Accounting Theory and Contemporary Issues

This document discusses the horizon problem and risk aversion in accounting theory and contemporary issues. It explores how performance bonuses linked to shareholder return can mitigate these problems. It also emphasizes the importance of linking performance to a range of factors rather than a single factor.

Accounting Theory and Contemporary Issues
Answer 1
Horizon problem refers to the problem of time period where in a manager of the company who is
expected to stay for a smaller tenue shall focus on small time period and shall not consider the interest
of the company post that period. However, the owner of the company is expected to stay till closure or
winding up. Thus, the difference in time period of interest relation between the owners and the
management gives birth to horizon problem. (Accounting Essays, 2019)
Risk Aversion: This problem is created on account of risk and return relationship. It is a general
perception among the owner of the company that with higher risk they shall be paid higher return.
However, such perception does not exist among the management, they general believe in taking lower
risk and ensure steady source of income because it is management key source of income. Thus,
generally managers prefers lower risk project while owners prefers higher risk project for better
returns.
Answer 2
Linking performance bonuses to range of factors encompassing total shareholder return helps to
mitigate the risk of risk aversion and horizon problem in the following manner:
Since the compensation is linked to the return of the shareholders, the higher the returns to
shareholders the higher the pay shall be for management. Thus, managers shall be instigated to take
risky project for better return. Thus, risk aversion issue shall be resolved.
Further, horizon problem is solves in a manner that such composition of payment is not of short term
nature and shall take long time to earn a handsome bonus. Further, it shall motivate to think from long
term perspective rather than short term.
Answer 3
It is important to link the performance with a range of factors rather than single range of factor has
been detailed here-in-below:
(A) Single factor growth of business: For instance if bonus is linked to revenue growth than only
revenue shall be focussed irrespective of growth of other critical factors of business like net
profit, gross profit etc.
(B) Holistic growth of business; When more factors are considered, it mandates management to look
form a wider perspective and ensure wholesome growth of the company and business;
(C) Manipulative: It is easy to manipulate a single factor rather than range of factors. Thus, linking to
range of factors shall ensure proper payment policy.
Answer 4
The management shall agree to the new pension scheme where in the compensation scheme shall
depend on range of factors encompassing from free cash flow to total growth as it ensures
maximisation of wealth for the family as better returns of the company shall ensure increase funds.
Further, management shall work more to enhance the wealth of company which in turn shall benefit
the employees whose pay is linked to the overall growth of the company. Further, agency theory
conflict shall be resolved as pay is linked to growth and remove the major bias associated. (Agency
theory and performance appraisal:, 2019)

References:
Accounting Essays. (2019, April 14). Retrieved from accounting-essays.blogspot.com:
http://accounting-essays.blogspot.com/2011/07/what-is-agency-theory-and-what-are.htmlAgency theory and performance appraisal:. (2019, April 14). Retrieved from sro.sussex.ac.uk:
http://sro.sussex.ac.uk/id/eprint/68312/1/FINAL.pdf