Discusión General e Implicaciones

Agency theory, as an economic theory, was developed by Jensen and Meckling in 1976. In particular, this theory has been widely used by accounting researchers to explain and understand voluntary disclosure phenomena in many countries with a different social, political and economic background (e.g. Chow and Wong-Boren, 1987; Cooke, 1989a, 1991 and 1993; Hossain et al., 1994: Hossain et al., 1995; Meek et al., 1995; Raffournier, 1995; Inchausti, 1997; Depoers, 2000; Haniffa and Cooke, 2002; Ferguson

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et al., 2002; Hossain and Taylor, 2007; Chen et al., 2008; Akhtaruddin and Hossain, 2008).

s highlighted by Bric er and Chandar (1998, p. 487), “current mainstream accounting research is based extensively on economic models of agency that represent the operating company (firm) manager as “agent” and the individual investor as “principal”. From a theoretical perspective, agency theory is mainly concerned with the principal- agent relationship between the principals (for example, owners) and agents (for example, the corporate managers).

n agency relationship is defined as: “a contract under which one or more persons (the principal(s)) engage another person (the agent) to perform some service on their behalf which involves delegating some decision making authority to the agent” (Jensen and Meekling, 1976, p. 308). According to Baiman (1990), an agency relationship will exist after one or more principals employ others as their agents in order to delegate responsibilities to them. In particular, agency theory is founded on the premise of maximisation of individual advantage, it therefore assumes that the principal and agent are opportunistic and systematically seek their own self-interest and preferences (Lacoste et al., 2010).

Clearly, this theory would suggest that the interests of principals and agents differ mainly due to their different utility functions. In this context, the agency theory attempted to explain how shareholders, as principals, and companies’ managers as agents, arrange the relationship to protect their own interests.It also tries to predict the conflicts of the parties within the companies (i.e. conflicts of interest between companies’ managers and shareholders, as can be seen in Figure 3.1), because their goals are not in perfect agreement (Depoers, 2000).

The conflict of interest is described as “a situation where an individual or an organisation (an agent) has multiple interests and of those interests one could possibly corrupt the motivation for an act in the other” (Ittonen, 2010, p. 15).

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Figure 3.1: Conflict of interest between shareholders and managers

Source: Adapted from Ittonen (2010) which has been adapted from Soltani (2007)

Lambert (2001) pointed out that there are four distinctive reasons for conflicts of interest between principals and agents comprising: (i) effort aversion by the agent, (ii) the agent can divert resources for his own consumption, (iii) divergence of time horizons, and (iv) differential risk aversion on the part of the agent. However, Lacoste et al. (2010) suggest that the conflict of interest (agency conflict), can be reduced or eliminated by two means: monitoring of the agent by the principal and alignment of the agent’s interests with that of the principal’s.

According to agency theory perspective, the principal can limit or reduce any potential conflict with the agent by founding appropriate incentives for the agent and by incurring monitoring costs designed to limit opportunistic action by the agent (Jensen and Meckling, 1976; Hill and Jones, 1992).

Agency theory is concerned with solving two problems arising in the agency relationships: firstly an agency problem arises when the desires of the principal and agent conflict and it is difficult or costly for the principal to confirm how the agent is actually behaving, the problem here is that the principal cannot prove that the agent has

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acted improperly, and secondly a problem of risk sharing, which arises when the agent and the principal have diverse attitudes toward risk, the problem here is that the principal and the agent may tend to select opposing actions when the risk happens (Eisenhardt, 1989).

Three commonsolutions have been suggested by Healy and Palepu (2001) to principal- agent problems. The first solution to the agency problem is generating optimal contracts between corporate insiders, as agents and outside shareholders, as principals, provide for corporate insiders to share in the outcome of their actions, which also encourages disclosure and support to align the actions and choice of management with the interests of stakeholders (e.g. compensation agreements and debt contracts). In their view, such contracts regularly necessitate corporate managers to disclose appropriate information to enable company sta eholders to observe the companies’ managers’ compliance with contractual agreements, and to assess whether the management have managed the company’s resources in the shareholders’ interests.

Another important mechanism to alleviate the principal-agent problem, is the board of directors, who have the ability to control and discipline management on behalf of shareholders. Specifically, the board of directors are responsible for monitoring managerial performance in general, and financial disclosures in particular. A final, effective way of overcoming the agency problem is intermediaries (e.g. financial analysts, rating agencies and industry experts), involved in private information searches to discover managerial misapplication of company resources. As stated by Hossain et al. (1995) where there is a separation of ownership and control of a firm, the ‘agency costs’ are inevitable because of the conflicts of self-interest inherent between owners and management.

In line with this view, Raffournier (1995) asserts that the separation of ownership and control of a firm generates ‘agency costs’ resulting from conflicting interests between owners and management of a firm. As Watts and Zimmerman (1979) pointed out, the agency costs arise because the company managers (as the agents) interests do not necessarily agree with the interests of shareholders (as the principals). Also, agency costs arise in any situation involving a cooperative by two or more persons even though

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there is no clear cut principal-agent relationship (Jensen and Meckling, 1976). Agency costs comprise monitoring costs, bonding costs and residual loss.

Monitoring costs refer to the expenditure that the principals are agreeable to pay to facilitate the monitoring of agents’ actions, such as audit costs; bonding costs are the costs incurred by the agents to guarantee that they will not take certain actions to harm the principal’s interests, or that they will compensate the principal if he does ta e such action, for example, the cost of internal audit or appointing outside members to the board of directors; residual loss refers to the expenses that principals have to incur due to poor managerial decisions (Jensen and Meekling, 1976; Hill and Jones, 1992).

It has been suggested that one of the possible ways to decrease agency costs is to disclose more information concerning the management activities and the economic reality of the firm and through such information, stakeholders and other investors can monitor management more appropriately (Álvarez et al., 2008).

In this regard, Akhtaruddin and Hossian (2008) affirm that information disclosure is motivated by the wish of the managers to efficiently treat the potential conflicts between companies’ managers and sta eholders. Consistent with this view, Gray et al. (1995, pp. 46-47) claim that “accounting information is a mechanism for conflict resolution between various sta eholders for both explicit and implied contracts”.

From the agency theory point of view, both parties to a contract (the principal and the agent) often do not have the same information and this situation is called “asymmetric information” (Noreen, 1988). Typically, information asymmetry between the principal and the agent occurs when the agent has more information than the principal.

More importantly, information asymmetry gives rise to moral hazard or adverse selection problems. Moral hazard problems arise because of the principal’s inability to detect the agent’s action choice and when the preference ran ings of the principal and the agent over the set of alternative actions diverge (Walker, 1989). Adverse selection is a problem that occurs when the agent has access to information preceding his action choice which cannot be noticed by the principal (Walker, 1989). However, moral hazard and the adverse selection problems can be overcome by disclosing improved public information (Walker, 1989).

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In the context of the firm, the information asymmetry problem arises because outsiders to the economic entity (i.e. stakeholders and other investors) have limited access to information about the current and likely future operations of an economic entity. In other words, information asymmetry arises where the company managers have the competitive benefit of information within the company over that of the shareholders and other investors (Arnold and Lange, 2004). In addition, the separation of management and ownership awards company managers with superior information regarding companies’ current activities, financial position and future prospects ( squith and Mullins, 1986).

Consequently, firms’ managers have superior information compared to external owners and other investors about the firms’ current performance and future prospects. As htaruddin and Hossain (2008, p. 30) among others, affirmed: “it is well nown that managers have better access to private information than outside shareholders”. Hill and Jones (1992) stated that company managers are in a position to filter or distort the information that they disclose to sta eholders and managers’ control over critical information complicates the agency problem. It is, therefore, problematic for stakeholders to identify if managers are performing in their interests. A company manager could mitigate the information asymmetry problem by increasing the amount of information they voluntarily provide to the outsiders of a company (Hossain et al. 2005).

It can be argued that the degree of information asymmetry between corporate managers and external users of financial information is particularly high in a country where financial reporting standards and corporate reporting requirements offer less disclosure (Young and Guenther, 2003). In other words, in a country with high quality accounting and financial reporting standards, the corporate annual reports external users may face fewer information asymmetry problems than a country with a low quality of accounting and financial reporting standards.

Generally, due to the potential of the information asymmetry problem, management of the firms would simply utilise the annual reports of firms to provide additional information and other useful private information to outside stakeholders. As Healy and Palepu (2001) assert, increased demand for financial reporting and disclosure arises

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from an information asymmetry problem and the agency conflicts between company insiders and outsiders.

Moreover, companies’ managers now that stakeholders seek to control their behaviour through bonding and monitoring activities, therefore they will have more incentive to increase the level of disclosure to convince stakeholders that they are acting optimally (Watson et al., 2002). In this regard, Inchausti (1997) highlights the fact that increased financial and non-financial information disclosure in corporate annual reports may be used to reduce both agency costs and information asymmetries between managers and outsiders. In this respect, Gray et al. (1995, p. 46) explain that clearly “the firm is viewed as a ‘nexus of contracts,’ and accounting information is demanded by outside owner-shareholders as a means of monitoring contracts with managers”.

Accordingly, external owners and other investors require timely and reliable financial and non-financial information about the company in order be able to monitor the activities and effectiveness of management, and to make investment decisions. Hence, from the corporate annual reports, external users must be able to obtain information they need in a timely manner in the situation where they are in a position to make or anticipate a decision (Mustafa et al., 2007). With this regard, Imam (2000, p. 133) highlighted the primary focus of corporate financial reporting as follows:

Financial reporting is the communication of information about an entity's resources, obligations, earnings, expenditures, and revenues to users. Financial reporting is concerned with the communication of information to those users who have limited authority, ability or resources to obtain the needed information. It communicates information about an economic entity to the users.

It was recognised that the corporate financial reporting and disclosures are potentially important means for managers to communicate company performance and governance to stakeholders (Healy and Palepu, 2001) and stakeholders such as creditors, employees, suppliers, customers, competitors, financial analysts, and regulatory authorities are dependent on the information disclosed in the companies’ annual reports in making economic decisions and reviewing the companies’ performance. This view was supported by ArabSalehi and Velashani (2009) who affirm that the users of companies’ annual reports, and predominantly investors, require useful financial and non-financial information for their decision making.

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Additionally, it has been asserted that a company disclosure is needed to evaluate the timing and uncertainty of present and upcoming cash flows, which will help outside investors to evaluate the company performance or make other economic decisions (Meek and Roberts, 1995). Indeed, corporate financial reporting, managerial statements, and security analysts’ reports all supply valuable information to sta eholders and other investors in the markets (Asquith and Mullins, 1986).

As a conclusion, according to agency theory, disclosing additional information by companies’ managers on a voluntarily basis tends to reduce the agency costs resulting from conflicts between companies’ managers and shareholders. It also considers corporate annual reports disclosure as a mechanism to decrease information asymmetry between the company insiders (as agents) and outsiders’ investors (as principals).

As underlined by Raffournier (1995) the principal-agent relationship is likely to play a major role in the corporate disclosure policy since those corporate annual reports can be utilised to reduce monitoring costs. In a similar vein, corporate financial reporting and disclosures play the role of a control mechanism for managers’ performance recognitions to which managers are likely to disclose more voluntary information (Khlifi and Bouri, 2010). An overview of agency theory is presented in Table 3.1.

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Table 3.1: Agency theory overview

 Key Idea • Principal-agent relationships should

reflect efficient organisation of information and risk-bearing costs  Unit of Analysis • Contract between principal and agent

 Human Assumptions • Self-interest

• Bounded rationality • Risk aversion

 Organisational Assumptions • Partial goal conflict among participants

• Efficiency as the effectiveness criterion

• Information asymmetry between principal and agent

 Information Assumption • Information as a purchasable commodity

 Contracting Problems • Agency (moral hazard and adverse selection)

• Risk sharing

 Problem Domain • Relationships in which the principal and agent have partly differing goals and risk preferences (e.g.,

compensation, regulation, leadership, impression management, whistle- blowing, vertical integration, transfer pricing)

Source: Adapted from Eisenhardt, 1989.