Agency theory

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Agency theory and its importance in business world

Abstract: - The object of this paper is to investigate working of agency theory

and agency theory in the corporate governance define relationship between

the principal and agent mainly listed or public limited company as most of the

decision making has been implemented. Implication in the agency theory

several points raised in this paper are conflicts in the companies, Ethics,

internal audit and dispute between agent and principal. Agency theory comes

under in importance of corporate governance which play prominent role in the

business world. Agency theory is vast field hence this paper “Mainly through

light on agency theory on IAF in Belgian companies”

Introduction to the agency theory:-

Agency theory: - definition, “the agency relationship is a contract under which

one party (the Principal) engages another party (the agent) to perform some

services on their behalf”. (Jensen & Meckling, 1976). Jensen and Meckling

primarily develop agency theory.

In broad sense, it is theory which is also investigate the relationship between

the investor on equity or shareholder (principal) and owner or manager of the

particular company (agent). The board of directors of the company work as

essential key to get to the issue between agent and principal.

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Agency theory consider in account from long timeline, especially in the area of

the business and economics. Study have done on agency theory by different

scholar in various field such as sociology (e.g., Eccles, 1985, White, 1985)

accounting (Demski and Feltham, 1978), organizational behaviour (Eisenhardt,

1985, 1988; Kosnik, 1987), Marketing (Basu, Lal,Srinivasan, & Staelin, 1985),

Economics (Spence and Zeckhauser), political science (Mitnick, 1986), and

Finance (Fama, 1980). Corporate industries use different methods to convey

information related to their company prospects to their investors. Depending

on the company’s prospects of the investment, type of financing used under-

pricing of initial public offerings, management have full control over what

types of methods sent out to their investors. (Allen, F.; Faulhaber, G.R. (1989)

North-Holland.Downes, D.H.; Heinkel, R. (1982)

Overview of Agency theory

Table 1

Key Idea Principal and Agent relationships able to reveal organisations risk-bearing cost and information

Analysing Unit Principal and Agent contract

Human assumption Bounded rationality Risk averse Self-interest

Information Assumption Information like purchasable commodity

Organisational Assumption Information asymmetry between

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Agent and Principal Partial goal conflict between participants

Problem Domain

Relationships in which agent and principal have partly differing goals and risk preferences.

Problem related to contract Risk Sharing Moral Hazard and adverse selection

Agency Cost: - it can be define as the agency relationship in contract where

one party (principal) appoint another (agent) to execute service on their

behalf. On behalf of principal, agent receives authority to carry out decisions-

making.

As with certain cost agency problem will undertake in financial market

reflected in market reputation and market share price of company.

Monitoring cost: - it can be explain as the expenditure paid by the

principal to observe, control and measure control an agent’s behaviour.

The several economic influence of asymmetric information also results

in various corporate agency problems. Firm manager also called as

insiders know more about their own firm than debt financier and

shareholders can be point as outsider. When performance of firm is not

in conditions to judge by outsider than it qualify as moderate. This

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asymmetric information result in depreciation of share or undervalue

even though it doing well in market and vice versa.

Bonding cost: - Monitoring cost is finally suffered by the agent this cost

is structure set up by the concern of shareholders. The cost of adhering

and establishment to this system is known as bonding cost. Bonding cost

is born by the agent this are not financial all the time as it may also

include cost of supplementary information revelation to the

shareholder. When marginal decrease in monitoring is equal to marginal

increase in bonding then management agent will stop incurring bonding

cost.

Residual Loss: - Despite of bonding and monitoring, the interest of

shareholder and manger is not aligned. Due to these agency conflicts of

interest agency loss arises this situation can be define as residual cost.

Inception of agency theory

This table show timeline development and research outcomes on agency

theory:-

Table 2

Serial no

Authors Agency variables Investigation stream

Dependable Variable

Model Companion theory

Outcome

1 Amihud& Lev(1981)

Manager vs. Owner controlled

Positivist Conglomerate mergers & diversification

309 Fortune 500 firms

None Support

2 Walking & Long(1984)

Management’s equity & options

Positivist Managerial resistance to

105 U.S firms

Shareholder welfare &

Support

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takeover bid other controls

3 Anderson(1985)

Importance of nonselling activities, length of selling cycle, difficulty evaluating sales performance

Principal-Agent

Representative vs. corporate sales force

159 sales districts in 13 electronics firms

Transaction cost

Mixed

4 Eisenhardt(1985)

Information system, cost of outcome measurement, & outcome uncertainty

Principal-Agent

Salary vs. Commission

54 retail stores

Organizational control

Support

5 Eccles(1985) Decentralization Principal-Agent

Type of transfer price

150 interviews in 13 chemical, electronics heavy machinery, & machin component firms

Equity Inductive model

6 Wolfson(1985)

General partner’s track record

Positivist Share price 39 oil & gas limited partnerships

Tax effects Support

7 Argawal & Mandelker(1987)

Executive stock holdings

Positivist Acquisitions divestitures,& debt/equity ratio

209 major corporations

None Support

8 Kasnik(1987) Proportion of outside directors, equity held by outside director, & outside directors with executive experience

Positivist Payment of greenmail (yes/no)

110 major corporations targeted for greenmail

Hegemony Mixed

9 Eisenhardt(1988)

Job programmability, span of control, & outcome uncertainty

Principal-Agent

Salary vs. Commission

54 retail stores

Institutional Support

10 Conlon & Parks (1988)

Monitoring Principal-Agent

Performance contingent compensation

40 dyads Institutional Support

11 Barney(1988)

Employee stock ownership

Positivist Cost of equity 32 Japanese electronics firms

Sales & growth control

Support

12 Singh & Harianto (in press)

Managerial stock ownership & takeover threat

Positivist Golden parachute contracts

84 fortune 500 firm

Managerialist Support

Source:- Kathleen M. Eisenhardt, Agency Theory: An Assessment and Review

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Agency conflicts: - it is arise due to conflict of interest between two parties to

a contract and is limitless in nature. Four key problematic area earnings

retention, risk aversion, time horizon and moral hazard.

Moral hazard: - moral hazards first explain by Jensen and Meckling (1976).

They assume a situation where there is a single manager who owns the firm

and in this model have incentive to consume private perquisites instead of

investing in the positive (NPV) net present value projects here his ownership

stake in company decline. Same condition applies in companies in which

majority of share not controlled by manager and ownership structure is

diverse. Manager may select investment best suited to personal skill through

this Value to the firm for individual manager and also increase the cost of

replacing (manager) him. Higher level of remuneration allowed from the

company extracted by manager. It has been found that reduction on stock

price of company also depend upon the statement of an executive director to

the board of different company. Value of company depends on diminishing

managerial efforts.

Earning retention agency conflicts: - Cash distribution to shareholder and

Grandiose Managerial visions deliver more concern to the moral hazard. When

manager required fund for major investment project than earning retentions

decrease the need for external financing. Useful monitoring function in

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constraining grandiose managerial investment policy in external market

acquired along with gain in new capital. Due to this management encourage

value of maximising decisions take place.

Time horizon agency conflicts: - With respect to the timing of cash flow

conflicts of interest arise between manager and shareholder. In indefinite

future all future cash flow of the company undertaken by the shareholder.

During term of employment management only concerned with company cash

flow, approaching to short term high return on expenses of long term positive

(NPV) project. Problem increase, when senior executive approach retirement

or when they plan to leave the company. It has been find that accounting

earning tend to higher in year when CEO (chief executive officer) leave their

position.

Managerial Risk Aversion Agency Conflicts: - Arise because of portfolio

diversification restraints with respect to managerial income. Due to this

investor demand to diversify their holdings with little cost. Financial

policy of the firm affected by managerial risk aversion. Because of debt

increase the risk of default and bankruptcy.

Agency theory on risk:-

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Risk in any business was critical during period of 1960 and 1970 economist find

risk sharing among groups and individual. Risk occurs when corporate parties

have different desire toward their goal agency theory widened this risk sharing

literature to include the so called agency problem. Agency theory tries to draw

this relationship using the metaphor of a contract, (Jensen & Meckling, 1976)

Agency theory is directed at the ubiquitous agency relationship, in which one

party (the agent) delegates work to another (the principal). Agent works for

principal.

The ideas of agency theory has become much more important now than ever

before, especially because of the corporate collapses of major multinational

companies from last one decade such as WorldCom in 2001 Enron in 2001 and

Lehman brothers 2008.

Agency theory plays very important role in planning and management of on-

going or running concerns. To explain agency theory study on internal audit

and financing choice has been thoroughly explain including empirical model.

Agency theory in financing choice:- To determine the financing choice on the

equity, debit finance and convertible debt. Following calculation will be helpful

in further findings,

Equity

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One possibility in the listed company’s issue of the equity implement by the

manager to issue equity. When the project is undertaken, cash flow from

operations, minus interest expenses equals:

X + R – kd,

Here

k is the fraction of debt service

d corresponding to interest payments.

Consequently taxes equal:

(X + R − kd)( т ),

and the total cash flow to equity holders is:

(X + R − kd)(1 − т) − (1 − k) d

which can be rewritten as:

(X + R)(1 − т) − d + k т d,

Which mean, after tax cash flow from unlevered firm, minus cash flow to debt

holders, plus tax shields from debt.

Here ∂ Denote the share of the ownership over the cash flows allocated to the

outside financier, i.e. the dilution. At the end of the period outside financiers

obtain:

∂ [(X + R) (1 − т) − d + k т d],

while the manager obtains:

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т (1 − ∂)*(X + R)(1 − т ) − d + k т d].

Debt financing

The manager can issue debt.

D denotes the service of the new debt.

kD corresponds to interests payments, while (1−k)D corresponds to

compensation.

To prove this equation it is assume that debt d is senior and the new debt D is

junior. Financial distress can be generated by leverage. Before the firm

effectively defaults on its debt, the corresponding costs and financial distress

can arise. In a simple manner we present one–period model, to get that

financial distress and default both events have to collapse into a single event,

This happens when

R + X < D + d

It means when the earnings before taxes and interests were not enough to

service the debt.

This case lead to the cost of financial distress, create by the junior debt

holders, this is assume to be equal to: c(R+X−d),

Here c is a constant between 0 and 1.

In spite of give simplified hypothesis, it is essential to tolerate in mind that in

calculation related to direct bankruptcy costs, which include c reflects indirect,

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legal fees, economic costs, firms face problems while reducing their value

because it is related to the fact call financially distressed.

In this situation, at the end of the period the manager obtains this equation

when the project is financed by debt,

Max {0, (R + X)(1 − т ) − (D + d) + т k(D + d)},

This mean the unlevered firm manager obtains the after tax cash flow, plus the

tax shields from debt and minus the service of debt.

Financier from outside obtains:

Min*R + X − d,D+ − c(R + X − d)1(R < D + d − X),

Here 1(R < D + d − X) is the indicator variable captivating the value one when

R < D + d − X, When financial distress occur in the firm.

Convertible debt

This is a financing scheme use to issue convertible debt. Repayment promise

commit by outside financer holds debt, denoted by D. This is convertible to

debt into the fraction ᵞ of equity. In the end when cash flow (R) is realized. This

option implement by outside financer when value of fraction ᵞ of the equity is

worth more than the repayment on the debt.

Here ᵞ {(R + X) (1 - т) – d + kтd} > D

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outsider financer obtain by convertible bonds

Min {R + X – d, Max {D, ᵞ ([R + X] [1 – т+ – d + k т d+)} - c (R + X – d) 1 (R < D + d –

X},

Here manager obtain,

Max {0, Min [(R+X) (1-т) – (D + d) + kт (D + d), (1- ᵞ) {(R + X) (1 – т) – d + kтd)+}

Convertible bond is only done by equity here D=0 and as far as concern about

debt which is particular case for ᵞT > D, and the value of ᵞ and D is never ideal

to convert bond into equity.

Prophesy the size of internal audit function in Belgian companies through

agency theory: - The information asymmetry studied between agent and

principals by using literature on agency theory. This study frames an agency

model to recognize the elements of the size of the internal audit function in

Belgian companies. (Mohammad. J, 2007) in this study all of data attained

from annual reports of a large sample of Belgian companies, General finding of

study were important descriptive power for the agency model. Precisely model

suggest a positive relationship among the size of the IAF (internal audit

function) and the diffusion of ownership, also approve the monitoring role of

the IAF in decreasing external agent and principal problems.

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Internal audit function, following variable has included in the study of the

hypothesis.

These are various assumptions taken to estimate econometrics approach of

IAF.

Management share ownership:-More the ownership interest of the manager

means more chance to align their preference with those of outside owners

claim by (Defond, 1992). An entrepreneurial gain is an opportunity for the

owner managers. (Francis and Wilson, 1988) To increase value of the firm they

have incentives as well. But manager have lesser amount of proportion of his

companies’ shares even in recent years it has been seen because of increasing

popularity of share and stock based compensation contract (Bolton,

Scheinkman and Xiong, 2006).higher the Portion of ownership depend upon

interest of the managers and shareholders as more aligned will be the interest

of managers and shareholder. Because managers with negligible or small stock

ownership may involve in the allocation resource and moral hazard problems

in ways that are not reliable with the interest of the non-managing

shareholders (Chow, 1982).

H1 this conclusion lead to hypothesis: - 1

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Diffusion of ownership: - Francis and Wilson (1988) and DeFond (1992)

studied the significance of the separation of control and ownership.

Specifically, the higher the divergence in the preference of the manager and

owner more diffused the ownership of a company, and lower the control of

agent action by the principal and the lower observe ability, vice versa. As the

demand for monitoring increase so does the diffusion of ownership.

Significance of this conclusion is that larger the internal audit functions need to

observe the owners interest in more diffused ownership structure.

H2 this reflects hypotheses: 2

Company Size:-In this context, the company’s top management is viewed as

the principal who delegates authority and responsibility to subordinate

managers (agents) for effective operation of a portion of the firm’s resources,

leading to the possibility of moral hazard problems between top management

and divisions. Fama (1980) also used agency theory to inspect the hierarchical

relationships in multidivisional and large companies. Abdel-Khalik (1993)

proposes that it is more problematic for the top management in bigger firms to

oversee the firm, which makes a higher demand for internal auditing to

compensate for the loss of control. In support of these arguments, a recent

paper offers a positive correlation between company size and the demand for

both external and internal auditing (Carcello et al., 2005b). Top management

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tries to extenuate this problem by instituting organisational controls also

including IAF (Govindarajan, San Miguel and Shank 1977).This statement

recommends that there is more need for internal auditing in large

multidivisional companies than in smaller ones (Abdel-Khalik, 1993;Chow,

1982). The size of the internal audit function is positively related to the

company size.

H3 this lead to hypothesis: - 3

Leverage: - It has been argue by Jensen and Meckling (1976) that

agent/principal problem between management and shareholder there is a

struggle between management and debt holders (DeFond, 1992). Precisely,

the need for monitoring through auditing required as the percentage of debt in

a company’s capital increase (cf. Chow, 1982; Francis and Wilson, 1988).

Previous study (e.g., Chow, 1982; Abdel-Khalik, 1993; Winters, 1998 and

Blackwell, Noland,) reports suggest in provision of a positive connotation

between the demand for external auditing and the level of debt. This outcome

is grounded on the importance of accounting numbers in debt contracts, which

diminishes the information asymmetry between management and debt

holders. As it has been argued by Watts and Zimmerman (1986), that auditor

promise lessens lenders’ monitoring costs. Carcello et al. (2005b) describe that

a raised proportion of debt also impress a company’s investment in its internal

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auditing. Lead to the positive relationship between the size of the IAF and

proportion of debt.

H4: The size of the IAF is positively related to financial leverage.

Organisational Complexity:- Greater decentralisation is often associated by

organisational complexity which also leads to greater demand for monitoring

(Carcello et al., 2005b). Greater propensity to establish an IAF if more

decentralised the company (Wallace and Kreutzfeldt 1991). Organisational

complexity is used to construct effects on various factors ranging from the

business in which the company operates to acquisition and mergers, to

international operations are taken into consideration.

Also result in more IAF because of various cultural backgrounds such as

integrating different culture in mergers and acquisitions, different languages in

international settings and the culture prevalent in the industry.

H5 this lead to hypothesis.

Mean size of IAF is positively related to organisational complexity.

Number of Reporting Levels: - In broad sense, by personal observation and

means of direct supervision the operations of a company with only one or few

levels of hierarchy are primarily controlled. However, as businesses grow,

authority is often delegated down the chain of command and multi-layered

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hierarchies evolve (Abdel-Khalik, 1993). Williamson and Ouchi studied that

reduced observe ability in the hierarchies may result into loss of control. This

occurs because of three factors. Firstly, communications down the series of

command passes through various filters which subject to possible intentional

manipulation, summarisation and misinterpretation. Secondly observe ability

of subordinate as actions decreases when chain of commands expands. Thirdly

more communication will become distorted when longer chain will occur (Katz

and Kahn, 1966). Demand for monitoring increase, as the number of

hierarchical levels in the company increases,

Need of IAF indicated by increased demand for monitoring.

Hypothesis 6 reflected by this variable.

Research Method Data Collection:-

Belgian companies that were known to have an internal audit function and

acquired membership with Belgian Institute of Internal Audit (IIABEL) out of

these 260 companies are identified. Data taken from sources: for domestic

Belgian companies, the 2005 annual reports from the Belfirst database to

collect financial data.

Model Specification for data analyse

Econometric approach for the model

This equation is presented from the variable which discuss above.

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Ln (IAF_Staff) = a0 + a1 NYSE + a2 Finance + a3 Position_IAF + a4 Age_IAF + a5 Outsourcing

+ a6 Belgian domestic + a7 Dif_Owner + a8 Mgt_Stocks + a9 Ln (Total Assets) + a10 Leverage + a11 Org_Complex + a12 Report_Level

Here

NYSE (+) Company or parent company is listed on the NYSE:

Dummy variable (0/1)

Finance (+) Dummy variable (0/1) Company operates in the

financial sector.

Position_IAF (+) Position of the IAF on the corporate level or not:

Dummy variable (0/1)

Age_IA (+) Age of the internal audit function

Outsourcing (-) IAF outsources part of their tasks or not: Dummy

variable (0/1)

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Belgian Domestic (-) Belgian domestic company or not: Dummy variable

(0/1)

Dif_Owner (-) Diffusion of ownership measured by the largest

individual percentage of stock ownership

Mgt_Stocks (-) Management share ownership measured by the

percentage of shares owned by managers

Ln (Total Assets) (+) Company size measured by the logarithm of total

assets Agency Model and Size of the IAF 12

Leverage (+) Leverage measured by the proportion of long-term

debt compared to total assets

Report_Level (+) Number of reporting levels between top

management and the lowest operating unit

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Org_Complex (+)

international scale: Organisational complexity measured by industry

complexity, recent involvement in merger/acquisition

and operation on an Dummy variable (0/1)

Result: -

Outcomes of this study are that IAF needed to monitor the interests in more

diffused ownership structure. These result supplements previous studies, and

also throw light on external auditing that external auditing also play a

mentoring role in dropping external agent/principal problem.

Supported by literature that external and internal auditing complementary in

reducing agent/principal problem and also find that internal audit in corporate

governance is growing.

Conclusion: -

This paper mainly emphasised on the agency theory and presents structural

analyse of its aspects on corporate world. Outcome can be concluded after

study on structure of agency theory and case study on several industries. It has

been found that earlier studies presenting that external auditing plays a

monitoring role in dropping external agent/principal problems. In finance

model Agency theory presents estimation of optimal agency cost and finance

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choice. This is also a useful in asymmetric information to create quantitative

approach instead of simple insights in decision making in corporate finance.

Time scale project plan for the paper work:-

Phases Content Appr. Necessary time/days

1. Collecting data from various sources 10.0

2. Development of theoretical concept 10.0

3. Organization of the information and research setting

3.0

4. Review of existing case studies and experiments

2.0

5. Reinterpretation of the data 3.0

6. Writing and corrections 5.0

Total 33

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