Abstract

This paper attempts to provide an overview of the major literature which has developed in the area of agency theory and corporate governance in the 25 years since Jensen and Mecklings (1976) groundbreaking article proposing their theory of the firm. A discussion is provided as to why such problems arise within the nexus of contracts which is described as characterizing the corporation and why managers and shareholders may act to maximize their own benefits therefore, control the resources in order to maximize their own interest. The major articles cover areas where managers interests are likely to diverge from those of t he shareholders who employ them. There are conflicts of interest between shareholders and management; a vast literature has explained both the nature of these conflicts, and means by which they may be resolved. Finance theory has developed both theoretically and empirically to allow a fuller investigation of the problems caused by divergences of interest between shareholders and corporate managers. What is attempted is to provide a summary of the major research that has taken place on the key topics which have emerged in terms of both the causes of agency conflicts, and the means by which they can be resolved. Additionally, an attempt is also made to incorporate various dimensions of agency relationship and conflicts among this relationship. In this paper, the nature of the agency relationship which exists between managers and shareholders and the agency costs which arise from them are also examined. Finally a discussion of the various mechanisms that have been discussed as means of reducing agency conflicts between shareholders and managers and section five concludes these findings. The major articles covering areas where managers interests are likely to diverge from those of the shareholders who employ them are also reviewed. Papers which have both proposed and empirically tested means by which such costs can be arise are also surveyed. Finally, some concluding remarks are offered along with some suggestions for future research.

Table of Contents
Abstract ...................................................................................................................................... i Introduction ................................................................................................................................1 Literature Review.......................................................................................................................2 Methodology ..............................................................................................................................3 Agency Theory...........................................................................................................................4 Positivist Agency Theory .......................................................................................................4 Principal Agent Research .......................................................................................................5 Proposition of Agency Theory ...................................................................................................6 Origins of Agency Theory .........................................................................................................8 Dimension of Agency Relationship ...........................................................................................9 Measures of Agency Relationship ...........................................................................................10 Where Agency Conflicts Arise ................................................................................................11 Agency Theory and the Organizational Literature ..................................................................14 The Impact of Agency Theory on Risk and Perception ...........................................................16 Agency Costs ...........................................................................................................................17 Contribution of Agency Theory ...............................................................................................19 Findings and Recommendation................................................................................................21 Conclusion ...............................................................................................................................22 Bibliography ............................................................................................................................ iii

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Introduction
Agency relationship is a contract, under which one party (the principal) delegates some decision-making authority to another party (the agent). Agency conflict arises because of the separation of ownership and control. The self opportunistic behavior of agent (management) is also responsible for agency conflicts. As there is misalignment of interest between principal (owner) and agent (management), the principal (owner) needs to induce the agent (management) to act in the best interests of the principal. Thus the principal has to bear the cost of monitoring and bonding the activities of the management. Because of agency conflict, it is essential to find ways so that the interest of the shareholders and management can be aligned. In the absence of proper control mechanisms, management can pursue their own interest with the expense of the shareholders interest. While describing agency theory, several issues have been taken into consideration. There are some propositions of agency theory which are discussed in order to investigate the origin of agency theory. There are different dimension of agency theory which are identified to measure the intensity of agency relationship in different organization. In this paper, the causes of arising agency conflict are also demonstrated along with the agency costs. Finally, it is tried to find some contributions of agency theory. This paper also describes agency theory and to indicate ways in which organizational researchers can use its insights.

Literature Review
Agency costs can manifest in various forms, including self-serving behavior on the part of managers focused on status or empire-building objectives, excessive perquisite consumption, non-optimal investment decision-making or acts of accounting mismanagement or corporate fraud. There are several empirical literatures on agency theory which focus on economic role of agency theory and agency relationship, agency cost arises from agency relationships and the role of corporate governance. However, these literatures suggested that agency costs are arise because of management opportunistic behavior as there is contractual relationship between owner and management. There are some other literatures which provide guidelines that can reduce agency cost by internal governance mechanisms and there is empirical evidence in support of this argument. Jensen and Meckling (1976) point out that agency costs occur due to misalignment of the agents and the owners interests. The separation of ownership and control may generate agency costs. They also argued that this delegation authority reduces the value maximizing decisions taking by the manager in the firm. Himmelberg, Hubbard and Palia. (1999) argued Jenson and Meckling (1976), by saying that principal agent problem are not similar in all firms rather they are different in different firms, different industries and also in different cultures. Chances (1997) argue on a derivate substitution of executive compensation. He suggests giving the manager stocks without right to vote, which could be beneficial in preventing an executive from wielding too much control. Gompers, Ishii, and Metrick (2003) in their research on agency cost also said that agency cost is the strengthen relationship between the shareholders rights and its associated with the corporate governance. Ang et al. (2000), and Fleming et al. (2005), shows that agency costs generated from the conflicts between outside equity holders and owner-manager could be reduced by increasing the owner-managers proportion in equity, i.e., agency costs vary inversely with the managers ownership. Stulz (1990), Alvarez et al. (2006) and Kent et al. (2004) suggest the manager always want to invest all available funds even if paying out cash is better for outside shareholders, and conflict between the manager and equity holders cannot be resolved through contracts based on cash flows and investment expenditures. Agrawal and Knoeber (1996) conclude that debt leverage, internal equity, institutional ownership, large shareholders and an active market of corporate merger and acquisition helped to reduce the agency problem and agency costs.

Methodology
This study uses the descriptive approach. To illustrate the descriptive type of research, Calmorin and Calmorin (1995) will guide the researcher when he stated: Descriptive method of research is to gather information about the present existing condition. The purpose of employing this method is to describe the nature of a situation, as it exists at the time of the study and to explore the cause/s of a particular phenomenon. However, this study will perform, for most of its part, qualitative research based on secondary data, since there has to be more descriptive accounts of the subject matter, and a deeper understanding of the phenomena of interest from the respondents eyes. This study used an extensive survey of literatures on the topic related with agency theory, agency costs, and agency problem in different economies etc. as the determining factors. Several books of corporate finance, articles, thesis papers, and literatures were extensively investigated as source of theory and knowledge related with this paper.

Agency Theory
A simple agency model suggests that, as a result of information asymmetries and selfinterest, principals lack reasons to trust their agents and will seek to resolve these concerns by putting in place mechanisms to align the interests of agents with principals and to reduce the scope for information asymmetries and opportunistic behavior. An agency relationship arises when one or more principals (e.g. an owner) engage another person as their agent (or steward) to perform a service on their behalf. Performance of this service results in the delegation of some decision-making authority to the agent. This delegation of responsibility by the principal and the resulting division of labor are helpful in promoting an efficient and productive economy. However, such delegation also means that the principal needs to place trust in an agent to act in the principals best interests. Agents are likely to have different motives to principals. They may be influenced by factors such as financial rewards, labor market opportunities, and relationships with other parties that are not directly relevant to principals. This can, for example, result in a tendency for agents to be more optimistic about the economic performance of an entity or their performance under a contract than the reality would suggest. Agents may also be more risk averse than principals. As a result of these differing interests, agents may have an incentive to bias information flows. Principals may also express concerns about information asymmetries where agents are in possession of information to which principals do not have access. From its roots in information economics, agency theory has developed along two lines: positivist and principal-agent. The two streams share a common unit of analysis: the contract between the principal and the agent. They also share common assumptions about people, organization and information. However, they differ in their mathematical rigor, dependent variable and style.

Positivist Agency Theory

Positivist researchers focused on identifying situations in which principal and agent are likely to have conflicting goals and then describing the governance mechanisms that limit the agent's self-serving behavior. Positivist research is less mathematical than principal-agent research. Also, positivist researchers have focused almost exclusively on the special case of the principal-agent relationship between owner and management of large public corporations. From a theoretical perspective, the positivist stream has been most concerned with describing the governance mechanisms that solve agency problem. At its best, positivist agency theory can be regarded as enriching economics by offering a more complex view of organizations.
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However, it has been criticized as minimalist and by micro economists as tautological and lacking rigor. Nonetheless, Positivist agency theory has ignited considerable research and popular interest.

Principal Agent Research

Principal-agent researchers are concerned with a general theory of principal-agent relationship, a theory that can be applied to employer-employee, lawyer-client, buyersupplier and other agency relationships. Characteristics of a formal theory, the principalagent paradigm involves careful specification of assumptions, which are followed by logical deduction and mathematical proof. In comparison with the positivist stream, principal-agent theory is abstract and mathematical, and therefore, less accessible to organizational scholars. Indeed, the most vocal critics of the theory have focused their attacks primarily on the more widely known positivist stream. Also, the principal-agent stream has a broader focus and greater interest on general, theoretical implications. In contrast, the positivist writers have focused almost exclusively on the special case of the Owner/CFO relationship in the large corporation. Finally, principal-agent research includes many more testable implications. Positivist theory identifies various contract alternatives and principal-agent theory indicates which contract is most efficient under varying level of outcome uncertainty, risk aversion, information and other variables. The focus of principal-agent literature is on determining the optimal contract, behavior versus outcome, between the principal and the agent.

Proposition of Agency Theory

Kathleen M. Eisenhardt (1999) has identified ten propositions related to agency theory. The first two propositions are focused by positivist agency theory researchers and the others are focused by principal-agent researchers. In the following section these propositions are described. The argument is that such contracts co-align Proposition 1: When the contract between the preferences of agents with those of the the principal and agent is outcome based, principal because the rewards for both depend the agent is more likely to behave in the on the same actions and therefore, the conflict interest of principal. of self-interest between principal and agent are reduced. Proposition 2: When principal has The argument here is that, since information systems inform the principal about what the agent is actually doing, they are likely to curb agent opportunism because the agent will realize that he/she cannot deceive the principal. In the case of unobservable behavior, the Proposition 3: Information systems are principal has option to discover the agent's positively related to behavior-based behavior by investing in information systems.

information to verify agent behavior, the agent is more likely to behave in the interest of the principal.

contracts and negatively related to outcome Such investments reveal the agent's behavior to based contracts. the principal, and the situation reverts to the complete information case. Proposition 4: Outcome uncertainty is As uncertainty increases, it becomes

positively related to behavior to behavior- increasingly expensive to shift risk despite the base contracts and negatively related to motivational outcome-based contracts. contracts. As the agent becomes increasingly less risk Proposition 5: The risk aversion of the averse, it becomes more attractive to pass risk agent is positively related to behavior- to the agent using an outcome-based contract. based contracts and negatively related to Conversely, as the agent becomes more risk outcome-based contracts. averse, it is increasingly expensive to pass risk to the agent. Proposition 6: The risk aversion of the As the principal becomes more risk averse, it is
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benefits

of

outcome-based

principal is negatively related to behavior- increasingly attractive to pass risk to the agent. based contracts and positively related to outcome-based contracts. As goal conflict decreases, there is a decreasing Proposition 7: The goal conflict between motivational imperative for outcome-based principal and agent is negatively related to contracting and the issue reduces risk sharing behavior-based contracts and positively considerations. Under assumption of a riskrelated to outcome-based contracts. averse agent behavior-based contracts become more attractive. The argument is that the behavior of agents Proposition 8: Task programmability is engaged in more programmed jobs is easier to positively contracts related and to behavior-based observe and evaluate. Therefore, the more related to programmed the task, the more attractive the behavior-based contract because information about agent's behavior is readily determined. Proposition 9: Outcome measurability is When outcomes are measured with difficulty, negatively related to behavior-based outcome-based contracts are less attractive. In

negatively

outcome-based contracts.

contracts and positively related to outcome- contrast, when outcomes are readily measured, based contracts. outcome-based contracts are more attractive. It is likely that the principal will learn about the Proposition 10: The length of the agency relationship is positively related to agent and so will be able to assess behavior more readily. Conversely, in short-term agency relationship, the information asymmetry

behavior-based contracts and negatively related to outcome-based contracts.

between principal and agent is likely to be greater, thus making outcome-based contracts more attractive.

Origins of Agency Theory

Agency theory is developed on the basis of self-interest assumption, a rational individual acts for his or her own best interest. In 1776, Adam Smith mentioned some indication of personal self-interest by economic man and self love. During the 1960s and early 1970s, economists explored risk sharing among individuals or groups. This literature described the risk-sharing problem as one that arises when cooperating parties have different towards risk. Agency theory broadened this risk-sharing literature to include the so-called agency problem that occurs when cooperating parties have different goals and division of labor. Specifically, agency theory is directed at the ubiquitous agency relationship, in which one party (the principal) delegates work to another (the agent), who performs that work agency theory attempts to describe the relationship using the metaphor of a contract. Agency theory is concerned with resolving two problems that can occur in agency relationship. The first is the agency problem that arises when (a) the desires or goals of the principal and agent conflict and (b) it is difficult or expensive for the principal to verify what the agent is actually doing. The second is the problem of risk sharing that arises when the principal and agent have different attitudes towards risk. The problem here is that the principal and the agent may prefer different actions because of different risk preferences. Agency problem exist for the following grounds. 1. The agent is generally assumed to be risk-averter and the principal to be a risk-seeker or risk-averter. 2. The agent might have a shorter duration with the organization than the principal. 3. The earnings of the agent are fixed while the principal is the residual claimant. 4. The principal doesnt directly take part in decision-making and control. 5. There is information asymmetry between the agent and the principal.

Dimension of Agency Relationship

Agency relationship exists when there is a contractual relationship between two or more persons and one or more persons (the principal) engage other person (the agent) to perform some service on their behalf under contractual relation. As both the principal and the agent are assumed to be rational economic person and therefore motivated solely by self-interest. In public corporation there are several contractual relations. i. Between shareholders and board of directors.

ii. Between board of directors and executives. iii. Between executives and their subordinates. In every contractual agreement one party delegates some decision making authority to another party. Board of Directors supervises the funds and resources provided by the shareholders. Executives perform according to the guideline of the board of directors as subordinates perform on behalf of executives.

Measures of Agency Relationship

There are many dimensions of differentiating firms such as size, organizational complexity, operating environment and ownership structure etc. These dimensions also affect in measuring intensity of agency relationship and therefore agency problem. 1. Size of Firm: In a large firm there are more operational activities which may lead managers to behave their own interest than a small firm. Again there is more political scrutiny which provides greater incentives to manager to exercise discretion to minimize political cost. Larger firms are more likely to have highly diffused ownership structure where there is not many big shareholder to monitor managers activities closely. Thus larger firms have higher intensity of agency relation and agency conflicts. 2. Organizational Structure: Again a firm, which organizational hierarchy is larger, relatively has more agency problem. 3. Stage of Growth: When growth rate of a firm is high there is information asymmetry and managers of this firm are more likely to have more power due to more resources under their control. 4. Ownership Structure: In assessing agency relation another important factor is ownership structure. When managers share little ownership there is possibility to deploy organizational resources in their benefit. Again in a family business firm where most of the resources are provided by family members and they look after the financial and operational activities of the business there is minimum agency problem. 5. Presence of Non-executive Director: Non-executive directors are intellectual and most importantly outsiders of the organization having immense knowledge and expertise. In a firm, where board composition with non-executive directors (independent in nature) has lesser intensity of agency problem than other firms which boards lack non-executive director.

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Where Agency Conflicts Arise

Agency problems arise from conflicts of interest between two parties to a contract, and as such, are almost limitless in nature. However, both theoretical and empirical research has developed in four key problematic areas. These are moral hazard, earnings retention, risk aversion, and time-horizon. The next section aims to provide a discussion of these major themes. 1. Moral-Hazard Agency Conflicts: Jensen and Meckling (1976) first proposed a moral-hazard explanation of agency conflicts. Assuming a situation where a single manager owns the firm, they develop a model whereby his incentive to consume private perquisites, rather than investing in positive net present value (NPV) projects, increases as his ownership stake in the company declines. This framework is easily applied in companies where ownership structure is diverse and the majority of the companys shares are not controlled by corporate managers. This is more often than not the case in most market based contracting economies. As managers are not investing, they may choose investments best suited to their own personal skills. Such investments increase the value to the firm of the individual manager and increase the cost of replacing him, allowing managers to extract higher levels of remuneration from the company. Moral-hazard problems are likely to be more paramount in larger companies. While larger firms attract more external monitoring, increasing firm size expands the complexity of the firms contracting nexus exponentially. This will have the effect of increasing the difficulty of monitoring, and therefore, increase these costs. Furthermore, larger, mature, companies, free cash flow problems will heighten the difficulties created by moral hazard. Where managers have such funds at their disposal, without any strong requirements for investment, the scope for private perquisite consumption is vastly increased, as it becomes more difficult to monitor how corporate funds are utilized. Moral-hazard problems are also related to a lack of managerial effort. As managers own smaller equity stakes in their companies, their incentive to work may diminish. It is difficult to directly measure such shirking of responsibilities by directors. However, company stock prices decline upon the announcement of the appointment of an executive director to the board of another company. This would be consistent with diminishing managerial effort being damaging to company value.

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2. Earnings Retention Agency Conflicts: Moral hazard based theories over-simplify the agency problem as one of effort aversion. Grandiose managerial visions and cash distribution to shareholders may be of more concern. Here, the problem of overinvesting may be more paramount than that of perquisite consumption and underinvestment. Studies of compensation structure have generally found that director remuneration is an increasing function of company size, providing management with a direct incentive to focus on size growth, rather than growth in shareholder returns. Furthermore managers prefer to retain earnings, whereas shareholders prefer higher levels of cash distributions, especially where the company has few internal positive NPV investment opportunities. Managers benefit from retained earnings as size growth grants a larger power base, greater prestige, and an ability to dominate the board and award themselves higher levels of remuneration. This reduces the amount of firm specific risk within the company, and therefore, strengthens executive job security. However, finance theory dictates that investors will already hold diversified portfolios. Therefore, further corporate diversification may be incompatible with their interests. Empirical evidence suggests that such a strategy is ultimately damaging to shareholder wealth. Returns to shareholders in undiversified firms are greater than for those who had attempted to reduce their exposure to risk through this diversification and the value of these firms is reduced as they diversified further. Such earnings retentions reduce the need for outside financing when managers require funds for investment projects. However, despite the potential costs of raising new capital, external markets provide a useful monitoring function in constraining grandiose managerial investment policies. Earnings retention reduces the likelihood of this external monitoring encouraging management to undertake value maximizing decisions. 3. Time Horizon Agency Conflicts: Conflicts of interest may also arise between shareholders and managers with respect to the timing of cash flows. Shareholders will be concerned with all future cash flows of the company into the indefinite future. However, management may only be concerned with company cash flows for their term of employment, leading to a bias in favor of short-term high accounting returns projects at the expense of long-term positive NPV projects. The extent of this problem is heightened as top executives approach their retirement, or has made plans to leave the company. Research and development (R&D) expenditures as top executives approach retirement and find that these tend to decline. R&D expenditures reduce
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executive compensation in the short-term, and since retiring executives wont be around to reap the benefits of such investments; this could explain the above findings. Such a problem may also lead to management using subjective accounting practices to manipulate earnings prior to leaving their office in an attempt to maximize performance-based bonuses. Accounting earnings tend to be significantly higher in the year prior to a Chief Executive Officer (CEO) leaving their position, and attributes such findings to the problem of earnings manipulations. 4. Managerial Risk Aversion Agency Conflicts: Conflicts relating to managerial risk aversion arise because of portfolio diversification constraints with respect to managerial income. Should private investors wish to diversify their holdings they can do so at little cost with. However, company managers are more akin to individuals holdings a single, or very small number of stocks. The majority a company directors human capital is tied to the firm they work for, and therefore, their income is largely dependent upon the performance of their company. As such, they may seek to minimize the risk of their companys stock. Therefore, they may seek to avoid investment decisions which increase the risk of their company, and pursue diversifying investments which will reduce risk. There is an inverse relation between the risk of a firms stock and levels of ownership concentration. Executives in high risk companies prefer to place a smaller fraction of their personal wealth in the company. This problem may be heightened when executive compensation is composed largely of a fixed salary, or where their specific skills are difficult to transfer from one company to another. In addition, risk increasing investment decisions may also increase the likelihood of bankruptcy. Such a corporate event will severely damage a managers reputation, making it difficult to find alternative employment. Managerial risk aversion will also affect the financial policy of the firm. Higher debt is expected to reduce agency conflicts and also carries potentially valuable tax shields. However, risk-averse managers will prefer equity financing because debt increases the risk of bankruptcy and default.

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Agency Theory and the Organizational Literature

Agency theory is different from organizational theory because at its roots, agency theory is consistent with the classic works of Barnard (1938) on the nature of cooperative behavior and March and Simon (1958) on the inducements and contributions of the employment relationship. As in this earlier work, the heart of agency theory is goal conflict inherent when individuals with differing preferences engage in cooperative effort, and the essential metaphor is that of a contract. Agency theory is also similar to political models of organizations. Both agency and political perspectives assume the pursuit of self-interest at the individual level and goal conflict at the organizational level. Also in both perspectives, information asymmetry is linked to the power of lower order participants. The difference is that in political models goal conflicts are resolved through bargaining, negotiation and coalitions-the power mechanism of political science. In agency theory, they are resolved through the co-alignment of incentives-the price mechanism of economics. Agency theory is also similar to the information processing approaches to contingency theory. Both perspectives are information theory. They assume that individuals are boundedly rational and that information is distributed asymmetrically throughout the organization. They are also efficiency theories; that is, they use efficient processing of information as a criterion for choosing among various organizing forms. The difference between the two is their focus. In contingency theory researchers are concerned with the optimal structuring of reporting relationship and decision making responsibilities whereas in agency theory they are concerned with the optimal structuring of control relationships resulting from these reporting and decision making patterns. For example, using contingency theory, we would be concerned with whether a firm is organized in a divisional or matrix structure whereas using agency theory, we would be concerned whether managers within the chosen structure are compensated by performance incentives. The most obvious tie is with the organizational control literature. For example, Thompsons's (1967) and later Ouchi's (1979) linking of most known means/ends relationships and crystallized goal to behavior versus outcome control is very similar to agency theory's linking task programmability and measurability of outcomes to contract form. That is, known means/ends relationships (task programmability) leads to behavior control and crystallized goals (measurable outcomes) lead to outcome control. Similarly, Ouchi's (1979) extension of Thompson's (1967) framework to include clan control is similar to assuming law of goal
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conflict in agency theory. Clan control implies goal congruence between people and, therefore the reduced need to monitor behavior or outcomes. The major differences between agency theory and organizational control literature are the risk implications of principal and agent risk aversion and outcome uncertainty. It is not surprising, that agency theory has similarities with the transaction cost perspectives. As noted by Barney and Ouchi (1986), the theories share assumption of self-interest and bounded rationality. They also have similar dependent variables; that is, hierarchies roughly correspond to behavior-based contracts and markets correspond to outcome-based contracts. However, the two theories arise from different tradition of economics. In transaction cost theorizing we are concerned with organizational boundaries whereas in agency theorizing the contract between cooperating parties, regardless to boundary, is highlighted. However, the most important difference is that each theory includes unique independent variables. In transaction cost theory these are asset specificity and small number bargaining. In agency theory there are the risk attitudes of the principal and agent, outcome uncertainty and information systems. Thus, the two theories share a percentage in economics but each has its own focus and several unique independent variables. All these can be summarized as in the table presented below.

Perspectives Assumption Political Contingency Self-interest Goal Conflict Bounded Rationality Information Asymmetry Preeminence of Efficiency Risk Aversion Information as a Commodity Organization Transaction Agency Control Cost

Table 1: Comparison of Agency Theory Assumptions and Organizational Perspectives

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The Impact of Agency Theory on Risk and Perception

There are some works which have found that agency theory has impact on risk-taking. Both smaller board sizes and remuneration with stocks or options were found to lead to increased risk-taking. Moreover, financial education and work experience were found to positively impact risk-taking. This hints at the fact that there is a larger inclination for boards with high financial literacy. Despite some positive results, simultaneous board positions and independence were either insignificant or contrary to expectations. Therefore it seems inordinate to argue unequivocally that promote risk-taking rather that some ideas do so through stronger shareholder alignment. Regarding the effect on ethical perceptions this paper finds little difference between moral philosophies and humanistic assumptions amongst business majors versus other majors. However, the literatures uncover significantly stronger shareholder dominance amongst business majors. Additionally, these exposed an issue that may add some light to the argument that business majors are inherently immoral and unethical. Despite holding similar perceptions of right and wrong, when it comes to maintaining convictions, business majors appear less inclined to do so in comparison with other majors. As such, it is clear that despite potentially strong ethical and moral values this cohort do not follow these ideals when it comes to carrying out an action.

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Agency Costs
Agency relationship is a contract, under which one party (the principal) will delegate some decision-making authority to another party (the agent). These agency problems arise because of the impossibility of perfectly contracting for every possible action of an agent whose decisions affect both his own welfare and the welfare of the principal. Arising from this problem is how to induce the agent to act in the best interests of the principal. Managers bear the entire cost of failing to pursue their own goals, but capture only a fraction of the benefits. This inefficiency is reduced as managerial incentives to take value maximizing decisions are increased. As with any other costs, agency problems will be captured by financial markets and reflected in a companys share price. Agency costs are can be seen as the value loss to shareholders, arising from divergences of interests between shareholders and corporate managers. Agency costs are the sum of monitoring costs, bonding costs, and residual loss. Monitoring Costs: Monitoring costs are expenditures paid by the principal to measure, observe and control an agents behavior. They may include the cost of audits, writing executive compensation contracts and ultimately the cost of firing managers. Initially these costs are paid by the principal, but ultimately be borne by an agent as their compensation will be adjusted to cover these costs. Certain aspects of monitoring may also be imposed by legislative practices. Monitors must have the necessary expertise and incentives to fully monitor management, in addition such monitors must provide a credible threat to managements control of the company. Too much monitoring will constrain managerial initiative. Optimal levels of monitoring managerial policies are specific to an individual firms contracting environment. Increased level of monitoring may act as a deterrent to managerial entrepreneurship. Bonding Costs: Given that agents ultimately bear monitoring costs, they are likely to set up structures that will see them act in shareholders best interests, or compensate them accordingly if they dont. The cost of establishing and adhering to these systems are known as bonding costs. They are borne by the agent, but are not always financial. They may include the cost of additional information disclosures to shareholders, but management will obviously have the benefit of preparing these themselves. Agents will stop incurring bonding costs when the marginal reduction in monitoring equals the marginal increase in bonding costs. The optimal bonding contract should aim to entice managers into making all decisions that are in the shareholders best interests. However, since managers cannot be made to do everything that shareholders would
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wish, bonding provides a means of making managers do some of the things that shareholders would like by writing a less than perfect contract. Residual Loss: Despite monitoring and bonding, the interest of managers and shareholders are still unlikely to be fully aligned. Therefore, there are still agency losses arising from conflicts of interest. These are known as residual loss. They arise because the cost of fully enforcing principal-agent contracts would far outweigh the benefits derived from doing so. Since managerial actions are unobservable ex ante, to fully contract for every state of nature is impractical. The result of this is an optimal level or residual loss, which may represent a trade-off between overly constraining management and enforcing contractual mechanisms designed to reduce agency problems.

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Contribution of Agency Theory

The agency theory reestablishes the importance of incentives and self-interest in organizational thinking. It reminds us that much of organizational life, whether we like it or not, is based on self-interest. Agency theory also emphasizes the importance of a common problem structure across research topics. Organization research has become increasingly topic, rather than theory, centered. Agency theory reminds us that common problem structures do exist across research domains. Therefore, result from one research area may be germane to other with a common problem structure. Agency theory also makes two specific contributions to organizational thinking. The first is the treatment of information. In agency theory, information is regarded as a commodity. It has a cost and it can be purchased. This gives an important role to formal information systems, such as budgeting, MBO and boards of directors and informal ones such as managerial supervision which is unique in organizational research. The implication is that organizations can invest in information systems in order to agent opportunism. An illustration of this is executive compensation. A number of authors in this literature have expressed surprise at the lack of performance based executive compensation. However, from an agency perspective, it is not surprising since such compensation should be contingent upon a variety of factors including information systems. Specifically, richer information systems control managerial opportunism and therefore, less performance contingent pay. One particularly relevant information system for monitoring executive behaviors is the board of directors. From an agency perspective, board can be used as monitoring device for shareholder interest. When boards provide richer information, compensation is less likely to be based on performance. Rather, because the behaviors of top executives are better known, compensation based on knowledge of executive behavior is more likely. Executives would then be rewarded for taking well-conceived actions whose outcomes may be unsuccessful. Also, when boards provide richer information, top executives are more likely to engage in behaviors that are consistent with shareholders interest. Operationally, the richness of board information can be measured in terms of characteristics such as frequency of board meetings, number of board subcommittees, number of board members with long tenure, number of board members with managerial and industrial experience and number of board members representing specific ownership groups.A second contribution of agency theory is its risk implications. Organizations are assumed to have uncertain futures. The future may bring prosperity, bankruptcy or same intermediate outcome and that future is only partly controlled by organization members. Environmental effect such
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as government regulation, emergence of new competitors, and technological innovation can affect outcomes. Agency theory extends organizational thinking by pushing the ramification of outcome uncertainty to their implication for crating risk. Uncertainty is viewed in terms of risk/reward trade-offs, not just inability to preplan. The implication is that outcome uncertainty coupled with differences in willingness to accept risk should influence contracts between principal and agent. According to agency theory, we would predict that risk neutral principal is relatively uninfluenced by outcomes uncertainty.

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Findings and Recommendation

Agency theory is one of the most powerful theories of organization. It assists in determining several contractual relationships within the organization. Again, how each parties act in order to maximize its own benefits can be ascertained by using this theory. Agency theory is also important for organization in assessing how organizational resources are uses, whether they are deployed in pursuit of the managers or the owners. This theory is also important in determining whether conflicts between management and owners arise because of interest or other issues. Agency conflict arises due to the self opportunistic behavior of the management and the separation of ownership and control. Misalignment of managers and shareholders interest is the main reason for agency cost. So, the principal (shareholders) have to incur costs in order to monitor the activities of the agents (management) and try to induce them to work for the interest of the agent. For this, it is essential to align the interest of the managers and shareholders. A good corporate governance system is a key element to lead and control the performance of a business in the best interest of shareholders. So, there is need for governance control mechanisms to align managers and shareholders interests. Several corporate governance mechanisms and devices can be used in mitigating managerial agency problems in the market, such as board characteristics, managerial remuneration, managerial ownership, ownership concentration and debt financing. These mechanisms can be useful in mitigating the agency cost but there are certain limitations on the importance of these mechanisms. Again, Auditor can play a significant role in mitigating this problem by providing an independent check on the work of agents and of the information provided by an agent, which helps to maintain confidence and trust.

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Conclusion
Agency theory has been used by scholars in accounting, economics, finance, marketing, political science, organizational behavior and sociology. Yet, it is still surrounded by controversy. Its proponents argue that a revolution is at hand and that the foundation for a powerful theory of organization is being put into place. Its detractors call it trivial, dehumanizing and even dangerous. Although agency theory may not occupy a niche in any discipline, agency relationships are omnipresent, under cover of other aliases bureaucracy, organizations, professions, roles, markets, labor, government, family, trust, social exchange, and so on. Drawing on agency theory in more disciplines, it has been sensitized not to lose sight of the interaction between agent selection, specification of preferences, designing incentives to align the interests of principal and agent, monitoring, and sanctioning in the acting for relationships that unfold on their substantive terrain. But that is just the beginning.

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