Agency theory, agency costs and governance of information technology

A chief executive earns a salary tied to the size of the company. The shareholders want profit. She wants to grow the business, so she buys a competitor for more than it is worth. Nobody broke a rule. The interests of the person in charge and the owners simply did not match. Agency theory explains why this happens and what it costs. It is the base of most governance codes.

This topic covers the law of agency and a director’s fiduciary duty, the agency relationship in Jensen and Meckling’s theory, the five agency conflicts (moral hazard, effort, earnings retention, risk aversion and time horizon), agency costs, ways of reducing the agency problem, accountability, the ethics of agency theory, agency in public bodies and charities, the scope of governance, and the board’s responsibilities for information technology, including personal data, cyber risk and IT controls.

The previous topic covered the meaning of governance and stakeholders. The next covers governance codes and rules-based and principles-based approaches. Neither the May 2014 nor the November 2014 Pathfinder sets a stand-alone question on this topic.

Key terms in plain English

Syllabus check

This topic is in syllabus area D (corporate governance, 5% of the marks). It covers:

• agency theory and other theories of corporate governance;
• agency costs and ways of reducing them;
• governance and IT, including data protection and cyber risk.

CAMA 2020 and agency

The Companies and Allied Matters Act 2020 (CAMA 2020) is the company law of Nigeria.

The law of agency

An agent acts on behalf of a principal in dealing with others. A selling agent sells for a manufacturer. A stockbroker buys and sells shares for a client. In company law the directors are agents of the company. The board, and individual directors, can bind the company in contracts. They have wide powers over objectives, strategy, investment and targets.

That raises the question of how owners can make sure directors act in their interests.

Directors have a fiduciary duty to the company, a duty of trust. They must act in total good faith and not put their own interest before the company’s. A breach can lead to legal action by the company, usually through the rest of the board or a majority of shareholders. In practice shareholders find it hard to use the law.

They can remove a director only by a majority vote, and in court they must show that the directors acted against the company’s or particular shareholders’ clear interests.

Agency theory

Agency law concerns the legal link between the company and its directors. Agency theory concerns the link between owners and managers. At first the owners are the managers. As the company grows they appoint managers and an agency relationship forms. Lenders also have an interest, because they want to be repaid.

Jensen and Meckling (1976) built a theory on the conflicts of interest between shareholders, managers and major lenders. Shareholders want dividends and a higher share price, which depend on long-term prospects. Managers who own no shares have little direct interest in shareholder returns, and care mainly about pay and status unless pay is linked to profit or share price.

Lenders want sound management so that debt is repaid in full and on time. The relationship is a contract in which owners delegate decision-making. A perfect contract is impossible, because managers’ decisions affect their own welfare too.

Agency conflicts

• Moral hazard: managers seek the perks of the job (car, driver, aircraft, hospitality), more so when they own few shares. Worst in large companies.
• Effort level: managers may work less hard than owners would, lowering profit and share price. This applies at middle level as well as senior level.
• Earnings retention: pay often depends on the size of the company, not its profit, so managers prefer to reinvest and grow, even in projects with a negative net present value, instead of paying dividends.
• Risk aversion: managers rely on one employer for income and prefer stability, so they avoid risky projects that shareholders with diversified portfolios would accept.
• Time horizon: managers with annual bonuses and short tenure focus on short-term accounting return on capital employed. Shareholders value long-term value, measured by net present value.

Agency costs

Agency costs are the costs of having an agent decide for the principal. They are zero when owners and managers are the same people, begin when some shareholders are not directors and are highest in large companies. They are the value loss to shareholders from the divergence of interests. There are three parts:

Monitoring and bonding costs cannot prevent all residual loss.

Reducing the agency problem

Jensen and Meckling argued that managers who act for shareholders bear all the cost of giving up their own goals but gain only a share of the benefit, so incentives are needed. Methods:

• Remuneration that rewards both long-term and short-term financial targets and non-financial targets.
• More debt in the capital structure. Agency problems are bigger in profitable, low-growth companies with large free cash flow. Shareholders want free cash flow invested in positive-NPV projects or paid out as dividends. Managers of a low-growth firm may use it for marginal or negative-NPV growth. Debt interest must be paid, which cuts free cash flow, and managers must make sure new investments earn enough to cover the interest.
• An effective board. A board dominated by the chief executive, especially one who is also chairman, cannot monitor. Fama and Jensen (1983) argued that an effective board must be mostly independent non-executive directors, who should decide on conflicts such as executive pay. Jensen (1993) argued that a large board reacts slowly and is less critical.
• Accountability. Agents report back, answer questions and can be rewarded or punished. The cost of accountability should not exceed its benefit. Day and Klein note that the right to call to account must be matched by the power to do so.

Ethics and agency theory

Agency theory says:

• ownership is separate from control
• individuals act in their own interest
• interests conflict
• managers cannot be relied on to act for shareholders
• so costs arise, which are minimised by better monitoring and by incentives
• codes of governance apply these ideas

Simon Caulkin summed it up: the board’s main role is to align executives with the owners, which justifies separating chairman and chief executive, large executive pay and the insistence on independent non-executives. There is an ethical aspect: the theory assumes people cannot be trusted to act other than in their own interest.

Stewardship theory is a common alternative view, it assumes managers want to do a good job for the company, so the board should trust and support them and not only monitor them. Stakeholder theory, covered in the previous topic, widens the aim beyond shareholders.

Agency in other organisations

In the public sector, principals are a varied group who may not agree what value for money means, and audit often covers integrity but not performance. In charities, the key question is whether donations are used for the stated purpose. Remedies are a board overseen by trustees, open financial disclosure and audits of both finances and effectiveness.

Governance and information technology

Governance covers all functions: finance, operations, marketing, administration, human resources, IT and information systems, risk and internal control, strategy, compliance, financial reporting and policies. Directors cannot delegate their governance accountability. They delegate management tasks to senior managers who report back.

The board’s duties on IT

• Adequate IT and information systems are in place to achieve objectives.
• Adequate funding supports them.
• There is an IT strategy aligned with the organisation’s goals.
• A robust system of internal control prevents, detects and corrects errors.
• IT assets and data are safeguarded.

Three specific areas

• Personal data protection: the right of individuals to have personal data kept private and not exploited, for example through targeted advertising. ICAN cites the Nigerian constitution’s right to privacy and the NITDA data protection rules, and the European GDPR of 2018.
• Cyber risk: illegal hacking to steal data or disrupt systems, and also deliberate acts by disgruntled employees such as introducing a virus. The board must make sure there are controls to prevent attacks and to detect and correct them quickly.
• IT controls: controls over IT operations and procedures and within systems and software. The board is responsible for the effectiveness of internal control, including IT controls. As algorithms, artificial intelligence and machine learning spread, controls matter more.

Management puts IT policy into effect, applies controls and is accountable to the board for failures, such as a cyber-attack. ICAN gives an example: an airline ticket system under-priced some tickets and favoured customers in some areas because of an algorithm fault. Management must find and fix it and account to the board.

The board may have to explain to shareholders, and the audit committee may ask internal audit to check the fix.

The rules in more depth

Why agency costs cannot be zero

Monitoring is costly and incentives are imperfect. Beyond a point, extra control costs more than it saves.

Why pay linked to size is dangerous

It rewards growth, whether or not the growth adds value, so managers buy and expand.

Why debt disciplines managers

Interest is a fixed claim on cash. Cash that must go to lenders cannot be wasted.

Why independent directors matter

They have no stake in the executives’ pay or careers, so they can set pay and challenge decisions.

Effect on analysis

In a scenario, name the conflict, estimate the cost and propose the mechanism that best reduces it at a sensible cost.

Worked examples

1. Monitoring cost = ₦15m.
2. Bonding cost = ₦20m.
3. Residual loss.
   300 − 240 = ₦60m, the overpayment.
4. Total agency cost.
   15 + 20 + 60 = ₦95m.

1. With no debt, nothing stops the spending, and shareholders lose ₦40m of value.
2. If the company has debt interest of ₦200m, free cash flow falls to ₦300m.
3. Managers have less cash to waste and must make sure investments are profitable enough to pay the interest.

1. The manager prefers B.
2. Shareholders prefer A, which adds ₦40m more value.
3. Fix: pay bonuses on long-term measures, such as shares that vest over several years.

1. Personal data has been exposed, so data protection law and customer trust are at issue.
2. Management must stop the fault, find the cause and tell the board.
3. The board must consider the legal duty to report, compensation and control changes.
4. The audit committee should ask internal audit to test the change controls.

How to score full marks

• Name the principal and the agent.
• Name the conflict and show it with a fact from the question.
• Split agency costs into monitoring, bonding and residual loss.
• Give mechanisms and the weakness of each.
• For IT, link the board’s duty to the specific risk.
• Recommend and state who is accountable.

Common mistakes in the exam

• Saying agency costs are only the cost of bonuses.
• Missing residual loss.
• Confusing agency law with agency theory.
• Listing conflicts without examples.
• Forgetting that more debt reduces free cash flow available to managers.
• Treating IT as only a management matter and not a board duty.

Quick revision

• Directors are agents with a fiduciary duty.
• Conflicts: moral hazard, effort, earnings retention, risk aversion, time horizon.
• Agency costs: monitoring + bonding + residual loss.
• Remedies: pay, debt, independent board, accountability.
• IT governance: strategy, funding, controls, safeguards; data, cyber risk, IT controls.
• CAMA 2020: ss. 309, 305, 306, 308, 404(7).

Practice questions

These are original questions written in the style of the Institute of Chartered Accountants of Nigeria (ICAN) exam. Try each one before you open the answer. Full model answers follow the written questions.

Recall check: multiple choice

The real ICAN paper has no multiple-choice section. These questions are for quick recall. The written questions that follow are closer to the exam.

Written questions

Model answers

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