Agency Theory:

Agency theory is defined as:

                         "Agency theory identifies the agency relationship where one party,the principal,delegates work to another

                          party,the agent.In the context of corporation,the owners are the principal and the directors are the agent".

 

        There are some work available within the context of the Principal-agent framework.The work of Jensen and Meckling(1976) in particular,and Fama and Jensen(1983) are important.Agency theory deals with the agency realationship between the Principal and the agent;where principal delegates work to another party,the agent.The agency relationship have some problems relating to opportunism or self-interest of the agent;for example the agent may not act in the best interest of principal.There can be a number dimensions to this including for example the agent misusing his power for pecuniary or other advantage and the agent not taking appropriate risks in pursuance of the principals interests because he(the agent) views those risks as not being appropriate for him to take because he and the principal have different attitudes to risk.There is also the problem of information asymmetry whereby the principal and the agent have access to different levels of information;In practice his means that the principal is at a disadvantage as the agent will have more information.

 

If we look in the context of corporations and issues of corporate control,agency theory views corporate governance mechanisms,especially the board of directors as being an essential monitoring device to try to ensure that any problems that may be brought about by the principal-agent relationship,are minimized.

Blair(1996) states

                     "Managers are supposed to be the "agents" of a corporations "owners",But managers must be monitored and institutional arrangements must provide some checks and balances to make sure they donot abuse their power.The costs resulting from managers misusing their position,as well as costs of monitoring and disciplining them to try to prevent abuse,have been called "agency cost"."

 

Much of agency theory as related to corporations is set in the context of the seperation of ownership and control as described in the work of Berle and Means(1932).

According to Berle and Means(1932)"the agents are the managers and the principals are the shareholders and this is the most commonly cited agency relationship in the corporate governance context.However it is useful to be aware that the agency relationship can also cover various other relationships including that of company and creditor,and employer and employee. 

In simple terms,if you want something done properly,the way you want it done than do it yourself!

Agency Problem:

Agency relationships are caused when a principal employs someone(the Agent) to do something for them.The potential problem is that the Agent may not act in the best interests of the Principal:

• They might simply not perform the task to a high enough standard.

• They might perform the task for their own advantage.

 

A number of agency relationships involving accountants can exist:

• Shareholders employ directors as agents to run companies for them.

• Shareholders employ auditors as agents to check the truth and fairness of the published Financial Statements.

 

The potential for agency problems in companies has increased in recent years because:

• As companies have become larger/global,the gap between the directors and the shareholders has increased,increasing the chance that directors donot act in shareholder interests.

• Recent corporate disasters have reduced the level of trust in company directors.

• Even the largest shareholders have relatively small shareholdings, making it difficult for any shareholder to get enough support(in terms of % of votes) to achieve change.