78 ACCOUNTING FOR MANAGERS
A theoretical perspective on financial statements
A necessary ingredient for shareholder value (see Chapter 2), given the separation
of ownership from control in most large business organizations, is the control
of what managers actually do. Control is considered in the rational-economic
paradigm (see Chapter 4) through the notion ofcontract,inwhichtheroleof
control is to measure and reward performance such that there will be greatergoal
congruence, i.e. that individuals pursuing their own self-interest will also pursue
the collective interest.
There are two main versions of contractual theory: agency theory and transac-
tion cost economics. Agency theory sees the economy as a network of interlocking
contracts. The transaction cost approach sees the economy as a mixture of markets
and hierarchies (transaction cost economics is discussed further in Chapter 13).
Agency theory.........................................
Agency theoryis concerned with contractual relationships within the firm, between
a principal and an agent, whose rights and duties are specified by a contract of
employment. This model recognizes the behaviour of an agent (the manager),
whose actions the management accounting and control system seeks to influence
and control. Both are assumed to be rational-economic persons motivated solely
by self-interest, although they may differ with respect to their preferences, beliefs
and information.
The principal wishes to influence what the agent does, but delegates tasks to the
agent in an uncertain environment. The agent expends effort in the performance
of these tasks. The outcome depends on both environmental factors and the
effort expended by the agent. Under thesharing rule, the agent usually receives a
reward, being a share of the outcome. The reward will depend on the information
system used to measure the outcome. Consequently, financial reports play an
important role in regulating the actions of agents. The assumption of agency
theory is that the agent obtains utility (a benefit) from the reward but disutility
from expending effort. Both principal and agent are assumed to be risk averse and
utility maximizers.
The agency model involves seeking an employment contract that specifies
the sharing rule and the information system. An accounting system can provide
output measures from which an agent’s efforts can be inferred, but the measures
may not accurately reflect the effort expended. This leads to uncertainty about the
relationship between the accounting measure and the agent’s effort. If the principal
cannot observe the agent’s effort, or infer it from measured output, the agent may
have an incentive to act in a manner different to the employment contract – this
is calledmoral hazard. A principal who can observe the agent’s effort but does not
have access to all the information held by the agent does not know whether the
effort expended has been based on the agent’s information or whether the agent
has ‘shirked’. This is calledadverse selection.
Moral hazard and adverse selection are a consequence ofinformation asymmetry.
This happens because principal and agent have different amounts of information. A