Managers are hired to act on behalf of the shareholders of a firm. However, this is not always the case as both parties have different objectives. The difference in interests between shareholders and managers ‘derives from the separation of ownership and control in a corporation’ (Berk and DeMarzo, 2011: 921). Whereas shareholders are interested in maximising their own wealth, managers may have more personal interests which differ to that of the shareholders. Downs and Monsen (no date, cited in Chin, Cooley and Monsen, 1968:435) suggest that managers self-interest lies in maximising their life-time income and that ‘such self-interest will be congruent with profit maximisation for the firm only in special cases’. This conflict between both the shareholders and the managers is termed the agency problem. Alongside the agency problem comes agency costs, which is the costs incurred to prevent the managers from prioritising their interests over the shareholders. It can be argued that the extent to which managers will have discretion to pursue actions that are not consistent with shareholder wealth maximization is severely limited. However, this is not always the case.
Managers may have discretion to pursue their objectives before those of the shareholders as there is information asymmetry between the two parties. Berk and DeMarzo (2011:533) state that the managers’ ‘information about the firm and its future cash flows is likely to be superior to that of outside investors’. This statement is reinforced by Aboody and Lev (2000:2749) who assert that ‘managers can continually observe changes in investment productivity’. This is a consequence of the responsibilities of manager being to run the business on a day-to-day basis, meaning they will have access to management and financial accounting data. As a result, managers will be in a position to make investment decisions that will maximise their wealth, without detection by the shareholders. On the other hand, shareholders ‘obtain only highly aggregated information on investment productivity at discrete points of time’ (Aboody and Lev, 2000:2749). Their primary source of information about the performance of the company is from the annual reports, whose figures may be subject to manipulation. Healy and Palepu (2001:406) argue that, because of information asymmetry and agency conflicts between managers and outside investors, there has been a demand for such financial reports and disclosures. As suggested by Healy and Palepu (2001:408), a potential solution to the information asymmetry problem is ‘regulation that requires managers to fully disclose their private information’. This seems like a logical and simple solution, however, it will not be easy to carry out as there will be costs involved in the monitoring.
Although managers may be able to pursue their own objectives due to asymmetric information between them and the shareholders, this may be restricted by regulations such as the Sarbanes-Oxley Act of 2002. The act was passed following a number of high profile scandals, including the fall of Enron, with the overall intent of the legislation being to ‘improve the accuracy of information given to both boards and shareholders’ (Berk and DeMarzo, 2011:931). The act strengthened the criminal penalties for providing false information to shareholders and requires both the CFO and CEO to declare that the financial statements are accurate. With the act allowing penalties of fines up to $5 million and a maximum of twenty years imprisonment for providing misleading financial statements, managers will be more inclined to pursue actions consistent with maximisation of shareholder wealth, as they fear the risk of legal action being taken against them if they do not.
Corporate governance is, to a large extent, a set of mechanisms through which outside investors protect themselves against expropriation by the insiders’ (La Porta et al., 2000:4). One mechanism that is used to address the...
Please join StudyMode to read the full document