Topic 4, Question 6.
Contracting theory, which forms part of the second wave in the positive theory of accounting, focuses among other things on agency theory. What is agency theory? Elaborate the components of agency costs as described by Jensen & Meckling (1976).
Agency theory is based upon the more general contracting theory that the most cost effective form of organizing economic activity is through a firm based structure. Jensen & Meckling describe agency theory is a contract under one party (the principle) engages another party (agent) to perform some service on the principal’s behalf. Under this contract, the principle delegates some decision making authority to the agent. Both principle and agent are utility maximisers. There are no reasons to believe that the agent will always in the principle’s best interest. Because of that, therefore the principle introduces constraints to modify such aberrant manners. The first component of agency cost is monitoring costs. The purpose of this cost is to monitor agent’s behaviour by measure, observe and control the agent’s behaviour. These cost usually incurred in the first instance by the principle. For example is monitoring audit costs. The company engage the external auditor to audit the financial statement for observing and checking whether the agent perform their duty ethically and complied with laws and regulation. Second component is bonding costs. Cost to establishing and complying with mechanism to guarantee that agent will behave in the interest of the principal is called as bonding cost. This is the costs of bonding the agent interest to the principle. For example, manager (agent) may voluntarily provide shareholders (principle) with quarterly financial statement that the manager has comparative advantage on that and manager might contract not to disclose certain information to the competitors. The last component is residual loss which is purposely done by agent. It is incurred...
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