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Chapter 1
2.2 Key concepts of agency theory
A number of key terms and concepts are essential to understanding agency theory.
An agent is employed by a principal to carry out a task on their behalf.
Agency refers to the relationship between a principal and their agent.
Agency costs are incurred by principals in monitoring agency behaviour
because of a lack of trust in the good faith of agents.
By accepting to undertake a task on their behalf, an agent becomes
accountable to the principal by whom they are employed.
Directors (agents) have a fiduciary responsibility to the shareholders (principal)
of their organisation (usually described through company law as 'operating in
the best interests of the shareholders').
Stakeholders are any person or group that can affect or be affected by the
policies or activities of an organisation
Agent objectives (such as a desire for high salary, large bonus and status for a
director) will differ from the principal's objectives (wealth maximisation for
shareholders)
The most important agency costs are the external audit fee, attending meetings
and reading both annual reports and analyst’s reports.
2.3 The cost of agency relationships
Agency costs arise largely from principals monitoring activities of agents, and may be
viewed in monetary terms, resources consumed or time taken in monitoring. Costs
are borne by the principal, but may be indirectly incurred as the agent spends time
and resources on certain activities.
Examples of costs include:
incentive schemes and remuneration packages for directors
costs of management providing annual report data such as committee activity
and risk management analysis, and cost of principal reviewing this data
cost of meetings with financial analysts and principal shareholders
the cost of accepting higher risks than shareholders would like in the way in
which the company operates
cost of monitoring behaviour, such as by establishing management audit
procedures
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