Financial Accounting Report: Agency Costs and Investment Scenarios

This report delves into the concept of agency costs within financial accounting, exploring the conflicts that arise between management and shareholders due to differing interests. It defines various types of agency costs, including monitoring, bonding, and opportunity costs, and analyzes three distinct scenarios to illustrate these concepts. The first scenario examines Brim Equity, a firm facing potential takeover threats, highlighting the importance of long-term contracts with shareholders. The second scenario focuses on a graduate investor considering an investment in a listed company, emphasizing the impact of monitoring costs. The third scenario involves a small investor considering an investment in Dada PLC, a company with high debt, emphasizing the significance of bonding costs and the need for proper power balance. The report provides a comprehensive overview of agency costs, their implications, and strategies for mitigation, supported by relevant academic literature.

Advance Financial Accounting
1

Introduction
Agency costs are the costs incurred inside an organization and are payable to the agents who
act on the behalf of the chief of the organization or the “principal”. These costs are incurred
because of conflicts present between the management and shareholders because of their
difference in interests (Jensen & Meckling, 1976). Cases may arise where the shareholders
want the management to uplift the value of the business whereas the management is having
the agenda of making proper utilization of power and resources. There are several types of
agency costs: monitoring costs are those which are incurred by the principal for the
assessment of the actions of agent, bonding cost are those costs which are incurred by the
agents in relation to the assurance of best interest of principal and finally the opportunity
costs are incurred for the evaluation and determination of the best and profitable substitute.
First scenario
This scenario contains a view of a supreme firm named “Brim Equity”. The firm owns almost
the half portion stated to be 48% whereas the other half is owned by the shareholders. The
investors of the organization will have to pay an opportunity cost for the behaviour which
may have its own hidden interest (Bernanke & Gertler, 1986). This generates the value of a
long-term contract to be made with the shareholders of the organization so that they stay
faithful to the firm if any other organization tries to take over the business. The organization
is facing the threat from the ABC Limited, which is trying to take over the business of the
organization.
If a situation arises where Brim Equity is separated from the organization, a lot of cash flow
will be observed because of the huge shareholdings. This may because a problem of
liquidation as the organization will not be having the required amount to be paid, because of
which the company may get terminated. If the company will remain intact, it will still be
volatile in nature and no cash will be lost. The only problem observed will be the problems
present between the management and the shareholders which can be resolved by making
2

long-term contracts with the investors. The top management structure of the organization can
try to fill the gap that exists between the owners and the shareholders of the company.
Second scenario
This scenario consists of a graduate who wants to invest $0.5 million in a listed company.
The listed company is already having many shareholders and have continuously raised its
fund with the help of the general public. Each and every action of the shareholders of the
organization is monitored by the management. The shareholders of the organization have
requested an audit report to be submitted periodically which may require few monitoring
costs. Hence, the investors will be liable to pay a small agency cost generally referred to as
the monitoring cost.
Even after the benefits such as tax allowances, it has been observed that the firm is trying to
acquire material benefit by making the information available to the shareholders and the
general public (Kim & Sorensen, 1986. This may lead to leakage of confidential information
to the competitors and thus decrease the share price because of which low profit will be
yielded from the Stock Exchange market. Improper decision making by the management may
also be noticed because of the losses. Therefore, it is very important for the organization to
conduct the process of auditing in time and then provide the useful information to the
shareholders.
Third scenario
This scenario consists of a small investor Tori who wants to invest in Dada PLC. It is very
risky to invest in this organization because it has large loans and may declare itself bankrupt
if the obligations are not met successfully (Coffee, Jackson, Mitts & Bishop, 2018). The
agency cost that will be paid by the investor will be higher because of the bonding cost that
will be paid by the investor for inducing the principal to depend on it. The complete analysis
of the organization states that it will have delayed decision making because of improper
management and also the poor structure of the company will be damaged if the bank loans
will not be repaid. Therefore, proper power balance and clearly defined roles are needed by
the organization for smooth and flexible operation.
3

Bibliography
Bernanke, B.S. and Gertler, M., 1986. Agency costs, collateral, and business fluctuations.
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?
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.
4