THE AGENCY THEORY AND PROBLEM
An agency relationship arises where one or more parties called the principal contracts/hires another called an agent to perform on his behalf some services and then delegates decision making authority to that hired party (Agent) In the field of finance shareholders are the owners of the firm. However, they cannot manage the firm because:
- They may be too many to run a single firm.
- They may not have technical skills and expertise to run the firm
- They are geographically dispersed and may not have time.
Shareholders therefore employ managers who will act on their behalf. The managers are therefore agents while shareholders are principal.
Shareholders contribute capital which is given to the directors which they utilize and at the end of each accounting year render an explanation at the annual general meeting of how the financial resources were utilized. This is called stewardship accounting.
- In the light of the above shareholders are the principal while the management are the agents.
- Agency problem arises due to the divergence or divorce of interest between the principal and the agent. The conflict of interest between management and shareholders is called agency problem in finance.
- There are various types of agency relationship in finance exemplified as follows:
- 1.Shareholders and Management
- 2.Shareholders and Creditors
- 3.Shareholders and the Government
- 4.Shareholders and Auditors
- 5.Headquarter office and the Branch/subsidiary.
1. Shareholders and Management
There is near separation of ownership and management of the firm. Owners employ professionals (managers) who have technical skills. Managers might take actions, which are not in the best interest of shareholders. This is usually so when managers are not owners of the firm i.e. they don’t have any shareholding. The actions of the managers will be in conflict with the interest of the owners. The actions of the managers are in conflict with the interest of shareholders will be caused by:
i) Incentive Problem
Managers may have fixed salary and they may have no incentive to work hard and maximize shareholders wealth. This is because irrespective of the profits they make, their reward is fixed. They will therefore maximize leisure and work less which is against the interest of the shareholders.
ii) Consumption of “Perquisites”
Prerequisites refer to the high salaries and generous fringe benefits which the directors might award themselves. This will constitute directors remuneration which will reduce the dividends paid to the ordinary shareholders. Therefore the consumption of perquisites is against the interest of shareholders since it reduces their wealth.
iii) Different Risk-profile
Shareholders will usually prefer high-risk-high return investments since they are diversified i.e they have many investments and the collapse of one firm may have insignificant effects on their overall wealth.
Managers on the other hand, will prefer low risk-low return investment since they have a personal fear of losing their jobs if the projects collapse. (Human capital is not diversifiable). This difference in risk profile is a source of conflict of interest since shareholders will forego some profits when low-return projects are undertaken.
iv) Different Evaluation Horizons
Managers might undertake projects which are profitable in short-run. Shareholders on the other hand evaluate investments in long-run horizon which is consistent with the going concern aspect of the firm. The conflict will therefore occur where management pursue short-term profitability while shareholders prefer long term profitability.
v) Management Buy Out (MBO)
The board of directors may attempt to acquire the business of the principal. This is equivalent to the agent buying the firm which belongs to the shareholders. This is inconsistent with the agency relationship and contract etween the shareholders and the managers.
vi) Pursuing power and self esteem goals
This is called “empire building” to enlarge the firm through mergers and acquisitions hence increase in the rewards of managers.
vii) Creative Accounting
This involves the use of accounting policies to report high profits e.g stock valuation methods, depreciation methods recognizing profits immediately in long term construction contracts etc.