The Legitimacy Of Relationship With The Firm Accounting Essay

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This chapter describes the general theories aligned with the research. The research attempts to focus on the Agency theory, Stewardship theory and the Stakeholder theory which create a sound theoretical framework.

The Agency theory discusses the relationship between the agent and the principal and issues arise while working towards the same objective.

The Stewardship theory on the other hand is a substitute view of Agency theory, in which managers are expected to act in their own self-interests at the outlay of shareholders.

Stakeholder theory suggests that the drive of a business is to generate as much value for stakeholders. According to Drucker (1990), today corporations have to balance their responsibilities towards society in which they function, while meeting the ever increasing demands of their stakeholders to be competitive in a global economy.

Agency Theory

The concept of Agency theory is an important economic theory of accountability is defined as 'one or more people appoint another person to perform a service on their behalf which involves assigning some decision making authority to the agent' (Jensen & Meckling, 1976). Although this is mainly destined to be the relationship among the shareholders and directors, it has also said by Jenson & Meckling that there are other deals which could be measured within the framework such as directors and other interest groups and such relates to realise the role of external auditors.

The allocation of authority includes the belief among the agent and the principal whereby the Agency theory takes a view that people cannot be trusted to act in the public good and in the interest of the shareholders. This has resulted in rise of monitoring and controlling of the act of agents and mechanisms such as the external audit to strengthen this trust.

External auditors are subject to provide a reliable and a liberate opinion on the financial statements to the company shareholders but at the same time they are expected to work autonomously.

The separation of management and ownership leads to the problem of agent and principal. This is further explained by Watts and Zimmerman in 1978 by the positive accounting theory to find motives as to why managers cook their own books. In practical world, this is considered where the management have a full switch on the capitals of shareholders where they tend self-serve by maximising their own pockets.

When understanding the operating model of listed companies in Sri Lanka the most important basis of Agency theory is that the managers are usually motivated by their own personal gains and work to exploit their own personal interests rather than considering shareholders' interests and maximising shareholder value. For example, managers may be attracted to buying lavish offices, company cars and other extravagant items, since the cost is borne by the owners. However the concept of auditing and control carried out by a reputed audit firm will ensure that the operating model comes under proper scrutiny.

Thus, the key difficulty indicated by Agency theory is ensuring that managers pursue the interests of shareholders and not only their own interests. Eisenhardt (1989, p. 58) explains that agency problems commence when "The goals of the principal and agent conflict and it is difficult and costly for the principal to verify what the agent is actually doing".

Controversy occurs because principals are unable to monitor the performance of agents (Jensen & Meckling 1976). The pursuit of self-interest increases costs to the firm, which could include the costs of the formation of contracts, loss due to decisions being taken by the agents and the costs of observing and controlling the actions of the agents. Leuz et al. (2003) assert that the effects of such behaviour ultimately reflect in the company earnings. It is now evident that the investment in an audit needs to be apportioned to ensure that the performance of the agents or managers is monitored and proper feedback is provided.


It is also important that the management has an reason to manage the company's reported earnings in order to meet or beat earnings targets and, thus, to receive any bonuses that may be tied to the company's earnings (performance-related pay). This creates an information asymmetry in that managers can exercise the discretion they have on accruals, which in turn reduces the relevance and reliability of reported earnings, and the whole financial statements. Davidson et al. (2004) argues that when management provides inaccurate financial reporting information, it introduces earnings management as a type of agency cost. To counter this situation an internal audit may not be sufficient and the importance of an external audit must be conducted to understand the variances and changes that happen in the operating model of a company. The strict monitoring of managers by the principals or their representatives, such as the firm's board, is seen as fundamental to protecting shareholders' interest from being compromised when managers maximise their self-interest at the expense of the organisation's profitability.


In order to limit agency costs triggered by the separation of ownership and control, Fama and Jensen (1983b, p.309) propose that firms need a system that can separate decision management from decision control. This would limit agency costs by controlling the power of management and ensuring the proper consideration of shareholders' interests. It is clearly mentioned that the role of the external auditor is to reduce agency costs by cutting information asymmetry in financial reporting (Poit, 2001). This constitutes the importance of external audit and how it can positively impact the transparency in financial reporting.

Agency theory recognises external auditing as the most important monitoring mechanism because it controls conflicts of interest and diminishes agency costs. Watts and Zimmerman (1983) confirm that high quality external auditing will undermine the opportunistic behaviour cost (agency cost) introduced by management. 

These monitors act on behalf of the shareholders. As a result, high audit quality involving specialised independent auditors like the Big 4 audit firms can decrease opportunities for managers to pursue self-interest at the expense of owners and, thus, principals obtain more favourable returns. Hence the agency theory can be looked upon as a basis to develop theories for determining the relevance and composition of audit fees for companies public quoted companies in Sri Lanka.

Stewardship Theory

Unlike the Agency theory, the Stewardship theory, based on a psychological and sociological approach, maintains that the interests of corporate executives (as stewards) are aligned with those of the organisation and its owners (Albrecht et al., 2004). The stewardship theorists focus on structures that empower and facilitate rather than monitor and control. They reject the highly individualistic model of Agency theory that promotes a suspicious "policeman's" approach, thinks that agents are egocentric and whereby both the principal and agent share unalike interests. This is a theory that contradicts and challenges to a certain extent the concept of external auditing for all intents and purposes of monitoring management and employees of firms. The theory also goes on to reject the view that principals need to invigilate the opportunistic agents by monitoring them and apply sanctions or incentives as means of control.

Stewardship theory takes an opposite perspective in suggesting that the agents are trustworthy and good stewards of the resources are entrusted to them, which makes monitoring unnecessary (Donaldson, 1990; Donaldson & Davis, 1994; Davis et al., 1997). Since managers are not opportunistic and act in the finest welfare of the owners, they should also be given independence grounded on belief, which reduces the cost of governing their conduct. This means that according to the Stewardship theory managers are considered loyal and their conduct does not need to be scrutinised. However Donaldson and Davis (1994, p. 51) witness, "organisational role-holders are regarded being motivated by having to gain responsibility and then to gain appreciation from colleagues.

In most listed companies in Sri Lanka we see a significant proportion of dividend paying companies (i.e. Hayleys PLC, John Keels Holdings and etc.). From a Sri Lankan perspective a dividend paying company is considered stable and attractive to most investors. As per the Stewardship theory, the conduct of the steward is co-operative, because the steward looks out to accomplish the organisation's goals (e.g. profitability). This, in turn, benefits the principals through the positive effects of profits on dividends and share prices (Davis et al. 1997). In most local companies managers believe that their interests are aligned with those of the firm's owners. Thus, Stewardship theory maintains that the optimum governance structures are those that enable effective coordination in the enterprise. The stewardship perspective sees directors, as well as managers, as stewards of the. Davis et al. (1997) suggest that stewards gain more satisfaction by achieving corporate objectives than chase behind to fulfil their own pockets.

Davis et al. (1997) argue that achieving organisational success also satisfies the personal needs of the stewards. Thus, the stewardship theory considers that managers' decisions are also influenced by non-financial motives, such as need for achievement and recognition, the intrinsic satisfaction of successful performance, and respect for authority and the work ethic. However it is interesting to analyse, if this would be more prominent as opposed to the financial incentives a manager would visualise. This may well contradict the Stewardship theory in the Sri Lankan context.

However, according to this theory, it makes sense for corporate governance to be based on the view that the directors, on behalf of stakeholders, want to be good stewards of the corporate assets, and there is no conflict of interest or opportunistic behaviour at the expense of stakeholders. They work diligently to gain high levels of corporate profit and shareholder return. These concepts have been documented in organisational studies, such as in Muth and Donaldson (1998). To this effect the importance of an audit procedure may seem far-fetched and the value proposition may not be as clear, if this theory were to be considered.


When understanding the impact of the Stewardship theory from a level of the board, it considers the board of directors as an instrument of assistance to a steward chief executive officer rather than a controlling mechanism (Albrecht et al., 2004). It also considers that management is less likely to practice earnings management. However, the problem lies in the extent to which the management aspires to attain a good corporate performance. This could also take a turn where chief executive officers' may aspire for personal incentives & benefits over broader shareholder expectations.

The concept of identifying key people and drivers is common in most local companies. This enables a selected bunch of mangers to take on more responsibility and authority to drive a firm towards success. Davis et al. (1997) recommend that key managers identified within the firm leads to a personal relationship with achievement or failure. Daily et al. (2003) reason that management personals also want to guard their statuses as proficient decision makers. As a result, managers run businesses in a manner that increases performance in terms of profitability, while gaining a good return on shareholder funds.


The Stewardship theory goes on to argue that the firms which are managed by expert managers allow them to make the most of profits. Also, the dominance of executive directors on board is much desirable as they are capable in making better decisions due to their expert knowledge, dedication and accessibility to information (e.g. Boyd, 1995). In the listed companies a committee is appointed to make decisions of the audit practices both internal and external. This would mean that the committee would be a cross section of managers, directors and the board who would collectively take decisions on behalf of the audit practice within the company and ensure best practice.

In summary, the Stewardship theory argues that the responsibility and authority of executive managers provides a better focus on company objectives, leadership and implementation of operational decisions, leading to more effective corporate governance and corporation. Donaldson & Davis (1994) contend that the Stewardship theory remains the theoretical foundation for better regulation and legislation in corporate governance. Muth and Donaldson (1998) relate the likelihoods of Agency theory with those of Stewardship theory and treasure backing for the latter as a good model of reality. The question of how important this this theory is for determining external audit is somewhat unclear. Yet it adds a basis from which external audit is to be determined in the context of the audit practice and good governance.

Stakeholder Theory

The stakeholder theory revolves around the concepts that managers should on the one hand manage the corporation for the benefit of its stakeholders in order to ensure their rights and the participation in decision making and on the other hand the management must act as the stockholder's agent to ensure the survival of the firm to safeguard the long term stakes of each group. However the definition of a stakeholder, the purpose and the character of the organisation and the role of managers are very unclear and contested in literature and has changed over the years.

Bisset (1708) primarily defined the term stakeholders as "a person who holds the stake or stakes in a bet". Freeman (1984) quotes as "any group or individuals who can affect or is affected by the accomplishments of the organisation goals" and supports that the firm's actions should be anticipated in a wider outlook and also it should be useful to all relevant stakeholder rather limiting it only to the share owners. Moreover it includes the safeguarding of the benefits of employees, shareholders, customers, government, society, suppliers and prospective shareholders. The feature of "enlightened Stakeholder theory" has been suggested by Jenson (2001) as a result of incapability to protect the stakeholder interests in a business. This proposes that shareholder return growth is interlinked and therefore initially the company should maximise the returns of shareholders and that would routinely lead to the profit maximisation of stakeholders as a whole.

In answering the stakeholder prospects directors have a larger deal of accountability on meeting their prospects whereas auditors provide an assurance on the information provided by the directors through statutory audits. The concept of a Stakeholder theory around 60 years ago was proposed by Mary Parker Follett (Schilling, 2000) and it re-emerged in the 1980's. Freeman (1984, p.52 quoted in Schilling 2000, p.225) defines a stakeholder as "any group or individual who can influence or is influenced by the achievement of the organisation's objectives". The term 'stakeholder' may, therefore, include a large group of participants, in fact anyone who has a direct or indirect 'stake' in the business (Carroll 1993, p.22 quoted in Schilling 2000, p.225).

In a Sri Lankan context it is important to identify direct stakeholders and what their impact is on the performance and operating models of a firm. This is very important in the context of the listed companies since shareholders are particularly concerned about the direct stakeholders of a listed entity. Direct stakeholders are shareholders, employees, investors, customers and suppliers whose interests are associated with the organisation. An example of an indirect stakeholder is the government, which is indirectly affected by the company's role (Kiel and Nicholson 2003).


In a nutshell the Stakeholder theory supports that "companies and society are co-dependent and that the business aids a wider social drive than its duties to shareholders" (Kiel & Nicholson, 2003a, p. 31). Donaldson and Preston (1995, p. 85) recognise stakeholders as "persons or groups with genuine interests in practical aspects of corporate activity". Wheeler and Sillanpaa (1997) identify the stakeholders that needs to be taken into attention in the governance structure as investors, managers, employees, customers, business partners (e.g. suppliers and subsidiaries), local communities, civil society and the environment. Mitchell et al. (1997) claim that stakeholders can be identified by a few characteristics of:

Power to impact on the firm

the legitimacy of relationship with the firm

the urgency of their claim on the firm

This allows managers to pay attention and react to several forms of stakeholders.

Gaining strength during the 1970s and 1980s the Stakeholder theory would reflect the fear at a societal level that large national corporations were becoming too powerful and beyond accountability to stakeholders, including governments. With the time, the topic raised increased social awareness and the tendency toward triple bottom line reporting. In the context of Sri Lankan companies it is vital that this theory be looked upon critically. The reason for this is that the Colombo Stock Exchange is dominated by a few large conglomerates and ownership rests with the government and a few high net-worth investors.

Given the monopolistic nature of the market the Stakeholder theory is more of an addition of the agency theory, which believes boards of companies to take care of the benefit of shareholders. However, this fine focus on shareholders has been prolonged to take into account the interests of many diverse stakeholder groups (Freeman, 1984; Donaldson & Preston, 1995; Freeman et al., 2004). However, contrary to this Margaret Blair (1995) argues that, although stakeholder theory has more substantial historical roots, practical applications, and intellectual appeal than agency theory, it has had much less impact on thinking and policy-making about corporate governance.


Additionally it is important that the managers' incentives may not necessarily be associated with the interests of shareholders. However, managers who claim that this is due to consideration of other stakeholders' objectives "may be using stakeholder claims as a smokescreen to obscure what is really their inability to deliver value to the company's shareholders" (Healy 2003, p.24). Freeman et al. (2004) suggests that managers should attempt to produce as much value as possible for stakeholders by solving clashes among them so that stakeholders do not withdraw the deal.

The theory summarises external audit as effective monitoring systems that could protect all stakeholders' interests. In terms of audit quality, Baker et al (2002) suggest that the role of external auditor as monitoring mechanisms is not only directed for shareholders' benefit, but also for the interests of all Stakeholders. This change in the role of the boards has directed to the improvement of Stakeholder theory. Stakeholder theory can be seen as not necessarily supporting the view that amplifying shareholder value is the top priority for a business. Managers may legitimately follow objectives that do not increase shareholder wealth. Finally Sundaram and Inkpen (2004a) argue that shareholder value strengthening matters because it is the only objective that leads to decisions that boost results for all stakeholders. They claim that recognising a large number of stakeholders and their main morals is an impractical duty for managers. Supporters of the stakeholder viewpoint also argue that shareholder value maximisation will lead to an expropriation of value from non-shareholders to shareholders. This discussed the importance of the Stakeholder theory as an extended version of the Agency theory and lays a distinct foundation of theoretical research.


Among the findings it can be concluded that the Agency theory recognises external auditing as the most important monitoring mechanism because it controls conflicts of interest and diminishes agency costs. The delegation of authority involves the trust between the agent and the principal, however the agency theory takes a view that people cannot be trusted to act in the best interest of the shareholders. This has given rise to the need of monitoring and controlling of the performance of agents and therefore need to put in place mechanisms such as the external audit to reinforce this trust. The Stewardship theory argues that the effective control held by professional managers empowers them to maximise the firm's performance and corporate profits. Consequently, boards that are dominated by executive directors are preferable because of their expertise and knowledge, access to essential information and commitment to the firm. Stakeholders' theory views external audit as effective monitoring systems that could protect all stakeholders' interests. Stakeholder theory goes on to propose that the emphasis of managerial activity should be on the growth and maintenance of all stakeholder relationships, not just that with shareholders. Based on the theoretical framework it is evident that the role played by the external auditor in the listed companies is one of the great sensitivities and needs further research for developing an audit fee model.