Agency Theory 3u6v1u

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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 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) ing (Demski and Feltham, 1978), organizational behaviour (Eisenhardt, 1985, 1988; Kosnik, 1987), Marketing (Basu, Lal,Srinivasan, & Staelin, 1985), Economics (Spence and Zeckha), 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 underpricing 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

Analysing Unit Human assumption

Principal and Agent relationships able to reveal organisations risk-bearing cost and information Principal and Agent contract Bounded rationality Risk averse

Information Assumption Organisational Assumption

Self-interest Information like purchasable commodity 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 decisionsmaking. 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 1

Authors

Agency variables

Amihud& Lev(1981)

Manager vs. Owner controlled

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Walking & Long(1984)

Management’s equity & options

Investigation stream Positivist

Positivist

Dependable Variable Conglomerate mergers & diversification Managerial resistance to

Model 309 Fortune 500 firms 105 U.S firms

Companion theory None

Outcom e

Shareholder welfare &



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PrincipalAgent

takeover bid Representativ e vs. corporate sales force

PrincipalAgent

Salary vs. Commission

54 retail stores

Organizationa l control



Eccles(1985)

Importance of nonselling activities, length of selling cycle, difficulty evaluating sales performance Information system, cost of outcome measurement, & outcome uncertainty Decentralization

PrincipalAgent

Type of transfer price

Equity

Inductiv e model

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Wolfson(198 5)

General partner’s track record

Positivist

Share price

Tax effects



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Argawal & Mandelker(1 987)

Executive stock holdings

Positivist

None



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Kasnik(1987)

Positivist

110 major corporation s targeted for greenmail

Hegemony

Mixed

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Eisenhardt(1 988)

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Conlon & Parks (1988)

Proportion of outside directors, equity held by outside director, & outside directors with executive experience Job programmability, span of control, & outcome uncertainty Monitoring

Acquisitions divestitures,& debt/equity ratio Payment of greenmail (yes/no)

150 interviews in 13 chemical, electronics heavy machinery, & machin component firms 39 oil & gas limited partnership s 209 major corporation s

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Barney(1988 )

Employee stock ownership

Positivist

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Singh & Managerial stock Positivist Golden Harianto (in ownership & parachute press) takeover threat contracts Source:- Kathleen M. Eisenhardt, Agency Theory: An Assessment and Review

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Anderson(19 85)

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Eisenhardt(1 985)

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159 sales districts in 13 electronics firms

other controls Transaction cost

Mixed

PrincipalAgent

Salary vs. Commission

54 retail stores

Institutional



PrincipalAgent

Performance contingent compensation Cost of equity

40 dyads

Institutional



32 Japanese electronics firms 84 fortune 500 firm

Sales & growth control Managerialist





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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 ing 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 ongoing 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
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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.

ᵞ

Here {(R + X) (1 - т) – d + kтd} > D

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outsider financer obtain by convertible bonds

ᵞ

Min {R + X – d, Max {D, ([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

ᵞ

debt which is particular case for T > 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 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 ing 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 es 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 hip 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 (-)

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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. ed 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

1. 2. 3.

Collecting data from various sources Development of theoretical concept Organization of the information and research setting Review of existing case studies and experiments Reinterpretation of the data Writing and corrections Total

4. 5. 6.

Appr. Necessary time/days 10.0 10.0 3.0 2.0 3.0 5.0 33

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References:      

Abdel-Khalik, A.R. (1993). ‘Why do private companies demand auditing? A case for organizational loss of control’. Journal of ing, Auditing and Finance, 8 (1): 3152. Bolton, P., Scheinkman, J. and Xiong, W. (2006). ‘Executive compensation and shorttermist behaviour in speculative markets’. Review of Economic Studies, 73 (3): 577-610. DeFond, M.L. (1992). ‘The association between changes in client firm agency costs and auditor switching’. Auditing: A Journal of Practice & Theory, 11 (1): 16-31. Fama, E. (1980). ‘Agency problems and the theory of the firm’. Journal of Political Economy,88 (2): 288-307. Francis, J.R. and Wilson, E.R. (1988). ‘Auditor changes: a t test of theories relating to agency costs and auditor differentiation’. The ing Review, 63 (4): 663-682. Jensen, M.C. and Meckling, W.H. (1976). ‘Theory of the firm: managerial behaviour, agency costs, and ownership structure’. Journal of Financial Economics, 3 (4): 305-360. Williamson, O.E. (1967). ‘Hierarchical control and optimum firm size’. Journal of Political Economy, 75 (2): 123-138.

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Williamson, O.E. and Ouchi, W.G. (1981). ‘The markets and hierarchies and visible hand perspectives’ in A.H. Van de Ven and W.E. Joyce (Eds.) Perspectives on Organization Design and Behavior: 347-370. New York: Wiley.

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The institute of Internal auditors Belgium, [online] Available:http://www.iiabel.be/Default.aspx?PageName=M6_Types&MenuGroup=7&MenuI tem=112 (assessed on 15/11/2010)

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Brian W Kulik, agency theory reasoning and culture at enron in research of a solution, 2005 [online] Available http://www.jstor.org/stable/25123568 (assessed on 19/11/2010)

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Michael C. Jensen,[online]available http://www.sfu.ca/~wainwrig/Econ400/jensenmeckling.pdf (assessed on 19/11/2010)

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Abdolmohammadi, 2007 [online] available http://aaahq.org/audit/midyear/08midyear/papers/21_sarens_agencytheory.pdf (assessed on 21/11/2010)

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Kathleen M. Eisenhardt, Agency Theory: An Assessment and Review http://www.jstor.org/stable/258191

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William Armah , [online] available http://warmah.com/articles/agency_theory.html (assessed on 21/11/2010)