how to reduce agency problem in financial management

The agency problem can be defined as a conflict when the agents entrusted with the responsibility of looking after the interests of the principals choose to use the power or authority for their benefits and in corporate finance. It is a conflict of interest between its management and stockholders.

It is a common problem in almost every organization, whether a church, club, company or government institution. A conflict of interest occurs when responsible people misuse their authority and power for personal benefits. However, it can be resolved if only the organizations are willing to fix it.

Types of agency problems, solutions to agency problems, recommended articles.

You are free to use this image on your website, templates, etc., Please provide us with an attribution link How to Provide Attribution? Article Link to be Hyperlinked For eg: Source: Agency Problem (wallstreetmojo.com)

Every organization has its own set of long-term and short-term goals and objectives that it wishes to achieve in a predetermined period. In this context, one must also note that the management’s plans may not necessarily align with the stockholders.

The management of an organization may have goals that are most likely derived to maximize their benefits. On the other hand, an organization’s stockholders are most likely interested in their wealth maximization Wealth Maximization Wealth maximization means the maximization of the shareholder’s wealth as a result of an increase in share price thereby increasing the market capitalization of the company. The share price increase is a direct function of how competitive the company is, its positioning, growth strategy, and how it generates profits. read more . This contrast between the goals and objectives of the management and stockholders of an organization may often become a basis for agency problems. Precisely speaking, there are three types which are discussed below: –

ABC Ltd. sells gel toothpaste for $20. The company’s stockholders raised the selling price of the toothpaste from $20 to $22 to maximize their wealth Wealth Wealth refers to the overall value of assets, including tangible, intangible, and financial, accumulated by an individual, business, organization, or nation. read more . This sudden unnecessary rise in the cost of toothpaste disappointed the customers and boycotted the product sold by the company. Few customers who bought the product realized a fall in the quality and were utterly disappointed. It resulted in agency problems between the stockholders and the loyal and regular customers of the company.

There can be various causes of agency problems. These causes differ from the position of an individual in the company. However, the root cause of these problems is the same in all mismatch or conflict of interests cases. When the agenda of the stockholder Stockholder A stockholder is a person, company, or institution who owns one or more shares of a company. They are the company's owners, but their liability is limited to the value of their shares. read more clashes with the other groups, the agency problem will occur. In the case of employees, the reason would be the failure of stockholders to meet employees’ expectations concerning salary, incentives, working hours, etc.

In the case of customers, the cause would be the failure of stockholders to meet customers’ expectations like the sale of poor-quality goods, poor supply, high pricing, etc. In the case of management, the causes of agency problems could be the misalignment of goals, separation of ownership and control, etc.

The companies can resolve the agency problems between the stockholders and the company’s management by offering stock packages or commissions for the decisions taken by the administration and their outcomes on the shareholders Shareholders A shareholder is an individual or an institution that owns one or more shares of stock in a public or a private corporation and, therefore, are the legal owners of the company. The ownership percentage depends on the number of shares they hold against the company's total shares. read more . In addition, the companies can try to resolve these problems that can exist between its stockholders and management/ creditors/ other stakeholders (employees, customers, society, community, etc.) through taking instituting measures like tough screening mechanisms, offering incentives for good performance, and behavior and likewise penalizing for poor performance and bad behavior, and so on. However, an organization cannot completely heal from agency problems since the associated costs outweigh the total outcomes sooner or later.

Agency problems are the mismatch of interests between the company’s management/ creditors/ other stakeholders (employees, customers, society, community, etc.) and its stockholders, which may sooner or later result in a conflict of interest. Therefore, companies must address the underlying problems to ensure that their regular profit business operations are not impacted. This problem can exist anywhere: a company, club, church, or government institution.

The three types of agency problems: stockholders vs. management, stockholders vs. [wsm-tooltip header="Bondholders" description="A bondholder is an investor who buys or holds a government or corporate bond." url="https://www.wallstreetmojo.com/bondholder/"]bondholders Profit Profit refers to the earnings that an individual or business takes home after all the costs are paid. In economics, the term is associated with monetary gains. read more / creditors, and other stakeholders like employees, customers, community groups, etc. Companies can resolve it with the help of measures like offering incentives for good performance and behavior and penalizing for poor performance and bad behavior, tough screening mechanisms, etc. Of course, it is almost impossible for companies to eliminate agency problems, but it can still minimize the same implications.

This article is a guide to an Agency Problem and its definition. Here, we discuss types and agency problem solutions, their causes, and an example. You can learn more about accounting from the following articles: –

8.5 Agency Problems

Learning objective.

What are agency problems and how can they be mitigated?

The principal-agent problem is an important subcategory of moral hazard that involves postcontractual asymmetric information of a specific type . In many, nay, most instances, principals (owners) must appoint agents (employees) to conduct some or all of their business affairs on their behalf. Stockholders in joint-stock corporations, for example, hire professional managers to run their businesses. Those managers in turn hire other managers, who in turn hire supervisors, who then hire employees (depending on how hierarchical the company is). The principal-agent problem arises when any of those agents does not act in the best interest of the principal, for example, when employees and/or managers steal, slack off, act rudely toward customers, or otherwise cheat the company’s owners. If you’ve ever held a job, you’ve probably been guilty of such activities yourself. (We admit we have, but it’s best not to get into the details!) If you’ve ever been a boss, or better yet an owner, you’ve probably been the victim of agency problems. (Wright has been on this end too, like when he was eight years old and his brother told him their lemonade stand had revenues of only $1.50 when in fact it brought in $10.75. Hey, that was a lot of money back then!)

Stop and Think Box

As the author of this textbook ideas.repec.org/a/taf/acbsfi/v12y2002i3p419-437.html and many others have pointed out, investment banks often underprice stock initial public offerings (IPOs). In other words, they offer the shares of early-stage companies that decide to go public for too little money, as evidenced by the large first day “pops” or “bumps” in the stock price in the aftermarket (the secondary market). Pricing the shares of a new company is tricky business, but the underpricing was too prevalent to have been honest errors, which one would think would be too high about half of the time and too low the other half. All sorts of reasons were proffered for the systematic underpricing, including the fact that many shares could not be “flipped” or resold for some weeks or months after the IPO. Upon investigation, however, a major cause of underpricing turned out to be a conflict of interest called spinning: ibanks often purposely underpriced IPOs so that there would be excess demand, so that investors would demand a larger quantity of shares than were being offered. Whenever that occurs, shares must be rationed by nonprice mechanisms. The ibanks could then dole out the hot shares to friends or family, and, in return for future business, the executives of other companies! Who does spinning hurt? Help? Be as specific as possible.

Spinning hurts the owners of the company going public because they do not receive as much from the IPO as they could have if the shares were priced closer to the market rate. It may also hurt investors in the companies whose executives received the underpriced shares who, in reciprocation for the hot shares, might not use the best ibank when their companies later issue bonds or stock or attempt a merger or acquisition. Spinning helps the ibank by giving it a tool to acquire more business. It also aids whoever gets the underpriced shares.

Monitoring helps to mitigate the principal-agent problem . That’s what supervisors, cameras, and corporate snitches are for. Another, often more powerful way of reducing agency problems is to try to align the incentives of employees with those of owners by paying efficiency wages Wages higher than the equilibrium or market clearing rate. Employers offer them to reduce agency problems, hoping employees will value their jobs so much they will try to please owners by behaving in the owners’ interest. , commissions, bonuses, stock options, and the like . Caution is the watchword here, though, because people will do precisely what they have incentive to do. Failure to recognize that apparently universal human trait has had adverse consequences for some organizations, a point made in business schools through easily understood case stories. In one story, a major ice cream retailer decided to help out its employees by allowing them to consume, free of charge, any mistakes they might make in the course of serving customers. What was meant to be an environmentally sensitive (no waste) little perk turned into a major problem as employee waistlines bulged and profits shrank because hungry employees found it easy to make delicious frozen mistakes . (“Oh, you said chocolate. I thought you said my favorite flavor, mint chocolate chip. Excuse me because I am now on break.”)

In another story, a debt collection agency reduced its efficiency and profitability by agreeing to a change in the way that it compensated its collectors . Initially, collectors received bonuses based on the dollars collected divided by the dollars assigned to be collected. So, for example, a collector who brought in $250,000 of the $1 million due on his accounts would receive a bigger bonus than a collector who collected only $100,000 of the same denominator (250/1,000 = .25 > 100/1,000 = .10). Collectors complained, however, that it was not fair to them if one or more of their accounts went bankrupt, rendering collection impossible. The managers of the collection agency agreed and began to deduct the value of bankrupt accounts from the collectors’ denominators. Under the new incentive scheme, a collector who brought in $100,000 would receive a bigger bonus than his colleague if, say, $800,000 of his accounts claimed bankruptcy (100/[1,000 – 800 = 200] = .5, which is > 250/1,000 = .25). Soon, the collectors transformed themselves into bankruptcy counselors! The new scheme inadvertently created a perverse incentive, that is, one diametrically opposed to the collection agency’s interest, which was to collect as many dollars as possible, not to help debtors file for bankruptcy.

In a competitive market, pressure from competitors and the incentives of managers would soon rectify such mishaps. But when the incentive structure of management is out of kilter, bigger and deeper problems often appear. When managers are paid with stock options, for instance, they are given an incentive to increase stock prices, which they almost invariably do, sometimes by making their companies’ more efficient but sometimes, as investors in the U.S. stock market in the late 1990s learned, through accounting legerdemain. Therefore, corporate governance looms large and requires constant attention from shareholders, business consulting firms, and government regulators .

A free-rider problem, however, makes it difficult to coordinate the monitoring activities that keep agents in line . If Stockholder A watches management, then Stockholder B doesn’t have to but he will still reap the benefits of the monitoring. Ditto with Stockholder A, who sits around hoping Stockholder B will do the dirty and costly work of monitoring executive pay and perks, and the like. Often, nobody ends up monitoring managers, who raise their salaries to obscene levels, slack off work, go empire-building, or all three! www.investopedia.com/terms/e/empirebuilding.asp This governance conundrum helps to explain why the sale of stocks is such a relatively unimportant form of external finance worldwide.

Governance becomes less problematic when the equity owner is actively involved in management. That is why investment banker J. P. Morgan used to put “his people” (principals in J. P. Morgan and Company) on the boards of companies in which Morgan had large stakes. A similar approach has long been used by Warren Buffett’s Berkshire Hathaway. Venture capital firms also insist on taking some management control and have the added advantage that the equity of startup firms does not, indeed cannot, trade. (It does only after it holds an IPO Offering of stock to investors with the aid of an investment bank. or direct public offering [ DPO Offering of stock to investors without the aid of an investment bank. ]). So other investors cannot free-ride on its costly state verification. The recent interest in private equity, funds invested in privately owned (versus publicly traded) companies, stems from this dynamic as well as the desire to avoid costly regulations like Sarbanes-Oxley. www.sec.gov/info/smallbus/pnealis.pdf

Investment banks are not the only financial services firms that have recently suffered from conflicts of interest. Accounting firms that both audit (confirm the accuracy and appropriateness of) corporate financial statements and provide tax, business strategy, and other consulting services found it difficult to reconcile the conflicts inherent in being both the creator and the inspector of businesses. Auditors were too soft in the hopes of winning or keeping consulting business because they could not very well criticize the plans put in place by their own consultants. One of the big five accounting firms, Arthur Andersen, actually collapsed after the market and the SEC discovered that its auditing procedures had been compromised. How could this type of conflict of interest be reduced?

In this case, simply informing investors of the problem would probably not work. Financial statements have to be correct; the free-rider problem ensures that no investor would have an incentive to verify them him- or herself. The traditional solution to this problem was the auditor and no better one has yet been found. But the question is, how to ensure that auditors do their jobs? One answer, enacted in the Sarbanes-Oxley Act of 2002 (aka SOX and Sarbox), is to establish a new regulator, the Public Company Accounting Oversight Board (PCAOB) to oversee the activities of auditors. www.pcaobus.org The law also increased the SEC’s budget (but it’s still tiny compared to the grand scheme of things), made it illegal for accounting firms to offer audit and nonaudit services simultaneously, and increased criminal charges for white-collar crimes. The most controversial provision in SOX requires corporate executive officers (CEOs) and corporate financial officers (CFOs) to certify the accuracy of corporate financial statements and requires corporate boards to establish unpaid audit committees composed of outside directors, that is, directors who are not members of management. The jury is still out on SOX. The consensus so far appears to be that it is overkill: that it costs too much given the benefits it provides.

Government regulators try to reduce asymmetric information. Sometimes they succeed. Often, however, they do not. Asymmetric information is such a major problem, however, that their efforts will likely continue, whether all businesses like it or not.

Key Takeaways

IMAGES

Agency Problem
How can we reduce agency problem
What is the Agency Problem?
Agency Problem
Resolve Common Financial Management Challenges with ERP
Agency problems in Financial Management

VIDEO

Financial Management
NET INCOME PROBLEM FINANCIAL MANAGEMENT M.Com Capital Structure Problems
Financial Management
Financial Management || Financial Disision || Introduction
Educated Indians Are Becoming Beggars BUT WHY ?
What is financial Management I Definition of Financial Management I Objectives I Finance World

COMMENTS

Agency Problem: Definition, Examples, and Ways To Minimize Risks
Through regulations or by incentivizing an agent to act in accordance with the principal's best interests, agency problems can be reduced. 1:36. Agency Problem
Conflict of Interest: Resolving the Agency Problem
Perhaps the simplest method for eliminating the agency problem is to remove financial incentives that encourage conflicts of interest. Returning
Agency Problem: Definition, Example and How To Mitigate
How can you mitigate an agency problem? · Practice transparency · Use concise contract language · Introduce corporate governance · Seek intervention
How can we reduce agency problem
Performance Evaluation and Performance Measurement · Risk and Reward Sharing · Corporate Governance and Internal Control · Communication and Conflict Resolution.
Ways of Resolving Agency Problems and Costs
Greater financial leverage can help reduce the agency costs by impacting managers including threat of liquidation, and the pressure of making money to pay for
(PDF) The Agency Problem: Measures for Its Overcoming
lead toward the better company profit-the goal that the shareholders strive to as their main interest. ... increasing the value of the shares. Eun and Resnick (
Agency problem & how it can be minimized
In other words, advisors are to put their clients' interests above their own. The goal is to protect investors from advisors who are concealing any potential
Agency Problem
read more/ creditors, and other stakeholders like employees, customers, community groups, etc. Companies can resolve it with the help of measures like offering
8.5 Agency Problems
That's what supervisors, cameras, and corporate snitches are for. Another, often more powerful way of reducing agency problems is to try to align the incentives
to control agency problems between managers and shareholders
Carolina, the University of South Carolina, the 1995 American Finance Association meetings ... Several mechanisms can reduce these agency problems.