and set strategies that will maximize their joint payoffs. They may decide to form a cartel, setting a high price and dividing all profits equally between the managers. Clearly, this will help the duopolies at the expense of the consumers. But curtails and collusion in restraint of trade are illegal in most market economics, the highest hurdle is self-interest. Say, that the prices have been collusively set in cell A, then Starship secretly decides to sell a little output at a lower price, in effect moving to cell C. Starship might be able to do this undetected for a while. The same situation is applicable for Manager-A also. We can also apply this reasoning in perfectly competitive equilibrium as here each manager maximizes the profit and each consumer maximizes utility, leading to a 0 profit outcome in which price equals marginal costs. So, even each person is behaving in a non-cooperative manner, the economic outcome is socially efficient. Moreover, the competitive equilibrium is a Nash Equilibrium in the sense that no individual would be better off by changing strategies as long as all other individuals continue with their strategies.

In the perfectly competitive world, non-cooperative behavior produces the socially desirable state of economic efficiency. By contrast, if some prices (such as the duopolies in the given example) co-operated and decide to move to the monopoly price in cell A, the efficiency of the economy would suffer. This suggests why governments want to enforce antitrust laws that contain harsh penalties for those who collude to fix prices or divide up the markets.

• The prisoner’s dilemma: – By an almost miraculous coincidence of economic life, Adam Smith’s hand produces in perfectly competitive markets an efficient allocation of resources. But the beneficial outcome of the invisible hand does not arise in all circumstances. This is illustrated in the prisoner’s dilemma.

Here, it refers to prisoners Molly and Knuckles, who are partners in crime. The district attorney interviews each separately, mentioning that he had enough on both of them to send to the. But he would like to make a deal with him. If she alone confesses, she will get off with only a three months sentence, while her partner will be produced for 10 years. If they both confess, both of them get five years of convictions.

Suppose, Molly does not confess, and unbeknownst to her, Knuckles does confess. Molly stands to get 10 years. It is better in this situation for Molly to confess and get 5 years rather than 10 years. Similarly, Knuckles is in the same dilemma. The significant result here is that when both prisoners act selfishly by confessing, they both end up with long prison terms. Only when they both act collusively or altruistically will they end up with a short prison term.

• The pollution game: – An important example, similar to the prisoner’s dilemma, is the pollution game shown in the diagram.

Significant to the accounting profession

According to the instructions, to explain the most important terms of managerial accounting like capital structure, dividend, acquisition, maximizing some of the managers maximizing some professional’s decisions of several listed companies, it needed to have a clear concept about Agency Theory or Agency Relationships.

Managers are empowered by the owners of the manager-the shareholders-to make decisions, and that creates a potential conflict of interest known as agency theory. So, an agency relationship arises whenever one or more individuals, called principals, hire another individual organization, called an agent, to perform some service, and delegate decisions making authority to that agent. That means it is the theory between the shareholders and the company managers. This term includes the expense of solving the potential conflicts between the two relevant groups. According to this theory, because of incomplete information and uncertainty, two types of problems can arise. Such as-

• By Adverse selection: Refers to the condition that is not certain regarding the principal while the agent perfectly represents his capacity of doing the task for which the payment is made.
• Moral Hazard: Refers to the condition under which the principal is not sure in case of putting the maximum level of effort by the agent.

How Agency Theory relates to accounting

In managerial accounting, the primary agency relationships are those between:

• Stockholders versus Managers:

A potential agency problem arises whenever the manager of manager owns less than 100% of the manager’s common stocks. However, if the owner-manager incorporates and then sells some of the stocks to the outsiders, a potential conflict of interests immediately arises. In most large listed companies, potential conflicts of interests are important, as those manager’s managers generally own only a small percentage of the stocks. In this situation, shareholder wealth maximization could take a back seat to any number of conflicting managerial goals.

Some specific mechanisms used to motivate managers to act in shareholder’s best interests include-

• Managerial compensation.
• Direct intervention by shareholders.
• The threat of firing.
• The threat of take-over.

Stockholders versus Creditors

In addition to the conflict between stockholders and managers, there can also be conflicts between creditors and stockholders. Creditors have a claim on the part of the manager’s earning stream of payment of interest and principal on the debt, and they have a claim on the manager’s assets in the event of bankruptcy. Stockholders have control of decisions that affect the profitability and risk of the manager. Creditors lend the manager based on maximizing some:

• The risk of the manager’s existing assets.
• Expectations concerning the risk of future assets additions.
• The manager’s existing capital structure (that is the amount of debt financing used).
• Expectations concerning future capital structure decisions.

These are the primary determinants of the risk of a manager’s cash flows, hence the safety of its debt issues.

After focusing on the nooks and corners of agency theory, now we can focus on major aspects of financial decisions logistics. That is:

Capital Structure: A manager’s capital structure is that mix of debt and equity that maximizes the stock price. At any point in time, management has a specific target capital structure. Capital structure policy involves a trade-off between risk and returns:

• Using more debt raises the risk born by stockholders.
• Using more debt generally leads to a higher expected rate of return on equity.

Four primary factors influence capital structure decisions:

• The business risk or the risk inherent in the manager’s operations if it used to debt. The greater the manager’s business risk, the lower its optimal debt ratio.
• The manager’s tax position which is a major reason for using debt is that interest is tax-deductible, which lowers the effective cost of debt.
• Financial flexibility or the ability to raise capital on reasonable terms under adverse conditions. The greater the probable future need for capital, and the worse the consequences of the capital shortage, the stronger the balance sheet should be.
• Managerial conservatism or aggressiveness refers to profit-maximizingsome managers are more aggressive than others, hence some managers are more inclined to use debt to boost profits. This factor does not affect the true optimal, or value-maximizing, capital structure, but it does influence the manager-determined target capital structure.

Consider an economy with externalities such as pollution. In a world of unregulated managers, each profit maximizing manager would prefer to pollute rather than install expensive pollution-control equipment. Moreover which behaves altruistically and cleans up its wastes will have higher production costs, higher prices,of the and fewer customers. The pressure of Darwinian competition will drive all managers to starred Nash Equilibrium in cell D. Here neither manager can improve its profits by lowering pollution. When the Nash Equilibrium is insignificant, governments may step in. By setting efficient regulations, or by establishing efficient property rights, government can induce managers to move to outcome A, the “low pollute”, “low pollute” world.

The game theory can also put it to somebody why foreign antagonism can lead to greater price competition. Whereas the foreign managers may decline to play the game, they possibly will not agree with the rules, so they must price cut policy to gain market share and thus collusion may break down. A key feature in lots of games is that the attempt of players to build trustworthiness. Anyone would be credible if he has expected to keep his promises and carry out his threats. Credibility is required to be dependable with the incentives of the game. Business constructs credible promises through writing contracts that impose penalties if they do not carry out as promised.

Conclusion

The idea of game theory and agency theory has been extremely functional in serving economists as well as other social scientists thinking about circumstances where small numbers of inhabitants are well known and try to outwit each other. Thus scrutinizing the different issues concerning game theory, it could comprehend that this theory can be incessantly used in corporate investment appraisal in the aggressive product market effectively but while implementing such perception, a company should be ready to act about the responsive points of accounting theories.

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