Agency Theory Essay

  • Length: 8 pages
  • Sources: 10
  • Subject: Accounting / Finance
  • Type: Essay
  • Paper: #56977009

Excerpt from Essay :


Agency theory is a theory explicating the relationship between the shareholders, who act as the principals, and the managers, who act as the agents. Within this relationship, the principal either employs or delegates an agent to carry out work and take actions in the best interests of the principal (Scott and O’Brien, 2003).

Imperatively, when the decision-making power and authority is delegated to another party, this can result in a loss of efficiency and subsequently increased costs. For instance, if the owner of a company partakes in the delegating of decision-making power to a manager, the agent in this case, it is conceivable that the manager will not work or operate as hard and with determination as the owner would, bearing in mind that the manager does not have any direct shares in the financial results of the company (Tearney and Dodd, 2009).

As a result, this could give rise to agency problems for the reason that this theory encompasses the costs incurred in solving conflicts between the company principals and agents and ensuring that the interests of these two parties are in alignment (Ballwieser et al., 2012).

The purpose of this paper is to carry out an independent review of the literature on agency theory as it applies to decision-making in accounting, describing and explaining three important ways in which agency theory might impact decisions made in a company in relation to the recording and presentation of financial information.

Agency Theory & Decision-Making in Accounting

There are important ways in which agency theory might have an effect on decisions that are made by a company in association with the recording and presenting of financial data and information. These ways include moral hazard, adverse selection, and information asymmetry.

Moral Hazard

Moral hazard alludes to the agent’s conceivable lack of determination to in carrying out or effectively performing delegated tasks and the actuality that it is challenging for the principal to assess the effort level that the agent has in actual fact used (Mitnick, 2015).

Moral hazard is explicated as the risk that a party encompassed in a particular transaction has to come into the contract in good faith, had conveyed deceptive information concerning its resources, responsibility and credit ability. In addition, moral hazard involves circumstances in which one certain party becomes engaged in a risky state of affairs with the knowledge that it is protected against the risk and that the other party will eventually incur the costs.

Notably, moral hazard comes about when both of these parties have incomplete information concerning each other. It arises when a party takes a risk because they know that there is an improbability that they will be affected by the ensuing consequences (Buockova, 2015).

Information Asymmetry & Principal-Agent Problem

Information asymmetry implies that the general outcome of the relationship between the principal and the agent is impacted by numerous uncertainties, and these two parties will by and large have dissimilar information to make an assessment or evaluation of these uncertainties (Mitnick, 2015).

The principal-agent problem takes place when a principal generates a setting in which the incentives of an agent are not in alignment with those of the principal. In general, the burden or obligation lies with the principal to generate incentives for the agent to make certain that they act in the manner that the principal wants. More often than not, the agent possesses more information than the principal. The significance is that the principal does not know the manner in which the agent will act and cannot at all times guarantee that the agent will act in the best interests of the principal (Scott and O’Brien, 2003).

Adverse Selection

Adverse selection alludes to the agent misrepresenting their competencies and skills to perform the tasks and the principal lacking the ability to completely substantiate this prior to making the decision to employ them. A fundamental way of evading this is for the principal to contact individuals for who the agent has in the past rendered such services (Mitnick, 2015).

Basically, this is a situation in which involvement is impacted by information that is misleading, in the sense that the agent and the principal have different information. In this regard, the party that has the private data and information concerning a particular transaction will selectively participate in transactions that are beneficial to them the most, with disregard to the interests of the other party. Significantly, the party without the information becomes apprehensive…

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…line with the strategy of Nabors Industries. To begin with, taking into consideration the situation of the company, Nabors Industries needs to provide a proper and satisfactory remuneration package in order to attract and motivate potential CEOs to come in and fix the existing issues and also facilitate the company to move forward.

Notably, Isenberg took over the role of Chairman and CEO of Anglo Energy at the outset of 1987. During this same period of time, the company was in serious trouble. The company was bearing a huge amount of debt and also accrued interest payments. Bearing this in mind, it is perceptible that Nabors Industry is in serious need of an effective leader to guide the company to success.

Secondly, the manner in which the company designed its compensation package basically encompassed the substantial use of stock options, and this motivated the CEO to work hard towards the sustainment of the company in regard to the financial performance (Larcker and Tayan, 2007).

Another agency issue is referred to as dividend retention. This is the case where the managers of the company make the decision to pay out less of the earnings generated by the company so as to retain more of them with the main intention of investing in the growth of the company. Yet again, this point of view is usually in contrast with the perspective of the shareholders whose main endeavor is to get higher dividends as a return to their investment (Eisenhardt, 1989).

Lastly, there is the issue of horizontal disparity. This is associated to the longstanding bonus incentives that are placed with the main aim of overcoming agency problems. Specifically, this is the situation whereby the manager anticipates to remain with the company for a minimal period of time and therefore are solely concerned with the short term sustenance of the firm. Subsequent to their departure, they lack any sort of interest.

In order to deal with the event of such an agency problem, the principal is encouraged to provide the agency with a long term perspective of the company and a deal that keeps him or her with the company (Eisenhardt, 1989). For instance, in the case of Nabors Industries, the remuneration package offered to Isenberg is one…

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