Agency Costs and Corporate Governance Mechanisms in Different Scenarios

ADVANCED FINANCIAL ACCOUNTING
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SCENARIO 1
Birm Equity is separated from management
In this scenario, an investor would have medium level of agency cost since there is separation
of management and dominant shareholder. This would result in the management being under
check. The agency costs would be in the form of “bonding costs” of agents considering 48%
control of the voting rights by Birm Equity and hence they can change the management if
they wish (Jensen & Meckling. 1976). Also, for small investors, there may be risk of
exploitation from a large investor like Brim Equity owing to which the board structure
becomes critical especially in relation to majority representation of independent non-
executive directors on the board so that minority interests can be safeguarded (Coffe et. al.,
2018).
Birm Equity is not separate from management
In this scenario, an investor would have high level of agency cost as the management and
dominant shareholder are not separate. The agency costs would be in the form of monitoring
the agents and also agents acting in an opportunistic manner as there may of collusion
between the management and dominant shareholders which enhances the risk of financial
fraud (Jensen & Meckling. 1976). In order to address the same, various corporate governance
measures include independence of external auditor, independent working of risk
management, audit committee, remuneration committee and all being composed primarily of
independent non-executive directors coupled with the board of director being headed by an
independent non-executive director (Arens et. al., 2013).
Scenario 2
In this scenario, Tori would have medium levels of agency costs as while there is no risk of
exploitation from fellow shareholders, there is risk of management acting in an opportunistic
manner. The type of agency cost would be incurred in the form of monitoring costs on the
part of the principal besides the agent acting in a manner that tends to serve his/her self-
interest instead of shareholders (Jensen & Meckling. 1976). Since there is no dominant
shareholder hence proper corporate governance mechanisms need to be put in place. These
include the following (Arens et. al, 2013).
 CEO and Chairman of the Board to be vested in separate people.