AGENCY THEORY NOTES
Agency refers to the relationship which submits between two parties, one
party called the principal engages another one called agent and gives
agent authority and mandate to act on the principal’s benefit. The
actions of agent are binding on the principal. In finance, stockholders
are owners of the firm and are therefore the principal. However, they
are not involved on the management of running of the firm for a number
of reasons.
- They may not have the necessary skills and expenditure of managing
the firm. - They may not have them to run the firm.
- They may be geographically dispersed to manage the firm.
- They may be too many to manage a single firm.
Therefore enjoy management directors who ask on their behalf the
directors are the Agents. They are given capital authority and other
resources for use or that they can generate profits on behalf of
principle stakeholders. The concept of entrusting resources with
individuals where they are expected to give an account of how the
resources are used is called stewardship. The directors/top management
are required to combine the where they have utilized he resources
entrusted. Usually a conflict of interest arises when the agents pursue
their own interest at the expense of the stockholders.
1.2 Types of Agency relationships
- Shareholders versus Management
- Shareholders versus Long-term Creditors
- Shareholders versus Auditors
- Shareholders versus Government
- Shareholders versus Branches
1.2.1 Shareholders versus Management
The management of a firm take some actions which are inconsistent with
the goal of shareholders of wealth maximization and this will cause a
conflict of interest.
The various causes of this conflict include the following:
- Incentive Problem
Top managers have a fixed salary and may not have the
incentive/motivation to work harder in order to maximize the
shareholders wealth. This is because, irrespective of the benefit
they make, their records is fixed they will therefore maximize on
leisure’s and work less. This will be against the interest of the
shareholders hence the conflict. - Consumption of perks/perquisites
Perquisites refer to the high salaries and generous fringe benefits
which directors’ award themselves. This will take the form of
directors’ remuneration, expensive cars, expensive holidays,
expensive assistance, post office etc. all these will constitute an
expense to the company and will therefore reduce the amount of
dividend paid to ordinary shareholders and who are the true owners
of the company. Therefore, the consumption of perks by directors is
against the interest of shareholders as it reduces their wealth. - Differences in Risk Profile
Shareholders prefer high risk; high return projects since they have
diversified investments that is, if one firm
or project one collapses it will have an insignificant effect on their overall wealth. Managers on the other hand, will prefer low return investment since they have a personal fear of losing their jobs in case of a given project/company collapsing. This is because managers do not have multiple jobs and can therefore not be diversified. This forces them to strive for returns for shareholders and not necessarily the maximum. This difference is risk profile is therefore a source of conflict. - Difference in Investment/Evaluation Horizon
Managers prefer to undertake profit which are profitable in the
short-term so that they can take credit when they are still in the
company shareholders. On the other hand, prefer long-term investment
which is consistent with the going concern concept of the firm. A
conflict will therefore occur since directors will undertake short
term investment against shareholders’ desire for long term
investment projects. - Management Buyout
The management may attempt to acquire the business of the principal
(shareholders). They would do this by forming nominees companies who
buy the shares of the company at the stock exchange. Once they get a
majority shareholding. This is equivalent of staging a coup and
taking over the business of the shareholders. This causes conflict
between agency and principal.
Solutions to the preceding type of agency problem
- Compensation plans
- Board of Directors
- Takeovers
- Specialist Monitoring
- Auditors
1.2.2 Shareholders versus Long-term Creditors
The shareholders who are the owners of the firm have the responsibility
to raise capital for the business. Where they are unable to rise, they
go to long-term creditors. These creditors will extend loans to the firm
with hopes that, they will get interest of the principal amount. In such
a situation a debt holder becomes the principal while shareholder the
agent. The interest charged will depend on the riskiness of the
borrower, the existing capital structure, asset backing as well as the
expected capital structure and the future asset structure of the firm.
Debenture traders may require security for their loan either having a
specific charge or a general charge on all the assets of the business.
Shareholders may prejudice the position of creditors hence conflict of
interest in the following ways.
- Disposal of assets used as collateral for the debt
In this case, the bond holder (creditor) is exposed to more risk
because he/she may not receive the loan given in case of liquidation
of the firm. - Assets/investment situation
In this case, the shareholder and the bondholder will agree on a
specific low risk project. However, this project may be substituted
for a high risk project whose flows have a high standard deviation.
This exposes the bond holders because should the project collapse
they may not recover all the amounts lend. - Payment of high dividends
Dividends may be paid from the current net profit and the existing
retained earnings. Retained earnings are an internal source of
finance. The payment of high dividends will lead to a low level of
capital investment and this will reduce the market value of the
shares and the bond. Also the firm may borrow debt to finance the
payment of the bonds, from which no returns are expected this will
also reduce the value of the firms and the bond. - Borrowing more debt capital
A firm may borrow more debt using the same assets as collateral for
the new debts. The value of the old debt will therefore be reduced
if the new debt takes priority on the collateral incase of the firm
is liquidate. This exposes the first bond holders/lenders to more risk. - Under investment
This is where the firm fails to undertake a particular project or
fails to invest money or capital in the entire project if there is
an expectation that, most of the returns from the project will
benefit the bond holders. This will lead to the reduction in the
value of the firm and subsequently in the value of the bond.
Solutions of the above type of agency problems
The Bond holders can take the following actions to protect themselves
against the actions of the shareholders:-
- Improve restrictive debt grants
This involves including strict terms and conditions in the loan
agreement or bond covenant. These restrictions may include; No
disposal of assets without permission of lenders; No payment of
dividends from retained earnings; No borrowing of additional debts
until the current debt capital is fully repaid or serviced. The bond
holders may recommend the type of project to be undertaken in
relation to the risk level of the project. Maintenance of a given
liquidity level by the borrower as indicated by the current ratio.
Restriction on merges and acquisitions especially where any merger
or acquisition will change the future cash flow pattern of the borrower - Sinking fund provisions
Some amounts of profits to be transferred annually into a fund for
the purpose of the loan repayment. - Callability provision
This is where the debt lender is given a lee way to demand early
payment of the debt by the borrower. If the borrower fails to pay
interest charges on the due date, the lender might demand the
repayment of the due loan before the end/lapse of the repayment
period in which case the debt is said to have been “called”. - Convertibility
This will enable the lender to convert the bond into ordinary shares
so that the bond holder becomes a shareholder
This is particularly so if the borrower
is unable to pay on the debt and is facing liquidation. - Refuse to Lend
The bond holders may refuse to provide capital to the borrower who
has been involved in the misuse of debt capital in the past. Such a
borrower will not be in a position to undertake viable project due
to lack of investment capital. Alternatively, the lender can charge
higher rates as deterrent mechanism. - Representation
The bond holder nay demand to have a representative in the board of
directors of the borrowing company where the representative will
oversee proper utilization of the debt capital - Transfer of Assets
On provision of debt capital, the lender may demand that, the assets
used as collateral will be transferred to the firm (legal Ownership)
passes to the lender and upon repayment of the loan, the asset is
transferred back to the borrower.
1.2.3 Shareholders versus Auditors
Shareholders appoint auditors to satisfy the financial statement and to
establish whether they show a true and fair view of the state of as at a
particular date. Auditors are supposed to monitor the performance of
management on behalf of the shareholders. Since auditors act on behalf
of shareholders; they become agents, while the shareholders become the
principal.
AGENCY THEORY
Auditors may prejudice the interest of shareholders, thus causing agency
problems in the following ways:
- Colluding with the management in the performance of their duties
whereby their independence is compromised. - Demanding very high audit fees although there is insignificant audit
work due to the strong accounts in existence. - Issuing unqualified reports
which might be misleading of which may make the public to lose upon
relying on them. - Failure to apply professional cadre and due to diligence in the
performance of the audit work
Solutions to the preceding agency problem
- Firing
- Auditors may be removed from office by shareholders at the Annual
General Meeting (AGM). - Legal Action
- Shareholders can institute legal proceedings against the auditors
who issue misleading reports, hence leading to investment losses. - Disciplinary Action by the Profession governing Accounting Practice
- The profession governing Accounting practice in the country in
question e.g. IGPAK in Kenya can also intervene on behalf of the
shareholders. Such may be through suspension of the auditors,
withdrawal of the practicing certificate, fines and penalties etc.
1.2.4 Shareholders versus Government
Shareholders and by extension the company operate in the environment
using license granted by the government. The government will expect the
company to operate the business in a manner which is beneficial to the
entire economy and society. The government is the principal and the
company is the agent. The company also carries on business on behalf of
the government because the conclusive investment environment for the
company and benefits from the company inform of taxes. The company and
its shareholders may take some actions that may prejudice the
interest/position of the government as the principal.
These actions include the following:
- Tax Evasion, this involves failure to give the accurate picture of
the earning of the firm to minimize the tax liability. - Involvement in illegal business in the firm e.g. drug trafficking,
smuggling e.t.c. - Lukewarm reception to social responsibility calls by the government.
- Lack of adequate interest in the safety of employees and the
products and services of the company including lack of environment
awareness concerns by the firms. - Avoiding certain types and areas of investment as encouraged by the
government through incentives so that investment can be done in such
areas.
Solutions to the preceding agency problem
The government can take the following actions to protect itself and its
interest.
- Incurring monitoring costs
For example the government will incur costs associated with
statutory audits, investigation of company’s under company’s Act,
back duty in the investigation cost to recover tax evaded in the
past and VAT refund audits. - Opening investment incentives
To encourage investments in given areas and locations, the
government offers incentives in form of capital allowance laid down
in the second schedule of Cap 470. - Legislations
The government has provided a legal framework to govern the
operations of the company and provide protection to certain people
in the society e.g. regulations associated to disclosure of
information, minimum wages and salaries, environmental protection
e.t.c., guidelines on minimum disclosure in financial statements
1.2.5 Head Office versus Branch
Multi-national companies have diverse operations set up in different
geographical locations. The head office will Act as the Principal and
the subsidiary will act as the Agent. The subsidiary will pursue their
own goals, hence creating an agency relationship.
These conflicts can be resolved in the following ways:-
- Frequent transfer of managers
- Adopting a global strategic planning to ensure better communication
of its vision. - Having a voluntary code of Ethical practices to guide the brand
management. - An elaborate performance reporting system providing a two way
feedback mechanism. - Performance contracts for managers with commensurate compensation
package for the same.
