Introduction of the concept of the agency theory

 According to R Kraakman, J Armour, P Davies, L Enriques, H Hansmann, G Hertig,

K Hopt, Hi Kanda and E Rock (2009), an agency problem arises whenever the
welfare of one party, known as the ‘principal’, depends upon actions taken by another
party, referred to as the ‘agent.’
 -According to According to R Kraakman, et al,(2009), the agency theory exists almost
in any contractual relationship , in which one party (the ‘agent’) promises
performance to another (the ‘principal’).
 The problem is birthed when trying to encourage or motivate the agent to act in the
principal’s interest rather than in his own interest.
 In the agency problem, it is very common that the agency possesses vast quantities of
information compared to that known by the principal, thus the principal cannot easily
assure himself that the agent’s performance is precisely what was promised.
 Since managers know a lot about the work of the company, they can make decisions
that benefit themselves such as entering into contracts with greater returns for
themselves (such as entering high-risk and high return projects) or can even divert to
themselves the returns that were promised to the principal during the inception of
their contractual agreement.
 As a result of this aforementioned problem, the interests of the principal (wealth
maximisation) will not be achieved because the agent has different interests (profit
maximisation).
 There are three agency problems that exist in organisations and these are between:
i. The firm’s owners as the parent against the hired managers as the agents.
-The managers are expected to pursue the owners’ interest (wealth maximisation)
not their own interest (profit maximisation).
ii. The majority shareholders as the agents against the minority shareholders as the
principal.
-The majority shareholders are not supposed to expropriate the principal in
matters such as voting for important decisions.
iii. The firm (the owners) as the agent against the external stakeholders such as the
customers as the principal.
-The firm should not behave in ways that are unethical such as exploiting of
employees or charging large prices for inferior products and services.
  The principal will try to manage or monitor the agent in order to mitigate the chances
of the agent pursuing his personal interests and in so doing, the principal will incur
what are known as ‘agency costs’.
 According to Brigham and Gapenski (1993), agency costs are the costs incurred
by shareholders to encourage managers to maximise shareholder wealth rather
than act in their self-interest.
- Examples of these cost include; auditing, structuring and insurance costs among
others.
 The agency costs vary with the complexity agent’s duties, i.e. the more complex the
agent’s duties are, the more privacy he ought to be given, resulting in more agency
costs being incurred for the monitoring of the agent.
 According to Cohen and Uliana, (1990), there are several costs that are incurred by
the family as a result of this conflict and these include:
i. High levels of management remuneration;
ii. the appropriation of corporate resources in the form of excessive levels of perks;
iii. avoiding investing corporate resources in potentially profitable ventures to the
detriment of the shareholders;
iv. the pursuit of sales growth at the expense of profit or shareholder wealth; etc

Addressing the agency theory in the real world.

 There are several different mechanisms that can be used to prevent management from
pursuing their own interests over the interests of shareholders and these can be
divided into two groups namely, internal measures and external measures.
 Internal measures
1. internal auditing;
 This is the appointment of an auditing team from the employees of the firm. This
team is responsible for checking if financial statements are free from errors and
mistakes as well as checking if the managers are effectively carrying out their
assigned responsibilities. This is practiced in many firms today as a way of
monitoring management performance.
 This measure is key especially when management’s rewards are based on their
performance because in their goal to earn more incentives they can manipulate
financial statements (books cooking) so as to present statements that show
accomplishment of targets.
2. Performance based incentive measures;
 Westerfield & Jaffe, (2008) outline that one of the measures of overcoming the
agency problem is by offering management percentage based incentives. Some
firms have adopted this kind of measure and they pay their management bonuses
based on sales, profit, etc.
 If managers’ rewards are based on sales, they will be motivated to make decisions
that are in favour of the shareholders’ interests, thus increasing the shareholder
value.
 There are several incentives that can be rewarded in this sector such as:
i. Share option schemes
 The most common way of this being implemented is by offering management
personnel the right to purchase a number of shares at a fixed price as part of their
remuneration.
 This measure ensures that management becomes part of the shareholders so that they
will make decisions that benefit the principal knowing well that they too will benefit
from the accomplishment of the objectives assigned to them.
ii. Performance based share options
 This method is similar to the one in (i) except for the introduction of performance
aspect.
 Managers are remunerated with shares on the condition that they have attained or
achieved certain objectives.
 Performance measures that can be used include earnings per share, return on equity,
etc.
 Rappaport (1986) enlightens on the problems that can be encountered in using
performance measures aforementioned above such as manipulation of accounts by
management.
iii. Value creation as performance measurement

3. Quality corporate governance/management

 According to Larcker and Tayan (2011), corporate governance is the collection of
control mechanisms that an organization adopts in order to prevent self-interested
 managers from pursuing tasks or objectives that benefit themselves not
shareholders.
 Under this measure there is an introduction of several further techniques discussed
below.
i. Shareholder control and interference
 Control is the capability of a company to elect the board of directors. This is
according to Cohen and Uliana, (1990). Although shareholders do not make active
decisions in the organisation, they do make key decisions such as the appointment
of key management personnel.
 Brigham & Gapenski (1993) state that management can directly influence
management on how to manage the company or by making proposals at Annual
General Meetings, which are then voted for or against.
 In the modern business world, it has been observed that shareholders appoint their
own management which they can influence unlike non-executive directors whom
they have no control over.
4. Threat of dismissal
 The stick and carrot treatment is now applied not only in control of shop flow
workers but also on top management. Shareholders will threaten management that
if they do not put all effort towards the achievement of their (shareholders’)
interests then management will be replaced by competent management which are
selfless.

 External measures
1. External auditors.
 According to (ISA200:3), the main objective of an external auditor is to give
an expression of an opinion on whether the financial statements are prepared,
in all material respects, in accordance with the applicable financial reporting
framework.
 Shareholders hire external auditors so they can assess if assertions made by
management about the business performance are true or not.
  External auditors have primary objectives which include detection of errors
and fraud in the preparation of financial statements or operations of the
business which when identified will be reported back to the auditors.

2. Threat of take overs

 This measure is not adapted by shareholders but the business environment.
 Management is forced to work extra hard in pursuit of shareholders’ interests
of wealth maximisation such as increases in future earnings instead of self-
interests.
 According to an article by Jensen and Ruback quoted by Cohen and Uliana
(1990), takeover threats are effective in monitoring performance of
management.
 This is effective because management understands that if future earnings
decrease, the share price of the firm will also decrease thereby exposing the
firm as a take-over target.

Conclusion

1. The agency problem between management and shareholders exists in all business
organisations thereby posing a big risk to shareholders whose interests can be
ignored by management.
 The problem can be solved by several measures as given in the previous
section but success of the measure applied depends not only on the
management performance but can also be affected by markets.
 An example of measures affected by business environments include sales
based bonuses, management might be pursuing interests of shareholders and
pushing sales but customers might not be interested in the firm’s products or
maybe there is too much competition in a market with few customers.