Agency Theory: A brief Review by N. Waweru
The agency theory assumes that there exists a contractual relationship between members of a firm. It recognises the existence of two groups of people; principals or superiors and agents or subordinates. The principals will delegate decision making authority to the agents and expect them to perform certain functions in return for a reward. Both the principals and the agents are assumed to be rational economic persons motivated solely by self-interest but may differ with respect to preferences, beliefs and information (Jensen and Meckling, 1976). The principal/agent relationship can exist throughout any organisation and usually starts from the shareholder-director and ends with the supervisor-shop floor worker (Figure 1.1). In an organisation context, which involves uncertainty and asymmetric information, the agent’s actions may not always be directed to the best interests of the principal. Agents’ pursuit of their self-interest instead of those of the principal is what is called the agency problem (Jensen and Meckling, 1976). To counter this behaviour, the principal may monitor the agents’ performance through an accounting information system. The owner can also limit such aberrant behaviour by incurring auditing, accounting and monitoring costs and by establishing, also at a cost, an appropriate incentive scheme (Jensen and Meckling, 1976).

According to Jensen (1998), agency theory seeks to understand: (1) how to assign decision making responsibility to agents, (2) how to monitor agents’ behaviour, and (3) how to design incentives that cause agents to behave in a way that enhances the principal’s interests. Agency theory is built around the key ideas of self-interest, adverse selection, moral hazard, signalling, incentives, information asymmetry and most persuasively, the contract.

Figure 1.1: The principal agent relationship Principal (superior)

Direction of activities

CONTRACT

INTERFACE Supply of Effort

Agent (subordinate)
(Source: Mitchell, Reid and Smith, 1998:31)

Agency theory is based on several assumptions;
1) Individuals are assumed to be rational and to have unlimited computational ability. They can anticipate and assess the probability of all possible future contingencies.
2) The contracts are assumed to be costless and accurately enforceable by courts. The contracts are expected to be comprehensive and complete in the sense that for each verifiable event, they specify the actions to be taken by the contracting parties. However this assumption may not hold in most developing countries where judicial systems still lack the necessary resources to act efficiently.
3) Both principals and agents are motivated solely by self-interest.
4) The agent is assumed to have private information to which the principal cannot gain access without cost.
5) The agent is usually assumed to be work averse and risk averse (Baiman, 1990:343).

Baiman (1990) claims that the efficiency loss from agency problems creates the demand for management accounting procedures and processes within the firm. Examples of such procedures and processes include monitoring systems, variance investigation systems, budgeting systems, cost allocation systems and transfer pricing systems. The principal/agent model provides a coherent and useful framework to view managerial accounting procedures and pose managerial accounting questions. One would therefore expect to find a managerial accounting procedure only in the context in which individuals would benefit from its use.

In an organisation the demand for management accounting therefore lies in the need to monitor and control subordinates, to assess their performance and provide a basis of computing their remuneration. Agency theory offers an elegant way to think about management accounting and control systems in an organisation. In looking at the management accounting practices in the sampled organisations, this research recognises the reporting structures in organisations where top managers require monitoring of the activities of subordinates, hence the need for a management accounting system.

According to Jensen and Meckling (1976:311) a firm may be viewed as a nexus around which interested parties interact with respect to inputs and outputs, each trying to maximize their own utility (self interest). Consequently a firm may be viewed as a focal point around which the conflicting objectives of various individuals, each representing their own interests, are brought together. To maximize the value of the firm there arises a need to bring the conflicting objectives of the participants into equilibrium (Uliana, 1991). Developing countries suffer from the problem of low corporate governance when compared to developed countries mainly resulting from the lack of skilled manpower (Jhingan, 1993). The conflicting objectives discussed above are therefore likely to be more prevalent in developing countries thus necessitating a greater need for control.

Stated simply, agency theory has its roots in the relationship between the owners (principals) and managers (agents). Since this relationship is mainly based on self-interest, agency conflicts may arise when managers who initiate decisions are not the major beneficiaries of such decisions (Fama and Jensen, 1983a: 304). According to Jensen and Smith (1985) the conflict between owners and managers may be generalised into three major areas:
1) Choice of effort- an increase in the effort by the manager would increase the value of the firm but this constitutes a cost to the manager. A manager would therefore increase his/her efforts only if he/she expects to obtain more benefits than the costs of his/her effort.
2) Differential risk exposure- in terms of human capital, managers have made a significant investment in the firm unlike shareholders who usually operate a diversified portfolio. Managers are therefore exposed to total risk, whereas shareholders are only exposed to market or portfolio risk.
3) Differential time horizon- the manager’s interest in the firm is limited to his period with the firm whereas the shareholder’s interest is indefinite. In developed countries like Japan the manager’s horizon is almost indefinite, as most firms tend to engage managers on a lifetime basis. However in developing countries managers’ time horizons tend to be relatively short. There is a shortage of skilled manpower in most developing countries hence a high demand for managers. When the manager’s time horizon is short he is likely to sacrifice the long-term goals of the firm in favour of short-term goals. This will reduce the value of the firm. The use of non-financial measures of performance (BSC) may therefore be of a greater need in developing countries than in the developed world.

Despite the contributions of agency theory to management accounting, it has some limitations. The principal/agent model typically ignores the effect of the capital market by assuming a single owner rather than a group of owners and debt holders (Baiman, 1990:345). The theory also leaves no room for trust and fairness, which are also claimed to influence behaviour.

The agency theory concentrates on problems encountered by the owner when the manager relies on asymmetrical information to cheat and shrink (Mackintosh, 1994:36). Asymmetric information is also not a one-way street as is assumed by agency theory. Owners would also have access to private information, which they would use in negotiating contracts.

However according to Baiman (1990), the above criticisms are less compelling if we view the principal-agent model as a framework for analysing issues and highlighting problems which arise and must be considered in applying managerial accounting procedures to real world situations. Consequently agency theory offers insights into some of the tough issues and difficult problems involved in the design of management accounting systems.
References:
Baiman, S., 1990. Agency research in managerial accounting: A second look, Accounting, Organisations and Society, 14 (4): 341-371
Fama, E.F and Jensen, M.C., 1989 (a). Separation of ownership and control, Journal of Law and Economics, 23 (2): 301-325
Jensen, M.C and Meckling, W.H., 1976. Theory of the firm; Managerial behaviour, agency costs and ownership structure, Journal of financial economics, 305-360
Jensen, M.C and Smith, C.W., 1985. Stockholder, manager and creditor interests: applications of agency theory, In Altaman, E.I and Subrahmanyam, M.G. Recent advances in corporate finance, Richard D. Irwin, Homewood Illinois
Jensen, M.C., 1998. Foundations of organisational strategy, Harvard University Press, Cambridge London.
Jhingan, M.L., 1993. The economics of development and planning, Konark Publishers Pvt Ltd, New Delhi
Mitchell, F., Reid, G and Smith, J., 1998. A case of researching management accounting in SME’s, Management Accounting (0ctober), 30-32
Uliana, E.O., 1991. The effect of control structures on financial strategies of companies listed in the JSE, Unpublished PhD Thesis, University of Stellenbosch