Essay Example on Agency Theory: Explaining the Relationships Between Parties

Introduction

The Agency Theory, which is also known as the Principal-Agent Theory, is a typical theory within the company's economics text. The great scholar initially pioneered this type of the philosophy of the social sciences; Rose (1974) to help in explaining the relationships between the two major parties with interests like that relationship between the employers as well as their employees (Lan, & Heracleous, 2017), between an entity and its stakeholders and in between the buyers as well as the sellers, who have got different objectives and interests. Typically, the main aim of the Agency Theory involves specifying the maximum contracts as well as the situations under which such particular contracts may assist in reducing the effects of the physical dissimilarity.

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Besides, the main perspectives of this particular theory include; human beings are usually self-driven or self-interested people, bounded very rational, as well as risk-taking oriented individuals. Moreover, Agency Theory can be majorly used at the personal level or the institutional level. The main two parties in this particular theory include the principal as well as the agent. The principal employs and works closely with the agent to execute specific tasks on his behalf. Whereas the principal's main objective includes quick as well as appropriate completion of the delegated work, the agent's primary goal involves operating at his own pace, avoiding any form of risks at the workplace, as well as acquiring self-interest like personal pay over the corporate interests. Therefore, the real incongruence between the two parties.

Hence, accommodating the nature of the challenge may be the source of the asymmetry challenges led by the inability of the principal to observe and determine the behavior of the agent effectively or maybe appropriately evaluating various skills set. Consequently, such asymmetry challenges can easily lead to the agency problems where the agent may not be able to ensure practical efforts required urgently to ensure the work is done appropriately (ethical choice of an issue). Additionally, the agent may decide to misrepresent its skills and experience to complete the assigned job, but may not perform it as expected, (adverse choice of an issue). For instance, one of the typical contracts existing between two parties, which are behavior-based, like monthly salary payment, cannot effectively solve these particular problems.

Therefore, the Agency Theory proposes the use of the outcome-based contracts, like the commissions or maybe the fee payable upon the completion of a given job, or perhaps the mixed contracts which combine both the behavior-based as well as the outcome-based contract motivations. The stock option programs of a given employee are one of the typical examples of the outcome-based contract, whereas, worker's pay is the typical example of the behavior-based commitment. Besides, the agency theory proposes a unique approach that several principals may apply with an aim of enhancing the effectiveness of the behavior-based contracts, like putting more investments on the monitoring approaches like hiring senior and strict supervisors to counter various pieces of information asymmetry usually caused by the ethical disaster, adopting renewable contract mechanisms on the performance level of an agent hence, makes it easily observable.

Research Studies on Agency Theory

For a more extended period of time, the researchers have conducted several research study based on the Agency Theory. According to Jensen & Meckling (2015), the agency relationship is a type of contract between the entity's shareholders as well as its managers, whereby the shareholders as the (principal) appoint an agent (managers) to manage the organization on their behalf. As part of this given agreement, the shareholders must hand over the authority of the decision making process to the management. The shareholders expect their agents (managers) to act in the best interest of the company's shareholders. Typically, the contract between the shareholders as well as the managers should ensure that the executive officers of the company who are the agents usually act and perform in the best interests of the company's shareholders.

Nevertheless, it is highly impossible to organize for the best contract, since most decisions made by the agents (managers) influence their own and personal interests and the welfares of the company's shareholders. Hence, this challenge raises an essential question amongst the researchers. That is, how can the agents who are the organization's managers get persuaded effectively in order activity in the best interests of the company's owners?

Agency Conflicts or Challenges

Generally, the agency conflicts arise due to the differences in the interests of the entity's shareholders and the managers. Hence, these challenges occur in the following several ways:

Moral Hazard: The assumption that a given party gets insulated from the risk exposure may act differently from the way he would behave if he were completely exposed to that particular risk (Safieddine, 2019). Usually, a company's managers who are the agents have an interest in receiving various benefits from their positions as the entity's managers. These benefits that originate from the status of the managers, like the use of the company's assets such as cars, airplane, as well as lunches and other company's sponsored activities. Hence, both Jensen & Meckling recommended that the managers' incentives towards obtaining these advantages are in overall higher when they have no shares, or maybe only a few stocks, within the organization. Therefore, moral disaster is a significant challenge affecting most organizations.

Risk Aversion: The executive directors, as well as top level managers, frequently receive most of their salaries from the organizations they duly work for. Thus, they are generally interested in the organization's stability, since this aspect will assist in protecting their job as well as their future earnings. This means that the management might be risk-averse, as well as reluctant to carry out investment in projects with higher risks (Safieddine, 2019). In contrast, the company's owners might desire for the organization to take more significant perils if the targeted outcomes are adequately high. The owners frequently conduct investment in a given portfolio of different organizations; hence, it matters less to the owners if just one particular entity takes risks.

Time Horizon: Usually, the company's owners are majorly concerned with the long-term financial assumptions of their institution, since their shares' value dramatically relies on the expectations for the more extended period future. Whereas the company's managers might only get interested in the short-term future performances, as well as partly (Roberts, 2015) since they might not be expected to be in the organization for more than a given period. The managers, thus, have incentives to increase the rate of the accounting results on the given capital employed on investment, while the entity's owners have more significant interests towards the long-term value as measured by the net current worth.

The Agency Costs

Typically, the agency costs are referred to as those costs incurred when having or hiring an agent to make significant decisions on behalf of the principal. Using this aspect towards the corporate governance, the agency costs are costs that the company's owners incur by hiring or having managers to run and control all the activities of the company, instead of managing the company themselves. However, the agency costs do not exist when the shareholders, as well as the managers of the company, are the same people. Also, the agency charges start to increase. Some of the company's owners immediately are not even the directors of the given entity. Besides, there exist three major concepts of the agency costs, which include: The costs involved in monitoring, residual loss as well as the bonding costs.

Reducing Agency Conflicts

Both Jansen & Meckling made an argument that when they generally act within the interest of the owners only, the agents (managers) might bear the overall cost of failing to follow the main objectives that are in their best interests but gain only a few numbers of benefits. Therefore, in other words, to make appropriate decisions that benefit the company's owners by optimizing their shares' value (Raelin, & Bondy, 2015), the following methods should be applied to solve the agency challenges: First, the company should adopt the remuneration packages for the senior executive directors as well as the top managers of the company. Secondly, they should have a large proportion of debt based on the long-term structure of the capital of the organization, and lastly, the company owners should have board of directors which will help in monitoring all the decisions made by the managers of the company, as this will effectively reduce the agency conflict between the owners and managers of the company.

Conclusion

Generally, the Agency Theory in corporate governance begins to gain momentum for many reasons. As the markets start becoming very unpredictable as ever before, it becomes essential that both the company's owners as well as managers' interests are adequately considered. The agency theory concept has contributed significantly to the success of the company in many ways. First, this theory helps in solving various agency conflicts since it has a different appetite for risk to solve any arising interest problem.

Similarly, it helps in solving different interests of the two parties. Nevertheless, there exists a challenge of objective congruence between the two interested parties, which may enhance conflict between the principal and agent. Therefore, they should adopt an effective mechanism to solve any problem caused by agency theory.

References

Lan, L. L., & Heracleous, L. (2018). Rethinking agency theory: The view from the law. Academy of management review, 35(2), 294-314.

Raelin, J. D., & Bondy, K. (2015). Putting the good back in good corporate governance: The presence and problems of doublelayered agency theory. Corporate Governance: An International Review, 21(5), 420-435.

Roberts, J. (2015). Agency theory, ethics, and corporate governance. Advances in Public Interest Accounting, 11, 249-269.

Safieddine, A. (2019). Islamic financial institutions and corporate governance: New insights for agency theory. Corporate Governance: An International Review, 17(2), 142-158.