AGENCY COSTS

Agency Costs - Definition

An agency cost is a cost incurred by the shareholder in monitoring the activities of company agents (i.e. directors). Agency costs are normally considered as ‘over and above’ existing analysis costs and are the costs that arise because of compromised trust in agents (directors). 


Types of agency costs

1. Costs relates to director remuneration – or literally the cost of employing the agent to ensure that they run the company in the interest of the principal. The most effective method of incurring the employment cost is to align the interests of the agent with the shareholder. 

Ways to resolve this agency problem
The interests of directors can be linked to the objective of shareholders (long term growth of the company) by linking executive remuneration to the performance of the company in the long term to ensure that directors maximise the market value of their shares. Provision of share option schemes and linking performance to increases in shareholder value helps to provide this alignment.



2. Additional agency costs arise from information asymmetry where the directors of a company know more about company than shareholders; this means that shareholders effectively have to pay to obtain internal information about their company. This information is mainly in the form of the annual report; directors tend not to provide information for shareholder consumption at all. 

Ways to resolve this agency problem
The financial statements are prepared by the directors for the shareholders – the agent reporting to the principal. To provide creditability to those statements (and to check overall accuracy), the auditor provides a report to the shareholders stating that the directors have properly prepared the statements. The auditor is therefore reporting on the actions of the agent to the principal. This method of control only works where the auditor is independent of the directors – any potential influence between the two parties would decrease the integrity of the auditor and therefore the extent of reliance that could be placed on the audit report.



3. Agency costs are also incurred where directors do not perform their management role with duty of care, ie it is expected that the directors will ensure that appropriate internal control systems are established within a company to help fulfil their fiduciary duty to the shareholders. However, the agency cost is incurred where those control systems are ineffective and unnecessary or unauthorised expenditure is incurred.  

Ways to resolve this agency problem
The board of directors can implement good control to avoid company failure. However, these systems are not infallible but are subject to directors ignoring their own rules. For example, the board of Enron allowed Andy Fastow to control various Special Purpose Entities to 'hide' Enron debts in direct breach of the requirement of a director not to be on the board of more than one company in a group