Agency Theory In Corporate Governance
Corporate governance is a system by which the organization is directed and controlled. This structure specifies the distribution of rights and responsibilities among different people in the corporates such as shareholders, managers, board directors, etc and spells out the rules and procedures for making decisions on corporate affairs.
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There are four broad theories to explain and understand corporate governance:
- Agency Theory.
- Stewardship Theory.
- Stakeholder Theory.
- Sociological Theory.
The overview of Agency Theory In Corporate Governance is as mentioned below.
This theory was studied by ADAM SMITH who identified the agency problem in the joint-stock company. The concept of agency theory is quite simple, it states that corporate management should act in the best interest of a company’s stakeholders. The theory states that corporate executives have a moral and financial duty to act in the best interests of the parties they serve.
By the emergence of the idea of limited liability, with shareholders not being responsible for the debts of the company. With directors acting as agents of the principle, the shareholders, and with often a large degree of separation, evidence emerged of cases, of instances, where the agents were not acting in the best interest of the principle resulting in the primary objective of shareholder wealth maximization not being pursued. Instead, some directors and their appointed managers pursue their own perceived best interests. A consequence is often the promotion of short-term personal interests over longer-term organizational benefits. These issues can result in actions that are, at best questionable, and at worst, unethical, and on occasions, illegal. The challenge for shareholders is to identify ways in which they can exercise control over the directors.
What is Agency Theory?
Agency theory examines the relationship between the agents and principals of the business. There are two parties – the agent and principal, whereby the former acts and takes decisions on behalf of the latter in an agency relationship. The theory revolves around the relationship between the two and the issues that may exist due to their different risk perspectives and business goals.
The most talked-about agency relationship exists between shareholders and executives of a corporation, in finance, where the top brass is elected to act in the interest of the company’s true owners. Agency theory in Corporate Governance identifies the agency problem and it specifies mechanisms which help to reduce agency loss which can occur due to agency problem.
Problems of Agency Theory:
1.Control of management is neither feasible nor required.
2.Managers act to optimize their personal payoffs.
3.Executives act to protect their status.
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Importance of Agency Theory:
Agency theory provides a clear framework for corporate officers and board members while making strategic decisions. The decision-makers have the advantage of being greedy and earning profit at the same time in the company.
Decision-making protocols: In agency theory, buying a share of company stock gives you a vote in major company decisions. This right is weak by the fact that some stockholders may have a single share, giving them a single vote, while others having thousands of shares have thousands of votes. Agency theory is a step toward finding these complex and sometimes conflicting obligations.
The shareholders are reluctant to increase the current and future value of their holdings, the executives are more interested in the long-term growth of the company. Thus, the differences in their approach create a feeling of distrust and disharmony.
- A common example of agency theory is between the employees and employers of an organization. The employees are hired to work following the objectives of the organization. However, the growing number of corporate scams shows that this relationship is not always taken in the way it is meant to be. The employees work against the ethics of the organization causing huge financial and reputational damage. Sometimes, the loss caused by such corrupt employees is beyond repair and an organization has to wind up its business altogether.
- In the corporate world, there are some greedy executives. The people with the power to make corporate decisions are often benefited from some of these decisions, especially concerning issues of corporate pay. Also, high pay and large bonuses for executives would motivate them for quality work that brings in extra income for all shareholders. In reality, high corporate pay can come at the expense of the bottom line that is divided among the broader pool of shareholders.
- Long-term vs. short-term interests. We all know that a company should invest in the future, but such investments often come with the expense of short-term rewards such as shareholder dividends. Executives regularly practicing corporate agency theory will use this knowledge and skills which will help them in management positions to make the best calls possible for the organization as a whole.
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The agency problem is defined as a conflict that exists when parties (agents) are entrusted to take care of another party’s (principal) interest but decide to use their power for their interest. Also, conflict of interest can be prevented by mandating firms to put in place restrictive and monitoring measures as well as putting limitations on the amount of cash that a firm can borrow. Firms can utilize their financial leverage to boost shareholders’ wealth without increasing the amount of debt.
Author- Moksha Gala
About the Author-Currently, a graduate in the field of accountancy and finance. Commerce has been a part of my life now. Exploring the available choices, finance was always distinct among them. Credits, investments, and markets were always a part of my interest. So decided to embrace finance as a career for life.