Agency Theory

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Agency Theory
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Class Announcements

• Assignment 7 due March 6th available on-line
• Research Paper Part 3 due March 13th
• Reading in Chapter 9 (Agency Theory) skip
  examples and calculation type discussions
• Midterm returned in-class
• Mondays class (March 10th) is at 500-700pm in
  SCHW 110 (Movie)
• Business Banquet - April 2nd 545-8pm, Catering
  - Gabrieau's Bistro Keynote Speaker - Annette
  Verschuren, Past President of Home Depot for
  Canada and Asia

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Research Paper Part 3

• Discuss the current academic research on your
  topic area
• A brief synthesis by topic not by paper
• Three (3) academic references required (excluding
  text and CPA/CICA Handbook)
• Due March 13th (500pm)
• Worth 2.5
• Length Cover page, One page submission (double
  spaced), reference page with Parts 1 2,
  Marking Keys 1 2attached to the back.
• Part 2 Average 1.86/2.5 (74)

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Class Objectives

1. Agency is a theory of contracts
2. Contracts as a means to manage the expectations
   and relationship between principals and agents
3. Types of agency contracts
4. Contracts as a means to manage the expectations
   and relationship between principals and agents
5. Corporate Governance addresses agency issue

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Agency Theory

• Positive accounting theory envisions firms as a
  nexus of contracts.
• (e.g. compensation agreements, debenture
  contracts
• Agency theory envisions firms as necessary
  structures to maintain contracts firms logically
  arise because of the need for a control system to
  mitigate a sort of destructive opportunism called
  shirking
• Two parties with conflicting interests to a
  contract 1) agent 2) principal
• Partys actions are motivated by the contract
  itself

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Agency Theory Rational Agents

• In agency theory, people are assumed to be
  rational profit maximizing individuals who will
  promote self interest.
• Separation between ownership and management
• Agents
• Self Interested
• Choose actions that maximize own expected utility
  (adverse selection)
• Have alternative opportunities of use of their
  time
• Effort-adverse (moral hazard)
• Tendency to shirk (moral hazard)
• Risk adverse
• See P9-8 (p. 370) http//www.cbc.ca/player/News/TV
  20Shows/The20National/ID/2437757413/

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Agency Theory Definition

• Agency theory is branch of game theory that
  studies the design of contracts to motivate a
  rational agent to act on behalf of a principal
  when the agents interest would otherwise
  conflict with those of the principal. (p. 340)
• Agents (manager) have an information advantage
  (i.e. information asymmetry)

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Agency Theory Contracts

• Accounting information (e.g. net income) has a
  role to play in motivating and monitoring manager
  performance (p. 369)
• Accounting information competes with other
  sources of information
• Contractual agreements have accounting
  implications
• Precise payoff and value of performance measure
• Sensitivity effort and value of performance
  measure
• Types of contractual obligations
• Employment contracts
• Lending contract

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Agency Theory Employment Contract

• Modeled as
• a principal who owns some productive resource
• an agent to whom work or decision making is
  delegated (contract motivates effort incentive
  compatible)
• Separation of ownership and control
• The running of an organization is a complex and
  specialized task for which the owner may not have
  the required skills.
• A compensation scheme is struck in advance that
  will reward the agent for his efforts leaving
  something for the principal

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Agency Theory Employment Contract

• The tendency of an agent to shirk is an example
  of moral hazard (information asymmetry)
• A) Principal could run the business himself
  (direct monitoring)
• B) Costless observation of managers efforts and
  provision of salary (indirect monitoring)
• C) Fixed contract (i.e. rental contract)
  (internalizing)
• D) Profit sharing (performance measure)

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Agency Theory Lending Contract

• Contacts exist between a lender (principal) and a
  firm (agent)
• Manager (agent) tries to find an effective
  contractual arrangement that would lower the
  interest rate
• Rational lenders will anticipate moral hazard
  (shirking) and will raise the interest rates for
  their loans
• Lender (principal) imposes covenants
• Limit dividends if interest coverage ratio is
  below some level
• Limit additional borrowing if shareholders
  equity is below a specific level

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Agency Theory Accounting Implications

• Profit sharing contract is most attractive
  contract (especially employment contract)
• Base compensation on performance measures
• Net income
• is most often used performance measure other than
  share price
• is informative about managerial effort but not
  fully informative
• Poor governance
• Recognition lag
• Adverse selection
• GAAP allows flexibility to avid rigidity
• Accounting information needs to be
• Precise - Performance Payoff
• Sensitive Performance Effort

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Corporations Corporate Governance

• Private and Public Corporations
• Separation of Ownership (Shareholders) and
  Management
• Corporate Governance is the relationship between
• Shareholders (owners)
• Board of Directors
• Corporate Officers

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Corporate Governance Conflict

• Separation of ownership and management
• Manager and shareholder interests alignment
• Information asymmetry
• Incentives to conceal bad news (agency theory -
  adverse selection)
• Incentives to shirk (agency theory moral
  hazard)
• Agency Theory attempt to modify behavior

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Corporate Governance Defined

• Corporate Governance is the relationship between
  shareholder, the board of directors and other top
  managers in the corporation
• Corporate governance processes attempt to ensure
  proper functioning of management
• Corporate governance is implemented and evaluated
  through various processes within the organization
• Board of Directors internal and external
  directors
• Audit Committee meet with auditor and review
  audited financial statements
• Compensation Committee set corporate officers
  compensation
• Nominating Committee nomination of qualified
  members
• Securities Exchanges (e.g. OSC, SEC)
• Reporting in Annual Report

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Corporate Governance Importance

• Why is corporate governance important?
• Owners can not easily observe the corporate
  officers who are managing the owners investment
• Companies lack oversight by investors
• Board of Directors have failed to provide proper
  checks and balances
• Markets have stirred distrust instead of building
  confidence (e.g. Enron)
• Rules for Board of Directors make accountability
  explicit

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Corporate Governance Need

• 94 of investors say corporate governance is
  important
• 83.5 believed new regulations should be put in
  place to strengthen investor confidence in global
  markets
• Regulatory requirement
• US SOX (2002)
• Canada National Policy 58-201(2005)
• Globalization of world capital markets
• Internally imposed obligation
• Ownership responsibility
• Competitive advantage

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Corporate Governance Issues

• 1. Better Boards
• Independence, skill, accountability
• 2. Executive Compensation
• Link pay to performance, disclose metrics and
  links, executive overcompensation (US Canada)
• 3. Financial reporting
• Improved disclosure in financial statements
• 4. CEO Performance
• 5. Cost compliance/time

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Corporate Governance Proposed Solutions

• Better Boards
• Director independence How many? Who is
  independent?
• Independent and financially literate audit
  committee to whom external auditors would report
  directly
• Independent compensation committee
• Only one management representative on board of
  directors
• Continuing education
• Truly independent directors

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Corporate Governance Proposed Solutions

• Financial Reporting
• Management attest to financial statements and to
  the presence of reasonable internal controls
• Codes of conduct/ethics
• Transparency

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Corporate Governance Proposed Solutions

• Audit Committees
• Charter
• Qualifications (financial literacy)
• Auditors
• Participate in public oversight program
  established by CPAB
• Reduce concerns over loss of client
• Reduce commodification of audit by reducing cost
  pressure
• Increase oversight with firm review

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Corporate Governance National Instrument 58-101

• National Instrument 58-101 - Disclosure of
  Corporate Governance Practices
• Board of Directors
• Board Mandate
• Position Descriptions
• Orientation and Continuing Education
• Ethical Business Conduct
• Nomination of Directors
• Compensation
• Other Board Committees
• Assessments

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Corporate Governance Multilateral Instrument
58-110

• Multilateral Instrument 58-110 - Disclosure of
  Corporate Governance Practices
• Audit Committee Charter
• Composition of the Audit Committee
• Relevant Education and Experience
• Reliance on Certain Exemptions
• Reliance on Exemption in 3.3(2) or 3.6
• Reliance on Section 3.8
• Audit Committee Oversight
• Pre-approval Policies and Procedures
• External Auditor Service Fees (by Category)

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Class Objectives - Revisited

1. Agency is a theory of contracts
2. Contracts as a means to manage the expectations
   and relationship between principals and agents
3. Types of agency contracts
4. Contracts as a means to manage the expectations
   and relationship between principals and agents
5. Corporate Governance addresses agency issue

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Midterm Results

• Average 47.79/65 (74)
• Hi 74/65
• Lo 13.5/65
• Comments
• Did not answer question(s)
• Insufficient knowledge of basic concepts
• Insufficient information about basic concepts
• Provide evidence or discussion for your
  opinions/conclusions do not assume
• Quality of the argument is important (no dumping)