What is Agency theory and what are the agency problems faced by entities?

Agency theory is a theory explaining the relationship between principals (shareholders) and agents (managers). In this relationship, the principal delegates or hires an agent to perform work in the best interest of the principal. The delegation of decision-making authority can lead to a loss of efficiency and consequently increased costs. For example, if the owner (the principal) delegates decision-making authority to a manager (the agent), it is possible that the manager will not work as hard as the owner would, given that the manager does not share directly in the results of the organisation. Therefore, this could lead to agency problems because this theory involves the cost of resolving conflicts between the principals and agents and aligning interests of the two groups. The agency problems that arise as a result of delegating decision-making authority from the owner to the manager are referred to positive accounting theory as agency costs of equity. PAT investigates how particular contractual arrangements based on accounting numbers can be put in place in order to minimize agency costs associated with the problems.

There are three main agency problems. They are risk aversion, dividend retention and horizon disparity. Risk aversion is a problem caused by the relationship between risk and return (Drever et al, 2007). According to the shareholders, it is generally accepted that the higher the risk, the higher is the potential return. This view is quite different from managers as they are willing to take less risk of the company because that is normally their key source of income. If managers continue to take less risky projects then this would lead to lower profits or return which is not what the shareholders want. However, this problem can be narrowed by providing bonus incentives (remuneration packages) linked to accounting earnings so that managers would engage in taking higher risks in order to achieve those bonuses. The second problem is called dividend retention which is the ability of managers to pay out less of the company’s earnings in dividends and retain more so that they could invest in the company’s growth which would benefit them in return. Once again, this view is opposed by shareholders because they would prefer more in dividends so that they could invest further wherever they want. The third problem is horizon disparity and can be easily linked to long term bonus incentives in order to overcome this problem. This is particularly a problem if the manager expects to stay with the company for a short period of time and is concerned with the performance of the company while they manage it. After they leave, they will have no interest in the company. (Drever et al, 2007). To avoid this problem by ensuring that the manager takes a longer-term view, their bonuses are linked to share price or rewards in the form of shares.