The manager of Golden Ray Corporation receives a bonus if company prof

The manager of Golden Ray Corporation receives a bonus if company profits exceed $1,000,000 this year.

During the final week of the year, the manager changes an accounting policy that will increase reported profits
from $950,000 to $1,025,000, triggering his bonus. The change in profits of $75,000 will reverse itself in the next
year, and the accounting change has no impact on Golden Ray’s cash flow. Discuss the above situation as it
relates to both an agency problem and efficient markets.

ANSWER

An agency problem exists when a manager (agent) acts in his or her own self-interest rather than in the best interests
of the shareholders (principals). In order to reduce agency problems, management activity may be monitored, such as
through audits and performance reviews, and management compensation can be designed to align the interests of the
managers with the interests of the shareholders. A bonus based on profits encourages the manager to focus on profits,
rather than on shareholder value. A better compensation scheme may include direct stock ownership by managers,
stock options for managers, or performance incentives based on the company’s stock price.
Given efficient markets, one would expect the increase in profits to have little effect on the company’s stock price. Stock
values are based on cash flows, not profits, and the stock market is not fooled by an accounting change that artificially
increases short-term profits. In this case, the stock price could go down because the company has to pay higher
compensation to the manager even though the company’s cash flows have not increased.