Agency Theory

Next class: Midterm (in-class) Assignment #2 returned in-class today Assignment #3 due November 10th Final Exam is 2:00pm December 17th

Agency Theory

Positive accounting theory envisions firms as a nexus of contracts.

(e.g. compensation agreements, debenture contracts

Two parties with conflicting interests to a contract 1) agent 2) principal Partys actions are motivated by the contract itself

Agency Theory: Contracting

Positive accounting theory envision firms as a nexus of 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 Corporations are residual owners entitled to the risky cash flow left over after all of the workers have been paid; residual owner will set up effective monitoring systems

Agency Theory

In agency theory, people are assumed to be rational profit maximizing individuals who will promote self interest. Agents:

Have alternative opportunities of use of their time Are effort-adverse (moral hazard) Choose actions that maximize own expected utility (adverse selection) Tendency to shirk (moral hazard)

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. 313)

Agency Theory: Contracts

Contractual agreements have accounting implications

Precise measurement of the payoff of effort Sensitive to management effort

Types of contractual obligations

Employment contracts Lending contract

Agency Theory: Employment Contract

Modeled as:

a principal who owns some productive resource an agent to whom work or decision making is delegated

Separation of ownership and control A compensation scheme is struck in advance that will reward the agent for his efforts leaving something for the principal

A) sharing of output must be observable (qualities: conditional predictability and hardness) B) optimal employment contract trades off risk and incentive efforts

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 B) Costless observation of managers efforts and provision of salary C) Fixed contract (i.e.. rental contract) D) Profit sharing (payoff is the performance measure)

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 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

Agency Theory: Accounting Implications

Profit sharing contract is most attractive contract (especially employment contract) Based compensation on performance measures Net income is most often used performance measure other than share price Net income is informative about managerial effort but not fully informative GAAP allows flexibility to avid rigidity Accounting information needs to be: Precise Sensitive