An agency relationship is a contract under which one or more persons (the principal(s)) engage another person (the agent) to perform some service on their behalf which involves delegating some decision making authority to the agent (Jensen and Meckling, 1976). If both parties to the association are utility maximizers and they may have different aims and objectives, it is inevitable that the agent will not always act in the best interests of the principal.
The concept of agency theory originated from the work of Adolf Augustus Berle and Gardiner Coit Means, who were discussing the issues of the agent and principle as early as 1932. Berle and Means explored the concepts of agency and their applications toward the development of large corporations. Michael C. Jensen and William Meckling shaped the work of Berle and Means in the context of the risk-sharing research popular in the 1960s and '70s to develop agency theory as a formal concept. Jensen and Meckling formed a school of thought arguing that corporations are structured to minimize the costs of getting agents to follow the direction and interests of the principals. (Renee O'Farrell, 2010)
The concept of agency theory recognizes there are fundamental differences in how shareholders, managers, and even bondholders interpret their respective relationships to an organization. While they may share some common goals and objectives, there is the potential for at least some objectives to emerge that are focused more on individual enrichment than on the well-being of the whole (Kleiman, 2010). For example, managers may be more focused on building a reputation for themselves, possibly creating their own power bases within the structure of the larger organizations. Shareholders may become more focused on earning dividends now and less on the future of the business. Bondholders may be concerned only with the project associated with the bond issue, and lose sight of how the overall stability of the company can have a negative impact on the return earned from that bond (Kleiman, 2010).
Contribution of agency theory to the development of accounting
Current mainstream accounting research is based extensively on economic models of agency that represent he operating company (firm) managers "agent" and the individual investors "principal". This principal agent model has also been implicitly adopted in the regulation of accountancy, which focuses on the needs and welfare of a diverse group of individual investors who entrust their wealth to the control of manager. (Bricker, Chandar 1998)
Accounting plays an important role as a vital part of the contracts that define a firm. For example, lending arrangements between a firm and its creditors often contain several accounting based covenants. Accounting-based bonus plans are frequently a component of executive compensation plans. Accounting measures are commonly used in the performance evaluation of a firm's cost and profit centers. (Bricker, Chandar 1998)
The concept of Positive Accounting Theory has emerged, in recent years, which is based on the theory of agency. It focuses on the relationships between the various individuals involved in providing resources to an organization and how accounting is used to assist in the functioning of these relationships. While normative theories tend to recommend what should be done. When decision-making authority is delegated, this can lead to some loss of efficiency and consequent costs. For example, if the owner (principal) delegates decision-making authority to a manager (agent) it is possible that the manager may not work as hard as would the owner, given that the manager might not share directly in the results of the organization. Any potential loss of profits brought about by the manager underperforming is considered to be a cost that results from the decision-making delegation within this agency relationship - an agency cost. The agency costs that arise as a result of delegating decision-making authority from the owner to the manager are referred to in Positive Accounting Theory as agency costs of equity. (http://www.download-it.org/free_files/Pages%20from%20Chapter%207%20Positive%20Accounting%20Theory-d0385ad3b7925717c0b72a06b16de4f4.pdf)
Positive Accounting Theory, as developed by Watts and Zimmerman and others, is based on the central economics-based assumption that all individuals' action is driven by self-interest and that individuals will always act in an opportunistic manner to the extent that the actions will increase their wealth. Notions of loyalty, morality and the like are not incorporated in the theory (as they typically are not incorporated in other accounting or economic theories). Given an assumption that self-interest drives all individual actions, Positive Accounting Theory predicts that organizations will seek to put in place mechanisms that align the interests of the managers of the firm (the agents) with the interests of the owners of the firm (the principals). (http://www.download-it.org/free_files/Pages%20from%20Chapter%207%20Positive%20Accounting%20Theory-d0385ad3b7925717c0b72a06b16de4f4.pdf)
Some of these methods of aligning interests will be based on the output of the accounting system (such as providing the manager with a share of the organization's profits). Where such accounting based 'alignment mechanisms' are in place, there will be a need for financial statements to be produced. Managers are predicted to 'bond' themselves to prepare these financial statements. This is costly in itself, and in Positive Accounting Theory would be referred to as a 'bonding cost'. If we assume that managers (agents) will be responsible for preparing the financial statements, then Positive Accounting Theory also would predict that there would be a demand for those statements to be audited or monitored, otherwise agents would, assuming self-interest, try to overstate profits, thereby increasing their absolute share of profits. (http://www.download-it.org/free_files/Pages%20from%20Chapter%207%20Positive%20Accounting%20Theory-d0385ad3b7925717c0b72a06b16de4f4.pdf)
Agency Theory and Corporate Government
Individuals are generally taken to be preoccupied with Generally the basic unit of analysis is taken as the 'individual' who is preoccupied with maximizing or at least satisfying their utility; conceived typically in terms of a trade-off between work and leisure. It is this blend of assumed independence and self-interested drive that creates the problems within agency relationships. (J Roberts, 2004)
Applying this concept to corporate governance, in consequence of the separation of ownership and control, it is the shareholder who is taken as the 'principal' and the problem is how the principal can make sure that his 'agents' - company directors - work for the fulfillment of shareholders interests rather than their own. The remedies to this conception of the agency problem within corporate governance involves the acceptance of certain 'agency costs' involved either in creating incentives/sanctions that will align executive self interest with the interests of shareholders, or incurred in monitoring executive conduct in order to constrain their opportunism. (J Roberts, 2004)
As these assumptions have been read onto corporate governance, and informed its reform in recent decades, they have resulted in what are now an almost universal set of techniques and practices designed to control the conduct of executives both within the corporation and externally (Walsh and Seward 1990). Inside the company, boards have essentially two means to exercise control over executives; they can fire them and they can give them incentives - share options, long-term incentive plans. For these levers to work, however, boards must be populated with 'independent' non-executives who are willing and able to monitor executive performance, particularly where there are potential conflicts of interest. The growth and development of both the number of non-executives on boards as well as the increased specification of their role and conditions of 'independence has characterized board reform around the world. The separation of the role of chief executive from that of the non-executive chairman has been part of this; in the language of Cadbury it is intended that this ensures that no one individual has 'unfettered' powers of decision. The creation of audit, remuneration, and nominations committees all staffed by independent non-executives, is also common and ideally ensures both the proper use of incentives and a high degree of monitoring of executive performance and decision-making. To these internal controls are added a range of external controls. Foremost here has been the focus on enhanced 'disclosure', and the 'transparency' that this allows, principally of financial performance but recently also of social and environmental performance (Dissanike 1999, Zadek 2001). The intention is that the share market is thereby better informed such that all relevant information is impacted into the share-price (Fama 1980, Barker 1998). There is also a market for corporate control (Cosh et al 1989, Robert 2004) that ideally allows for weak management teams to be displaced by strong teams that will run companies to better effect for shareholders. In recent years at least at a policy level there has also been concern that shareholders - in the form of the large institutional investors - taking on their responsibilities as owners (Myners, ISC 2002, Simpson and Charkham, Robert 2004) through exercising proper scrutiny and influence both publicly and through their private contacts with investors (Roberts et al 2003, Robert 2004).
Dealing with Agency Problems - Reward schemes
There are two polar positions for dealing with shareholder-manager agency conflicts. At one extreme, the firm's managers are compensated entirely on the basis of stock price changes. In this case, agency costs will be low because managers have great incentives to maximize shareholder wealth (Eugene and Jensen, 1985). It would be extremely difficult, however, to hire talented managers under these contractual terms because the firm's earnings would be affected by economic events that are not under managerial control. At the other extreme, stockholders could monitor every managerial action, but this would be extremely costly and inefficient. The optimal solution lies between the extremes, where executive compensation is tied to performance, but some monitoring is also undertaken. In addition to monitoring, the following mechanisms encourage managers to act in shareholders' interests:
performance-based incentive plans
direct intervention by shareholders
the threat of firing
the threat of takeover
Most publicly traded firms now employ performance shares, which are shares of stock given to executives on the basis of performances as defined by financial measures such as earnings per share, return on assets, return on equity, and stock price changes. If corporate performance is above the performance targets, the firm's managers earn more shares. If performance is below the target, however, they receive less than 100 percent of the shares. Incentive-based compensation plans, such as performance shares, are designed to satisfy two objectives. First, they offer executives incentives to take actions that will enhance shareholder wealth. Second, these plans help companies attract and retain managers who have the confidence to risk their financial future on their own abilities-which should lead to better performance wealth (Eugene and Jensen, 1985).
An increasing percentage of common stock in corporate America is owned by institutional investors such as insurance companies, pension funds, and mutual funds (Kleiman, 2010). The institutional money managers have the clout, if they choose, to exert considerable influence over a firm's operations. Institutional investors can influence a firm's managers in two primary ways. First, they can meet with a firm's management and offer suggestions regarding the firm's operations. Second, institutional shareholders can sponsor a proposal to be voted on at the annual stockholders' meeting, even if the proposal is opposed by management. Although such shareholder-sponsored proposals are nonbinding and involve issues outside day-to-day operations, the results of these votes clearly influence management opinion.
In the past, the likelihood of a large company's management being ousted by its stockholders was so remote that it posed little threat. This was true because the ownership of most firms was so widely distributed, and management's control over the voting mechanism so strong, that it was almost impossible for dissident stockholders to obtain the necessary votes required to remove the managers (Kleiman, 2010). In recent years, however, the chief executive officers at American Express Co., General Motors Corp., IBM, and Kmart have all resigned in the midst of institutional opposition and speculation that their departures were associated with their companies' poor operating performance.
Hostile takeovers, which occur when management does not wish to sell the firm, are most likely to develop when a firm's stock is undervalued relative to its potential because of inadequate management (Chen et al, 2006). In a hostile takeover, the senior managers of the acquired firm are typically dismissed, and those who are retained lose the independence they had prior to the acquisition. The threat of a hostile takeover disciplines managerial behavior and induces managers to attempt to maximize shareholder value (Kleiman, 2010).
In the best case scenario, agency cost is managed in such a way that the interests of all parties is protected, and the organization is able to thrive as a result (Tatum, 2010). Even if the various types of costs or expenses involved are identified, if the actions pursued to create a balanced divergence of control are not effective, the organization is highly likely to suffer, sometimes to the point of complete failure. When this occurs, the collective and personal goals and objectives of managers, shareholders, and bondholders are all undermined to some extent, resulting in losses for everyone concerned (Tatum, 2010).