The accounting theory I am going to be writing about in this essay will be "Agency Theory". I am going to be writing about what agency theory is and also the effect that it has had in the accounting industry. I will be describing the main problem that comes along with the theory. The main example I will be relating to in this essay is the relationship between shareholders and managers. I will use this example to describe the Agency theory principle. The shareholder and manager relationship example is the main example used for researchers when researching the theory.
I will now give a brief explanation of what the "Agency Theory" is. The agency theory is the relationship between two parties. One party being the "Principle"(e.g. shareholders) and the other party being the "Agents" (e.g. Managers). According to "Eisenhardt (1989a)" this theory is to solve following two problemsâ€¦
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1) Goals may not match
There is a conflict between the goals of the Principle and the goals of the Agent, and also it is sometimes very hard or expensive to monitor what the Agent is actually doing
2) Risk Related
both Principle and Agent may have different views/attitudes towards risk, and therefore they will both use different strategies when dealing with risk, which may cause a conflict.
I have included a table below that points out issues that are related to the "Agency Theory".
Principal - agent relationship should reflect efficient organisation of information and risk-bearing costs
Unit of analysis
Contract between principal and agent
Partial goal conflict among participants
Efficiency as the effectiveness criterion
Information asymmetry between principal and agent
Information as purchasable commodity
Agency (moral hazard and adverse selection)
Relationships in which the principal and agent have partially differing goals and risk preferences (e.g compensation, regulation. Leadership, impression management, whistle-blowing, vertical integration, transfer pricing)
Table 1: Agency theory overview
Source: Eisenhardt (1989a)
The principle agent diagram
The theory was originally created in the "economy theory", but it seems that this theory can be used in a range of different theories from "organisations theory" to Accounting and Finance.
By using "Agency Theory" an analysis of "corporate Finance" can be done. Relating to the example mentioned on the first page where the shareholders are the principles and the managers/board of directors are the agents. The board of directors should create a plan/structure in where the goals/expectations of the shareholders can be achieved. As stated both shareholders and directors may hold different values when considering risk, and because of that objectives can sometimes lead to conflict. The Agency theory can also affect other parts of the firm such as the relationship between management and employees, where in this situation the principle is the management and the agents are the employees (Eisenhardt, 1989b).
When analysing the relationship between the principle and the agent and when the relationship is underlined this can be known as the Positivist agency theory (Eisenhardt, 1989a). The approach of this two theories may be different as the "Positivist agency theory" prefers a more mathematical approach to the problem, but both approach may compliment each other as quoted by (Eisenhardt, 1998a: 60).
Rather, the important point is that the two streams are complementary: Positivistic theory identifies various contract alternatives, and the principal-agent theory indicates which contract is the most efficient under varying levels of outcome uncertainty, risk aversion, information, and other variablesâ€¦
The most used application of "Agency Theory" the directors - shareholders relationship. By being individuals and creating goals to self improve themselves may cause conflict between the principle and the agent. This has become the main focus of "Agency Theory" and has shown a need for "Agency theory". The main problem here can be said of what is the main role of the Agent in accounting profession.
Always on Time
Marked to Standard
As "Bricker and Chandar (1998: 488-489)" argueâ€¦
Contracts between shareholders and managers are written in order to reduce agency cost, and thereby, the dead weight loss in firm value as a result of the separation of ownership from control. Accounting is considered to play an important role as an integral part of the contracts that define a firm. For example, lending arrangements between a firm and its creditors often contain several accounting based covenants. Accounting-based bonus plans are frequently a component of executive compensation plans. Accounting measures are commonly used in the performance evaluation of a firm's cost and profit centers. Watts and Zimmerman argue [1986, p. 196]: "if accounting is an important part of the firm's contracting process and agency costs (and hence, firm value and/or managers' compensation) vary with different contracts, accounting procedures have the potential to affect firm value and/or the manager's compensation." This rationale has given rise to several hypotheses regarding the role of accounting information in market valuation of firms and managers' use of accounting discretion
Although this argument above may state otherwise, "Agency theory" can be used to reduced conflict between the Principle and the Agent by reducing the risk of opportunistic behaviour by the Agent.
The service sector have adapted to this by creating processes that enable the principle to monitor the Agents more closely. By having the directors create regular/annual reports on the business performance and this relates to the decisions they have been making. The report must be accurate and this is probably one of the main reasons firms have to be audited by an independent firm. Therefore by receiving this regular reports the principles can access in whether the agents are fulfilling their role as an Agent as stated on their contract.
This as mentioned above is reflected by "Kaplan (1984)" in the following statementâ€¦
"In this model [agency theory], accounting information is viewed as the basis of contracting between economic agents who have different ownership rights, different information, perhaps different prior beliefs, and different preferences for outcomes. Thus, rather than viewing the firm as a single organisational entity, agency theory models the diverse interests, information and beliefs of economic agents contracting with the firm. The information, or management accounting, system serves to inform the principal (owner, shareholder, central manager) and agent (management, division, or department head) about the actual outcome, to supply signals to the agent, and in some cases, to inform the principal about the likelihood of various state occurrences. It can also provide information to the principal about the agent's effort and action."
As known to most the main role of accountancy is to provide information. Whether it is external or internal. Internal information is information base in the past and is used to keep a record like a library for financial information. And there is external accountancy where information is used to predict the future instead of recording.
Apart from collecting information accounting can have other more specific objectives.
Using past information and doing a form of technical analysis to predict future production can use information to predict future trends.
This statement is quite important when relating it to the following case: "government contracts" in which an agent- principal relationship is also established.
For example "Reichelstein (1992)" relates to the agency models to explain the government contacts, and this is used to explain how incentive contracts can be designed and this shows that the agency models have actually influenced the way managerial economics work today.
Another way of looking at it is that accounting provides a way to control the agent over the principle. In this perspective and the other perspectives mentioned above, this demonstrates that that the relationship between the principles (shareholders) and the agents (management) influence the role of the accountancy as a key information provider. From this we can see that from accountancy reporting is a result of separating the owner from the management phenomena. It can also be argued although some may disagree that the reporting practice may be a result of the agency theory problem and serves to control the agent from going ahead and doing whatever he/she likes to achieve his/her own goals/needs.
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In this essay we have seen that the "agency theory" has affected more than one department of accounting. The agency theory has had a major affect on financial accounting, management accounting and in corporate finance.
From this research I have conducted I have found out that the theory/ contracts and the relationships both rely heavily on each other. This is probably the most arguable debate when is comes to the agency theory. Both accounting and the agency theory both rely on contracts, and this contracts we can see are the core of the relationship between principle and agent.
When it comes to agency theory it is the relationships between principle and agent that play a key role but accountancy aims at reducing the risk between the principle and agent by providing information about the agents actions. Also by reporting the behaviours of the agents and showing that he has kept to the conditions of the contract, it may provide the principle of an indication of the behaviour that the agent may have in the future. This can also increase the trust levels between the agent and the principle and therefore lower the amount/risk of conflicts, and therefore also lowers risk other risks associated with the relationship.
As a conclusion I can say that the accountancy service meets the problems of the agency theory very well. And both agency theory and the accounting practices both benefit each other. The agency theory identifies the risk and the accounting practice reduces/eliminates the risk. Accounting service provides information to avoid the behaviours of agents and increases trust between both parties.