Business, Legal & Accounting Glossary
A theoretical model, developed by academics, to explain how the relationship between a principal and an agent may have economic consequences.
The analysis of principal-agent relationships, in which one person, an agent, acts on behalf of another person, a principal.
Agency theory is a principle used to explain and resolve problems in the relationship between business owners and their agents. That relationship is most commonly between shareholders, as principals, and company executives, as agents.
In broad terms, an agency relationship is any relationship between two parties in which one, the agent, represents the other, the principal, in day-to-day transactions. The agent has been hired by the principal or principals to perform a service on their behalf.
Agents are delegated decision-making authority by principals. Because the agent makes many financial decisions affecting the principal, disagreements, and even differences in priorities and interests, can arise. The interests of a principal and an agent are not always aligned, according to agency theory. This is also known as the principal-agent problem.
An agent, by definition, uses the resources of a principal. The principal has been entrusted with funds but has little or no day-to-day involvement. The agent makes the decision, but bears little or no risk because any losses are borne by the principal.
Financial planners and portfolio managers act as agents for their principals and are responsible for their assets. A lessee may be responsible for the protection and safeguarding of assets that do not belong to them. Despite the fact that the lessee is tasked with taking care of the assets, the lessee is less interested in protecting the goods than the actual owners.
Agency theory deals with disagreements that arise primarily from two factors: a difference in goals or a difference in risk aversion.
For example, company executives may want to expand a business into new, high-risk markets in order to increase short-term profitability and compensation. This, however, may pose an unjustified risk to shareholders, who are most concerned with long-term earnings growth and share price appreciation.
Another central issue frequently addressed by agency theory is incompatible risk tolerance levels between a principal and an agent. Shareholders in a bank, for example, may object that management has set the bar too low for loan approvals, putting the bank at too great a risk of default.
Several proponents of agency theory have proposed methods for resolving disputes between agents and principals. This is referred to as “reducing agency loss.” The amount that the principal claims was lost as a result of the agent acting against the principal’s interests is referred to as agency loss.
Among these strategies is the provision of incentives to corporate executives in order to maximise the profits of their principals. The stock options granted to company executives are based on agency theory. These incentives are designed to improve the relationship between principals and agents. Other practises include tying executive pay to shareholder returns in part. These are some applications of agency theory in corporate governance.
Concerns have been raised that management will jeopardise long-term company growth in order to boost short-term profits and their own pay. This is frequently seen in budget planning, where management reduces estimates in annual budgets to ensure that they meet performance goals. These concerns have resulted in yet another compensation scheme in which executive pay is partially deferred and determined based on long-term objectives.
These solutions are similar to those found in other agency relationships. One example is performance-based compensation. Another option is to require the posting of a bond to guarantee the delivery of the desired result. Then there’s the last option, which is to simply fire the agent.
Agency theory deals with disagreements that arise primarily from two factors: a difference in goals or a difference in risk aversion. Management may want to expand a company into new markets, focusing on the prospect of short-term profit and higher pay. This may not sit well with a more risk-averse group of shareholders, who are more concerned with long-term earnings growth and share price appreciation.
A principal’s and an agent’s risk tolerance levels may also be incompatible. Shareholders in a bank, for example, may object that management has set the bar too low for loan approvals, putting the bank at too great a risk of default.
A conflict of priorities exists between a person or group and the representative authorised to act on their behalf in the principal-agent problem. An agent may act in ways that are detrimental to the principal’s best interests. The principal-agent problem is as diverse as the principal and agent roles. It can happen in any situation where the owner of an asset, or a principal, transfers direct control of that asset to another party, or agent. A home buyer, for example, may suspect that a realtor is more concerned with a commission than with the buyer’s concerns.
The amount that the principal claims was lost as a result of the agent acting against the principal’s interests is referred to as agency loss. Offering incentives to corporate managers to maximise the profits of their principals is one of the most effective strategies for resolving disputes between agents and principals. Stock options granted to executives are based on agency theory and aim to optimise the relationship between principals and agents. Other practises include tying executive pay to shareholder returns in part.
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This glossary post was last updated: 25th January, 2022 | 0 Views.