The agency theory of corporate governance views managers in a firm as the agents to the shareholders, who are the firm’s principals. The manager-employee theory highlights singleton conflicts in pursuit of self-interested actions rather than maximizing shareholder value. The contribution of agency theory in corporate governance can be said to help design constraints for managerial actions that match the interests of shareholders with the expectations of owners. However, there are advantages and disadvantages of the agency theory of corporate governance, and indeed, it is important to talk about solutions to minimize agency issues.
What is Agency Theory of Corporate Governance?
The agency theory of corporate governance suggests that agents (managers) may not work in the interests of principals (shareholders) due to differences in risk preferences, personal motives or financial incentives.
Such incentives might tempt a company’s CEO, for example, to pursue short-term profitability in order to win performance bonuses rather than make investments in longer-term growth strategies. This means the shareholder’s interest long-term when the manager’s interest is immediate financial gain. This creates a conflict between one another.
Principal-Agent Relationship in Corporate Governance
Agents are those who are part of executive management and report to the principals, i.e., the shareholders. Shareholders supply capital, and managers oversee operations and strategy. Good governance makes sure that managers do what is best for the shareholders. Here are some key aspects of this relationship in India
- Role of Shareholders (Principals): In India, shareholders are promoters, institutional investors and public shareholders. Many Indian firms follow a promoter-driven model giving a lot of control to promoters. However, as institutional investment has increased, the nature of corporate governance has increasingly shifted towards divorcing ownership from management.
- Corporate Governance and Regulations: Management is expected to behave ethically and legally, aiming to maximize the entity’s value on behalf of shareholders. To ensure that the management acts in the shareholders’ best interests and maintains these investors’ trust, the Companies Act, 2013, along with timely guidelines announced by the Securities and Exchange Board of India (SEBI), set.
- Directors and Executives (Agents): Directors and executives handle the company’s day-to-day operations. It is their responsibility to align business decisions with shareholder interests. Indeed, the system probably works in most cases, but conflicts can arise if executives seek financial rewards to themselves high salaries, for instance, or job security over long-term gain for the company.
Role of Corporate Governance in Agency Theory
Corporate governance is a unit that mitigates the conflicts of interest in the classical agency theory of corporate governance. It sets rules, mechanisms, and structures in place to ensure that managers work in the best interest of its shareholders.
Ensuring Accountability and Transparency
Corporate governance attributes rules that make managers accountable for their decisions. Internal and external reports, independent audits and clear communication enable shareholders to track the company’s performance. Clear policies help businesses reduce the risk of fraud and mismanagement and ensure that executives act in the best interests of investors.
Reducing Conflicts of Interest
Agency conflicts like that arise when people (managers, in this case) care about their beneficial interests above the company’s success. Corporate governance provides independent directors, strict regulations, and ethical policies to avoid nepotism.To relieve future conflicts, means adopting measures that create a management culture that is focused on long-term sustainable growth, not short-term gains or self-interest.
Strengthening Shareholder Protection
Corporate governance provides protections of the rights of shareholders through vote rights, general meetings at regular intervals, and clear decision-making.. And when companies share with their shareholders the motions of making big decisions, they build trust and ensure that managers can’t just exercise power arbitrarily. Robust governance mechanics ensure that the scales of management control versus investor influence are balanced.
Implementing Performance-Based Incentives
Widespread corporate governance links executive compensation to corporate performance via stock options, profit sharing, and bonuses[1]. It, thus, encourages managers to focus on growing shareholder value rather than their pay. Performance-based incentives help align managerial interest with company goals, which leads to ethical leadership and sustainable business.
Ensuring Legal and Ethical Compliance
And, this is where Corporate governance comes into the picture, to maintain compliance with the SEBI regulations, the Companies Act, other relevant laws and to prevent unethical practices. Governance mechanisms establish a framework that provides guidelines determining legal and moral boundaries for businesses to operate, ultimately minimizing the risk of financial losses, legal penalties, and reputational damage, thus fostering a secure and trustworthy corporate climate.
Agency Problems in Corporate Governance
The agency problem occurs when managers act in their own interests instead of the interests of shareholders. Such conflicts lead to financial loss, corporate scandals, and unethical decision-making.
- Overpaid CEOs: CEOs who pay themselves excessive salaries in poor-performing companies. Disproportionate pay without justification lowers shareholder morale and investor confidence.
- Misuse of Company Resources: Managers using company money for non-work-related expenses. Such unscrupulous practices put financial strain on a company and cuts back on how profitable the company can be.
- Empire Building: Executives growing businesses beyond the necessity for greater control. Unlimited growth consumes resources and can result in company ineptness.
- Short-Termism: Prioritization of short-term profits over long-term sustainability. This only allows for future expansion while making progressive finance more precarious.
- Risk Aversion: Managers hedging against big investments for fear of personal failure. Limited business growth is driven by a failure to innovate and invest strategically.
Mechanisms to Mitigate Agency Problems
The companies tackle these agency problems of corporate governance via numerous mechanisms to ensure that the managerial actions are aligned with that of the shareholders.
- Performance-Based Pay: Aligns managers with long-term goals. They receive bonuses and incentives tied to company performance. This incentivizes executives to prioritize sustainable growth over short-term profits.
- Stock Ownership Plans: Align the financial interests of managers with those of shareholders. Executives whose compensation is tied to company shares have an incentive to maximize shareholder value. It makes conflicts of interest smaller, thus enhancing good decisions.
- Independent Board of Directors: Provide impartial review of management decisions The corporate governance law has become a mercenary law for independent directors, a preventive tool against unethical practices and mismanagement. This objective mindset enhances corporate governance and increases investor trust.
- Regulatory Compliance: Reduces misconduct and safeguards from corruption. Laws such as SEBI regulations and the Companies Act help promote transparency. Doing so mitigates the legal ramifications, and stakeholders’ interests are protected.
- Accountability through Shareholder Activism: When shareholders have voting rights, they can hold management accountable. Active shareholders affect the fate of big company decisions. Their participation fosters transparency, accountability, and ethical leadership.
Relevance to ACCA Syllabus
The agency theory of corporate governance is one of the Strategic Business Leader (SBL) Financial Management (AFM) paper in the ACCA syllabus. It describes how the interests of shareholders (the principals) conflict with those of managers (the agents), and the mechanisms available to monitor for accountability. How do agency problems get mitigated by corporate governance structures, board independence, executive compensation and financial transparency, are all essential for ACCA professionals to understand.
Agency Theory of Corporate Governance ACCA Questions
Q1: What is agency theory essentially about?
A) Shareholders vs Managers
B) For tax purposes, the structure of corporations
C) The professional obligations of accountants
D) Formation of financial statements
Ans: A) distinction between owners and managers
Q2: In agency theory, the cost of monitoring management behaviour.
A) Audit fees
B) Advertising expenses
D) Research & Development Expenses
D) Depreciation
Ans: A) Audit fees
Q3: How does external auditing address agency conflicts?
B) Ensuring that the financial statements are correct and free of bias
B) Giving up on being part of financial reporting
C) By means of restrictions on management compensation
D) And when you give people unlimited discretion in how they want to manage
Ans: A) Financial statements are free from error and bias
Q4: What would mitigate agency risk?
A) The six goals on internal controls and governance
B) Reduced compliance with regulations
C) Elimination of shareholder meetings
D) Limiting financial disclosures
Ans: A) Establishing strong internal controls & governance
Q5: Why is agency theory important to financial auditing?
A) It shows the impact of Auditors on how they reduce the movements on the illegal payment
B) Restricted knowledge needed for financial reporting
C) It seeks to slash at managerial discretion
D) It is not for small businesses
Ans: A) It talks about the role of auditors in thwarting financial mismanagement
Relevance to US CMA Syllabus
Agency theory is a core concept to explore in the strategic management and corporate governance segment of the US CMA syllabus; corporate managers must align an organization through a combination of mutually beneficial incentives for them and the shareholders. CMA experts have to assess financial governance mechanisms, pay for performance structures and risk appetite policies.
Agency Theory of Corporate Governance CMA Questions
Q1: What are the Are agency problem in the companies?
A) The shareholders get eaten first, followed by the personal goals of managers
B) Shareholders’ Interest comes First Insted of Managerial Arbitation
C) The prices of stocks keep on flater over a period of time
D) We don’t need corporate governance
Answer: (A) Managers work in their own best interest rather than optimizing for shareholders
Q2: An agency cost is defined as which of the following?
A) Management vs Shareholder cost
Option B – The Cost of Issuing New Shares
C) Cost of gaining market share
D) The tax on company profits
Ans: A) Cost of conflict between management and shareholders
Q3: Identify a corporate governance mechanism that reduce agency conflicts?
B) A independent board of directors
B) Reducing executive compensation
C) Through abolishing money accounting
D) The rising burden of debt
Ans: A) Board of Directorse. Independent
Q4: Why is agency theory relevant for investment decisions?
Answer A) What shareholders do to ensure their capital is not squandered
B) It prevents corporations from paying dividends
C) It restricts companies from fundraising
D) It applies only for accounting policies
Ans: A) It demonstrates how shareholders protect their investment
Q5: How do shareholders reduce agency problems in publicly traded corporations?
A) Expanding voting rights to stockholders
B) By reducing the people’s salaries
C) By limiting company size
D) Same: The corporate governance practice of letting a matter fall.
Ans: A) Expanding stockholder voting rights
Relevance to US CPA Syllabus
The Agency Theory of Corporate Governance is an important topic in Business Environment & Concepts (BEC) and Auditing & Attestation (AUD) in the US CPA syllabus. Therefore, CPAs should evaluate corporate governance structures, financial reporting mechanisms, and regulatory compliance to promote ethical business practices and protect investors.
Agency Theory of Corporate Governance CPA Questions
Q1: How is agency relationship defined in finance management?
A) Contractual business arrangement between two firms
B) A relationship between a principle and an agent that acts on the principle’s behalf
C) An agreement relationship between employees with suppliers
Ans: B) Principal-agent relationship
Q2: Which of the following is NOT a means of mitigating agency problems?
A) Executive stock options
B) Putting a restriction to managerial decision making
C) Viewing through the lens of board oversight
D) Salary tied to performance
Ans = B) Constraints to managerial decision making
Q3: What part do financial controls play in easing agency conflicts?
A) Through the un-voting of shareholders
B) Balance sheet to notice2 and apparent
C) By preventing competition in the market
D) by expaning executive rule
Ans: B) Providing transparency in the financial reporting
Q4: What causes agency costs to arise in corporations?
A) Because of the separation of ownership and control
B) Many cities where taxes are high and people are polite
C) Because of poor logging of transactions
D) Due to restrictions imposed by the government
Ans: A) Because of division of ownership and management
Q5: In what ways does corporate rate governance provide a solution to agency conflicts?
A) Saboteur independence and transparency of Board
B): Restricting financial reporting
C) Eliminating company debts
D) Covid containment measures
Ans: A) Greater independence and transparency of the board
Relevance to CFA Syllabus
The Agency Theory of Corporate Governance comes under the Ethics and Professional Standards and Corporate Finance topic of the CFA syllabus, which is one of the most important topics of the CFA exam. Corporate governance, shareholder rights and investment risk management are all essential areas CFA professionals constantly navigate and are exceptionally trained on, as they are core to financial decision-making, corporate responsibility, investor confidence, and indeed successful investing itself.
Agency Theory of Corporate Governance CFA Questions
Q1: In corporate governance, what does agency theory most focus on?
A) Maximize shareholder wealth
B) Interests of Management and Shareholder Are Aligned
Tax Compliance
D) Reducing operational costs
Ans: B) Managerial and shareholders interest are aligned
Q2: What did agency theory identifies to lead to conflicts between manager and shareholder?
A) Varying sets of accounting standards
Individual differences (Knowledge gap and different objectives).
C) Strict corporate governance regulations
D) D) Not having the funds
Ans: B)Incomplete information and conflicting interests
Q3: What do companies to reduce agency for financial management problems?
A) Pay-for-no-performance: more pay, no performance
B) Reward schemes for performance
C) Constraints on managerial autonomy
D) Ignoring shareholders concerns
Ans : B) Performance based incentive schemes
Q4: An agency cost occurs in a situation where:
A) Dividend payments
B) Audit fees
C) Employee salaries
D) Investment in new projects
Ans: B) Audit fees
Q5: How is a key aspect of agency theory facilitated by corporate governance?
A) Align management interests with those of shareholders
B) Reducing company taxes
C) Increasing debt financing
D) Expanding market share
Ans: A) Making sure management acts in the interest of shareholders
