AGENCY THEORY IN

CORPORATE
GOVERNANCE
 OUTLINE

 INTRODUCTION
 AGENCY THEORY
 IMPORTANT TERMS
 AGENTS
 PRINCIPALS
 AGENCY PROBLEM
 AGENCY LOSS
 AGENCY COST
 MECHANISM OF THE THEORY
 PROBLEMS OF THE THEORY
 INTRODUCTION
Corporate Governance is a system which the organization is directed
and controlled this structure specifies the distribution of rights and
responsibilities among different participants in the corporation. Such
as, the board, managers, shareholders and other stakeholders. And
spells out the rules and procedures for making decisions on corporate
affairs.
There are four broad theories to explain and elucidate corporate
governance.
 AGENCY THEORY
 STEWARDSHIP THEORY
 STAKEHOLDER THEORY
 SOCIOLOGICAL THEORY
 AGENCY THEORY

 THIS THEORY IS GIVEN BY ADAM SMITH WHO IDENTIFIED

AGENCY PROBLEM (MANAGEMENT NEGLIGENCE AND
PROFUSION) IN THE JOINT STOCK COMPANY.
 THIS THEORY IS BASED ON THE CONCEPT OF SEPARATION
OF OWNERSHIP AND CONTROL.
 AGENCY THEORY IS A BRANCH OF GAME THEORY.
 THIS THEORY IDENTIFIES THE AGENCY PROBLEM.
 IT SPECIFIES MECHANISMS WHICH REDUCE AGENCY LOSS
OCCURRED DUE TO THE AGENCY PROBLEM.
AGENCY THEORY
 IMPORTANT TERMS

o AGENTS – THESE ARE THE MANAGERS APPOINTED

BY THE SHAREHOLDERS. RUN THE COMPANY ON
BEHALF OF THE SHAREHOLDERS.

o PRINCIPALS – THESE ARE THE SHAREHOLDERS,

OWNER OF COMPANY DELEGATES
WORK/RESPONSIBILITY TO THE MANAGERS.
o AGENCY PROBLEM – THE OBJECTIVES OF MANAGER
(AGENT) ARE DIFFERENT FROM THE SHAREHOLDERS
(PRINCIPALS) THIS CONFLICT IN OBJECTIVE IS AGENCY
PROBLEM.

o SEPARATION OF OWNERSHIP AND CONTROL LEADS TO A

POTENTIAL CONFLICT OF INTEREST BETWEEN DIRECTORS
AND SHAREHOLDERS.

o THE AGENTS’ OBJECTIVE (such as desire for high salary,

large bonus and status for a director) WILL DIFFER FROM
THE PRINCIPAL’S OBJECTIVES (wealth maximization for
shareholders).
An Agency Relationship exists
WHEN:
o AGENCY LOSS – IT IS THE DIFFERENCE BETWEEN THE BEST
POSSIBLE OUTCOME FOR THE PRINCIPAL AND THE
CONSEQUENCES OF THE ACTS OF THE AGENT.

o AGENCY COST – THESE ARE THE COSTS BORN BY

SHAREHOLDERS TO PREVENT AGENCY PROBLEM WHICH
FUTURE RESULT AGENCY LOSS, TO MAXIMIZE
SHAREHOLDERS WEALTH. THEY HAVE TO INCUR FOUR
TYPES OF COSTS:
1. MONITORING
2. BONDING
3. OPPORTUNITY
4. STRUCTURING
 PROBLEMS OF AGENCY THEORY

 CONTROL OF MANAGEMENT IS NEITHER FEASIBLE

NOR REQUIRED.
 MANAGERS ACT TO OPTIMIZE THEIR PERSONAL
PAYOFFS.
 EXECUTIVES ACT TO PROTECT THEIR STATUS.
 INFORMATION ASYMMETRY.
 MECHANISMS

THAT HELP TO REDUCE AGENCY COST AND IMPROVE

CORPORATE PERFORMANCE:
 FAIR AND ACCURATE FINANCIAL DISCLOSURE
 EFFICIENT BOARD OF DIRECTORS
 ACCOUNTING INFORMATION (MONITORING MANAGER
PERFORMANCE)
 CONTRACTUAL OBLIGATIONS
 INCENTIVE SCHEMES FOR MANAGERS (WHICH REWARD THEM
FINANCIALLY FOR MAXIMIZING SHAREHOLDERS INTERESTS)