Agency Theory in Contemporary Corporate Governance - Literature review Example

CONTEMPORARY CORPORATE GOVERNANCE ISSUES by Student’s name Code+ course name Professor’s name University name City, State Date Contemporary Corporate Governance Issues Introduction An overview of corporate governance In regards to Jill Solomon, (2010).Corporate governance has been described variously as a collection of deliberate efforts, checks and balances, which may be both internal and external to the company, aimed at ensuring that an organization discharges transparency, responsibility and accountability to all main stakeholders, while acting in a socially responsible manner in all areas of business. Corporate governance is primarily concerned with the protection of the interests of the shareholders. Apparently this is to say that the main goal of corporate governance is concerned with the ultimate goal of business in a modern business environment – the goal f shareholders’ wealth maximization (Stout 2012). The corporate managers and functions are entrusted with the duty of protecting the assets and resources of the organization as such resources are a depiction of the financial commitment of the owners of the company. The role of corporate governance is pure stewardship and this forms the foundation of the agency theory. The primary features of corporate governance revolve around such concepts as accountability, transparency and responsibility. The primary roles of corporate governance are many, controlling being the most fundamental. The institution of checks and balances is the fundamental goal of the efforts of corporate governance. Proper corporate governance ensures that there is no possibility of a single individual dominating the decision making process of an organization. Further, corporate governance concerns itself with the subordination of individual interest to the organizational interest (Jill Solomon, 2010). Similarly, corporate governance is the concept at the center of the associations among the board of directors, the shareholders and all other major stakeholders. The primary efforts of corporate governance are concerned with prioritization of the interests of the shareholders in an effort to maximize the returns due for the shareholders. Corporate governance as well concerns itself with reporting the true and fair analysis of affairs of the corporation. In so doing, the corporate managers uphold transparency and accountability in such a way that the financial reports reflect the financial activity of the relevant period under review. An overview of the agency theory An agency relationship is one in which one party, referred to as the agent, and is given the go-ahead to act on behalf of the other, referred to as the principal, to the extent of making decisions concerning the subject matter of such agency. In the organizational and business content, an agency relationship is the association between the shareholders, who are the principals, and the management, who are the agents, to the effect that such agents make decisions on behalf of the shareholders regarding to how the funds of the owners will be put to use (Walker Review, 2009, p. 19)Apparently, the main role of the agents in this case is to invest the money and other resources of the shareholders in those projects that they consider viable on behalf of the owners. Worth noting is the actuality that the shareholders cannot be in a position to manage the business by themselves due to many reasons. The agency theory is rooted in the facts that the liability of a company’s shareholders is limited in such a style that the company assumes the status of a legal person. This means that the organization can enter contracts, sue or be sued in its own name. The agency theory is as well rooted in the divorce between ownership and control. The ownership remains with the shareholders while the control of the assets and resources remain in the hands of the managers Berle and Means (1932). In essence therefore, the agency theory is the justification behind such concepts as delegation, where powers to do things are shifted to other parties, other than those in direct ownership and control of the subject matter. In the agency theory, decision making power shifts from the shareholders to the managers. The shareholders therefore become the principals while the managers remain to be the agents. The extent to which the company exists only for the benefit of the shareholders Apparently, the shareholder remains the most important stakeholder in the company. This is primarily because of the financial theory. According to the theory, the shareholders’ funds are the basis for the existence of the company. It is the investment of such funds in various projects that will encourage the growth of the company. This explains why the profit maximization goal has long been replaced by the shareholders’ wealth maximization. The manner in which the wealth maximization is calculated is designed to incorporate risk and the concept of time value of money (Moyer & Moyer 2012). Other functions such as corporate social responsibility are subordinate to the wealth maximization goal. Apparently, the only way through which an organization’s shareholders can benefit is through having their wealth maximized. This explains why shareholders appoint stewards that will act in the best interests of the owner. Ultimately all goals of a business point to the overall shareholder maximization. It is worth noting that when a company acts in a socially responsible manner, it is not only the broad public that gains, but also the owners of the business. The merits of social responsibility point to better performance of the organization and higher returns to the shareholders’ invested resources (Long & Sorger 2010). For instance social responsibility boosts corporate image. Good corporate image on the other hand leads to a wider client base. This boosts the sales and consequently the returns of the shareholders. Similarly, modern business organizations consider social responsibility as one of the ways of marketing. It is an issue of common understanding that marketing is aimed at maximizing profits. Such increase in profits causes the organization’s stakeholders to expand their wealth. The place of agency theory modern corporate governance Established in the year 1960, as a by-product of the risk distribution theory, agency theory maintains that an organization exists purely for the interests of the shareholders. The agency theory, in which the shareholder is the principal and the manager is the agent, is a complicated relationship as there are many weaknesses associated with the theory. The primary weaknesses revolve around interests. Apparently, the interests of the managers are bound to differ with those of the shareholders. The primary reason for such difference is the actuality that the interests of the shareholders are rooted in the long term while those of the managers are limited to the short term (Li 2007). This causes a variance in the decision making timeframe. Apparently, managers associate success with the financial performance which is analyzed and published annually. As such, they invest in short-term projects that are associated with high return and high risk. Research indicates that there is a constant conflict of interest problem between the owners and the shareholders of a business. The conflict comes in when managers tend to subordinate shareholders’ interest to individual interest. Such subordination is unjustified as the primary goal should be wealth maximization. These causes the agency problem since such conflicts stands in the way of proper corporate governance. The most effectual way of going about conflict of interest has yet to be established as the two groups – the principals and the agents – are substantially reliant on one another (Lau 2010). The decision by the managers to act in the unsurpassed interest of the shareholders can be seen in the risk profiles in which they commit funds to. The average shareholder is risk averse as he won’t approve of risky projects that are likely to case business failure. Research indicates that the main problem arises where and when the managers make such decisions as awarding themselves enormous perquisites and allowances. This has been identified as one of the most prominent ways of abusing the trust that should be characteristic of agency. Shareholders may react negatively to such unjustified gestures if they manage to discover such acts. For the shareholders to identify and deal with such problems effectively, they have to incur expenses referred to as agency costs. Agency costs are cost incurred in order to eliminate inefficiencies in agency relationship (Fernando 2009). The most common agency costs are the audit fees incurred by the shareholders to have transparency checked and administered. Auditors, both internal and external act as the watch dogs of the shareholders by monitoring the activities within an organization to ensure conformity with shareholder expectations and statutory requirements. Auditors, in their interim and final reports, reveal all inconsistencies in the organization’s internal environment. Apart from incurring agency costs, the shareholders can as well apply performance-based management evaluation and remuneration. Tying performance to remuneration is a way of motivating the managers to work hard in the best interest of the owners. In instituting performance based remuneration, the shareholders should endeavor to align their goals with those of the management (Blumstein 2010). For instance, they should try to select those investments with the effect of maximizing the earnings per share. Earnings per share determine the level of attractiveness that the share of a publicly traded company will be associated with by potential investors. Aligning the interests of the directors to the interests of the owners is particularly difficult considering that the horizons and risk profiles relating to decision making is different for either party. Criticism of the agency theory Apparently, the presumption that the company exists solely for the benefit of the shareholders is a serious misconception since, clearly, an organization does not exist as an island. An organization from the sixties is considerably different from an organization operating in the contemporary world since, currently; all stakeholders are becoming equally significant (Calder 2008). The relationship between shareholders and such stakeholders as suppliers and customers is becoming exceptionally critical with globalization and business competition being the primary reasons. The primary inference therefore is that such stakeholders should have their interests incorporated in the long term objectives of the business. Many organizations today have the interests of the clients in their visions and missions. Seeing such words as customer satisfaction in an organization’s mission today is not something peculiar. It is common since organizations are fast realizing that the shareholder is not the only reason behind the existence of the company. The main reason why shareholders are considered the primary stakeholders in a company is because the managers remain answerable to them at all times. When people talk of accountability, they refer to the manner in which the managers will be responsible for their actions on behalf of the shareholders (Ciliberti et al 2011). If the wealth of the shareholders shrinks, the agents or rather the stewards will be held accountable. On the contrary, nobody will question the board if they fail to act socially responsible. This means that other stakeholders do not have full rights but have implied interests in the company. Even if their interests are not express, they are considerably important as they determine the extent to which wealth maximization will be achieved (Bruno & Ruggiero 2011). Apparently, the returns received by the shareholders of a socially responsible company are fairly better than those due for the shareholders of a socially insensitive organization. The agency theory has been criticized for its tendency to ignore such important stakeholders as customers, employees, suppliers, the government and the members of the community within which such an organization operates. Research has it that employees are the life and blood of the organization. Without the workforce, no activity could be possible. The agency theory focuses on the management and the owners only. The implied fact here is that the workforce is used as a tool or as a vehicle towards the achievement of shareholder goals (Baker & Powell 2005). On the contrary, the employees are paramount factors as they determine efficiency in production and the quality of the final product. Similarly, the customers are exceptionally important as they determine the market share of the organization through such concepts as consumer loyalty. Consumer loyalty is particularly important in the contemporary world, where competition is stiff. As such, it is a weakness that the agency theory ignores other stakeholders. Alternatives to the agency theory The alternatives to the agency problem revolve around the actuality that there are many stakeholders to a company than just the shareholders. The alternatives to the agency theory emphasize the actuality that an organization’s stakeholders are equally important since they contribute in near equal proportion to the success of the business (Dayananda 2002). The alternatives are based on the critique of the agency theory and endeavor to remedy the shortcomings of agency. The stakeholder theory The stakeholder theory is based on the exchange relationship among the various parties with interest in the effective operation of a business. The hypothesis is based on the actuality that the stakeholders of a business are in a mutually important relationship. Mutual importance implies that the organization’s existence and smooth operation is not only dependent on the suppliers, employees and customers, but is as well beneficial to them (Dunning 2012). Typically, a manufacturing concern for example produces goods. Such goods are bought by consumers. Through the purchase, either parties gain in one way or another, for instance, the organization gains revenue and the customer acquires the product. Similarly, the goods are made from materials. These materials are brought in by suppliers. Through the material acquisition transaction, both parties gain such that the organization acquires the much needed raw material and the supplier gets the profits from the sale. The essence of this theory then is that there is no particular principal or agent. On the contrary, the relationships are mutual. In advancing the stakeholder theory, Edward Freeman explained that even the competitors of an organization were important stakeholders as they were in a position to affect such decisions as the pricing decision. Other stakeholders identified by Freeman include the government, political interest groups and so on. The government is an exceptionally important stakeholder since noncompliance can cause litigation issues that can cause failure (Joshi 2004). In criticizing the stakeholder theory, contemporary philosopher Charles Blattberg argues that the interests of all stakeholders cannot be compared and weighed against those of other groups as the commitment made to the business varies from one stakeholder to another. Charles Blattberg’s point was the actuality that shareholders contributed more than other stakeholders and have to be given priority. Normative stakeholder theory In reference to (Brennan and Solomon, 2008), The normative approach has been explained by Edward Freeman as a framework entailing the directors of a company relating to a certain class of stakeholders according to the intrinsic value of such stakeholders’ interests. Essentially, the interests of stakeholders have intrinsic value which can be estimated effortlessly. Therefore, in making decisions, the organization’s directors should consider the effects on the various stakeholders .This has been criticized as a discriminatory way of handling corporate governance. Corporate governance should emphasize equality and fairness. Stakeholder theory is based on the applications of ethics in management. Ethically speaking, it is morally wrong for an organization’s managers to consider the interest of one stake holding group more important than that of another. Further, many business practitioners and gurus in philosophy have dismissed the theory of normative stake holding as one impracticable aspect. Instrumental stakeholder theory This theory emphasizes the merits of corporate social responsibility. Apparently, the instrumental approach to stakeholder theory is rooted in morals and values. Being an ethicist approach, the organization that adopts instrumental approach to stakeholder relationships is one that is ready to operate in the modern business world. Unlike the traditional approaches that concentrated on stockholder supremacy, the instrumental approach to stakeholder relationships is a dynamic approach that embraces flexibility in decision making (Lan & Heracleous 2010). The fact that this approach ignores stockholder supremacy explains the reason why it is commonly linked to corporate social responsibility. Corporate social responsibility is, under the agency theory, a contravention of the shareholders’ wealth maximization. The agency theory considers CSR a sunken cost as it relates to expenses that have no direct benefit. On the contrary, the organization that observes stakeholder theory prioritizes CSR as such a concept reaches out to many stakeholders boosting the well being of the organization indirectly. Conclusion In conclusion it is apparent that, from the above mentioned and discussed factors, agency theory has no place in contemporary corporate governance. Contemporary business organizations do not recognize the stockholder as the most important stakeholder. Rather, they value relationships among the various stakeholders. It is therefore, worth mentioning that the stakeholder theory has replaced the agency theory in explaining the relationship between business decisions and stakeholders. The agency theory has many shortcomings, the primary one being the actuality that it focuses of one stakeholder and the goal of such a stakeholder. Freeman’s theory of stakeholder relationships considers a wide array of interests including the interests of the competitors and the government. Such ethical and morally founded stakeholder theories emphasize such concepts as CSR. Reference list Baker, H. K., & Powell, G. E. 2005. Understanding Financial Management a Practical Guide. 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