How Agency Theory Can Be Developed into an Accounting Practice - Essay Example

THE AGENCY THEORY Definition The agency theory is a hypothetical term that describes how to best organise the relationship between the principaland an agent. It basically concerns the cost of conclusively settling conflicts between the principal and agent, and adjusting interests of both sides (Investopedia, 2006). In a business situation, there is a player called a principal, and another player or players called agents. The agent has the quality, or state, of being useful to the principal in that the latter can act more effectively through the former, than directly. The principal therefore has to motivate the agent by designing incentive schemes that will persuade him to act totally, or at least partly, in the interest of the principal (About Inc., 2006). In economics, such a conflict that stems from the problem of providing adequate incentives to one party (agent) to act properly on behalf of another (principal) is called the ‘principal-agent’ problem. This problem is common in all employer/employee relationships (Wikipedia, 2006). The principal-agent problem, a particular game-theoretic reflection of a situation, mainly concentrates on formulating the incentive scheme (About Inc., 2006). The incentive theory is the nucleus of economics. The most impressive change in economics over the past four decades has been the evaluation of incentives as the mains to attain inherent mutual gains when the parties involved have different levels of knowledge. In the model case involving an existing accounting firm, the principals are the owners (partners) of the firm who determine the work needed to be done by the agents), while the agents are in most part the employees of the firm (who undertake to do the work entrusted to them by the principal in return for a financial benefit). In another relationship, the principal (firm) interacts with other agents – debtors of the firm (who undertake to pay monetary value in return for the accounting work done for them by the firm). How Agency Problems affect business The agency theory contends that there are two peculiarities in a business situation – incomplete information and uncertainty – that cause two agency problems: adverse selection and moral hazard. Adverse selection refers to a situation where the principal cannot determine with certainty if the agent correctly portrays his qualities to accomplish the work for which he is being paid. Moral hazard refers to a situation where the principal cannot find out conclusively if the agent has used optimum effort while doing the work entrusted to him (Mathieu, 1997). In the case of the model firm, these two problems are the main hurdles facing its business. Ways in which the Agency Theory can be developed into practice There are basically two ways in which the Agency Theory can be developed into practice – in the model firm case, it would be concerning the two sectors that concern the firm and its business: employees and debtors. a) Employees The first and foremost way is to regulate the role of employees. Employment contracts comprise the main technique to reorganise incentives to agents (employees). Various mechanisms that may be incorporated in the contracts should be used in the context of various types of employment, in an attempt to align the interests of the agents with those of the principal (Wikipedia, 2006). The agency theory has provided several useful perceptions into the formulation of remuneration systems (Rayton, 2005), which are undoubtedly the key components of employment contracts. As the existing accounting firm will surely have its own employment contract, it would do well to either borrow from the advisories mentioned hereinafter, or formulate new employment contracts based on these advisories. The advisories relate to agents (employees of the model firm) within the premier tier (CEO or manager), the second tier (accountants), the third tier (sales persons) and the fourth tier (filing clerks, messengers, refreshment servers). A common feature in employment category related to the premier, first, second and third tiers concerns the length of the agreement. The contract should have a long term. Longer term contracts lower the chances of the agent indulging in moral hazards or adverse selection due to three reasons. The long term range assists the principal in collecting information about the agent’s behaviour, thereby determining the agent’s type (and lowering the adverse selection risk). Secondly, it discloses the external effects on the agent’s performance, allowing the principal sufficient time to successfully undo those effects that are detrimental in nature, thereby remedying the agent’s shirking behaviour (and making agent moral hazard more difficult). Lastly, a longer period of time will make the agent realise that the amount he stands to gain by proper behaviour is vastly superior to the amount he would instead gain by shirking (Mathieu, 1997). There should be no fixed wage in the premier tier employment contract. A fixed wage to an agent in this crucial category may have an adverse effect; seeing that his wage will not change whatever the grade of work or amount of effort he puts into the job, this factor may motivate him to avoid or neglect his assigned duties. Instead of the fixed wage, he should be offered compensation based on residual claimancy on the profits of the firm (Mathieu, 1997). In this case, the agency theory interconnects wages with performance for certain agents (like the agent in the model firm’s premier tier) whose scale of physical and mental concentration is difficult to witness; the agency theory goes on to logically conclude that where effort levels are difficult to observe, it is sensible to draw a direct connection between wages and performance. The agency theory suggests that the profit sharing scheme should be linked to certain circumstances (Rayton, 2005). {It is advisable that the ‘circumstances’, in the model firm, be specific targeted amounts of business transacted over a given period of time [yearly or half-yearly]}. This system succeeds in greatly narrowing the chance of the agent engaging in moral hazard or adverse selection. In addition, he will be better motivated to supervise those working under him (Mathieu, 1997). The Watson Wyatt survey of U.K firms reported that 80 percent of all firms offer some employees a “profit-sharing plan that is directly tied to overall company performance” (Rayton, 2005). The second tier comprises agents (accountants) who undertake the main workload of the business by providing financial (accounting) services to the firm’s clients. They should be exposed to objective performance evaluation, in which a straightforward connection is drawn between performance and profitability. They should be paid by fixed wages on monthly or semi-monthly basis, with added incentives such as overtime (usually at a higher rate than calculated in their regular wages) {Wikipedia, 2006}, and bonus. A bonus scheme is beneficial, as it circumvents the misleading possibility of the firm concentrating too much on a single incentive strategy. A bonus scheme improves individual performance as well as other factors such as attendance and customer service. Most U.K business entities in the financial sector (like the model firm), use individual performance to calculate the individual element of a bonus scheme. Individual performance is derived from performance appraisals (Ashworth Black Limited, 2005). In the model firm, the best exogenous factor to link this incentive is a favourable report from a client of the firm, attesting to the suitability of the accounting work done by the firm, its compliance with the time frames earlier allocated, and audit approval of such work. By receiving a bonus, the agent’s job satisfaction increases and his desire to leave the firm and seek alternative employment is greatly reduced. The third tier involves agents (sales persons) who seek new customers to add to the firm’s clientele. The best way to motivate them is to pay a major part of their wages as commission on the contract amounts of new clients they bring to the firm (Wikipedia, 2006). This will motivate them into putting in optimum effort and sincerity in their work. The fourth tier agents are those placed in low or unskilled jobs, such as filing clerks, messengers and refreshment servers. The employment of such persons involves short term employment and almost no chance of promotion. Wages to such agents are best linked with the average wages present in the market for such jobs (Wikipedia, 2006). b) Debtors The second way the Agency theory can be developed into the practice of the model business is to regulate its business debts. Business debt is the debt held by businesses. In the model firm, the principal is the firm while the agent is the client who owes money to it related to the work done by the principal, but has not yet repaid it (either in full or in part). The format of the firm’s invoice to the agent should contain proper safeguard terms including the maximum time allocated for payment to be received, addition of a penalty percentage in case of delayed payment, and identifying the territory of adjudication in case of legal resort. If the firm is experiencing continual problems in debt recovery, it may be beneficial to pass on overdue invoices to professional debt collectors; this will save administrative costs and increase cash flow (Business Victoria, 2005). References used: Anon. 2006. Agency Theory. Investopedia [Online]. Available: http://www.investopedia.com/terms/a/agencytheory.asp [8 November 2006] Anon. 29 November 2005. Debt Recovery: Business Victoria [Online]. Available: http://www.business.vic.gov.au/BUSVIC/ STANDARD/1001/ PC_50307.html [8 November 2006] Anon. 2005. Employee Bonus Schemes: Ashworth Black Limited. [Online]. Available: http://www.ashworthblack.co.uk/ bonusschemes.htm [9 November 2006] Anon. 2006. Principal-Agent Problem: About Inc.. [Online]. Available: http://economics.about.com/od/economicsglossary/ g/principalag.htm [9 November 2006] Anon. 31 October 2006. Principal-Agent Problem. Wikipedia. [Online]. Available: http://en.wikipedia.org/wiki/Principal-agent_problem [8 November 2006] Mathieu, Jo Ann. 24 April 1997. Agency Theory Framework: Babson College. [Online]. Available: http://www.babson.edu/ entrep/fer/papers96/shane/ shane3.htm [8 November 2006] Rayton, Bruce A. 2005. Specific Human Capital as an Additional Reason for Profit Sharing: University of Bath. [Online]. Available: http://www.bath.ac.uk/ management/research/pdf/2005-01.pdf [9 November 2006] Read More