Agency Theory

Agency Theory

Introduction/Scene Setting

Agency theory examines the relationship between various levels of management such as managers and board of directors. The nature of their relationship is that one party; the principle, assigns decision-making authority to another party; the agent. A conflict of interest usually arises between these two parties, as they may each have different goals and objectives for the company. The agency problem is also caused by the fact that owners and managers are motivated by different factors and information might be asymmetric. Agency theory is important because it plays a crucial role during the company decision-making process, as it determines the extent to which the principal and the agent will be involved.

Aim/Purpose

This paper will examine how the relationship between the top management and board of directors of an organization can be explained using the agency theory. The paper will also examine the conflicts of interest that exist between these two parties. In addition to this, it shall also analyze the various problems that the agency role faces. An example can be seen in public corporations where the board of directors is elected by the owners of the company and the shareholders. The board of directors is charged with appointing managers. Therefore, the directors are the principals and the managers the agents. Therefore, managers are supposed to act on behalf of the Board of directors, but due to a conflict of interest, this is not always the case (Dutta & Reichelstein, 1999). A moral hazard takes place when there is an information asymmetry, such that the agent has more information than the principle. Hence, the agent may take advantage of the information asymmetry to act in his or her own interest at the expense of the company. Thus, this paper will try to interpret then relationship within the management and bring out the conflicts that occur in it like in the example above.

Body/Content

The board of directors of an organization sets the mission and goals of the organization and tasks the managers with the mandate of implementing them. They also assess the progress that the managers are making towards the attainment of the goals. The difference between these two parties is that the Board of Directors is appointed by the shareholders and therefore usually works towards their interests. The management on the other hand is more concerned with the progress and performance of the organization. The conflict therefore arises because the board of directors is interested with the maximization of the shareholder’s wealth while the management is interested in the maximization of the firm’s asset base, and hence their attention and efforts are centered on the organization’s performance (Gareth, 2010).

The board of directors is answerable to the shareholders and is therefore concerned with ensuring that the shareholder’s Earning per Share (EPS) is increasing and that the share prices are optimal. Managers on the other hand are also concerned with the maximization of shareholder wealth as long as the company itself is doing well. To this effect, managers and directors may differ over issues such as whether to plough back the organization’s profits, or pay it to the shareholders in form of dividends.

According to the agency theory, managers may also take advantage of company resources and funds to maximize their own utility. This may come in form of increasing their own salaries and perquisites at the expense of the shareholders. Managers may also propose that the company undertakes expansionary activities in order to credit themselves with the expansion. The expansion and growth of the company gives the managers a larger sphere of influence, greater job security and more influence over the board of directors, who they may control in order to award themselves higher salaries, increase their job tenure and making decisions that put the shareholder’s wealth at great risk (Kulkarni, 1988).

An agency problem may also exist between the board of directors and managers when the two parties have different attitudes towards risk. The directors for example may be risk adverse, wanting to approach investment opportunities with extreme caution in order to protect the shareholder’s wealth and assets of the firm whereas the managers may be risk-neutral, whereby they are willing to take calculated risks in order to increase the firm’s and shareholder’s wealth. This makes it difficult for them to arrive at a conclusion over how to utilize the organization’s funds, and may result in foregone investment opportunities or loss of funds due to investment in risky projects.

Ethical issues arise when an individual is unable to create a barrier between his own personal interests and the best interests of the firm. The managers may for instance want to increase their power and salaries at the expense of the firm and the board of directors may want to invest the firm’s resources in very risky projects, this challenges resort to the question of ethicality. Ethicality is closely related to the agency problem, as it provides a guide on the best course of action when the managers and directors have different interests pertaining to the firm and its shareholders. Ethics provides a guideline for helping to decide whether an action will work for the good of the firm or against it. Some of the issues that management and directors differ over are very challenging and complicated. Therefore, it is important that they refer to a code of ethics that will enable them to settle for the best and most suitable alternative. Unethical decisions and actions affect the organization and the stakeholders negatively, while ethical decisions work to the advantage of both the organization and the stakeholders.

The agency theory is based on the assumption that human beings prefer to act in their self-interest. It also assumes that in an organization the managers and board of directors are bound by limited rationality and are therefore likely to make decisions that do not serve the good of the shareholders (Gareth, 2010). According to the theory, the managers and board of directors are motivated by different factors and have different goals for the organization. The theory also asserts that within the organization, information is asymmetric in nature, and it is therefore not possible for both the top managers and the board of directors to hold the same level of information about the firm. It is assumed that the agents, who in this case are the top managers, are more informed about the firm, since they interact with its operations at a closer level than the board of directors. The other assumption of this theory is that the principal and the agent have different risk preferences and therefore do not agree on how to handle investment opportunities (Carlson, 2005).

The agency theory has been criticized for its assumptions that suggest that principals and agents are at a constant tug-of-war with each other and thus in reality may promote cynicism between these two parties in an organization. The theory has also been criticized for its assumption that principals and agents, who in this case are the board of directors and managers, are always driven by self-ambition and greed, and are therefore desire to use the organization’s resources for their own benefit. This assumption is detrimental to the performance of the company because it promotes suspicion and may even lead the suspected party to steal since it is already expected of them. The theory may also eventually result in a complacent and a nonchalant towards wrong management practices, because it suggests that all managers and board of directors are the same because they are self-seeking and having negative motives. This may create a culture of impunity within the organization. The reality is that not all managers and directors are self-interested; this should be the exception and not the norm. Any self-serving individuals should be dismissed from their positions. The theory has also been criticized for being too harsh and pessimistic. It lays emphasis only on the negative aspects of the human being and the organization. It is not constructive because it gives a blanket criticism and assumes that a human beings primary motivation is self-ambition, and hence all managers and directors are prone to using organizational funds for their own benefit. If this were true, then stealing would be so commonplace that it would be necessary for the organization to provide a contingency fund from which managers and directors would be able to satisfy their selfish motives. The theory also ignores the fact that not all individuals are driven by a desire for power and wealth. Many individuals are motivated by altruistic factors (Bowie & Freeman, 1992).

Research/Investigation

The agency theory is best illustrated by the case of Enron. The top managers of the organization led the company into bankruptcy through unethical financial practices. The board of the directors failed in their role of protecting and maximizing shareholder’s wealth through their negligence. The managers, who in this case are the agents, falsified the financial statements of the company in liaison with the company’s lawyers and accountants. The management gave a false reflection of the true value of the firm, in order to attract more investment, which the managers would channel into their own interests. The managers of Enron were therefore governed by their own self-interests as opposed to the interests of the shareholders (Carlson, 2005). Their behavior was unethical, because the shareholders were duped into believing that their investment would earn a substantial return on investment, while in reality the managers had concocted the actual figures, which were much lower than the ones portrayed. The board of directors did not play their role adequately, and entrusted the managers to make all the decisions pertaining to the company. The board of directors similarly acted in their own self-interest by acting negligently, and thus allowing for the collapse of the company. Some of the directors also participated in the embezzlement of the shareholder’s funds ( Freeman & Bowie, 2005).

Conclusion

The preceding discussion has revealed three key things about the relationship between top managers and the board of directors under the agency theory (Perry, 1979). Firstly, that the agency problem is brought about by conflicting interests, goals and motives between the two parties. Secondly, it also reveals that this agency problem results in each party seeking to satisfy their own selfish ambitions and motives, at the expense of the company and the shareholders (Carlson. 2005). Thirdly, it proposes that the best solution to this problem is the implementation of a code of ethics and values by which the management and board of directors should base their decisions and analyze the ethicality of their actions and decisions.

Recommendations/Applications

The agency theory can be applied in five areas within an organization. Firstly, it can be used to identify the areas of conflict of interest between the top managers and the board of directors or the management and the shareholders. It provides a point of reference for the individual to diagnose the agency problems of a company. Secondly, the agency theory also enables the agents and principal identify the level of asymmetry in the organizational information. They are hence able to correct the problem if the information is too asymmetrical. Thirdly, the agency theory can be used in setting the mission and goals of the organizations, the goals of the board of directors should be aligned to the goals of the top managers in order to prevent a situation where their goals are mismatched and thus, the shareholders suffer due to their lack of cohesive goal setting. Fourthly, the agency theory can be used to prepare a code of ethics for the organization, which will provide a guideline for the business practices to adhere to and thus prevent business malpractices. Fifthly, the agency theory can also act as a guide for decision making, it enables the top management and board of director decide on issues such as the correct capital structure, investment portfolio and asset mix, that will maximize the shareholder’s wealth (Harrell & Harrison, 1998). The agency problem may be solved by putting in place mechanisms that unite the interests of the principles to the interests of the agents. Such a mechanism includes rewarding the principles and agents in accordance with their performance.

 

References

Bamberg, G.., Spremann, K., & Ballwieser, W. (1989). Agency theory, information, and incentives. New York, NY: Springer Press.

Bowie, N. E. & Freeman, R. (1992). The Ruffin series in business ethics. Oxford, UK: Oxford University Press.

Brennan, M. J. & Trigeorgis, L. (1999). Project Flexibility, Agency, and Competition: New Developments in the Theory and Application of Real Options Analysis. Oxford, UK: Oxford University Press.

Carlson, M. F. (2005). Agency theory: is there a relationship between rewards and organizational commitment for adjunct faculty teaching in adult degree completion programs at Christian colleges. Upper saddle, N.J.: Nova Southeastern University.

Dutta, S. & Reichelstein, S. (1999). Asset valuation and performance measurement in a dynamic agency setting: Review of Accounting Studies. Oxford, UK: Oxford University Press.

 Freeman, B., & Bowie, R. (2005). Ethics and agency theory: an introduction. Cambridge, UK: Cambridge University Press.

Gareth, R. J. (2010). Organizational Theory, Design and Change. Upper Saddle River, NJ: Pearson Prentice Hall Publishing Co.

Harrell, A. & Harrison, P. (1998). Self-interest, ethical considerations and the project continuation decisions of managers who experience an agency conflict. Advances in Management Accounting. Hoboken, N.J.: Wiley Publishers.

Kulkarni, M. S. (1988). Managerial Finance. York, UK: Barmarick Publications.

Laffont, J. (2003). The Principal Agent Model: The Economic Theory of Incentives. NewYork, NY: Edward Elgar Publishing.

Mahoney, J. & Thelen, K. (2009). Explaining Institutional Change: Ambiguity, Agency, and Power. Cambridge, UK: Cambridge University Press.

Pacharn, P. (2008). Accounting choice and optimal incentive contracts: A role of financial reporting in management performance evaluation. Oxford, UK: Oxford University Press.

Perry, W. E. (1979). How to Manage Management. West Linton, UK: Vangard Press.

Raymond, J. (2010). Finance ethics : critical issues in theory and practice Hoboken, N.J. : Wiley.

Stremitzer, A. (2005). Agency theory: methodology, analysis : a structured approach to writing contracts. Barnsley, UK.
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