Agency Theory

University Degree Business and Administrative studies

INTERNATIONAL

FINANCIAL ACCOUNTING THEORY

During this essay an attempt will be made to underline the importance of Agency Theory within the accounting practice. The area that will be discussed will be, Agency Theory its self, Agency problems, Corporate Governances, Scandals in the accounting practices and the general contribution that Agency theory has had within the existing practice of international accounting.

The development of Agency Theory

An Agency Theory describes the relationship between two individuals regarding delegating decision making. The theory also known as “principle – Agent theory explains the relationship between Principle such as a share holders, and Agents such as companies executive. In this relationship the principle hires the agent to perform work.

In the mid 1700s Adam smith noted the troubling aspect between the agent and the principle. In his first book “The Theory of Moral Sentiments 1759” Adam Smith expressed the view of human motivation and argued that the struggle is described with term he used “Passions” and “Impartial spectator” which I will provide further clarification. In effect by the early 1970s it had become its own subject of economic enquiry called “Agency theory” with significant papers published Jensen and Meckling 1976.

The Theory effectively restated the Smith puzzle as to how to acquire an agent (Executive-manager) to act in the best interests of principle (shareholder-owners) while the agent has both more information and different interests than the principal. The theory attempts to deal with two specific problems, first is Agency Problem this arises when the goals of the creditor and the shareholder have conflictive ideas on how the company should be run. And second is where the principle and agent reconcile different Tolerance for Risk. Some problems that have been highlighted in further studies are moral hazard where by the agent takes unobserved actions for their own self interest. To clarify the term Smith (1759) used “Passions” such as (Drive, Emotion and Motivational feelings) “he viewed that behaviour was under the direct control of the passions, but believed that people could override passion-driven behaviour by viewing their own behaviour from the perspective of an outsider i.e. the “Impartial spectator”. This moral problem has been a matter of concern for shareholders, as the complications to monitor all managerial decisions is not practical or easily achieved, with that in mind mangers goals may be motivated with the desire to pursue their self interest by securing their own position. In comparison to shareholders objectives that would be to maximise their wealth, the conflict lie’s between the diverse interests of the two parties.

There are various choices in accounting methods that can be used to align the competing interest, Introducing share based pricing, power sharing incentive’s, threat of dismissal or

threat of a take over can encourage the agent to work in conjunction with shareholders vision. This theory is explained as the best way to organise the relationship between the two parties where by the principle determine the work the agent undertakes (Eisenhardt, 1985).

Adverse selection is when the Agents immoral behaviour takes advantage of Asymmetric flow of information. Annual reports can be subject to manipulation from the agent due to the advantage gained through access of data and financial report. This creates many difficulties for the shareholders, for instance the principle maybe uncertain as to the efficiency of the work carried out by its agent as the principle is vulnerable to the interest of their agents.

However it is also if the agent can accurately represent their ability to do the work which their being paid for.

Corporate governance

Due to ...

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However it is also if the agent can accurately represent their ability to do the work which their being paid for.

Corporate governance

Due to the lack of social responsibilities of most businesses in the 1980s, past studies has proved that inefficient governance of executives who take immoral decisions can lead to private companies being placed into administration. With Robert Maxwell irresponsible actions as well as the failure of auditors to expose the succession of scandals in businesses at the time. A significant committee was formed and lead by Sir Adrian Cadbury, the Cadbury (1992) reports from the committee was aimed at the internal control and accounting systems of the business to minimise the risk of corporate governance risk and failures. This includes the participation from the boards of directors, stakeholders (shareholders, debt holders, government etc) management and external auditors. The internal control in particular is the most important function of corporate governance as to determine the reliability of their financial reports and compliance with laws and regulations. As the role of internal auditors would be oversee by external auditors.

In order to oversee, evaluate and control the operations of internal and external auditors and financial reporting, an audit committee has to be formed, in every publicly-held company. Higgs (2003) believed that had the Cadbury report been in power prior to Robert Maxwell scandal then the evidence would have been transparent and discovered before any more damage would have been done. Subsequently the Turnbull report (1999) reminded director of their obligations keeping good “internal control” through addressing the issue within the company’s final report. It address the point raised in the Cadbury report of having an internal structure within business that limited the possibility of fraud protecting shareholder interest will lead to corrupt practices and complete collapse.

There are many reasons why companies may want to achieve better corporate governance, it is a way to reduce or eliminate the principle-agent problem, by a means of underlining the requirement of the firm with the intention for aims and objective to be achieved. The variety of cost benefits that can be attained in the long run, when segregating corporate responsibility by evaluating an organisations performance and operations, in addition to overseeing managers comply with laws and regulations. Effective corporate governance is the only way that can promote the interest of investors and protect them against executives who have been given the authority to take decision in their own interest rather than deciding what is the best decision collectively

One of the most pinnacle comebacks in regards to public relation is the drastic actions taken by Johnson & Johnson for their subsidiary McNeil Consumer product which makes Tylenol. It was stated that a presumably unknown person replaced Tylenol Extra-strength capsules with cyanide laced capsules, once sealed and delivered seven people had purchased the item and died within 48hours, at which time Tylenol an alternative for aspirin was the leading product in its field by which they had held 37% of market share (Berge, 1998). The chairman James Burke first strategy guidance was “how to protect the people” and second “how do we save this product”; which resulted in a national recall of every capsule regardless of the financial implications it had. As we measure the true corporate environmental behaviour the company has, we look at how the risk for public safety was regard far higher than their financial growth. With the help of media coverage and sympathy i.e. compensation to the victims family; today the firm has fully recovered and is considered as an examples of how organizations should react, which was demonstrated by taking the decisions to act promptly when confronted with a crisis.

Triple bottom line accounting means expanding the traditional reporting framework to take into account the ecological and social performance in addition to the financial performance of the business. This phrase was used by John Elkington in 1994, which was later expanded on in his 1998 book “Cannibals with Forks: the Triple Bottom Line of 21st Century Business”.

However some failures of corporate governance in agency theory have contributed to accounting scandals which has caused the world to look at the disclosure of accounting policies. As we observe how the indecisions of elected officials affected the public confidence of the US market. During the early 2000s many companies faced extreme financial difficulties these include such familiar names as Xerox, Global Crossing, Merrill Lynch, Enron, WorldCom, Arthur Andersen.

To elaborate on the issue of how agency theory contributed to the development of current accounting practices we will review one of the biggest corporate frauds in history which was Enron corporations and its auditors Arthur Anderson LLP. Enron’s lengthily relationship with it auditors Arthur Anderson has consequently lead them to a series of events driven by behind scenes deals, hidden by questionable accounting. Many employees lost their jobs and banks and lenders lost millions of dollars in loans made to Enron based on the fraudulent earnings reports. The company filed for bankruptcy in December 2001 and to the repercussion of their actions has been a positive influence in accounting industry as a whole. WorldCom scandal was conceived to fall in the same category as Enron due possible illegal activity discovered by WorldCom auditors; the internal auditors uncovered approximately $3.8million dollars in fraud. The CEO Bernard Ebbers become increasingly under pressure from banks to cover margin calls on his WorldCom stock that was used to his other businesses and luxury comings and goings.

With respect to the Sarbanes Oxley Act Roberts, J (2004) said ‘In the USA the Sarbanes-Oxley act can be read almost as a perfect mirror of the collapse of Enron and perhaps suggests a loss of faith in the self-regulatory capacities of both boards and markets by increasing the criminal liabilities of directors. In the UK the response has been more muted but has involved the further strengthening of the role of the non-executive within boards (Higgs 2003) and of the monitoring responsibilities of investors in relation to voting and remuneration and activism (ISC 2002).’

SARBANES-OXLEY ACT 2002; This law was passes by the US government in 2002 in –order to restore confidence in corporate governance. This was the reaction of major accounting scandals in Enron, Tyco and WorldCom, as investors had lost confidence in capital market of US. The main objectives of Sarbanes-Oxley act were;

Improve the quality and accuracy of financial reporting
Reduce fraud and false accounting
Raise awareness of internal controls
Increase executive responsibility
Strengthen the independence of audit firms

Minor changes has been made in the UK accounting policies in comparison to the major alteration after the collapse in Enron’s scandal. In 2002 Gordon Brown and Patricia Hewitt appointed Derik Higgs to review and he suggested, In order to achieve its aims and objectives; the committee has to monitor the roles of the internal auditors and evaluates their performances. The committee reviews the integrity of the internal financial control and risk management systems, which would include approving the statements to be included in the annual report. The committee ensures that the function of internal audit has adequate standing and is free from management or other restrictions. The committee would be required to assess the internal audit plan and reports promptly and to analyse their recommendations. This is would help in achieving high levels control and integrity within the organisation and would minimize any chances of fraud. Regarding financial reporting, the committee shall have to monitor the integrity of the financial.

Statements of the company, including its interim, preliminary and annual results announcements and other related announcements. The committee shall have to review the consistency of and any changes to accounting policies on a yearly basis and across the company or group. Whether the company has followed appropriate accounting standards will also be looked upon by the committee. For e.g. in the World Com scenario, expenses in the company were said to have improperly reported as capital investments which should have been caught up the audit committee in principal, even though initially over looked by internal audit. This shows that how Enron had affected on the world, even though it happened in the US but other countries had to review their accounting policies to see whether they had problems in their policies. A consequence of Enron was the Higgs report which had a direct impact in the FRC changing regulations in 2003. The collapse also raised issues like rotation of auditors were made necessary, try to eliminate the conflict of interest between share holders and executives and revise the standards set by the FASB and SEC

The Higgs report was written in response to address the issues that assisted the fall of Enron and WorldCom. The report chaired by Derek Higgs in 2003 aimed towards corporate governance directed by the UK government. Complimenting the combined code by recommending annual reports as well as suggesting that non executive directors should meet once year without the participation of the directors as this was the purpose of the Higgs report.

Overall the contribution of Agency Theory towards accounting practices is quite vast. The relationship developed between two parties is relevant in order to achieve high levels of success just as long as the interests between both are aligned and not at the expense of one another. Accounting practice has a close relation to factors involved within the theory such as information asymmetry. To develop accounting policies to be beneficial on a wider scale, the increase knowledge of the self-interests of the agents may be a reliable source in order to achieve and improve relevant standards and policies. Not only has Agency Theory been an impact on the accounting practices but the effects of Enron and WorldCom and the scandals that occurred have proven to change the accounting practices by which the Sarbanes-Oxley Act 2002 was introduced. With companies moving more gradually towards an understanding of the value created by good corporate governance.

References:

Books

Riahi-Belkaou.A, (2004) Accounting Theory 4th edition, Thomson
Roberts, J. (2004) Agency Theory, Ethics and Corporate Governance
Jensen, M, and Meckling, W (1976). Theory of the firm: Managerial behaviour, agency costs, and ownership structure. Journal of Financial Economics, 3: p.11-25
Niskanen, W. (2005) After Enron – Lessons for Public Policy, Roman & Littlefield
Loren Fox, Enron: The Rise and Fall, 2003, Published by John Wiley & Sons, Page Preface 1, 2
Cannibals with Forks: The Triple Bottom Line of 21st Century Business

Journals

Eisenhardt, K. (1989), “Making fast strategic decisions in high-velocity environments", Academy of Management Journal, Vol. 32 No.3, pp.543-76.
Denis, D.J and T.A Kruse, (2000), `Managerial Discipline and Corporate Restructuring following Performance Declines’, Journal of Financial Economics, Vol.55,pp.391-424.
Kaplan, S.N. and D.Reishus. (1990), `Outside Directors and Corporate Performance’, Journal of Financial Economics 27 (2), 389-410
Higgs, D. (2003) Review of the role and effectiveness of non-executive directors (report)
Journal – J Unerman, BO’Dwyer; Enron, WorldCom, Andersen et al: A Challenge to Modernity, 2004 – Elsevier

Bibliography:

Patrick A. Gaughan, “ What Can Go Wrong and How to prevent it”,2002, John Wiley & sons,Inc
Adam Smith “The Theory of Moral Sentiments (1759)
Riahi-Belkaou, A (2005) Accounting Theory 5th edition, Thomson
, Schroeder, Financial accounting theory and analysis : text and cases / Richard G. Schroeder, Myrtle W. Clark, Jack M. Cathey, 9th ed., Hoboken, NJ : John Wiley & Sons, 2009
Roberts, J. (2004) Agency Theory, Ethics and Corporate Governance
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