Agency Theory

1. Agency Theory

2. Class Announcements • Assignment #7 due March 6th; available on-line • Research Paper Part #3 due March 13th • Reading in Chapter 9 (Agency Theory) – skip examples and calculation type discussions • Midterm returned in-class • Monday’s class (March 10th) is at 5:00-7:00pm in SCHW 110 (Movie) • Business Banquet - April 2nd – 5:45-8pm, Catering - Gabrieau's Bistro; Keynote Speaker - Annette Verschuren, Past President of Home Depot for Canada and Asia

6. Research Paper Part #3 • Discuss the current academic research on your topic area • A brief synthesis by topic not by paper • Three (3) academic references required (excluding text and CPA/CICA Handbook) • Due: March 13th (5:00pm) • Worth: 2.5% • Length: Cover page, One page submission (double spaced), reference page with Parts #1 & #2, Marking Keys #1& #2attached to the back. • Part #2 – Average 1.86/2.5 (74%)

7. Class Objectives • Agency is a theory of contracts • Contracts as a means to manage the expectations and relationship between principals and agents • Types of agency contracts • Contracts as a means to manage the expectations and relationship between principals and agents • Corporate Governance addresses agency issue

8. Agency Theory • Positive accounting theory envisions firms as a nexus of contracts. • (e.g. compensation agreements, debenture contracts • Agency theory envisions firms as necessary structures to maintain contracts; firms logically arise because of the need for a control system to mitigate a sort of destructive opportunism called “shirking” • Two parties with conflicting interests to a contract 1) agent 2) principal • Party’s actions are motivated by the contract itself

9. Agency Theory: Rational Agents • In agency theory, people are assumed to be rational profit maximizing individuals who will promote self interest. • Separation between ownership and management • Agents: • Self Interested • Choose actions that maximize own expected utility (adverse selection) • Have alternative opportunities of use of their time • Effort-adverse (moral hazard) • Tendency to shirk (moral hazard) • Risk –adverse • See P9-8 (p. 370) http://www.cbc.ca/player/News/TV%20Shows/The%20National/ID/2437757413/

10. Agency Theory: Definition • “Agency theory is branch of game theory that studies the design of contracts to motivate a rational agent to act on behalf of a principal when the agent’s interest would otherwise conflict with those of the principal.” (p. 340) • Agents (manager) have an information advantage (i.e. information asymmetry)

11. Agency Theory: Contracts • Accounting information (e.g. net income) has a role to play in motivating and monitoring manager performance (p. 369) • Accounting information competes with other sources of information • Contractual agreements have accounting implications • Precise –payoff and value of performance measure • Sensitivity –effort and value of performance measure • Types of contractual obligations • Employment contracts • Lending contract

12. Agency Theory: Employment Contract • Modeled as: • a principal who owns some productive resource • an agent to whom work or decision making is delegated (contract motivates effort; incentive compatible) • Separation of ownership and control • The running of an organization is a complex and specialized task for which the owner may not have the required skills. • A compensation scheme is struck in advance that will reward the agent for his efforts leaving something for the principal

13. Agency Theory: Employment Contract • The tendency of an agent to shirk is an example of moral hazard (information asymmetry) • A) Principal could run the business himself (direct monitoring) • B) Costless observation of manager’s efforts and provision of salary (indirect monitoring) • C) Fixed contract (i.e. rental contract) (internalizing) • D) Profit sharing (performance measure)

14. Agency Theory: Lending Contract • Contacts exist between a lender (principal) and a firm (agent) • Manager (agent) tries to find an effective contractual arrangement that would lower the interest rate • Rational lenders will anticipate moral hazard (shirking) and will raise the interest rates for their loans • Lender (principal) imposes covenants • Limit dividends if interest coverage ratio is below some level • Limit additional borrowing if shareholders’ equity is below a specific level

15. Agency Theory: Accounting Implications • Profit sharing contract is most attractive contract (especially employment contract) • Base compensation on performance measures • Net income • is most often used performance measure other than share price • is informative about managerial effort but not fully informative • Poor governance • Recognition lag • Adverse selection • GAAP allows flexibility to avid rigidity • Accounting information needs to be: • Precise - Performance & Payoff • Sensitive – Performance & Effort

16. Corporations: Corporate Governance • Private and Public Corporations • Separation of Ownership (Shareholders) and Management • Corporate Governance is the relationship between: • Shareholders (owners) • Board of Directors • Corporate Officers

17. Corporate Governance: Conflict • Separation of ownership and management • Manager and shareholder interests alignment • Information asymmetry • Incentives to conceal bad news (agency theory - adverse selection) • Incentives to shirk (agency theory – moral hazard) • Agency Theory – attempt to modify behavior

18. Corporate Governance: Defined • Corporate Governance is the relationship between shareholder, the board of directors and other top managers in the corporation • Corporate governance processes attempt to ensure proper functioning of management • Corporate governance is implemented and evaluated through various processes within the organization • Board of Directors – internal and external directors • Audit Committee – meet with auditor and review audited financial statements • Compensation Committee – set corporate officers compensation • Nominating Committee – nomination of qualified members • Securities Exchanges (e.g. OSC, SEC) • Reporting in Annual Report

19. Corporate Governance: Importance • Why is corporate governance important? • Owners can not easily observe the corporate officers who are managing the owners’ investment • Companies lack oversight by investors • Board of Directors have failed to provide proper checks and balances • Markets have stirred distrust instead of building confidence (e.g. Enron) • Rules for Board of Directors make accountability explicit

20. Corporate Governance: Need • 94% of investors say corporate governance is important • 83.5% believed new regulations should be put in place to strengthen investor confidence in global markets • Regulatory requirement • US – SOX (2002) • Canada – National Policy 58-201(2005) • Globalization of world capital markets • Internally imposed obligation • Ownership responsibility • Competitive advantage

21. Corporate Governance: Issues • 1. Better Boards • Independence, skill, accountability • 2. Executive Compensation • Link pay to performance, disclose metrics and links, executive overcompensation (US & Canada) • 3. Financial reporting • Improved disclosure in financial statements • 4. CEO Performance • 5. Cost compliance/time

22. Corporate Governance: Proposed Solutions • Better Boards • Director independence: How many? Who is independent? • Independent and financially literate audit committee; to whom external auditors would report directly • Independent compensation committee • Only one management representative on board of directors • Continuing education • Truly independent directors

23. Corporate Governance: Proposed Solutions • Financial Reporting • Management attest to financial statements and to the presence of reasonable internal controls • Codes of conduct/ethics • Transparency

24. Corporate Governance: Proposed Solutions • Audit Committees • Charter • Qualifications (financial literacy) • Auditors • Participate in public oversight program established by CPAB • Reduce concerns over loss of client • Reduce commodification of audit by reducing cost pressure • Increase oversight with firm review

25. Corporate Governance: National Instrument 58-101 National Instrument 58-101 - Disclosure of Corporate Governance Practices: • Board of Directors • Board Mandate • Position Descriptions • Orientation and Continuing Education • Ethical Business Conduct • Nomination of Directors • Compensation • Other Board Committees • Assessments

26. Corporate Governance: Multilateral Instrument 58-110 Multilateral Instrument 58-110 - Disclosure of Corporate Governance Practices: • Audit Committee Charter • Composition of the Audit Committee • Relevant Education and Experience • Reliance on Certain Exemptions • Reliance on Exemption in 3.3(2) or 3.6 • Reliance on Section 3.8 • Audit Committee Oversight • Pre-approval Policies and Procedures • External Auditor Service Fees (by Category)

27. Class Objectives - Revisited • Agency is a theory of contracts • Contracts as a means to manage the expectations and relationship between principals and agents • Types of agency contracts • Contracts as a means to manage the expectations and relationship between principals and agents • Corporate Governance addresses agency issue

28. Midterm Results • Average: 47.79/65 (74%) • Hi: 74/65 • Lo: 13.5/65 • Comments: • Did not answer question(s) • Insufficient knowledge of basic concepts • Insufficient information about basic concepts • Provide evidence or discussion for your opinions/conclusions; do not assume • Quality of the argument is important (no dumping)