Agency Relationship

The relationship between management and shareholders is sometimes referred to as an Agency Relationship, in which managers act as agents for the shareholders, using delegation powers to run the affairs of the company in the best interest of the shareholders.

Agency problem:
a potential conflict of interest between the agent (manager) and the outsider shareholders. (i.e. those not involved in running the business) and the creditors. For example, if managers hold none or very little equity shares of the company they work for, what is to stop them from working inefficiently, not bothering to look for profitable new investments opportunities, or giving themselves high salary or perks?

Agency theory:
proposes that, although the individual members of the business team act in their own self interest, the well being of each individual depends on the well being of other team members and on the performance of the team in competition with other teams.
One power that shareholders possess is the right to remove the directors from office but shareholders have to take initiative to do this, and in many companies, the shareholders lack energy and organisation to take such a step. Even so, directors will want the company’s report and accounts, and the proposed final dividend, to meet with the shareholders’ approval at annual general meeting.
Another reason why managers might do their best to improve the financial performance of their company is that managers’ pay is often related to the size or profitability of the company. Managers in very big companies, or in very profitable companies, will normally expect to earn higher salaries than managers in smaller or less successful companies.
Another source of conflict between managers and shareholders is that they have different attitude towards risk. A shareholder can spread his risk by investing his money in a number of companies; one company may go into liquidation but the shareholders’ financial security is not threatened. A manager’s financial security however, usually depends on what happens to the one company that employs him. The manager could therefore be less inclined than the shareholder to invest company’s funds in a risky investment.
A further situation in which conflict can arise is when a company is subject to takeover bid. The shareholders of the acquired firm very often receive above normal gains for the share price while managers loose their job, if lucky they may be picked by the new shareholders. It can therefore be argued that it is therefore not always the shareholders interest for the sought-after companies put up such a defence to drive the bidder away.
Agency theory suggests that audited accounts of a limited company are an important source of post- decision information minimising investors’ agency costs, in contrast to the alternative approaches which see financial reports as primarily a source of ‘pre-decision’ information for the equity investors.