1.3 Agency theory and the role of corporate governance

Question 1

What is “agency theory”?

Answer 1

The theory suggests that the modern corporation is based on the principal-agent relationship, where the owner (shareholder) is the principal and the manager is the agent.

The two enter into a contract whereby the manager aims to maximise the owner’s wealth

Question 2

Who developed the agency theory?

Answer 2

Jensen and Meckling

Question 3

What is the agency problem?

Answer 3

The idea of a conflict of interests between the principal & agent is the cornerstone of the agency theory.

The manager or agent may pursue their own interests at the expense of the principal.

Question 4

What is the solution to the agency problem?

Answer 4

The principal will incur agency costs to monitor the agent’s activities and take corrective action where necessary.

Question 5

What are agency costs?

Answer 5

Costs incurred by the inefficiency of a relationship between shareholders and business managers.

Question 6

What are the direct & indirect agency costs?

Answer 6

Direct agency costs – the monitoring costs such as fees payable to external auditors to assess the accuracy of the company’s FSs; excessive executive pay.

Indirect agency costs – refer to lost opportunities due to shareholder / management conflict but does not have a directly quantifiable value.

Question 7

What is the key objective of external audit?

Answer 7

To protect the principal by independently reporting on the state of the company’s finances.

Auditors give opinion on whether the financial statements give a ‘true & fair’ view of the co’s state of affairs