Agency theory (Jensen and Meckling, 1976) describes what happens when owners (principals) hire directors (agents) to run a company. Agents may act in their own interests, so owners incur agency costs to monitor and align them. Corporate governance exists largely to reduce these costs.
Key terms
| Term | Meaning |
|---|---|
| Principal | The party who delegates: usually shareholders |
| Agent | The party who acts on the principal's behalf: usually directors and managers |
| Agency problem | The agent's interests differ from the principal's |
| Information asymmetry | The agent knows more than the principal about the business |
| Moral hazard | The agent takes risks or shirks because the principal bears the cost |
| Agency costs | Monitoring costs + bonding costs + residual loss (Jensen and Meckling, 1976) |
Source: Jensen and Meckling (1976), Journal of Financial Economics.
Examples of agency problems
- Directors paying themselves excessive bonuses, or bonuses tied to short-term targets.
- Empire building: acquisitions that make the company bigger but not more valuable.
- Avoiding risky but worthwhile projects to protect their own jobs, or taking excessive risks when bonuses reward it.
- Manipulating reported results to hit targets.
Other agency relationships
The classic case is shareholders and directors, but SBL scenarios also feature: majority versus minority shareholders (especially in family firms), shareholders versus lenders (risky projects shift risk to lenders), and the board versus managers lower down.
How governance reduces agency costs
| Mechanism | How it helps |
|---|---|
| Independent non-executive directors | Monitor executives on shareholders' behalf |
| Audit committee and external audit | Check the accuracy of what agents report |
| Remuneration committee and long-term incentives | Align pay with shareholder value |
| Transparent reporting | Reduces information asymmetry |
| Shareholder engagement and voting | Owners hold directors to account |
Agency theory vs stewardship theory
Agency theory assumes agents are self-interested and need monitoring. Stewardship theory assumes directors want to do a good job and act as responsible stewards, so trust and empowerment work better than heavy controls. In an evaluation answer, mentioning both shows balance. See also stakeholder theory.
Agency theory in ACCA SBL
Use it to explain why a governance weakness in the case matters, for example a CEO who sets his own pay, then recommend governance fixes. Always tie the agency problem to a specific fact in the scenario.
FAQs
What is agency theory?
A theory of the relationship between principals (such as shareholders) who delegate work to agents (such as directors). Because agents may act in their own interests, principals incur costs to align and monitor them.
Who developed agency theory?
Michael Jensen and William Meckling, in their 1976 paper 'Theory of the firm: Managerial behavior, agency costs and ownership structure' in the Journal of Financial Economics.
What are agency costs?
Monitoring costs paid by the principal (for example audits and NED fees), bonding costs taken on by the agent to show they are trustworthy, and the residual loss that remains when interests are still not fully aligned.
What is the agency problem?
The conflict of interest that arises when agents can pursue their own goals, such as higher pay, an easier life or empire building, at the principals' expense, helped by information asymmetry.
How does corporate governance reduce agency problems?
Through independent non-executive directors, audit committees, external audit, pay linked to long-term performance, transparent reporting and active shareholder engagement.