Impact of Agency Theory on Corporate Governance - Essay Example

Corporate Governance Introduction Corporate governance is a practice that aspires to assign business resources in an approach that capitalizes on value for all stakeholders of the company. They are the shareholders, financier, investors, workers, clients, trader, contractors, environment and the society at large and they stand at the driving position to account by assessing their judgments on precision, inclusivity, justice and accountability (La Porta, et al., 2000). The World Bank classifies governance as the implementation of political power and the utilization of institutional properties to direct societys affairs and problems (Raut, nd). The Agency theory comes into place when the conflict of interest takes place between the principal (shareholders) and the agent (management of the organisation) and affects the corporate governance of the organisation. Agency theory presumes both the principal and the agent are encouraged by self-interest. This assumption of self-interest condemns agency theory to unavoidable intrinsic disagreement.  Therefore, if both revelries are enthused by self-interest, managements are likely to follow self-interested intentions that diverge and even clash with the purpose of the principal.  Thus, agents are expected to act in the sole interest of their principals (Saltaji, 2013). To resolve the corporate governance crisis, agency theory advocates a self-governing board arrangement and the application of equity-based reward for higher managements. This study helps to examine the degree to which agency theory proposals help to resolute the corporate governance issues. Corporate Governance Corporate governance is the set of procedures, behaviours, guidelines, commandments and institutions distressing the way a conglomerate (or company) is directed and controlled. Corporate governance also comprises of the associations amongst the many stakeholders concerned and the objectives for which the company is administered (Larcker, Richardson and Tuna, 2007). Figure 1: Flow Chart showing Corporate Governance in an Organization (Source: Denis and McConnell, 2003) In present-day business organisations, the chief external stakeholders are shareholders, debtors, trade creditors, trader, clientele and societies affected by the organisations performance. Internal stakeholders are the board of directors, management, executives and other employees (Bebchuk, Cohen and Ferrell, 2009). There are many diverse representation of corporate governance around the globe. These diverge according to the diversity of free and private enterprises in which they are embedded. The Anglo-American "model" tends to highlight the security and welfare of the shareholders (Denis and McConnell, 2003). The coordinated or multi-stakeholder model associated with Continental Europe and Japan also considers the goodwill of workers, contractors, executives, customers and the society (Saltaji, 2013). Corporate Governance conformity concerns Corporate Governance-compliance covers the GRC arena which is the overall term specifying a business approach concerning three areas primarily Governance, Risk Management and Compliance (Daily, Dalton and Cannella, 2003). As the areas are directly correlated concerns, governance, threat and conformity actions are more and more being incorporated and associated to several extents in order to evade disagreements, inefficient gaps and overlaps. Whilst construed differently in various firms, GRC characteristically includes activities as corporate governance, enterprise risk management (ERM) and corporate obedience with applicable regulations and policies (Saltaji, 2013). Governance explains in general organizational approach through which senior management co-ordinates and exercises power on the whole organization, via a combination of control structure of administrational information and hierarchical management (Xie, Davidson and DaDalt, 2003). Governance certifies that the essential management information propagated to the managerial team is adequately complete, on time and accurate to facilitate suitable organisational decision making concerning the management. (Roberts, 2004). Risk management is the procedures through which management recognizes, scrutinizes and answers appropriately to threats that might negatively influence recognition of the management’s objectives (Beasley, et al., 2000). The response to threats usually depends on their perceived significance or importance and engages in controlling, accommodating, avoiding or relocating them to a third party. The main concerns in GRC are the risks that the organizations regularly deal with and manages like the technological risks, industrial risks, market related and economic risks, information protection risks etc and external legal and regulatory conformity risks (Roberts, 2004). Compliance means meeting with the requirements. It is attained through management practices that recognises the appropriate needs (which are explained in laws, policies, agreements and strategies), measure the level of compliance, calculates the risks and potential costs of non-compliance aligned with the proposed expenditures to achieve conformity at a business level and therefore, emphasises, prioritises and commences necessary measures considered important (Roberts, 2004). Impact of agency theory on corporate governance In case of the corporate governance, the shareholder is considered as the ‘principal’ and the problem is related to the separation of the ownership and control over the company (Denis and McConnell, 2003). The problem arises when the principal is unable to ensure that the agents who are mainly the directors of the company are able to satisfy the interests of the shareholders of the organization. There are cases where the agents have the intensions to shirk in case they are not interested in maximising the shareholders returns (Klapper and Love, 2004). However, there are solutions to this problem like the acceptance of some sort of agency costs in the economy that is to be paid to the agents who plays the key role on behalf of principal. These costs are likely to arise due to the conflicts between the management of the organization as well as the share holders. The shareholders often expect the managers to run the business that lead to rise in share holder’s value in the economy (Eng and Mak, 2003). However, the management plan to run the company in such a way that would tend to maximise their power and wealth. Agency problem are likely to arise when there are conflicts between two parties regarding a contract. There are various types of agency conflicts that arise within the organization (Klapper and Love, 2004). Figure 2: Flow Chart explaining the Agency Theory (Source: Denis and McConnell, 2003) For example, the first type of Agency conflict is that of the moral hazard agency conflict where there is a single manager who owns the firm who do not have any intention to invest in the positive net present value projects (Klapper and Love, 2004). This concept is usually followed in companies where the ownership structure is diversified and the majority of shares of the company are not controlled by the managers of the corporate organizations. Nonetheless, it is usually common in the market based economies such as the UK (Lazonick and Osullivan, 2000). The managers are expected to invest in their own personal skills which would in turn increase the value of the firm. However, these moral hazard problems are considered to be very common in the large companies which involves complexity in monitoring process and further makes the firms incur huge costs. These problems arise when there is a lack of managerial effort. Managerial Risk Aversion Agency Cost Conflicts The conflicts arise when there is constraint in portfolio diversification with respect to the income of the managers. The intensity of this problem increases when the executive compensation comprises largely of the fixed salary or when the managers have special skills that can be transferred from one company to another (Klapper and Love, 2004). Apart from this, there is a risk factor that the firm may go bankrupt. This will severely damage the reputation of the managers and it becomes difficult for the managers to find alternative employment. The risk aversion by managers also affects the financial policy of the company. However, higher debt obligation is reduces the conflicts and carries a potentially valuable tax shields. The managers who prefer to be risk averse choose equity financing instead of the debt financing which increases the risk factor related to bankruptcy. Time-Horizon Agency Conflicts Conflicts are likely to arise between the managers and the shareholders regarding the time taken for cash flows within the company. The shareholders remain worried about all the future cash flows of the company, whereas, the managers would be worried about the cash flows during their employment period leading to a biasness in favour of short-term projects at the expense of long-term projects (Gillan and Starks, 2000). The problem takes a serious turn when the top executives decide to retire or leave the job. The research and development expenditures of the company declines as the top executives approach the retirement phase within the organization. It in turn reduces the compensation of the executives and they would not be able to reap the benefits the investments made (Gillan and Starks, 2000). Hence, they prefer to use subjective accounting to adjust their earnings before their retirement in order to earn high performance based bonuses from the company. Arguments and evaluation on Corporate Governance The financial structure and policy followed by the company has a strong implication for agency control. The researcher argues that the existence of debt obligation diminishes the level of equity and allows higher levels of insider ownership within the company (Gillan and Starks, 2000). However, there was another argument the presence of debt within the firm’s capital structure plays a key role in binding the company managers. By issuing debt, instead of paying dividends, the managers are bound to pay the future cash flows which cannot be financed through dividends. The costs that are expected to arise due to bankruptcy acts as a stimulator in encouraging the managers to be more productive. This fact is particularly common in firms which suffer from low internal growth and high free cash flows within the firms. Another researcher argues that the firm’s capital structure is important to ensure socially optimal liquidation. A study has revealed that a company with high leverage and low interest coverage on its debt obligation is expected to experience a turnover of the top management within the economy. Such turnover is likely to occur as a result of poor performance of the company in the past. The leverage also gives rise to bankruptcy costs as well as agency costs within the company. The capital structure is considered to be optimal where the marginal cost of debt equals its marginal benefits (Carter, Simkins and Simpson, 2003). According to a researcher, while the debt offers to reduce the risk of over-investment there is a possibility of under-investment due to the cost of new finance arising in the company (Carter, Simkins and Simpson, 2003). However, overly distributing cash flows result in a problem of insufficient fund for the firms and it reduces the amount of investible funds in the company which increases the need for external financing due to the increased costs of the organization. Ordinary shareholders are often unable to monitor the managerial activities due to lack of time and skill. Since they own a very small portion of the total share, it becomes difficult for them to control the entire organizations work process (Carter, Simkins and Simpson, 2003). In such cases, there is a presence of large shareholders in the economy known as block holders who monitor the costs incurred by the company. Conclusion Through this paper, the researcher has discussed the corporate governance within an organization. The research says that the agency theory comprises of a principle and an agent within an organization and various types of conflicts arises between them. There are conflicts related to the management of the organization. Problems arise when the agents have the tendency to shirk and their work is not properly monitored. There are conflicts among the shareholders and the managers related to the cash flows within the organization. Since the shareholders own a part of the company, they remain worried about the future cash flows, whereas, the managers remain worried only about the present cash flows. Often the shareholders own a small part of the company and hence there are block holders who deal within the managerial activities of the organization. The managers who prefer to avoid risk often carry out their financial activities through debt financing rather than the equity financing in order to avoid the occurrence of bankruptcy in the firm. The study that proper monitoring of the internal activities taking placed within the firm can help to resolve the conflicts that arise among the principal and the agents of an organization. Reference list Beasley, M. S., Carcello, J. V., Hermanson, D. R. and Lapides, P. D., 2000. Fraudulent financial reporting: Consideration of industry traits and corporate governance mechanisms. Accounting Horizons, 14(4), pp. 441-454. Bebchuk, L., Cohen, A. and Ferrell, A., 2009. What matters in corporate governance?. Review of Financial studies, 22(2), pp. 783-827. Carter, D. A., Simkins, B. J. and Simpson, W. G., 2003. 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