Answer the following questions regarding agency theory: a. What are the assumptions, focus, and hypothesis of agency theory? b. How does opportunistic behavior, or moral hazard apply to agency theory? c. How does an audit of financial statements pertain to agency theory?
What will be an ideal response?
ANSWER:
a. The underlying assumption of agency theory is that individuals act in their own best self-interest. Another assumption is that the enterprise is the intersection point for many contractual-type relationships that exist among management, owners, creditors, and government. As a result, agency theory is concerned with the various costs of monitoring and enforcing relations among these various groups. One hypothesis of agency theory is that management attempts to maximize its own welfare by minimizing the various agency costs arising from monitoring and contracting.
b. According to agency theory, management will try to maximize its compensation, but must do so within the framework of increasing net income, return on investment, or similar accounting measures. While the main management drive will usually be toward improving performance, management may also attempt to choose accounting rules that maximize income immediately rather than over time in order to maximize its own compensation. In this case, management actions may not always be in the best interest of stockholders. This is called opportunistic behavior or moral hazard.
c. The audit minimizes agency costs, and is an example of efficient contracting. It attempts to give assurances to outsiders, such as owners and creditors, about the governance of the enterprise by management.
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