The Definition, Origin and Accounting Applications of Agency Theory

Agency theory is a framework that examines the relationship between a principal (such as shareholders or
owners) and an agent (such as managers or executives) within an organization. The key premise of agency
theory is that the agent may not always act in the best interests of the principal due to differences in goals,
risk preferences, and information.

Agency theory was first introduced in the 1970s by economists Michael Jensen and William Meckling. It
built upon earlier work on the separation of ownership and control in large corporations, as described by
authors like Berle and Means.

In accounting, agency theory gained prominence in the 1980s and 1990s as a framework for analyzing
various accounting phenomena. Key accounting scholars who have contributed to the development of
agency theory include Watts, Zimmerman, and Fama. Accounting research has applied agency theory to
understand issues such as:

 The design of executive compensation schemes

 The role of external auditors in monitoring management
 The incentives and behavior of managers in financial reporting
 The use of budgeting and capital budgeting processes

The Agent:

The agent refers to the party who has been hired or appointed to act on behalf of another party. In the
corporate context, the agent is typically the managers, executives, or other employees who have been
entrusted with the control and decision-making of the organization.

The Principal:

The principal refers to the party who hires or appoints the agent to act on their behalf. In the corporate
context, the principal is typically the shareholders or owners of the organization.

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Different Types Of Agents

1. Managers:

They are responsible for the day-to-day operations, strategic decision-making, and running of the
organization on behalf of the owners/shareholders.

2. Executives:

Executives, such as the CEO, CFO, COO, and other C-suite leaders, are also considered agents. They
are responsible for the overall leadership, direction, and strategic management of the organization.

3. Employees:

Employees at various levels within the organization can be considered agents when they are delegated
specific tasks or responsibilities by their superiors. This includes middle managers, supervisors, and other
employees who act on behalf of the organization.

4. Professional Advisors:

Professionals such as accountants, lawyers, consultants, and investment bankers can also be considered
agents when they are hired to provide advice and services to the organization. They are expected to act in
the best interests of their client (the principal).

5. Board of Directors:

The board of directors, as a collective body, can be viewed as the agent responsible for overseeing and
governing the organization on behalf of the shareholders (the principal).

6. Trustee

In some cases, such as in the management of trusts or estates, the trustee can be considered the agent
acting on behalf of the beneficiaries (the principals)

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Advantages And Disadvantages Of The Agency Theory

Advantages of Agency Theory:

1. Alignment of Interests:

Agency theory provides a framework to align the interests of the agent (e.g., managers) with the
interests of the principal (e.g., shareholders).This can be achieved through appropriate incentive structures
and monitoring mechanisms.

2. Improved Monitoring and Control:

Agency theory highlights the importance of monitoring the agent’s actions and performance to ensure
they are acting in the principal’s best interests. This can lead to the implementation of various control
mechanisms, such as auditing, reporting requirements, and performance evaluations.

3. Efficient Division of Labor:

Agency theory recognizes the benefits of the separation of ownership and control, where the principal
can delegate the day-to-day operations to skilled and specialized agents. This division of labor can lead to
more efficient utilization of resources and expertise.

4. Reduced Coordination Costs:

By establishing clear roles, responsibilities, and contractual agreements, agency theory can help reduce
the coordination costs between the principal and the agent.

Disadvantages of Agency Theory:

1. Information Asymmetry:

As discussed earlier, the inherent information asymmetry between the agent and the principal can lead to
adverse selection and moral hazard problems.

2. Agency Costs:

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 The implementation of monitoring and control mechanisms, as well as the design of incentive
structures, can result in significant agency costs for the principal.

3. Oversimplification of Relationships:

Agency theory may oversimplify the complex and dynamic relationships between the principal and the
agent, potentially overlooking other important factors.

4. Difficulty in Aligning Interests:

In practice, it can be challenging to perfectly align the interests of the agent and the principal, especially
in the presence of conflicting personal or organizational goals.

5. Lack of Consideration for Societal Factors:

Agency theory primarily focuses on the principal-agent relationship and may not adequately consider
the broader societal and ethical implications of the agent’s actions.

Importance of the agency theory

1. Understanding the Principal-Agent Relationship:

Agency theory provides a structured way to analyze the relationship between the principal (e.g.,
shareholders, owners) and the agent (e.g., managers, executives) in an organization.

2. Addressing Information Asymmetry: Agency theory highlights the problem of information

asymmetry, where the agent has more information and knowledge than the principal.

3. Improving Corporate Governance:

Agency theory has been instrumental in shaping the development of corporate governance practices,
such as the role of the board of directors, executive compensation, and shareholder activism.

4. Informing Accounting and Auditing Practices:

Agency theory has had a significant influence on the accounting and auditing professions, as it has
highlighted the importance of financial reporting, internal controls, and external audits in addressing
information asymmetry and aligning the interests of agents and principals.

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5. Analyzing and Designing Incentive Structures:

Agency theory provides insights into the design of compensation and incentive schemes that can help
align the interests of agents and principals, such as the use of performance-based pay, stock options, and
clawback provisions.

6. Enhancing Economic Efficiency:

By addressing the agency problems and promoting the alignment of interests between agents and
principals, agency theory can contribute to overall economic efficiency and the optimal allocation of
resources.

Elements That Make Up Agency Theory

1. Principal-Agent Relationship

2. Separation of Ownership and Control

3. Information Asymmetry

4. Potential Conflicts of Interest

5. Moral Hazard

6. Adverse Selection

7. Agency Costs

8. Incentive Alignment

9. Monitoring and Bonding Mechanisms

10. Corporate Governance

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1. Information asymmetry

Information asymmetry refers to the situation where the agent (e.g., managers, executives) has more
information and knowledge than the principal (e.g., shareholders, owners).

Sources:

 Agents have direct involvement in the day-to-day operations and decision-making of the
firm.
 Agents have access to internal company information and resources not readily available
to principals.
 Agents have specialized expertise, training, and experience that principals may lack.

Implications:

 Principals have difficulty monitoring and evaluating the agent’s actions and performance.
 Agents can exploit their information advantage to pursue their own interests at the
expense of the principals.
 Information asymmetry can lead to adverse selection, where principals have difficulty
identifying the most capable or trustworthy agents.

Mitigation Strategies:

 Principals implement monitoring mechanisms (e.g., auditing, reporting requirements,

performance evaluation).
 Agents engage in voluntary disclosure or bonding mechanisms to signal trustworthiness.
 Compensation structures and incentive schemes are designed to motivate agents to share
relevant information.

Importance:

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  Information asymmetry is a central concern in agency theory as it can exacerbate the
potential for conflicts of interest between agents and principals.
 Addressing information asymmetry is a key focus in agency theory and its application in
accounting research and practice.

2.Conflicts of interest;

In the agency theory, conflicts of interest arise between the principal and the agent due to their divergent
objectives. The agent may act in their own self-interest, rather than in the best interest of the principal.
Some common conflicts of interest in the agency theory include:

1.Financial conflicts: The agent may prioritize their own financial gain over the best interests of the
principal. For example, an investment manager may invest in securities that generate higher fees for
themselves, rather than ones that offer better returns for their clients.

2.Information asymmetry: The agent may possess more information than the principal, giving them an
advantage in decision-making. The agent may withhold or manipulate information to their advantage,
which can lead to conflicts of interest.

3.Time horizon conflicts: The principal and the agent may have different time horizons for their
objectives, leading to conflicts of interest. For example, the agent may focus on short-term gains, while
the principal is interested in long-term growth

4.Risk taking conflicts: The agent may take risks that are not aligned with the preferences of the
principal, leading to conflicts of interest. For instance, a financial advisor may recommend a risky
investment strategy to a client, even though it may lead to significant losses

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3.Monitoring and bonding costs

In agency theory, monitoring and bonding costs are important concepts related to the relationship between
principals (such as shareholders) and agents (such as managers) in an organization. These costs play a
significant role in aligning the interests of the principal and the agent and reducing agency problems that
may arise due to divergent interests.

1. Monitoring Costs: Monitoring costs refer to the expenses incurred by the principal in overseeing
and controlling the actions of the agent to ensure that the agent acts in the best interest of the
principal. In the context of accounting theory, monitoring costs can include the costs associated
with conducting audits, implementing internal controls, performance evaluations, and other
mechanisms to track and monitor the agent’s behavior. These costs are necessary to mitigate
agency risks, such as moral hazard and adverse selection, by ensuring that the agent’s actions are
aligned with the principal’s objectives.

2. Bonding Costs: Bonding costs are expenses incurred by the agent to assure the principal that
their interests are being safeguarded. Bonding mechanisms are used by agents to signal their
commitment to act in the best interests of the principal. In accounting theory, bonding costs can
include expenses related to obtaining performance bonds, providing collateral, or acquiring
insurance to mitigate the principal’s concerns about the agent’s opportunistic behavior. By
incurring these costs, the agent signals their reliability and dedication to fulfilling their duties to
the principal.

4.Risk Sharing

In agency theory, risk sharing refers to the allocation of the uncertainty associated with an investment or
project between the principal (owner of the business) and the agent (manager).

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Principles of Risk Sharing:

• Diversification: The principal and agent share the risk by diversifying their investments across multiple
projects.

• Hedging: The agent can use financial instruments (e.g., insurance) to reduce the risk to the principal.

• Contingent Claims: The principal and agent can negotiate contracts that specify how risks will be shared
based on the outcomes of the investment.

Implications for Accounting:

Risk sharing has significant implications for accounting:

• Financial Reporting: The decision on how to allocate risks affects the financial statements.

• Asset Valuation: The allocation of risks impacts the valuation of assets.

• Capital Budgeting: The expected risk and return of an investment are considered in making capital
budgeting decisions.

Advantages of Risk Sharing:

• Reduced Risk for Principals: Principals can diversify their risks by sharing them with agents.

• Improved Incentive Alignment: Agents have an incentive to maximize returns while managing risks.

• Increased Efficiency: Risk sharing can lead to more efficient risk management.

Disadvantages of Risk Sharing:

• Potential Agency Costs: Agents may take excessive risks if they do not bear all of the costs.

• Complexity: Risk sharing arrangements can be complex and difficult to implement.

• Misalignment of Interests: Principals and agents may have different risk preferences, leading to potential
conflicts.

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5.Moral Hazard

Moral hazard, under agency theory in accounting, refers to the risk that an agent (e.g., manager or
executive) may take excessive or unnecessary risks, or engage in unethical behavior, when their interests
are not fully aligned with those of the principal (e.g., shareholder or owner). This can occur when the
agent is insulated from the consequences of their actions, or when their compensation is not tied to
performance.

Types of moral hazard:

1. Risk-taking: Agent takes excessive risks, potentially harming the principal.

2. Asset substitution: Agent uses principal’s resources for personal gain.
3. Earnings manipulation: Agent manipulates financial reports for personal benefit.

Agency theory suggests that moral hazard can be mitigated through:

1. Monitoring and reporting

2. Performance measurement and evaluation
3. Compensation contracts with risk-adjusted incentives
4. Governance structures (e.g., boards of directors)
5. Auditing and assurance services

6.Corporate governance

Corporate governance is a system of rules practices and processes by which a company is directed and
controlled. It also refers to the ways in which companies are governed and to what purpose.

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It has pillars such as

• Accountability
• Transparency
• Fairness
• Responsibility
• And risk management

In corporate governance there are three main participants that is, shareholders, directors and the officers

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