Agency Costs - Accounting Standards and Regulations

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Lydia Lam – 10849469 – Tut1, 07 – 2:00 – 3:00pm
A) Deegan explains that an agency relationship arises when the principal delegates the decision-making authority to an agent. An example of such a relationship is when the owner of a company delegates the decision-making authority to the manager. The costs of divergent behaviour that arises as a result of the agency relationship are referred to as agency costs. Furthermore, Watts and Zimmerman (1978) developed the theory of positive accounting which is focused on the assumption that ‘all individual action is driven by self-interest and that individuals will act in an opportunistic manner to increase their wealth’.

Based on Watts and Zimmerman’s theory, Deegan suggests that owners would expect managers to undertake activities that might not always be in the best interests of the owners due to the presumption that individuals act in their own interests. Furthermore, due to the position managers have within a firm, they may receive or have access to information that will not be available to owners or other stakeholders, allowing an opportunity for managers to exploit this information and increasing the potential for managers to take actions that are beneficial to themselves at the expense of the owners.

With the intention of aligning the interests of owners and managers, remuneration schemes that reward managers in a way that is tied to the performance of the firm may be established by owners. Accounting-based performance measures such as profit, typically receive a material, positive weight in determining compensation. Subsequently, if the performance of the firm improves, managers will be remunerated correspondingly.

B) Another company which utilises accounting numbers in their management compensation contracts is Woolworths Limited. The Woolworths Short Term Incentive Plan (STIP) provides an annual cash incentive that is calculated based on financial year results and is based on a maximum percentage of...
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