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Principle-agent Problem in Shareholders and Managers

This essay identifies the principle-agent problem between shareholders and managers. It also overlooks UK’s corporate governance compared to Germany and Japan. Furthermore effectiveness of UK’s system will be analyzed amid recommendations to reduce the vulnerability.
Economic theory speculates that a firm’s goal is to capitalize on shareholders wealth; achievable with entrepreneurial firm since owners are managers. However, ownership nowadays is significantly diluted, with companies owned by large shareholder groups. This causes the separation of ownership and management which hinders the relationship between shareholders and managers; where managers replace shareholders interest with their own. This may be due to information asymmetry [1] where managers have the power to act in accordance to shareholder needs. This is known as the “agency problem” and is common in modern corporate.
Under this theory the relationship is formed through a binding contract whereby principal’s (shareholders) appoint the agents (managers) to execute services with authority to make decisions. However such “contracts” are imperfect as the impracticality to include every action of the agent whose decisions has an impact on their and the principal’s benefits. Thus, self interested behaviour arises in organisations as the interest of both parties diverges, i.e. principal’s interest regards maximisation of shareholders wealth (profit maximisation) whereas agent’s interest lies in own utility maximisation (bonuses/promotion). Shareholders permit managers to run the firm’s assets; resulting in a conflict of interest. The fundamental problem therefore is to align the interests of both parties.
Furthermore, principals expect board of directors to base their decisions on maximising equity value. However the board of directors expect managers to follow strategies that support their goals. This situation illustrates that shareholders have no direct input into the operation and therefore have no power to tell managers what to do. This issue arises because of the separation of ownership and control and therefore managers are able to pursue goals beneficial to them and unfavourable to shareholders. Overall, detachment between the two parties increases lack of goal congruence.
The question arises as to why shareholders do not monitor management? There are three reasons why taking control causes difficulties. (1) Expensive to monitor managerial activities as obtaining information is difficult (2) disgruntled shareholders are unable to pose threats in order to reduce undesirable managerial behaviour i.e. hiring an outside member and (3) dispersed shareholders have an incentive to “free ride”. Keasy et al 1997 regards the above as economic costs to monitoring.
These limitations pose problems for shareholder wealth since undesirable managerial actions takes place in the absence of control. Shareholders may introduce incentive packages which include profit related bonuses, performance, promotion incentives and encourage employees to buy shares which increase their wages, to encourage agents to make “optimal effort”. Due to the above problems, nations have developed systems which carry out independent monitoring and control of the firm in order to align the overall goal.
OECD 1999 stated that “corporate governance structure specifies the distribution of rights and responsibilities among different participants in the corporation, and spells out the rules and procedures for making decisions on corporate affairs. By doing this, it also provides the structure through which the company objectives are set, and the means of attaining those objectives and monitoring performance.”
In UK capital markets play a vital role where share prices advocates performance levels. Management’s focus is to maximize shareholders wealth through the use of independent board of directors. The fear of takeover bids forces management to undergo effective actions. Approximately 50% of shares are held by institutional investors indicating dominant ownership. Cadbury Report 1992 states large proportion of shareholder ownership influence company’s actions.
In 2008 the Financial Reporting council developed the ‘Combined Code’ i.e. various reports/codes pertaining ‘good’ corporate governance. The most influential is Cadbury Report 1992 [2] , was produced as the lack of monitoring management activities caused several scandals whereby executives acted in their interest. Initially, Polly Peck [3] went into liquidation after years of false accounting leading to scrutinizing of the financial aspects and accountability. However after the scams of BCCI and Robert Maxwell, they revised the relationship between boards, auditors and shareholders. The final report states CEO’s and Chairman’s of companies should be separated. Jenson 1993 [4] states that if roles were mutual, conflict of interest would arise. Furthermore, 3 non-executive directors, two of whom should be independent [5] and an audit committee involving non-executives should be included.
Companies were encouraged to follow these practises alongside “the code of best practise” which outlines other areas of concern. However the “one size fits all” problem was recognised by Cadbury causing all companies registered in UK to follow the “comply or explain” system. Companies should comply with corporate best practise or have legitimate reasons for non-compliance. Furthermore, the board must offer a full explanation to shareholders and explicate how their practises are consistent with shareholders. It’s acceptable only when shareholders believe good governance has been achieved.
Greenbury committee, formed to evaluate director’s remuneration packages and the lack of disclosure of payments in the annual reports, commenced over public’s anger regarding increases in executive pay. The report added to the Cadbury Code and advised (1) each board include a remuneration committee involving independent non-executives briefing shareholders annually and (2) directors should have LT [6] performance related pay, all disclosed in the annual accounts. Moreover, progress should be reviewed every 3 years to ensure companies are operating effectively.
The Hampel committee [7] formed in 1998 suggested all previous principles should be collaborated into a “Combined Code”. Furthermore, the chairman of the boards should act as the ‘leader’, investors should consider voting the share and all remunerations information including pensions should be disclosed.
The Turnbull Committee, created the next year, advised that directors should be held accountable for internal financial and auditing controls. Several reports have contributed to the Combined Code namely the Higgs review outlining the actions of non-executives. More recently, after the collapse of Northern Rock and the financial crisis that followed, the Walker Review formed a report concerning banking sectors. The Financial Reporting Council produced a new Stewardship Code in 2010.
Germany’s corporate system is mainly stakeholder oriented and diffuses away from shareholders interests. The objective is maximising stakeholder value thereby revealing several distinctive differences.
Firstly, the banking sector is a major stakeholder. Charkham (1994) stated that banks hold a dominate position in financing and supervising companies for numerous reasons. (1) During 1870 companies were heavily reliant on credit. Banks began offering LT loans to LT clients who tied the companies, obtaining ownership and acting as ‘shareholders’ within industrial firms. (2) Banks hold 25% of voting capital in large corporations and 28% of seats on the supervisory boards. (3) Banks are shareholder representatives, authorised to vote for their shares plus proxy shares [8] , giving further control. Consequently companies are unlikely to face takeovers, since banks will support them through financial hardships unlike in the UK.
Secondly, “co-operative” culture is articulated under the Co-determination Act 1976 whereby workers obtain significant roles in the management process; known as work councils. Work council staff influence business actions and partake in decision making processes. Employees (elected by work councils) sit on the supervisory board when a firm has more than 2000 employees alongside shareholder representatives. This system reduces workforce conflicts by improving communication channels, increase bargaining power of workers through legislations and finally correct market failures. Overall productivity levels increase, with low levels of strikes as better pay and conditions entailing “good industrial relations”.
Finally, Germany involves a two – tier board compared to UK’s one – tier board. It includes a management board (Vorstand) where managers monitor daily operation and conduct of the firm. Plus a supervisory board (Aufsichtsrat) involving only non-executives [9] who monitor the management board responsibilities and approving decisions. Separation of the two increases the awareness of individual responsibilities and helps prevent management abuse. The downfall is having worker representatives on the supervisory board as they will opt for decisions beneficial for employees rather than company. For example closing down a factory may deem good for the company however problematic for redundant employees, making it is difficult to work in the best interest of the company.
Germany’s corporate system lies heavily on good industrial relations which considers it’s company, employees and public. It shows corporations are a social institution rather than an economic one as it “does not put financial value for shareholders at the top of the list of policy objectives” [10] . Shareholders are seen as one of many stakeholders and not just a privileged constituency.
The Japanese corporate governance revolves around banking relations like Germany along with life time employment. There are prominent features including the intervention of government and close alliances between government and companies. Business and industrial activities are monitored by the Japanese Ministry of Finance, involving them in the management and decision process.
Japanese corporate rely on main banks [11] which are all interlinked with firms, forming a concentrated ownership (shareholders). Prowse 1992 states that individuals hold 26.7% of a firm’s equity while corporations hold 67.3%. Unlike western countries, Japanese banks can hold equities up to 5%. The argument is by acting as lenders and shareholders, conflict of interests of debt providers and equity will be eradicated. Moreover banks hold these equities for long periods, building a LT “banking relationship” unlike UK’s “transactional banking”. Furthermore, they are involved with the internal management by obtaining seats on the board of directors. They actively contribute in the decision process and act as insurers for companies entering financial difficulties i.e. bankruptcy or takeovers. Like Germany, banks form LT contracts with companies based on financial services and supervision and act as representatives for other shareholders through proxy votes.
One major distinction in Japan is the Keiretsu system. Companies form close alliances mainly between banks, businesses and the government, by working towards each other success. The role of the government became important when they intervened in 1990s as Japan suffered a recession. The government wanted to restore the economy through its policies and regulations by improving the corporate governance to stimulate growth and investment.
Germany and Japan both work toward the interest of the company and workers as a collective. However Japan’s board structure is different as all members consist of former employees excluding “outside” directors apart from bank officials. The boards have more members than UK and Germany as some companies have over 60 directors. This proves very effective as no domination of directors occur.
According to Allen and Gale (2000), focusing on stakeholders rather than solely on shareholders, societies resources are being used efficiently as employees, suppliers and customers are taken into account. This enhances productivity, thus generating higher profits, benefiting the firm and shareholders.
Since 1990 the UK have implemented many policies reforming the management and governance of companies. These range from codes, reports, regulation and legislations; but how effective are they?
To ensure company interests are aligned with shareholders, UK has imposed various committees to monitor the effectiveness. For example, audit committees review audits annually and overlook financial relationships between companies and auditors. Nomination committees administer human resources and plans future directors. Compensation committees examine management actions and daily operations. Moreover the existence of institutional investors has its advantages as investing in firms they have incentive and motivation to monitor them. This leads to high performance levels which reduces agency costs. However, companies practise ST [12] profit maximisation without LT planning making companies underperform, therefore investors sell their shares and “exit” rather than “voice” their discontent (occurs mainly in Germany). Overall UK’s approach in monitoring company interest is effective as companies have majority of existing shareholders through the need of committees.
The ‘Code of best practice’ gives shareholders confidence that companies are operating with high levels of transparency during decision making processes. From this, the “comply or explain” system was created, whereby some freedom is left for companies to make effective decisions. The gains from this is that (1) managers and shareholders follow the LT interest of both the company and owners (2) distinguishes the culture barrier individual firms face since there are different levels, size and ownership of companies, whereas code of best practice instils “one size fits all” rule. Moreover, codes are more effective than regulations as companies can grow whereas enforcing strict internal controls companies are limited to procedures. Furthermore, codes tackle more ‘softer’ problems relating to best practise compared to regulations i.e. training and supporting directors in their role.
The Cadbury Report reflects the above whereby “The effectiveness with which boards discharge their responsibilities determines Britain’s competitiveness position. They must be free to drive their companies forward, but exercise that freedom within a framework of effective accountability. This is the essence of any system of good corporate governance.”
For this system to work effectively shareholders require full disclosure to facilitate them in their decisions and having rights when dissatisfied. Consequently companies must disclose information in their annual reports stating how they have applied the combined code and giving shareholders voting rights to discharge directors. All these requirements are set out under the company law making the system successful since it was adopted in EC [13] and included in the EUD [14] in 2006; outlining same principles.
Empirical evidence show that UK has drawn close to the concept of ‘good’ corporate governance. According to the FTSE ISS Corporate Governance Index and Governance Metrics International Reports, the UK has the highest average governance score out of all the countries. Moreover 94% [15] of UK pension Funds considered corporate standards in the UK has developed exceptionally.
The following reforms revolve around two primary issues (1) lack of separation of management and control and (2) dilemma faced by non-executive directors in terms of monitoring. Accordingly UK’s current reforms indicated the need for independent non-executive directors to minimise conflicts otherwise present. However, the disadvantage regarding this independence is, there is less incentive to spend a sufficient amount of time controlling company issues because they have no direct relationship with the company. In addition, doubts on how much knowledge they acquire also poses a problem.
One possible pivotal solution that could be incorporated into UK governance is increasing the frequency and duration of board meetings. Company information is very broad and complex especially relating to LT financial performances, competitive position and organisational structure. Therefore it is vital that directors assign more time to assess the information and deem upon past decisions and events. It is recommended that directors meet on a monthly basis for continual supervision and allow directors to address all areas and ask specific questions that affect the future of the company. There are issues surrounding this proposal for example, preparation, however the more frequent the meetings the less time needed to prepare as oppose to the time needed for meetings held every quarter. Moreover, meetings should not be limited to a time schedule but rather should last until all aspects are covered. This method is very flexible for example meetings could last more than one day when a company is in a difficult situation. The advantage is that opinions will be shared more openly and allows non-executive directors to be more involved; this should be carried when discussing the long term corporate strategy.
Another solution is altering the composition of the board. In the ‘Combined Code’ section A.3.2 it pronounces that “at least half the board, excluding the Chairman, should comprise non-executive directors determined by the board to be independent”. This does not specify the maximum number of seats in total. Therefore it is advisable that the fewer directors, the more likely that each director can play a dynamic and imperative role. The recommended number should consist of eight to ten directors in total. This is so that there is enough variety and sufficient array of viewpoints. When there are more than ten or twelve members on the board, there will be a “free rider” problem where some director’s will stop preparing for meetings and rely on the work of others resulting in topics not being discussed in depth.
Finally UK should consider adding a supervisory board like Germany and Japan as this will allow wider diversity among the decision making processes. Moreover it will reduce abuses from dominate directors since there is constant revision of management performance. Overall UK should cease to improve existing polices and the challenge lies in keeping UK’s corporate governance an asset rather than a liability for companies.

Arguments for Regulating Financial Reporting

Acoording to Leuz and Verrecchia (2000) the accounting literature presents proof that the quality of accounting has economic consequences for e.g. costs of capital , efficiency of capital assignment (Bushman et al. 2006)etc. Land and Lang (2002) in their research mentioned that economic changes also have homogeneous consequences by stating that the quality of accounting has improved globally since 1990s. Land and Lang (2002) also say that the reason for the advancement in the quality of accounting is primarily due to globalisation and visualization of international accounting consensus. The argument proposed by the accounting theory is that the main aim of financial reporting is to reduce information asymmetry between managers and owners and other stakeholders contracting with the company (Watts, 1977; Ball, 2001). Favouring this notion Frankel and Li (2004) states that financial reporting decreases information asymmetry by disclosing relevant and timely information.
Standard setting is ‘a form of regulation which lays down generally accepted accounting principles (GAAP)’ (Scott, 2003, p. 9). Also accounting standards for listed companies in the European Union are promulgated by the International Accounting Standards Board (IASB).
This report answers this question that whether or not we need this kind of regulation of financial reporting.
What is Financial Reporting? To answer the report question, firstly, there is a need to answer the questions like what is financial reporting, who are the users of financial reports and how is financial reporting regulated and what are the bodies responsible for regulating the financial reporting. By answering these questions a better understanding of financial reporting will be achieved and which will ultimately aid in answering the report questions.
Financial reporting enables an organization to communicate information about its performance externally (Atrill et al. 2005). So, financial reports provide summarized information about an organization’s transactions over a specific time period to external decision makers. (e.g. Investors).
The users of financial reports are employees, trade unions, government, creditors, lenders, customers, shareholders and investment analyst (Elloit et al. 2006). The needs of these various users of financial reports can be completely different. However, the main emphasis is put on the most usable statements like balance sheet, income statement and cash flow statement.
The Accounting standard boards (ASB) which is responsible for setting and issuing accounting standards, the ASB is part of a broader structure including the Financial Reporting Council, the review panel and the Urgent Issues Task Force (UITF). The Financial reporting Council (FRC) is the body charged with the broad overview of the standard setting system. Although the FRC oversees the process of producing accounting standards, it has no input into the detailed rules. Conversely the principle sources of such regulation are The Law and the Accountancy Profession.
The Law consists of certain Acts. Much of the legislation governing the UK’s preparation of accounts is personified in the companies Act 1985 and companies Act 1989. They are mainly concerned with the accounts of limited liability companies. These Acts state that all financial statements constructed under the Act must present a true and fair view. The Act also deals mainly with minimum disclosure requirements and is foremost concerned with the protection of shareholders and creditors. It provides a framework for general disclosure by requiring that certain financial statements such as the profit and loss accounts and the balance sheet, should be prepared and presented to the shareholders and requires the specific disclosure of certain items such as depreciation and so on. These disclosure requirements resolve some of the problems associated with the asymmetry of information between the directors and some user groups. They also enable user groups to compare the level of their inducements with those received by the other groups. The Act also requires that the directors not only present the financial statements to the shareholders each year but also that independent auditors are appointed to examine the financial statements and report their findings to the shareholders.
The law addresses the problem of information asymmetry by requiring the disclosure of certain key items of interest to user groups. The Accountancy Profession also recommend the same but in this role as regulator. The accountancy profession is more influential in achieving a significant increase in the comparability of financial statements. Whereas the law provides the general framework for what is to be accounted for in the financial reports, the accountancy profession provides detailed rules in the form of accounting standards about how items and transactions should be accounted for.
The two main regulatory bodies of financial reporting are “The Law” and the “Accounting Profession” with the Accounting Standards Board usually known as ASB (Elliot et al. 2008). In UK, most of the legislation related to the publishing of accounts is embodied in the Companies Act 1985 and 1989. The Companies Act 1989 is the main frame which the companies and accountants have to follow. All the financial statement drawn up under the act 1989 must present a true and fair view and its function is to protect all the users of the financial reports and statements. The second and the most important regulatory body is the accounting profession. The standard setters should be aware of the information needed by all users of financial reports and should know the impact and the outcome of a different accounting method on the needs of those users. The standard setters should also be able to resolve the conflicts which exist between the needs of different users. So, they have to find an alternative way which best satisfy user needs and this could be achieved by choosing the improvement of the “social welfare” instead of welfare of individuals.
We know that Accounting Standards Board is the main accounting standard setter. Because the ASB is composed of professional accountants, they may be unfamiliar with the user needs. So , when there is a need for a change in accounting standard the ASB prepare and publish a draft standard called the FRED (Financial Reporting Exposure Draft). After the publishing of these drafts the comments from the public is invited and in the light of these comments the FRED is changed (or unchanged). Now the FREDs are issued as FRS (Financial Reporting Standard). The main disadvantage of this system is the ASB members are unfamiliar with the different user needs and the comments from the general public may not be equally represented.
There are four things that standards in financial reporting supply people using it. The first one is “Comparability”; financial statements must allow people to compare one company with another one and evaluate the management’s performance without spending time and money adjusting them to a common format and common accounting treatments. It is essential that users of financial reports or investment decision makers be supplied with relevant and standard financial reports which have been regulated and hence standardized. The second thing that standards and regulations supply is called “Credibility”. Because all this standards and regulations exist accountants have to treat every company in the same way. If the accountancy profession permitted companies experiencing similar events to produce financial reports that disclosed markedly different results simply because of a freedom to select different accounting policies they would lose all of their credibility. So, the standards should be composed of rigid rules and should not be broken.
The third thing is “Influence” that means, setting up the standards has encouraged a constructive appraisal of the policies being proposed for individual reporting problems and has been a stimulus for the development of a conceptual framework. The last thing that the standards have to supply is “discipline”. Companies left to their own devises without the need to obey standards will eventually be disciplined by the financial markets. But in the short run investors in such companies may suffer loss. The Financial Reporting Council is aware of the need to impose discipline because most of the company failures in recent years are because of obscure financial reporting. Why should the Accounting Standards set? As we argued before, an important role of the regulations is to increase the comparability of accounts by limiting the choice of alternative accounting methods and to supply standardized accounts. This standardization can be achieved only by uniform accounting practice. If all accounting methods were standardized, two organizations which began the year with same balance sheets and which made the same transactions during the year, they would report the same balance sheets and the same profit and loss account at the end of the year. In addition to these advantages of regulations in financial reporting, there are also some more useful functions. Regulations can help to reduce the influence of personal biases and political pressures on accounting judgments. They can increase the level of user confidence in, and understanding of, financial reporting by clarifying the basis on which all accounts are prepared and presented. Finally, they can provide a frame of reference for resolving accounting problems which are not mentioned in legislation or accounting standards. As we argued earlier although the regulations in financial reports have very advantages it has many disadvantages too; One if these disadvantages is the “Adverse Allocative Effects”, this could occur if the ASB did not take into account of the economic consequences of the new standard or regulation they have issued. For example, additional costs could be imposed on preparers of accounts and suboptimal managerial decisions might be taken to avoid any reduction in earning or net assets. “Consensus-seeking” can be another disadvantage and this means the issuing of standards that are over-influenced by those with easiest access to the standard-setters. Most of the time this could happen with complex subjects. “Standard Overload” is composed of a number of statements which creates the most important disadvantages of standards. Some of them are;
1. There is more than one standard-setter body so, as well as it becomes more difficult to follow the new changes, the accountants are becoming so regulated that it becomes very difficult to use his/her accounting profession, to make judgments.
2. There are too many standards and regulations, so in the long run, they restrict the development of accounting profession by discouraging the accountants from experimenting new ways of recording transactions.
3. Some points are too detailed and some of them are not sufficiently detailed so, makes it hard to obey.
4. Standards are for general-purpose and sometimes they fail to respond to user’s and the firm’s needs.
For example, a company which wants to attract investment finance can not make the necessary judgment of how much information is necessary and what form it need take so, it couldn’t take the actions necessary to attract investors and may bankrupt. Some of the standards are lack of a conceptual framework this means they haven’t got a clear defensible logic and the rules tend to be rather arbitrary. This causes the standards to lose its credibility and acceptability.