Topic 4, Question 6.

Question:
Contracting theory, which forms part of the second wave in the positive theory of accounting,
focuses among other things on agency theory. What is agency theory? Elaborate the components of
agency costs as described by Jensen & Meckling (1976).

Answer:
Agency theory is based upon the more general contracting theory that the most cost
effective form of organizing economic activity is through a firm based structure. Jensen & Meckling
describe agency theory is a contract under one party (the principle) engages another party (agent) to
perform some service on the principals behalf. Under this contract, the principle delegates some
decision making authority to the agent. Both principle and agent are utility maximisers. There are no
reasons to believe that the agent will always in the principles best interest. Because of that,
therefore the principle introduces constraints to modify such aberrant manners.
The first component of agency cost is monitoring costs. The purpose of this cost is to
monitor agents behaviour by measure, observe and control the agents behaviour. These cost
usually incurred in the first instance by the principle. For example is monitoring audit costs. The
company engage the external auditor to audit the financial statement for observing and checking
whether the agent perform their duty ethically and complied with laws and regulation.
Second component is bonding costs. Cost to establishing and complying with mechanism to
guarantee that agent will behave in the interest of the principal is called as bonding cost. This is the
costs of bonding the agent interest to the principle. For example, manager (agent) may voluntarily
provide shareholders (principle) with quarterly financial statement that the manager has
comparative advantage on that and manager might contract not to disclose certain information to
the competitors.
The last component is residual loss which is purposely done by agent. It is incurred when the
agents act not entirely in the principles interest which lead to minimize or reduce the principles
wealth. For example, manager just put less effort than shareholders prefer and thus it will indirectly
cost the losses for shareholder.