There used to be a time when most business were small and mostly family run business. The scenario of the business world changed with the concept of liberalization, privatization and globalization (LPG) the key to capitalistic economies emerged. After liberalization, privatization and globalization competition from around the world flooded the local market with cheap quality goods. It soon became necessary for business to grow and capture the advantages of economies of scale to remain competitive. This led to a business structure i.e. joint stock companies where investors pool their resources to form a larger organization than they could have individually.
Well the business structure of a joint stock company is excellent and this is evident as most of the organization operating today are some kind of joint stock company. However, the business structure of a joint stock company has an inherent problem i.e. of Principle- Agent relationship. Since many investors pool their resources to form a joint stock company, all these investors are the owners and all of them has a say in the operation of the company. It would be increasingly difficult with the increase in number of owners to make decisions and take quick actions as there will be a need for consensus among all owners or a majority of them. Hence, in order to speed up decision making or to put it even simply to run the business, the owners i.e. the investors appoint managers to run the business on their behalf. Here the managers represent the agent while the owners/investors (shareholders) represent the principle. Board of directors are another set of agents that are also appointed by the owners/investors (shareholders) to monitor the managers.
The agency theory is the relationship between principle and agents in business and the problems that arise out of difference in interest between the principle and the agent. Agency theorists is of the notion that humans are self-interested and disinclined to sacrifice their personal interest for the interest of others.
Conceptual Framework of Agency Theory
The major problem here is that of asymmetric information and difference in interest. The managers that operate the business are the only ones that have the real information about the business while the investors and board of directors have to rely on the financial statements that are prepared by independent auditors. As stated earlier agents are self-interested and will try to maximize their own gain rather than the principles. This lead to a problem of conflict of interest.
Importance of Agency Theory in Corporate Governance
The agency theory brings to light the agency problems i.e. conflict of interest and asymmetry of information which are inherent in the business structure of a joint stock company. Keeping in mind the agency problems we can develop rules and procedures that help in formulation of corporate policies and practices that improves corporate governance. The actions taken to overcome agency problem can be best understood with the help of the concept agency cost. These also represent corporate policies to reduce conflict of interest and asymmetric information between agent and principle.
The above problem i.e. self-interest and asymmetric information is known as agency problem and the cost incurred to overcome this problem to align the interest of principle and agent and to reduce asymmetry of information is known as agency cost. Agency cost can be divided into 3 parts namely Bonding cost, Monitoring cost and Residual cost. These cost along with an explanation on how it helps to eliminate agency problem is explained below.
Bonding cost is the cost spent by the agent to guarantee that he/she will not harm the interest of the principle i.e. he/she will try to maximize the wealth of the shareholders. This is ensured with the help of the components of bonding cost listed below:
- Claw back Clause: Managers agree to give back a portion of their compensation if they are found to cause any harm to the principle.
- Guarantee: Managers guarantee that they will not cause any harm to the principle and will signoff accurate financial statements.
Monitoring cost is the cost spent by the principle to align the interest of the agent to their own and to monitor the agent’s activities. This is ensured with the help of the components of
Monitoring cost listed below:
- Executive Compensation: Principle agrees to pay the agent bonuses, stocks and other benefits based on their performance.
- Monitoring Infrastructure: Principle appoints Board of directors to monitor the action of managers, Independent auditors to validate if the Financial Statements are true and fair representation, and various other control functions to limit the degree of freedom with which managers can operate.
Well in spite of all efforts and cost bared to align the interest of the principle and the agent as discussed above there may still be situation where losses are incurred. This is represented under the head Residual cost.
Limitation of Agency Theory
Agency theory, despite being the most prominent corporate governance theory, it still isn’t the best one. It does not consider the other stakeholders such as creditors, suppliers, employees, government, etc. which is taken into consideration by stakeholder theory while another theory stewardship theory tries to eliminate the agency problem by presenting the managers as good stewards who will act in the best interest of their owners. These managers are motivated by their owner’s objectives and follow a sociological and psychological approach to corporate governance in contrast to economical approach followed by agency theory.