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1. AGENCY THEORY

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.