Agency Costs in Corporate Governance: Analysis of Different Scenarios

This article discusses the extent of agency costs in different corporate governance scenarios and the measures required to minimize the risk of financial fraud. It highlights the importance of independent non-executive members in the board composition. The article also emphasizes the strengthening of the disclosures mechanism and internal controls through maintenance of independence.

ADVANCED FINANCIAL ACCOUNTING
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SCENARIO 1
“Birim Equity is separated from management”
A given investor would be exposed to medium agency costs in the given scenario. On one
hand an activist dominant shareholder would act as a check on agent but there are risks of
minority shareholders being dominated coupled with higher risk of sensitive information
leaks. The primary agency costs will be incurred as agents “bonding costs” for convincing the
board as a dominant share of voting rights is with one investor i.e. Birim Equity Fund (Jensen
& Meckling. 1976). As an investor, there is chance of exploitation from the dominant
investor coupled with issues of information leak. As a result, corporate governance measures
would relate to strengthening the disclosures mechanism so that information asymmetry is
minimised. Also, board composition with regards to independent non-executive members is
pivotal (Coffee et. al., 2018).
“Birim Equity is not separate from management”
A given investor would be exposed to high agency costs in the given scenario as there is no
separation between the dominant shareholder and the management which enhances the risk of
financial fraud. The agents costs would comprise of the following (Jensen & Meckling.
1976).
 Opportunistic behaviour of the agents especially with no clear line between ownership
and management.
 Agency costs related to agent monitoring especially on the part of non-dominant
shareholders
In such a scenario, corporate governance mechanisms would aim towards maintaining the
independence of the board (appointment of majority non-executive and independent
directors), independence of internal audit committee, risk management & remuneration
committee (constituting entirely of non-executive independent directors) (Arens et. al., 2013).
Scenario 2
Considering the scenario provided whereby there is no large shareholder, the underlying
agency costs for an investor like Michael would be medium. The agents costs would
comprise of the following (Jensen & Meckling. 1976).

 Opportunistic behaviour of the agents especially with no clear line between ownership
and management.
 Agency costs related to agent monitoring especially on the part of non-dominant
shareholders
The above agency costs would be borne as no large shareholder exists for the given company
that can act as a check against the agents. Therefore, the type of corporate governance
mechanisms would aim towards maintaining the independence of the board (appointment of
majority non-executive and independent directors coupled with Chairman of board not being
the CEO), independence of internal audit committee, risk management & remuneration
committee (constituting entirely of non-executive independent directors) (Arens et. al, 2013).
Scenario 3
Based on the given scenario, the extent of agency costs which Tori would be exposed to
would be medium. Tori, a small investor would have significant agency costs with regards to
monitoring agents and possible opportunism particularly since the company has assumed debt
(Kim & Sorensen, 1986). Measures are required on part of small investors like Tori to ensure
that the risk of financial fraud is minimising as it might lead to liquidation (Jensen &
Meckling. 1976). The key mechanisms would include presence of independent board headed
by independent non-executive Chairman to protest the rights of minority shareholders. Also,
the internal controls in the form of audit committee and risk management ought to be
strengthened through maintenance of independence. Timely disclosures are also required
(Arens et. al., 2013).

References
Arens, A., Best, P., Shailer, G. & Fiedler,I. (2013). Auditing, Assurance Services and Ethics
in Australia, 2nd ed., Sydney: Pearson Australia
Jensen, M. C., & Meckling, W. H. (1976). Theory of the firm: Managerial behavior, agency
costs and ownership structure. Journal of financial economics, 3(4), 305-360.
Kim, W. S., & Sorensen, E. H. (1986). Evidence on the impact of the agency costs of debt on
corporate debt policy. Journal of Financial and quantitative analysis, 21(2), 131-144.
Coffee, J. C., Jackson, R. J., Mitts, J., & Bishop, R. (2018). Activist Directors and Agency
Costs: What Happens When an Activist Director Goes on the Board?, Columbia Business
School Research Paper <https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3100995>