Essay: The Theory of Executive Compensation

Sample Essay

The theory of executive compensation explains the relationship between performance and compensation packages of executives. The first view related to the theory stresses that executives should be paid according to peer averages rather than performance whereas the other view argues that executive compensation packages should be based on performance (Dorff 2006). The view related to this theory in the article is that executives should be paid based on long term performance as chief executives tend to manipulate quarterly and yearly earnings by either understating losses or overstating profits.

The agency theory of accounting describes the role of managers acting as agents on behalf of shareholders in making decisions regarding application of capital. The theory explains how principals who are the owners or shareholders of the company trust agents who are the managers or executives in an organisation to invest capital wisely (Chapman, Hopwood and Shields 2007). The article outlines this phenomenon of capital employment by executives based on their own benefits rather than seeking value maximisation for shareholders. Executives make quite risky decisions in order to achieve inflated short term earnings which eventually result in higher compensation.

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