Question

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. (Please write between 300-500 words)

Answer 1

When a manager does something in his own interest rather than in the interest of the company and shareholders this is known as agency problm.In the given question manager increases the reported profits to receive a bonus hence the problm here is an agency problem.

To to reduce agency problems activities of the manager should be monitored and compensation should be given in such a way which would combine the interest of the mangers with the company. When bonus is paid on profits this will encourage the manager to increase the profits anyhow which will not be in interest of the company. This can be avoided by different scheme such as bonus on the value of share price.

Efficient market assumes that increase in profits will not effect stock price. Stock price gets effected by the cash flows and not profits. If the profits are increased it will not effect the stock price but in this case since increase in profits will result in the additional bonus the stock price could go down due to additional compensation.