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INTRODUCTION

An agency in general, is the relationship between two parties, where one is a principal
and the other is an agent who represents the principal in transaction with a third party. Agency
relationship occur when the principal hire the agent to perform a service on the principal behalf.
In common, principal will delegate decision making authority to the agent.
Agency Theory is concerned with resolving problems that may exist in agency
relationship; that is, between principals (such as shareholders) and agent of the principals (such
as company executive). The two common problems that agency theory addresses are:
1) the problem that arise when the goals of the principal and the agent are in conflict.
2) the problem that arise when the principal and agent have different attitudes towards
risk.
Because of different risk tolerances, both principal and agent may each be refused to take
different action.
Agency problems may arise because of inefficiency and incomplete information. A
simple agency model suggest that, as a result of information asymmetries and self-interest
principals lack reasons to trust their agent and will seek to resolve these concerns by putting in
place mechanism to align the interests of agents with principals as well as to reduce the scope
of information asymmetries.

MOTIVES OF AGENTS AND INFORMATION ASYMMETRIES

At times, agent and principal are prone to have different motives. They may be
influenced by factors such as financial rewards, labour market opportunities, and relationships
with other parties that are not directly relevant to principals. Agents may also be more risk
averse than principals. As a result to these differing interests, agents may have an incentive to
bias information flows.

Principals Problems
Since principal has delegated the authority and responsibilities to agent, principal
depends on agents effort, and possibly other factors to determine his/her profit. Earning
maximum profit would be the main interest of the principal. However, the agent also would like
to maximises his/her utility. Doing work is a disutility, so agent needs compensation to be
induced to work. Besides that, agent may require a minimum level of utility before agreeing to
work. This contradict with principals objective, which is to maximize his profit.

Profit = Revenue generated by agent payment to agent

Agents Problems
Agents are somewhat the same like principal. They would also like to maximize their
utility. When such intention arises, it will compromise the principals interest. For example, in
dealing with a high risk business contract the has possibility high return, managers might as well
avoid such contract because they are afraid of the negative impact on them (no bonuses, being
laid off, etc.) should the contract fails. However, the managers action is not in the best interest of
the principal. Agents objective is not aligned with principals.

COSTS OF SHAREHOLDER-MANAGEMENT CONFLICT

Problems arise when the goals of principals are not completely shared by their agents.
For example, employees may exert insufficient effort, or managers may waste organizational
resources. The costs that arise when agents fail to act in the interest of principals are called
agency costs. The table below explains further:

General agency cost


Losses from poor
decisions

Explanation
Agents may not expand the
effort needed to gather
appropriate information and
make good decisions

Specific examples
Purchasing poor-quality raw
materials
Investing in an unprofitable project
Not prioritizing projects by
attributes that would benefit the
entity

Losses from incongruent


goals

Agents do not value the same


goals and objectives as
principals

Monitoring costs

Costs to monitor agents


behavior and to provide
information about agent effort

Costs for producing and auditing:


Financial statements
Internal financial reports

Goal alignment costs

Payments to encourage
agents to act in the best
interest of the principals

Contracting costs

Consumption of perquisites such


as expensive offices and travel
Excessive executive pay
Underinvestment in projects that
are in the principals best interest

Bonuses, share options and other


types of incentives
Sales commissions

Transactions costs incurred to


Legal fees to:
write and enforce employment Negotiate contracts between
contracts
entities and employees
Sue employees when they do not
meet contractual obligations

MECHANISMS FOR DEALING WITH SHAREHOLDER-MANAGER CONFLICTS


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There are two opposing positions for dealing with shareholder-manager agency conflicts.
At one extreme, the firm's managers are compensated entirely on the basis of stock price
changes. In this case, agency costs will be low because managers have great incentives to
maximize shareholder wealth. It would be extremely difficult, however, to hire talented managers
under these contractual terms because the firm's earnings would be affected by economic
events that are not under managerial control.
At the other extreme, stockholders could monitor every managerial action, but this would
be extremely costly and inefficient. The optimal solution lies between the two extremes, where
executive compensation is tied to performance, but some monitoring is also undertaken. In
addition to monitoring, the following mechanisms encourage managers to act in shareholders'
interests:
1) performance-based incentive plans
2) direct intervention by shareholders
3) the threat of firing
4) the threat of takeover
Most publicly traded firms now employ performance shares, which are shares of stock
given to executives on the basis of performances as defined by financial measures such as
earnings per share, return on assets, return on equity, and stock price changes. If corporate
performance is above the performance targets, the firm's managers earn more shares. If
performance is below the target, however, they receive less than 100 percent of the shares.
Incentive-based compensation plans, such as performance shares, are designed to satisfy two
objectives. First, they offer executives incentives to take actions that will enhance shareholder
wealth. Second, these plans help companies attract and retain managers who have the
confidence to risk their financial future on their own abilitieswhich should lead to better
performance.
Reward systems and incentive plans may align the interests of shareholders and
managers. The challenge from a managerial control system perspective is to do this in a way
that encourages better individual and organizational performance than if incentives did not exist.

When entities are small, principals minimize energy costs by personally overseeing
agent behavior and performance. However, as organizations grow larger, agent behavior is
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more difficult to observe, and agency costs tend to increase. To reduce agency costs, entities
establish accounting systems to monitor and influence agent behavior. For example, public
companies publish audited financial statements, and employees are often paid bonuses for
achieving profit goals.
Thus, accounting information is used not only to measure and monitor an organizations
activities, but also to measure, monitor and motivate the performance of agents. This would
form part of the management control system of the entity.
It is impossible to completely eliminate agency costs because agent behaviour and
decision making cannot be perfectly observed or measured. Poor results might be caused by
poor agent performance or by circumstances outside the agents control. Similarly, favourable
results cannot be attributed to the agents performance alone. For example, the sales generated
by a salesperson are partly a function of the effort and skills of the salesperson and partly a
function of the price and quality of the product, economic conditions, competition, customer
tastes and so on.
One way to reduce agency costs is to give specific decision-making authority to agents
and then hold them responsible for the results of their decisions. Shareholders on the other
hand give managers authority to decide how company resources are used. The shareholders
hold the managers responsible for creating shareholder value. To reduce agency costs,
individual employees are held responsible for their decisions, and limits are place on their
decision-making authority.

CONCLUSION

The principal-agent relationship form parts of our lives without we realized it. It is not
only restricted to business purpose only. It is just that the principal-agent relationship is reflected
more in business activity, where the shareholder (principal) delegate the responsibilities of
managing the business to managers (agents).
Although the agent is bound to work in the principals interest, we cannot deny that
agent is also people who seek for utility maximization. In the agent-principal relationship, it is
very rare that agent get tu maximize his utility while at the same time, maximize the principals
wealth. In most cases, only one party get to benefit at a time. Therefore, conflicts arise as both
party seek benefits for themselves.
Due to these conflicts, principal has to incur costs so as to ensure that the agent act in
their best interest and prevent further loss. These costs are called the agency cost. Besides
that, some measures can also be undertaken by principal to aligned the agents objective with
his.
In reality, despite the agency costs and measures taken by managers, the conflict
between agent and principal cannot be resolved completely. It can only be reduced to a
tolerable level.

Appendix
http://www.referenceforbusiness.com/encyclopedia/A-Ar/Agency-Theory.html

Eldenburg, Brooks, Oliver, Vesty & Wolcott. (2011). Management Accounting (2nd ed.). Australia:
Wiley.

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