Agency Theory

1 Agency Theory and Corporate Governance Introduction As corporations continue to grow in size and complexity, it becomes necessary for them to seek external sources of capital by incorporating shareholders into their ownership.

Shareholders have the capital required by the firm, but may not necessarily have the time or expertise to engage in the management of the company actively. As such, the shareholders (principal) enter into a contract with a CEO and manager (agents) to manage the company's resources and its operations on their behalf. This is referred to as the agency relationship.

The agency theory describes the relationship among the various stakeholders of a firm and examines the duties and conflicts of interests of the parties in the agency relationship. The principal hires the agent to run the firm on their behalf for three main reasons; firstly, they may lack the technical expertise and knowledge to run the firm; secondly, they may be too many to run the firm and therefore need to appoint someone to run it on their behalf and thirdly, they may not be present to run the firm for themselves.

Buy this excellently written paper or order a fresh one from ace-myhomework.com

2

The principal provides the capital while the agents utilize these resources in a manner that is consistent with the interests of the principal; this is referred to as stewardship accounting. The relationship between the agent and principal is based on trust and the assumption that the agent will act in the principal’s interest (Jerzemowska, 2006). An agent is expected to fulfill certain duties to the principal, these include; a duty to maximize the principal's wealth, a duty to relay accurate and timely information, a duty to act as per the contractual agreement and a duty of loyalty to the principal. In agency theory, a moral hazard occurs where the agents engage in hidden action due to the loophole caused by information asymmetry. Examples of moral hazard in a corporation include distorting financial statements to give a false picture of the firm's financial position, and managers' absconding their duties to run their private businesses.

Issues in Agency Theory The conflicts between shareholders and managers arise from the fact that each party has different motivators. Shareholders seek to maximize their wealth and return on investment, whereas managers are looking to maximize their income, increase revenues and gain recognition. Managers tend to act in a manner that harms shareholders’ value since they are inclined to develop short-term strategies, such as incurring heavy debt to finance rapid expansion plans, as opposed to medium and long term strategies which would yield more benefit to the corporation. To reduce this conflict, there should be a compromise between the satisfaction of shareholders’ and managers’ interests (Aluchna, & Idowu, 2017). Corporate governance attempts to introduce mechanisms to ensure that the interests of the principal and agents are aligned to facilitate the well-being of the organization. In the process of

3 implementing corporate governance techniques, various agency costs are incurred such as the cost of monitoring and auditing the firm’s financial activities and the agent’s bonding costs.

Agency theory primarily involves the delegation of a firm’s key tasks and decisions to the agent (CEO and top management) through an explicit or implicit contract. Usually, these contracts contain loopholes due to incomplete information and the inability to predict future events. Additionally, the cost of creating complete contracts is often too high for the firm. The agency theory argues that information is usually skewed in favor of the agent since it is not possible for the principal to monitor all the activities of the agent once the contract is closed.

The information asymmetry creates an opportunity for the agent to act in their own interests.

While agency theorists argue that managers tend to engage in self-serving activities, critics of this theory, otherwise referred to as stewardship theorists, argue that some managers are trustworthy and have a high sense of responsibility. Stewardship theorists further argue that the negative assumptions about managers held by agency theorists might cause good managers to become frustrated and become opportunistic and self-serving.

Agency Costs The exposure to moral hazard leads the agents to enforce measures that facilitate the reduction of information asymmetry such as measuring the performance of the managers, developing effective remuneration schemes, auditing financial statements on a regular basis and enforcing rules and regulations to govern managerial conduct. The principal appoints a Board of Directors (BOD) as a central monitoring mechanism to ensure that management acts in the best interests of the firm and supervise the ratification of essential decisions so as to reduce the risks associated with information asymmetry.

Corporate Governance and Principal Agency Problems

4 Shareholders appoint a board of directors to represent them in monitoring the activities of the agents (CEO and managers), but in many cases, some complications and inefficiencies may hinder the BOD from reflecting the principal's interest. Companies should minimize this conflict by creating solid corporate policies (Zimmerli, Richter, & Holzinger, 2010). While it may not be possible to eliminate the agency problem completely, principals can take certain measures to reduce its risk. Corporate governance is crucial in agency theory because it minimizes the potential of the occurrence of agency problems. There are two fundamental steps used in the process of reducing these risks. The first is designing an effective riskbearing strategy to handle any potential moral hazard and secondly, creating a system of monitoring the contracts and nexus of organizations. The second step is the use of contractual monitoring and bonding to develop suitable solutions to agency issues.

Corporate governance provides guidelines through which a company is directed and controlled, thereby defining the relationship between the principal and agents as well as the relationship between the organization and its stakeholders. It minimizes the risk of moral hazard, therefore enabling shareholders to earn value on their investment. Peters et al. (2012) identify the primary purposes of corporate governance as; to ensure that no single person has too much influence and control of the corporation, to facilitate that there are adequate control mechanisms to prevent theft and other forms of misappropriation, to ensure that there is transparency and accountability throughout the organization and to help in aligning the interests of the agents to the interests of the shareholders.

One of the ways through which principal-agent relationships are regulated is through contracts or laws; such as the fiduciary rule which states that financial advisors must disclose all the necessary information to their clients and thus put the clients' needs before their own.

5 Corporate governance can also be applied in the minimization of agency costs by offering agents incentives to motivate them to align their interests to the principal. These include; the threat of dismissal, the threat of a company takeover, managerial ownership, offering performance-based compensation and the direct involvement of shareholders. Principals should also appraise the agents' performance and decision-making to hold them accountable for their actions.

Besides the board of directors, it is crucial for the corporation to appoint committees such as the audit and remuneration committees to oversee the proper functioning of the corporation's internal control mechanisms to determine and address potential issues.

Ethical Issues Facing Finance Managers Finance managers are tasked with generating, investing, apportioning and managing the monetary resources of a corporation. Being in charge of the financial resources of a firm, finance managers are often faced with the temptation to take advantage of information asymmetry to make significant financial gains for themselves. Ethics plays a crucial role in finance management because it ensures the growth of the firm and the protection of the stakeholders' interests. Finance managers are expected to uphold high ethical standards since stakeholders require accurate financial information to make decisions effectively.

The Great Recession of 2008 occurred mainly due to unethical behavior in the financial industry. As a result of this event and other financial scandals such as the cases of Enron and Lehman Brothers, agents are paying more attention to the finance manager’s ethics to ensure that the individuals entrusted with their resources do not act in their own interests at the expense of the company and its shareholders (Said, Crowther, & Amran, 2014). The four

6 fundamental ethical issues encountered by finance managers in the execution of their duties are; integrity, timeliness, accuracy, and transparency.

Integrity The finance manager is the custodian of crucial company information and also makes decisions on behalf of the company, in this process they may encounter opportunities to increase their earnings by acting in conflict of interest, participating in insider trading or withholding crucial financial information from investors. Despite these temptations, the finance manager has a duty to uphold a high standard of integrity.

Timeliness Finance managers are obliged to provide timely information to the organization’s stakeholders. The timeliness of information significantly contributes to the firm’s ability to make the right decisions and alleviate any issues that may arise promptly. For instance, the finance manager should promptly disclose a significant drop in the number of shares traded to the BOD and other top management. Timeliness increases the relevance of information.

Accuracy A finance manager ensures that the financial statements of a company reflect a true picture of the financial position of the company, and are prepared according to the established accounting principles. Ethical issues arise where the finance manager augments financial information to create a false picture of the company’s financial condition, as was the case with Enron and WorldCom (Driver, & Thompson, 2018). These acts of financial fraud have a negative impact on shareholder’s wealth and also lead to the collapse of the company since it affects shareholders’ confidence in the motives of the appointed managers.

Transparency

7 The finance manager is required by regulatory agencies to make full disclosures of the company's financial position through preparing and submitting periodic financial statements.

The board of directors, management and shareholders of the company also require transparency in issues such as merger and buyout offers, potential opportunities to increase product line and win or loss of significant contracts. Ethical issues arise when finance managers obscure and falsify financial information. It is also deemed unethical to provide financial information in jargon that is not incomprehensible by the ordinary shareholder.

Conclusion The modern business environment necessitates the adoption of a corporate structure to facilitate higher expertise in management and to raise adequate capital for the expansion of the business and enhance competitiveness. Thus, shareholders (principal) recruit a CEO and managers (agents) to represent them in their dealings with third parties and manage the company on their behalf. However, this corporate structure introduces agent-principal problems due to the conflict of interest between the two parties. Finding solutions to the agency problem has been one of the critical mainstreams of finance since the collapse of major companies such as Enron and the Great Depression of 2008; fraudulent financial activities primarily caused both of which. Corporate governance provides tools for reducing information asymmetry and motivating agents to act in the best interests of both the shareholders and the corporation.

8 Reference Aluchna, M., & Idowu, S. (2017). Responsible Corporate Governance. Springer.

Driver, C., & Thompson, G. (2018). Corporate governance in contention. Oxford University Press.

Homayoun, S. & Homayoun, S. (2015). Agency Theory and Corporate Governance. International Business Management, 9: 805-815 Jerzemowska, M. (2006). The Main Agency Problems and Their Consequences, 2006(3), 917.

Peters, A., Handschin, L., & Högger, D. (2012). Conflict of Interest in Global, Public and Corporate Governance. Cambridge: Cambridge University Press.

Said, R., Crowther, D., & Amran, A. (2014). Ethics, governance and corporate crime.

Bingley: Emerald Group Publishing Zimmerli, W., Richter, K., & Holzinger, M. (2010). Corporate ethics and corporate governance. Berlin: Springer.