Evaluate the consequence of earnings management

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This assignment is a hypothetical case. You play a role as a CPA currently working as a consultant specialized in compensation and internal control.

Metflex Inc. is an internet-based media streaming company, listed on Nasdaq. Under the leadership of Mr. Bernard Roy, founder and CEO, Metflex's business operation has been growing substantially in the past several years. Recently, Mr. Roy stepped down for health reasons, and Metflex decided to hire Mr. Michel Fortin (a 60-year old industry veteran who has an extensive social network) as the new CEO.

During the contract negotiation, Ms. Geneviève Tremblay, the chairwoman of Metflex's Board of Directors approached you for professional advices. She provided you with the parameters of the new compensation contract under negotiation:

a. Salary: $1,000,000 / year;?b. Bonus: $1,500,000 / year;?c. Stock Options: $3,500,000 / year, with a vesting period of 7 years (i.e., the CEO is able to execute the options on the 7thanniversary after the option is granted).

Furthermore, Ms. Tremblay added the following details:?a. Metflex currently has a pool of three peer firms for Relative Performance Evaluation when deciding CEO's bonus. Mr. Fortin wanted to add two additional firms chosen by him.?b. In addition to earnings per share, Mr. Fortin wanted to also include the number of subscribers as an additional performance measure for bonus. Mr. Fortin argued that, under his helm, Metflex would invest heavily in new research and development, which will have a negative impact on the bottom line earnings figure.?c. Mr. Fortin wanted the stock options to be granted on the 15thday following the annual earnings announcement.?d. Metflex believes a $6 million compensation package is generous enough to attract Mr. Fortin, but wants to fine tune the compensation parameters, especially in light of Mr. Fortin's proposed changes, so as to better align Mr. Fortin's interest with the company's. Metflex is not considering other compensation methods (e.g., restricted stocks).

Requirement:

Respond to Ms. Tremblay. Note: In your response, justify your opinions. The assignment primarily concerns class materials covered in Weeks 7 - 9; however, you could also refer to concepts learned in Weeks 1 - 6 when applicable. You should acknowledge any potential disadvantages and problems associated with your proposals; you should also discuss possible ways to mitigate these problems-i.e., making the compensation more effective, especially from the financial reporting perspective. As always, intuitive and reasonable proposals will make your assignment stand out.

Agency Theory and Conflict of Interest

1. Understand the necessity of incentive contracts.

2. Comprehend the intuition to use different compensation components. Assess the role of risk in executive compensation.

3. Comprehend the intuition to use a mix of performance measures in evaluating executives' performance.

4. Evaluate implications of financial reporting in executive compensation.

5. Recognize alternative theories of executive compensation.

1. Comprehend managers' incentives in managing earnings.

2. Understand common practice of earnings management.

3. Evaluate the consequence of earnings management.

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Reference no: EM13872237

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