Advanced Financial Accounting: Agency Costs and Governance Analysis

This essay provides an analysis of agency costs in different scenarios, drawing upon the work of Jensen and Meckling (1976), Kim and Sorensen (1986), and Coffee et al. (2018). It examines how agency costs arise from the separation of ownership and management, the potential for opportunistic behavior by agents, and the exploitation of minority shareholders by dominant ones. The essay further explores appropriate corporate governance mechanisms to mitigate these costs, such as strengthening disclosure mechanisms, ensuring board independence, and establishing independent audit and risk management committees. Specific scenarios are considered, highlighting the varying levels of agency costs investors may face depending on the ownership structure and the presence of debt, emphasizing the importance of robust internal controls and timely disclosures to protect shareholder rights. Desklib offers a range of solved assignments and study resources to aid students in understanding these complex financial concepts.

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>