Agency theory addresses the question of the separation of ownership and control, as identified by Berle and Means (1932). They state that, in practice, managers of a firm pursue their own interests rather than the interests of shareholders. There are three significantly influential articles about agency theory discussed in Eisenhardt’s paper (1989). Jensen and Meckling (1976) investigate how equity ownership by managers aligns the interest of managers with that of owners. Fama (1980) describes the role of efficient capital and labor markets as information mechanisms to control the self-serving behavior of top executives.
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Fama and Jensen (1983) discuss the role of board of directors as an information system for the stockholders within large companies monitoring the opportunistic behavior of top executives.
Jensen and Meckling (1976) extended the risk-sharing literature by incorporating the so- called agency problem that occurs when co-operating parties having different attitudes towards risk. They define an agency relationship as a contract, in which one party (the principal) delegates work to another (the agent), who performs that work on behalf of the principal. In the paper carried out by Eisenhardt (1989), she proposes that agency theory is mainly concerned with two problems. Firstly, the agency problem arises when (a) the desires or goals of the principal and agent conflict and (b) it is difficult or expensive for the principal to verify what the agent is actually doing and whether the agent has behaved appropriately. Secondly, agency problem occurs when the principal and agent have different attitudes towards risk preferences or risk aversion. Since the interest of the agents is not always in line with that of the principals, the agents may act for themselves even though their behaviors will harm the interest of the principals. To ensure the agents act properly for the principal, the principals have to pay extra costs which are called ‘agency costs’.
Ownership structure is regarded as the primary determinant of agency cost. Following Berle and Means (1932), Jensen and Meckling (1976) and Roe (1994) indicate the agency problems stem from the conflict of interests between the shareholders and managers when ownership is diffuse such as in the USA and the UK. On the other hand, ownership is highly concentrated such as the circumstances in East Asia, the agency problem stem from the conflicts between controlling shareholders and minority shareholders (La Porta et al., 1998; Claessens et al., 2000; Faccio and Lang, 2002). One distinct feature of Chinese listed companies is that ownership is highly concentrated. Ding et al. (2007) argue that highly concentrated ownership determines the nature of the agency problem in Chinese listed companies. It coincides Shleifer and Vishny’s view (1997) that one of the two most effective solutions to the agency problem is concentrated ownership (the other is legal protection). Ownership structure is crucial to the firm’s value maximization. Concentrated ownership gives the largest shareholders a substantial discretionary power to use the firm’s resources for personal gain at the expense of other shareholders. Johnson et al. (2000) suggest that the controlling shareholders pursue their own benefits at the expense of minority shareholders referring to as ‘tunneling’. Furthermore, there is one more agency problem in Chinese state-owned
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enterprises than in privately-owned companies because there is an extra agency relationship in SOEs, as the controlling owners are themselves agents of the true owners: the state.
Controlling shareholders tends to have fewer agency conflicts with managers and boards of directors, because there is little separation between ownership and control, directors and managers can be hand-selected and appointed. Therefore, the demand for high-quality financial reporting disclosures for the purpose of monitoring management seems less important in firms with controlling shareholders than those with dispersed ownership which rely on outside directors to monitor management (LaFond and Watts, 2008). When government dominates as a controlling shareholder, its social purpose is considered to generate major conflict of interests between the controlling owner and the minority owner. Since the controlling shareholders have the incentives and access to extract private gains from control, for instance, self-serving investments (Shleifer and Vishny, 1997). Ajinkya et al. (2005) draw a similar conclusion that institutions with concentrated (block-holder) ownership have access to superior private information and are less likely to demand high-quality and timely disclosures of accounting information. Similarly, Fan and Wong (2002) and Francis et al. (2005) assume firms dominated by controlling shareholders have less governance-related demand for high-quality financial reporting, hence allowing controlling shareholders to protect proprietary information through less transparent financial reporting.
2.3.2.
Stewardship Theory
A different stream of literature takes a principal-agent approach and focuses on the stewardship role of financial reporting in which the manager's compensation is endogenously set by the principal (see for example, Beyer et al., 1996). As expressed by Davis et al., (1997, p.21) ‘Stewardship theory defines situations in which managers are not motivated by individual goals, but rather are stewards whose motives are aligned with the objectives of their principals’. In essence, this theory assumes that managers have the incentives to practice earnings management to influence their firms’ value in line with the wealth maximisation objective of shareholders. Therefore, accounting earnings are not only utilized in equity valuation, but also in measuring managerial performance and how well the managers are delegating the interest of their shareholders (Dechow, 1994).
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