AGENCY

THEORY
Muhib Islam

Contents
Background

of Agency Theory

Definitions
Assumptions
Reasons

for Agency Problem

Example of Application
Audit Committee vs Agency Theory
Recent Example of Theory

Background of Agency Theory (AT)

Berle

and Means (1932): separation of

ownership from control
Jesen and Meckling (1976):

agency relationship
agency cost= monitoring expenditures +
bonding expenditures + residual loss

Fama

and Jensen (1983): agency

problems arise because contracts are
both costly to write and enforce

Best Definition
Jensen and Meckling defined:
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. (1976, p.308)
This contract may be simply constitute implicit terms
about how the principal expects the mangers to behave
(Deegan 2009).

Agency Theory Diagram

Conflict

Princip
al

Goal
Orientation
Obligation and
Reciprocity
Risk
Self-Interest

Congruence

Agent

Assumptions Of AT

Bounded rationality
Opportunism
Information asymmetry

AT assumes that the interests of

principles and agents diverge (Hill,
Charles and Jones 1992)
Both parties intends to promote their own
self-interest (Kunz, Alexis and Pfaff, 2002)

Assumptions: Prior
literature

Two primary characteristics have been

suggested by the Prior literature :
the conflicts of interest
informational asymmetries between the
parties
(see Mas-Colell, Whinston and Green, 1995;
Milgrom and Roberts,1992)

Information Asymmetry

Information available to the insiders (managers) are

not the same available public or outsiders
(stakeholders) (Scott 2009)

Asymmetry of information does not allow the

principals to be sure whether the agents are carrying
out the duties that they should according to the
contract (Shapiro 2005)

Contract does not have to be written contract. That is, it may be

simply constitute implicit terms about how the principal expects
the mangers to behave (Deegan 2009)

Reasons for Agency Problem

Managers maximize their wealth at the cost of

shareholders

Focus on short-term performance at the expense

of long-term growth

Excessive remuneration or unjustified benefits

Dechow and Sloan (1991): horizon problem

remuneration intrinsically linked to short-term
performance goal

Differences in attitudes towards risk

Resolving Agency Problems

Contracts between agents and principals
specify the monitoring and bonding
arrangements:

Monitoring; observing the behaviour and

performance of agents

Bonding; arrangements that penalise agents

for acting in ways that violate the interests of
principals or reward them for achieving
principals goals

Resolving Agency
Problems
Burton

(2000) : limiting management

discretion through establishment of
structures to monitor and control
management behavior

Structures:
Independent

board of directors and

independent board chair (Dalton et. al 1999)
Independent board subcommittees- audit,
remuneration and nomination (Ellstrand et. al
1999)

Case Study Example

Peter, Baxter. "Factors Associated with the Quality of Audit
Committees." [In English]. Pacific Accounting Review 22,
no. 1 (2010): 57-74.

This paper has critically considered the AC quality to solve agency

problems.

Board of directors are responsible for monitoring the

management activities

delegate duties to AC for the oversight of financial reporting

minimize

the information asymmetry (Beasley and Salterio,

2001)

AT is the underlying theory which governs the formation

of Audit Committee

provide safeguard to the stakeholders.

Hypotheses

H1: The independence, expertise, activity and size of the

board are positively associated with the independence,
expertise, activity and size of the audit committee.

H2: The companys leverage is positively associated with

the independence, expertise, activity and size of the
audit committee.

H3: The existence of a Big 5 auditor is positively

associated with the independence, expertise, activity
and size of the audit committee.

H4: The extent of managerial ownership of equity is

negatively associated with the independence, expertise,
activity and size of the audit committee.

Findings

Audit Committee Quality is positively

associated with companys leverage, big
audit firms and the independence, expertise,
activity and size of the board. - (Hypothesis)

The agency problem can be minimized if the

factors discussed above can be improved

It is also possible by the reducing the

managerial ownership.

Audit Committee vs Agency

Theory
Expertise
Independence
Composition
Size
Level of
Activity

Responsible for
managing top
management
Board of
Director

Manageme
nt(Agents)

Delegates
Financial
Reporting
Oversight
Agency
Proble
m

Audit
Committe
e

Shareholders
(Principal)

Various Perspectives
Agency

Theory has been considered by

various Studies:
Economic
Management and corporate
governance
Legal
Normal Science

Future of AT
Wiseman

et al.s (2012) proposed to

make agency theory institutionally
sensitive

Institutional factors be taken into account

(Aguilera and Jackson, 2010)

However,

Heracleous and Lan (2012)

argues that such a move cannot address
fundamental problems

Thus they believe critical re-examination

of this theory and the development of
alternative conceptualizations

Reference List
Aguilera, R. V. and Jackson, G. (2010). Comparative and international corporate
governance. Academy of Management Annals, 4, 485556.
Beasley, M., and S. Salterio. "The Relationship between Board Characteristics and
Voluntary Improvements in Audit Committee Composition and Experience."
Contemporary Accounting Research 18, no. 2 (2001): 539-70.Dalton, Dan R., Catherine
M. Daily, Jonathan L. Johnson, and Alan E. Ellstrand. "Number of Directors and Financial
Performance: A Meta-Analysis." Academy of Management Journal 42, no. 6 (1999): 674-8
Berle, A.A.. Jr. and G.C. Means, 1932. The modern corporation and private property
(Macmillan, New York)
Burton, P. "Antecedents and Consequences of Corporate Governance Structures."
Corporate Governance: An International Review 8, no. 3 (2000): 194-203.
Davis, James H., F. David Schoorman, and Lex Donaldson. "Davis, Schoorman, and
Donaldson Reply: The Distinctiveness of Agency Theory and Stewardship Theory." [In
English]. Academy of Management. The Academy of Management Review 22, no. 3
(1997): 611-13.
Dechow P, and R. Sloan. "Executive Incentives and the Horizon Problem." Journal of
Accounting and Economics 14, no. 1 (2001): 51-89.
Ellstrand, Alan E., Catherine M. Daily, Jonathan L. Johnson, and Dan R. Dalton.
"Governance by Committee: The Influence of Board of Directors' Committee Composition
on Corporate Performance." Journal of Business Strategies 16, no. 1 (1999): 67-88.6
Fama, E., and M. Jensen. "Separation of Ownership and Control." Journal of Law and
Economics 26 (1983): 301-25.
Heracleous, Loizos, and Luh Luh Lan. "Agency Theory, Institutional Sensitivity, and
Inductive Reasoning: Towards a Legal Perspective." Journal of Management Studies 49,
no. 1 (2012): 223-39.

Reference List
Hill, Charles W. L., and Thomas M. Jones. "Stakeholder-Agency Theory." Journal of
Management Studies 29, no. 2 (1992): 131-54.
Jensen, M., and Meckling W. "Theory of the Firm: Managerial Behaviour, Agency
Costs and Ownership Structure." Journal of Financial Economics 3, no. 4 (1976):
305-60.
Jensen, Michael C., and William H. Meckling. "Theory of the Firm: Managerial
Behavior, Agency Costs and Ownership Structure." Journal of Financial Economics
3, no. 4 (1976): 305-60.
Kunz, Alexis H., and Dieter Pfaff. "Agency Theory, Performance Evaluation, and the
Hypothetical Construct of Intrinsic Motivation." Accounting, Organizations and
Society 27, no. 3 (2002): 275-95.
Mas-Colell, A., Whinston M. D., and Green J. R. "Microeconomic Theory." New
York: Oxford University Press, 2005.
P. Milgrom, and J. Roberts. "Economics, Organization and Management." London:
Prentice Hall, 1992.
Scott, W. Financial Accounting Theory. 5th ed. Toronto: Pearson Prentice Hall, 2009.
Wiseman, R. M., Cuevas-Rodriguez, G. and Gomez-Mejia, L. R. (2012). Towards a
social theory of agency. Journal of Management Studies, 49, 20222.