Agency theory:

 Attempts to describe financial statements and the accounting theories from which they
originate.
 explain their development based on the economic theories of prices, agency, public choice, and
economic regulation.
 Agency theory is a positive accounting theory that attempts to explain accounting practices and
standards.
 individuals maximize their own expected utilities and are resourceful and innovative in doing so.
 What is an individual’s expected benefit from a particular course of action? corporate decision?
 agency is defined as a consensual relationship between two parties, whereby one party (agent)
agrees to act on behalf of the other party (principal).
 shareholders and managers
 managers and auditors
 auditors and shareholders
 the stockholders must employ someone to represent them. These employees are agents who
are entrusted with making decisions in the shareholders’ best interests
 a threat exists that the agents will act to maximize their own wealth rather than that of the
stockholders.
 the challenge of ensuring that the manager/agent operates on behalf of the
shareholders/principals and maximizes their wealth rather than his or her own
 Inherent in agency theory is the assumption that a conflict of interest exists between the owners
(shareholders) and the managers.
 Shareholders desire to maximize profits on their investment in the company; instead, managers
may be maximizing their own utilities at the expense of the shareholders.
 a manager might choose accounting alternatives that increase accounting earnings when a
management compensation scheme is tied to those earnings. Because such choices affect only
how financial information is measured and thus the amount of reported earnings, they have no
real economic effect in and of themselves and thus provide no benefit to the shareholder. At the
same time, shareholder wealth declines as management compensation increases.
 The costs of an agency relationship have been defined as the sum of monitoring expenditures by
the principal, bonding expenditures by the agent, and the residual loss.
 Monitoring expenditures are defined as expenditures by the principal to control the agent’s
behavior,
 Ex: external and internal auditors, the SEC, capital markets including underwriters and lenders,
boards of directors, and dividend payments.
 Bonding costs are defined as expenditures to guarantee that the agent will not take certain
actions to harm the principal’s interest.
 Ex: managerial compensation, including stock options and bonuses and the threat of a takeover
if mismanagement causes a reduction in stock prices.
 the actions taken by the agent will differ from the actions the principal would take the wealth
effect of this divergence in actions is defined as residual loss.
 Ex: the extent to which returns to the owners fall below what they would be if the principals and
the owners exercised direct control of the corporation.
 all individuals act to maximize their own utility, managers and shareholders would be expected
to incur bonding and monitoring costs as long as those costs are less than the reduction in the
residual loss.
 a management compensation plan that ties management wealth to shareholder wealth will
reduce the agency cost of equity, or a bond covenant that restricts dividend payments will
reduce the agency costs of debt.
Agency theory is a concept used to explain the importance relationships between principles and their
relative agents because the principle relies heavily on the agent to make the decision. There may be
some conflicts or disagreements; for example, company executives with an eye toward short-term
profitability and elevated compensation may desire to expand a business into new high-risk markets.
However, this could pose an unjustified risk to shareholders who are most concerned with the long-term
growth of earnings and share price appreciation. The agency theory dives into such relationships, I will
discuss what agency theory is, major types of principal agency relationships, real world examples, and
strategies to help firms to reduce the chance of agency problems.

What is agency theory:

An agency refers to a relationship comprising two parties, where one party called the agents represents
the other party called the principal. An agent is usually hired by the principal to perform an actor service
on his behalf by implication. Sometimes the agent doesn’t only use the principal’s resources but also
makes decisions with the resulting risks to be borne by the principal alone. This makes agency
relationships complicated as disputes disagreements and conflicts of interest do arise. The agency theory
explains how to best organize agency relationships to prevent conflicts and other issues that arise
between agents and principles.

There are two key assumptions underlying the agency theory:

1. individuals are generally egoists who act in their own self-interest. In short, both the principal
and agent are out for their own benefits.
2. Agents have access to more information and are usually in a decision-making capacity.

As a result of the above we see that conflicts result from a clash of interests or from the information gaps
between the principles and agents.

Two principle-agent relationships:

There are two major types of relationships that are closely intertwined and are faced with some sort of
disagreement.

1. Shareholders and management teams:

 Management teams may be more willing to take on high levels of risk and operating, marketing
or investing.
 While shareholders desire maximized returns in the form of capital gains and dividends.
 Shareholders are generally risk-averse, which is viewed as prudent and conservative,
 this conflict gets even more evident if the management team receives a large portion of its
compensation and annual salaries and stock options managers have less to lose because salaries
are constant and stock option values rise in response to increased volatility which is embedded
with risk.
2. Investors and fund managers:
 The fund managers could create the potential connects with investors when they could make a
gain or avoid a loss to the firm at a client's expense.
  Has an interest in the outcome of a decision that is not the same as the clients.
 has an incentive to favor one client over another.
 Has an incentive to favor a service provider that is not the best for the clients.
 and is offered gifts or entertainment that may compromise objectivity.

Real-world examples:

here are two real world examples of the agency problem:

1. Enron sandal:

One particularly famous example of the agency problem is that of Enron. Enron Corporation was an
American Energy Commodities and services company based in Houston Texas. Despite being a multi-
billion-dollar company, Enron began losing money in 1997, the company also started racking up a lot of
debt fearing a drop in share prices, Enron's management team hid the losses by misrepresenting them
through tricky accounting resulting in confusing financial statements. The problems started to unfold in
2001, there were questions about whether the company was overvalued leading to a drop in share
prices from over $90 to under $1. The company ended up filing for bankruptcy in December 2001.
Criminal charges were brought up against several key Enron players including former CEO Kenneth lay,
CFO Andrew Fasto, and Jeffrey Skilling who was named CEO in February 2001 but resigned six months
later.

2. Bernie Madoff:

Ponzi schemes represent many of the better-known examples of the agency problem, agency theory
claims that the lack of oversight and incentive alignment greatly contribute to these problems. Many
investors fall into Ponzi schemes because they believe that taking fund management outside a traditional
banking institution could reduce costs and receive extra returns. Bernie Madoff scam is probably one of
the most notable examples of a Ponzi scheme. Madoff was former chairman of the NASDAQ Stock
Exchange; he created an elaborate sham business that ultimately cost investors nearly 65 billion dollars
in 2009. His scheme unraveled when he could no longer pay his investors and confessed ultimately
Madoff was criminally charged and convicted for his actions, he was sentenced to serve a 150-year
prison sentence and died behind bars at the age of 82 in April 2021.

Strategies:

in order to reduce the likelihood of the principal agent conflict here are some measures and principles
that can be followed:

1. Contracts:

A strong contractual agreement is necessary to pay the groundwork for seamless business operations.
The contract must be detailed thorough and inclusive regarding incentives performance evaluation and
compensation, it should also list procedures to oversee all regulatory measures.

2. Restrictions:
Imposing restrictions is a good way to significantly reduce the effect of agency loss, setting specific
restrictions on factors such as agency power allows the principal to feel more confident in their relative
agent.

3. Evaluations:

One can create mechanisms that will evaluate agents Performance based on their decisions. if the agents
follow these criteria well, they will receive a reward, however if it's clear that the agents are acting only
in self-interest they may get sanctions; for example, periodical performance evaluations are excellent
Solutions.

4. Bonuses:

Introducing incentives and bonuses lessens the chances of a relationship that consists of conflicts and
disagreements. introducing bonuses is a good way to motivate an agent and will allow them to make
decisions with the best intentions of the principle in order to achieve their desired incentive.

5. Transparency:

To reduce the potential influx of Agency problems it is crucial for both the principal and the agent to be
completely transparent with one another. once transparency is present conflict is reduced because there
is less confusion in decision making and fewer implications that one party is against the other.

Summary:

Now let's wrap up today's topic, agency theory is a concept used to explain the important relationships
between principles and their relative agents because the principle relies so heavily on the agent to make
the right decision. there may be an assortment of conflicts or disagreements, agency theory dives into
such relationships. the agency theory is based on two fundamental assumptions: individuals are
generally egoists, agents have access to more information and are usually in a decision-making capacity
to better address the potential Agency problems five strategies or principles should be followed those
strategies are contract, restrictions, evaluations, bonuses, and transparency.
 The collapse of energy giant Enron in 2001 showed just how dire the agency's problem could be.
Company officials and its board, including Chairman Kenneth Lay, CEO Jeffrey Skilling and CFO Andy
Fastow, were selling their Enron shares at higher prices because of faulty accounting reports that made
appear the shares more valuable than they really were. After the scandal came to light, thousands of
shareholders lost millions of dollars when the value of Enron shares plummeted.

Enron Corporation is an American energy products and services company headquartered in Houston,
Texas. In 2001, energy giant Enron filed for bankruptcy. Accounting reports have been fabricated to give
the impression that the business has more money than it actually made. Company executives used
fraudulent accounting techniques to hide debts of Enron subsidiaries and exaggerate revenues. These
frauds allowed the company's share price to soar at a time when executives were selling portions of their
stock. In the four years before Enron filed for bankruptcy, shareholders lost an estimated $74 billion in
value. Enron became the largest bankrupt in the United States at the time with its assets worth $63
billion. Although Enron management was charged with looking out for the best interests of shareholders,
the agency problem caused management to act in its best interest.

Madoff was arrested in 2008 and sentenced to 150 years in prison in 2009. The US government offered
more than $700 million to fraudulent Madoff investors, but that amount pales in comparison to the
thousands upon thousands of millions of dollars that investors have been defrauded. Some of Madoff's
early investors managed to recoup their entire investment from him, as well as a large profit

An American financier who ran the largest Ponzi scheme in history, defrauding thousands of investors
out of tens of billions of dollars over the course of at least 17 years, possibly longer. At one point, Madoff
lured investors in by claiming that he generated consistently large returns through an investment
strategy called split conversion, which is a legitimate trading strategy. However, Madoff deposited the
client's money into a single bank account that he used to pay existing clients who wanted to withdraw
cash. He financed the acquisitions by attracting new investors and their capital, but was unable to sustain
the fraud when the market took a sharp turn in late 2008. On December 10, 2008, he confessed his
mistake to his sons who worked at his company. The next day they handed him over to the authorities.
Bernie was adamant that his children were unaware of his plan. The latest data from the fund indicates
that he has $64.8 billion in client assets.

Bernie Madoff was arrested in 2008 and ultimately sentenced to 150 years in prison in 2009. The US
government ended up offering more than $700 million to fraudulent Madoff investors, but that amount
pales in comparison to the thousands upon thousands of millions of dollars that investors have been
defrauded. However, that some of Madoff's early investors managed to recoup their entire investment
from him, as well as a large profit. Bernie Madoff died behind bars at the age of 82 in April 2021.

Aviation pioneer Boeing provides an instructive example of how an agency problem can influence capital
markets. From 1998 to 2001, Boeing had more than 130,000 shareholders. Most of those shareholders
were Boeing employees who purchased company stock through 401(k) retirement plans. At the same
time, Boeing was planning to repurchase a significant portion of its stock, which caused its stock price to
plummet. The actions of executives tasked with looking after the company have damaged the value of its
employees' retirement accounts.

Second, agents have access to more information and usually have the authority to make decisions.

Agency theory is a concept used to explain the importance of relationships between managers and their
relative agents. This is because the principal relies on the decision making of the agent. Shareholders
who are major principals must appoint representatives. These employees are agents who make decisions
in the best interest of the shareholders. The agency theory is based on the premise that there is a
conflict of interest between the owner (shareholder) and the manager. Managers may choose
accounting alternatives that increase accounting profits that only affect how financial information is
measured. Therefore, there is no real economic effect on the amount of dividends reported and,
therefore, an increase in management compensation will reduce shareholder wealth.

The agency problem can never be 100% solved in a world where everyone has a healthy regard for their
own self-interest and the relevant information for evaluating performance is imperfect, costly to obtain
and unequally distributed. In some institutions, the incentives for agents faithfully to represent their
principals may become weak and ineffective. To address this, the academic disciplines of business
administration and public administration must identify and devise cheaper substitutes or remedies for
organizational arrangements that are characterized by costly agency problems.

Company officials and its board, including Chairman Kenneth Lay, CEO Jeffrey Skilling and CFO Andy
Fastow, were selling their Enron shares at higher prices due to faulty accounting reports that made the
shares appear more valuable than they really were. Enron Corporation is an American energy products
and services company headquartered in Houston, Texas.

He financed the acquisitions by attracting new investors and their capital but was unable to sustain the
fraud when the market took a sharp turn in late 2008.