The document discusses agency theory, which addresses the conflict that can arise between principals and agents in organizations. It defines key agency theory concepts like asymmetric information and defines agency theory assumptions around self-interest and bounded rationality. It provides examples of how agency theory applies to the relationship between shareholders and managers, and the role of audit committees in addressing agency problems. The document also discusses criticisms of agency theory and calls for making it more institutionally sensitive.

1. AGENCY
THEORY
Muhib Islam

2. Contents
 Background of Agency Theory
 Definitions
 Assumptions
 Reasons for Agency Problem
 Example of Application
 Audit Committee vs Agency Theory
 Recent Example of Theory

3. Background of Agency Theory (AT)
 Berle and Means (1932): separation of
ownership from control
 Jesen and Meckling (1976):
 agency relationship
 agency cost= monitoring expenditures +
bonding expenditures + residual loss
 Fama and Jensen (1983): agency
problems arise because contracts are
both costly to write and enforce

4. Best “Definition”
Jensen and Meckling defined:
“A contract under which one or more persons (the
principal(s)) engage another person (the agent) to
perform some service on their behalf which involves
delegating some decision making authority to the
agent.” (1976, p.308)
This contract may be simply constitute implicit terms about
how the principal expects the mangers to behave (Deegan
2009).

5.  Goal Orientation
 Obligation and
Reciprocity
 Risk
 Self-Interest
Agent
Conflict
Congruence
Principal
Agency Theory Diagram

6. Assumptions Of AT
 Bounded rationality
 Opportunism
 Information asymmetry
 AT assumes that the interests of principles
and agents diverge (Hill, Charles and
Jones 1992)
 Both parties intends to promote their own
self-interest (Kunz, Alexis and Pfaff, 2002)

7. Assumptions: Prior literature
 Two primary characteristics have been
suggested by the Prior literature :
 the conflicts of interest
 informational asymmetries between the
parties
(see Mas-Colell, Whinston and Green, 1995;
Milgrom and Roberts,1992)

8. Information Asymmetry
 Information available to the insiders (managers)
are not the same available public or outsiders
(stakeholders) (Scott 2009)
 Asymmetry of information does not allow the
principals to be sure whether the agents are
carrying out the duties that they should according
to the contract (Shapiro 2005)
 Contract does not have to be written contract. That is, it
may be simply constitute implicit terms about how the
principal expects the mangers to behave (Deegan 2009)

9. Reasons for Agency Problem
 Managers maximize their wealth at the cost of
shareholders
 Excessive remuneration or unjustified benefits
 Focus on short-term performance at the expense
of long-term growth
 Dechow and Sloan (1991): ‘horizon problem’
remuneration intrinsically linked to short-term
performance goal
 Differences in attitudes towards risk

10. Resolving Agency Problems
Contracts between agents and principals
specify the monitoring and bonding
arrangements:
 Monitoring; observing the behaviour and
performance of agents
 Bonding; arrangements that penalise
agents for acting in ways that violate the
interests of principals or reward them for
achieving principal’s goals

11. Resolving Agency Problems
 Burton (2000) : limiting management
discretion through establishment of
structures to monitor and control
management behavior
 Structures:
 Independent board of directors and
independent board chair (Dalton et. al 1999)
 Independent board subcommittees- audit,
remuneration and nomination (Ellstrand et. al
1999)

12. Case Study Example
Peter, Baxter. "Factors Associated with the Quality of
Audit Committees." [In English]. Pacific Accounting
Review 22, no. 1 (2010): 57-74.
 This paper has critically considered the AC quality to solve
agency problems.
 Board of directors are responsible for monitoring
the management activities
 delegate duties to AC for the oversight of financial
reporting
 minimize the information asymmetry (Beasley and
Salterio, 2001)
 AT is the underlying theory which governs the
formation of Audit Committee
 provide safeguard to the stakeholders.

13. Hypotheses
 H1: The independence, expertise, activity and size
of the board are positively associated with the
independence, expertise, activity and size of the
audit committee.
 H2: The company’s leverage is positively
associated with the independence, expertise,
activity and size of the audit committee.
 H3: The existence of a Big 5 auditor is positively
associated with the independence, expertise,
activity and size of the audit committee.
 H4: The extent of managerial ownership of equity is
negatively associated with the independence,
expertise, activity and size of the audit committee.

14. Findings
 Audit Committee Quality is positively
associated with company’s leverage, big
audit firms and the independence, expertise,
activity and size of the board. - (Hypothesis)
 The agency problem can be minimized if the
factors discussed above can be improved
 It is also possible by the reducing the
managerial ownership.

15. Board of Director
Management
(Agents)
Shareholders
(Principal)
Audit
Committee
Agency
Problem
Responsible for
managing top
management
Delegates
Financial
Reporting
Oversight
Expertise
Independence
Composition
Size
Level of Activity
Audit Committee vs Agency Theory

16. Various Perspectives
 Agency Theory has been considered by
various Studies:
 Economic
 Management and corporate governance
 Legal
 Normal Science

17. Future of AT
 Wiseman et al.’s (2012) proposed to make
agency theory institutionally sensitive
 Institutional factors be taken into account
(Aguilera and Jackson, 2010)
 However, Heracleous and Lan (2012)
argues that such a move cannot address
fundamental problems
 Thus they believe critical re-examination of
this theory and the development of
alternative conceptualizations

18. Reference List
Aguilera, R. V. and Jackson, G. (2010). ‘Comparative and international corporate
governance’. Academy of Management Annals, 4, 485–556.
Beasley, M., and S. Salterio. "The Relationship between Board Characteristics and
Voluntary Improvements in Audit Committee Composition and Experience."
Contemporary Accounting Research 18, no. 2 (2001): 539-70.Dalton, Dan R., Catherine M.
Daily, Jonathan L. Johnson, and Alan E. Ellstrand. "Number of Directors and Financial
Performance: A Meta-Analysis." Academy of Management Journal 42, no. 6 (1999): 674-8
Berle, A.A.. Jr. and G.C. Means, 1932. The modern corporation and private property
(Macmillan, New York)
Burton, P. "Antecedents and Consequences of Corporate Governance Structures." Corporate
Governance: An International Review 8, no. 3 (2000): 194-203.
Davis, James H., F. David Schoorman, and Lex Donaldson. "Davis, Schoorman, and
Donaldson Reply: The Distinctiveness of Agency Theory and Stewardship Theory." [In
English]. Academy of Management. The Academy of Management Review 22, no. 3
(1997): 611-13.
Dechow P, and R. Sloan. "Executive Incentives and the Horizon Problem." Journal of
Accounting and Economics 14, no. 1 (2001): 51-89.
Ellstrand, Alan E., Catherine M. Daily, Jonathan L. Johnson, and Dan R. Dalton.
"Governance by Committee: The Influence of Board of Directors' Committee Composition
on Corporate Performance." Journal of Business Strategies 16, no. 1 (1999): 67-88.6
Fama, E., and M. Jensen. "Separation of Ownership and Control." Journal of Law and
Economics 26 (1983): 301-25.
Heracleous, Loizos, and Luh Luh Lan. "Agency Theory, Institutional Sensitivity, and
Inductive Reasoning: Towards a Legal Perspective." Journal of Management Studies 49,
no. 1 (2012): 223-39.

19. Reference List
Hill, Charles W. L., and Thomas M. Jones. "Stakeholder-Agency Theory." Journal of
Management Studies 29, no. 2 (1992): 131-54.
Jensen, M., and Meckling W. "Theory of the Firm: Managerial Behaviour, Agency Costs
and Ownership Structure." Journal of Financial Economics 3, no. 4 (1976): 305-60.
Jensen, Michael C., and William H. Meckling. "Theory of the Firm: Managerial Behavior,
Agency Costs and Ownership Structure." Journal of Financial Economics 3, no. 4 (1976):
305-60.
Kunz, Alexis H., and Dieter Pfaff. "Agency Theory, Performance Evaluation, and the
Hypothetical Construct of Intrinsic Motivation." Accounting, Organizations and Society
27, no. 3 (2002): 275-95.
Mas-Colell, A., Whinston M. D., and Green J. R. "Microeconomic Theory." New York:
Oxford University Press, 2005.
P. Milgrom, and J. Roberts. "Economics, Organization and Management." London: Prentice
Hall, 1992.
Scott, W. Financial Accounting Theory. 5th ed. Toronto: Pearson Prentice Hall, 2009.
Wiseman, R. M., Cuevas-Rodriguez, G. and Gomez-Mejia, L. R. (2012). ‘Towards a social
theory of agency’. Journal of Management Studies, 49, 202–22.