Agency theory

Introduction
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 about a transaction that is unfair, which occurs when the party holding all the information capitalizes it in order to attain a competitive advantage.
Impact in Accounting Decision Making
In the case study “Financial Reporting Problems at Molex, Inc.” it is conceivable to see the issue of adverse selection. The Molex Corporation is a firm that deals with the manufacturing of electrical connectors and is based in Illinois. The company is experiencing financial accounting issue whereby there was an overstatement in the financial statements.
The CEO of Molex Corporation, Joe King, was hired in July 2001, and was accountable for management and inventory control, on top of other key responsibilities. Two years later, Diane Bullock was employed as a replacement of the former CFO. The main external auditors of the company, Deloitte & Touche, accused both King and Bullock for failing to disclose an 8 million pre-tax inventory valuation blunder (Healy, 2005).
The financial reporting issue made at the company was that the profit generated on inventory sales by the company between its subsidiaries, that however had yet to be retailed to external consumers had not been omitted from Molex’s consolidated earnings as well as in the firm’s inventory.
Essentially, the company reported extra inventory and earnings generated from the internal inventory sales. Consequently, this resulted in an overstatement of the company’s earnings, net income, as well as inventory, by $8 million before taxation and $5.8 million subsequent to taxation, of which roughly $3 million prior to taxation and $2.2 million after taxation was linked to the financial year ended June 30, 2004.
This entire amount was included in the financial statements as an adjustment to the current operating financial results, but the mistake was not disclosed. This issue emanated from the accounting decision making made by the CEO and the CFO of the company not to disclose this error within the financial statements when officially released in July 2004. The external auditors were not satisfied by this decision and therefore do not have trust in Molex’s CEO and CFO and have made an entreaty for these individuals to be fired and supplanted (Healy, 2005).
It is perceptible that in the case of Molex Solution, all the information that was available to the CEO and CFO at the time the decision was being made was also not available to stakeholders of the company such as the shareholders and the external auditors. As a result, this implies that the shareholders and the external auditors of the company could not be certain that the CEO and CFO of the company made the right decision in the circumstance (Healy, 2005).
In addition, it is perceptible that by making the decision not to disclose the transactions, both the CEO and CFO of the company did not have any incentive to reveal what they knew since this would make the stakeholders and owners of the company to, who are the principal, to effectively assess their actions in the future. This is referred to as information expectedness (Eisenhardt, 1989).
External auditors are independent accounting/auditing firms that are hired by companies’ subject to an audit. External auditors express their own opinions on whether the financial statements of the company in question are free of material misstatements. External audit firms are responsible for providing reasonable assurance that the financial statements are free from material misstatements and prepared according to an accounting framework.
External auditors are not there to fix the problems, although many will issue recommendations to management. External audit firms also are not responsible for providing absolute assurance of perfect financial statements; they only test enough data to provide reasonable assurance.
In the case of Molex Solutions, the company’s external auditors were Deloitte and Touche. Subsequent to conducting an assessment of the company, it was ascertained that even though not individually material, the profit generated from the inventory sales as a result of the wrong account could accumulate over the years and eventually become material and therefore be deemed as a material misstatement.
In this regard, the Deloitte auditors are skeptical because of the likelihood that future information will be withheld from them by the CEO and CFO of the company. More importantly, intercompany inventory ought to have been disclosed at an earlier date, that is July 21 rather than October 15.
The agency issues that emanate owing to delegating decision-making power from the owner of the company to the manager are considered to be, based on positive accounting theory, agency costs of equity. Imperatively, positive accounting theory examines the manner in which certain contractual agreements based on accounting figures can be put in place so as to minimize agency costs that are linked to the agency issues. There are three key agency issues. These include risk aversion, horizontal disparity and lastly, dividend retention (Eisenhardt, 1989).
To begin with, risk aversion is an agency issues that is caused by the relationship that exists between risk and return. Basically, in accordance to the company’s shareholders, it is widely acknowledged that the higher the risk, the higher the prospective return. This perspective is considerably dissimilar from that held by the managers owing to the fact that they are prepared to take less risk of the company for the reason that it is normally their fundamental source of income.
In the event that the managers continue to take projects that have less risks, this implies that they will most likely generate lower profits or generate lower returns and this is not what the owners or shareholders of the company want. Nonetheless, this problem can be diminished by providing managers with bonus incentives or remuneration packages that are associated to accounting earnings in order for managers to engage in taking greater risks so as to attain such bonuses (Eisenhardt, 1989).
This particular agency problem is perceived in the case of Nabors Industries. Compensation institutes the biggest section of the personnel retention course. The staffs always have high prospects concerning their reimbursement packages. Compensation packages differ from sector to another. Then, a striking payment package plays a significant function in retaining the personnel.
Njoroge and Kwasira (2015) study results that there is a bold relation between rewards & compensation and their performance thus retention in the organization. According to Savaneviciene and Stankeviciute (2010), the process of remuneration is important and is a significant source of contention in firms. A compensation scheme deals with paying individuals according to their value in the business. Further, the process of compensation is centered on both monetary and non-monetary paybacks.
Based on the analysis given, I consider the 1987 and 1988 remuneration packages to be appropriate for Mr. Isenberg. This is based on the thinking that the compensation plan is in 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 that has a long term view of the company. Therefore, there is a lower likelihood of there being an agency issue because the manager will be contemplating about the long term success of the company (Larcker and Tayan, 2007).
References
Ballwieser, W., Bamberg, G., Beckmann, M. J., Bester, H., Blickle, M., Ewert, R., ... & Gaynor, M. (2012). Agency theory, information, and incentives. Springer Science & Business Media.
Bou?ková, M. (2015). Management accounting and agency theory. Procedia Economics and Finance, 25, 5-13.
Eisenhardt, K. M. (1989). Agency theory: An assessment and review. Academy of management review, 14(1), 57-74.
Healy, P. M. (2005). Financial Reporting Problems at Molex, Inc.(A). Harvard Business School.
Larcker, D. F., & Tayan, B. (2007). Executive Compensation at Nabors Industries: Too Much, Too Little, or Just Right?. Rock Center for Corporate Governance at Stanford University Case Teaching No. CG-05.
Mitnick, B. M. (2015). Agency theory. Wiley encyclopedia of management, 1-6.
Scott, W. R., & O'Brien, P. C. (2003). Financial accounting theory (Vol. 3). Toronto: Prentice Hall.
Tearney, M. G., & Dodd, J. (2009). Accounting theory. H. I. Wolk (Ed.). New York: Sage.
Savaneviciene, A., & Stankeviciute, Z. (2010). The Models Exploring the “Black Box” between HRM and Organizational Performance. Journal of Engineering Economics. 21(4), 426-434.
Njoroge, S. W., & Kwasira, J. (2015). Influence of Compensation and Reward on Performance of Employees at Nakuru County Government. IOSR Journal of Business and Management, 87-93.