1.1 another person as their agent (managers)

1.1  Corporate
Governance

As
per the Cadbury Report (1992) Corporate Governance
is the system by which companies are directed and controlled. The concept of
corporate governance came in to place mainly because of the concept of agency
theory. An agency relationship arises when one or more principals
(shareholders) engage another person as their agent (managers) to perform a
service on their behalf. A simple agency model suggests that, as a result of
information asymmetries and self-interest, principals lack reasons to trust
their agents and will seek to resolve these concerns by putting in place mechanisms
to align the interests of agents with principals and to reduce the scope for
information asymmetries and opportunistic behavior (Institute of Chartered Accountants in England & Wales, 2005). When the
shareholders delegated the decision making power on behalf of them to the
managers the problem of information asymmetry arises. Within an agency theory
framework, separation of ownership and control in corporate organizations
creates information asymmetry problems between shareholders and managers that
expose shareholders to agency risk (Reverte, 2008). Agency risks are amplified when
shareholders cannot monitor the managers perfectly as a result of information
asymmetry (Jensen , 1986).

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Agents
(managers) are likely to have different motives from the motives of the
principles (shareholders). Managers may be influenced by the motives of
financial rewards, employment opportunities in other companies and
relationships with other parties that are not directly relevant to the
shareholders. Shareholders expects high performance of the organization, long
term survival and high dividends payments. 
As a result of these differing interests, agents may have an incentive
to bias information flows (Institute of Chartered Accountants in England & Wales, 2005). Information
asymmetries arise in the equity market because dispersed shareholders cannot
directly observe managers’ effort, which creates moral hazard problems, or know
the true economic value of the firm or the quality of management, which
potentially creates adverse selection problems. Moral hazard and adverse
selection problems result in agency risk that rational investor’s price in
determining firms’ cost of equity capital (Jensen & Meckling, 1976).

The
conflicts of interest between shareholders and mangers can be reduced up to
some level through implementing different strategies. The principal can reduce
the divergence by fixing suitable incentives for the agent, and by supporting
monitoring costs aimed to limit opportunistic actions carried out by the agent (Hill & Jones, 1992). The principal can
also pay the agent and spend resources to be sure that the agent itself will
not take some actions able to disadvantage the principal (Teti, et al., 2016). These strategies do not ensure that
the agency problem would be eliminated. Effective CG, together with investors’
legal protection at a country level, is able to reduce these conflicts, thus
increasing the value of the firm and ultimately reducing the cost of equity (La Porta, et al., 2000). As suggested in the
literature, an effective corporate governance monism is needed to reduce the
agency cost.