3.2 Theoretical framework
3.2.1 Justification for the choice of the theories underpinning this study
3.2.1.1 Agency theory
The agency theory originated from the work of Berle and Means (1932) and was advanced later by Jensen and Meckling (1976, 2004). Agency theory has been broadly employed in management studies and appears to be the dominant paradigm in several aspects of corporate governance research (Bendickson, Muldoon, Liguori, & Davis, 2016; Marie L’Huillier, 2014). In considering the literature on agency theory, defining the notions of principal and agent are the primary issues of concern (Teixeira, 2017), especially as it concerns a profit-oriented organisation or corporation. This theory is non-effective when transposed to the context of a not-for-profit entity because such entity lacks an identifiable owner (Teixeira, 2017). In the opinion of Saltaji (2013), the agency theory is considered as the leading theory in the business world, separating
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ownership from management, thereby creating an agency relationship between the principal/shareholders, and the agent/management. In the opinion of Ping and Wing (2011), agency theory is considered a neoclassical economic theory and mostly used in corporate governance debates.
On the agency relationship, Cossin and Lu (2019) view agency relationship as a contractual process whereby owners delegate some of their authority and responsibilities to a team consisting of expert member(s) and expect them to exercise their expertise in the best interest of firm’s operational success. Islam et al. (2010) assert that if the corporation is to fulfil its potentials, there would be the need for a little guidance of the market’s invisible hand. The corporation could indeed be the engine of growth, enterprise, and wealth creation, but human frailty would rather be a hindrance.
The assumption is that those in control of the corporation would fulfil the proposition that individuals are motivated primarily by self-interest in an agency relationship (Besley & Ghatak, 2014).
The principals delegate the decision-making responsibility to their agents (Choudhury, 2014). On the other hand, the assumptive idea is that the agent’s decision affects the parties involved in the contractual relationship. In economic and business life, such relationships are pervasive and are elements of the more general problem of contracting between entities in the economy (Besley & Ghatak, 2014). For example, in a public corporation, these contractual relationships exist between (a) the shareholders and the corporate board, (b) the corporate board and the executives, and (c) the executives and their subordinates. In the three relationships mentioned above, it is all about the principal and the agent. The main reasons behind the relationship are:
• to utilise the specialised skills and private information possessed by the agent;
and
• to relax constraints on the principal’s time.
The theory assumes that these two groups have different priorities as they relate to each other. These differences exacerbate the problems in the agency relationship by unsuccessful attempts by the principal/shareholders to monitor the agent/management, with enormous attendant costs (Islam et al., 2010; Michael, 2013), so their interests towards the company consequently lack alignment (Boshkoska, 2015).
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In an agency relationship, as observed by Islam et al. (2010), the differences or the non- alignment between the two could be a combination of either of these scenarios:
• Their different attitudes towards risk, considering the principal as risk-neutral and the agent as risk-averse;
• Their duration with the organisation, as that of the agent might be shorter than that of the principal;
• The agent has fixed earnings (when payments of incentive are lacking) while the entitlement of the principal is the residual claim;
• The principal does not participate directly in the control and management decision-making processes (separation of ownership from management); and
• There is information asymmetry between the agent and the principal; the principal is oblivious regarding many of the agent’s activities in detail.
Due to above different positions between the agent and the principal, the problems with agency relationships may arise because the parties in the association are assumed to seek to maximise their own best interests subject to the constraints imposed by the agency structure. Lee et al. (2018) recognises agency conflicts between these parties:
• between principal/shareholders and top management/agent,
• between majority and minority shareholders, and
• between owners/shareholders and debt-holders/creditors.
Young et al. (2001) identified some of the factors that make the agency problem worse in emerging economies, for example, family ownership and control, state-owned enterprises, weak legal protection of minority shareholder rights, concentrated ownership structures, and strategy and competitiveness.
The agency theory assumes that, by itself, maximising the principal’s wealth will be impracticable because the agent and principal have varying objectives, as noted above.
The misalignment (mentioned earlier) is the reason for agency problem which have two primary sources: adverse selection and moral hazard (Ali & Kamardin, 2018;
Boshkoska, 2015). The first source, adverse selection, is when managers hide from the
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shareholders important information regarding their traits and ambition. It describes a situation where one party in a contractual relationship has more accurate and contrary knowledge than the other partner. The partner with less knowledge is at a disadvantage to the partner with more knowledge (Heath & Norman, 2004; Islam et al., 2010). As a way of motivation, managers receive incentives (financial incentives) like bonus payments, stock options, profit-sharing, and others to encourage performance. Suppose two managers with the desire to achieve a profit threshold that will qualify them for a financial incentive, they both eventually achieve this threshold, but one of them achieves it through RAM practices. However, the shareholders without further information cannot differentiate who engages in RAM to achieve the threshold but will instead approve the financial incentives to both managers based on perceived performance. The manager that manipulates real activities knows fully well that he could not have achieved the threshold in the ordinary course of operational activities. It leads to adverse selection. The company is at a disadvantage for granting financial incentives to both managers.
On the other hand, the second source, moral hazard, is when the agents act in self- interest and with opportunistic behaviour. It is the risk that the agent will not use the firm’s resources as was intended (become wasteful) or get involved in unnecessary risks or become nonchalant in reducing risk (Heath & Norman, 2004; Islam et al., 2010;
Michael, 2013). This condition causes the manager to use their more intimate knowledge of the activities within the firm to enrich themselves to the detriment of the shareholders. The agent/management withholds vital information, which implies that management can take actions beyond the knowledge of the shareholders (Velasco, 2006). Such actions constitute a breach of contract which is unethical. Also, the moral hazard problem adds significantly to the incompetence of management effort which may eventually affect or harm the company’s worth (Michael, 2013).
The agency cost is a function of information deficiency about the agent’s activities in any enterprise, and include the costs of monitoring and analysing the management’s performance, the costs of devising a bonus scheme which rewards the agent for maximising the welfare of the principal and the costs for determining and enforcing policy regulations. Such costs will also depend on the supply of replacement managers.
Competitive pressure in the market for managers will limit the freedom of agents to pressure their interests (Fama, 1980). Similarly, agency costs will adversely affect the
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opportunities available to sell the enterprise in the market. Shareholders bear the burden of agency costs (Ross, Westerfield, & Jaffe, 2010). Jensen and Meckling (1976) and Saltaji (2013) argue that agency costs are the sum of (a) the monitoring cost of the principal, (b) the bonding cost by the agent, and (c) the residual loss.
Monitoring costs
Monitoring management actions are inclusive in agency cost, and judging managers’
performance depends on maximising the shareholders’ wealth. Monitoring costs are the expenditures paid for controlling, rewarding and measuring managers’ behaviours.
There is also a possibility to add in the auditing cost, and the hiring and training costs for top management. In the beginning, the shareholders bear these costs, but much later, it becomes managements’ burden since their reward depends on covering these costs (Fama & Jensen, 1983). Also, these costs are affected by regulations and corporate governance codes in Nigeria. Most of the codes reviewed in Chapter Two require companies to report compliance through a statement presented at the AGM and forwarded to regulatory authorities. Governance codes ensure the monitoring function of control systems used to reduce conflicts of interests between principal and agent.
Bonding costs
The cost of establishing and acting based on the monitoring system in place is called a bonding cost (Jensen & Meckling, 1976; Saltaji, 2013). Bonding costs occur when managers remain committed to a binding contract that inhibits or limits their activities.
Consider a manager that agrees to remain in the employment of a company even after a successful take-over bid. It implies that the manager foregoes other potential appointment opportunities; the foregone employment opportunities are agency bonding costs. Bonding costs could also be maintaining a good reputation. Managers can limit bonding costs through managerial balancing as decreasing monitoring costs is equal to increasing in bonding costs. Conflict of interests between shareholders and managers can be solved through contracts, bonding managers to act precisely according to the shareholders’ interests in any circumstance facing the company (Saltaji, 2013).
Residual loss
Residual loss is the loss that remains after monitoring and bonding costs. The difficulty of aligning the interests of shareholders and managers will continue to exist coupled with other differences between managers’ desires and the decision to maximise the
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benefits of shareholders. The generated agency loss from conflict of interests is known as residual loss. This loss is not amenable to shareholders’ expectations or high-level managers’ performance. Hence, maximising managers’ roles will attempt to minimise agency costs (monitoring cost, bonding cost, residual loss) to promote an idea of giving bonuses for managers to sign contracts appropriating imposing costs (monitoring cost and bonding cost) making differential cost equal to differential benefits to cut down residual loss.
Solving agency problems should reduce agency cost (Besley & Ghatak, 2014; Saltaji, 2013). Agency problems in modern economies are pervasive due to the extensive specialisation and division of labour. Therefore, how to solve them within organisations, or between individuals or organisations, is a crucial determinant of the productivity of organisations as well as countries (Besley & Ghatak, 2014). Saltaji (2013) proffered six options at solving agency problems which include: (i) the managerial labour market, (ii) corporate boards, (iii) corporate financial policy, (iv) block holders and institutional investors; (v) the market for corporate control; and (vi) managerial remuneration
Corporate governance is an elaborate theory that seeks to align the interest of management with that of the shareholders (Besley & Ghatak, 2014; Dühnfort, Klein, &
Lampenius, 2008). Several definitions of corporate governance emphasise the potential conflict of interest between insiders (managers, boards of directors, and majority shareholders) and outsiders (minority shareholders, and creditors) of the firm (Bendickson et al., 2016; Dühnfort et al., 2008; Marie L’Huillier, 2014).
Therefore, corporate governance specifies the distribution of rights and responsibilities among the different actors inside the corporation (Goyer, 2001). Levitt and Dwyer (2002) defined corporate governance as the relationship between the investor, the management team and the board of directors of a company (Levitt & Dwyer, 2002).
Parker (2017) viewed corporate governance as the set of mechanisms that influence the management’s decisions based on the separation of control and ownership, and this separation gives rise to potential conflicts of interest among stakeholders in the corporate structure. These conflicts of interests often occur from two main viewpoints.
First, various stakeholders have diverse goals and preferences. Second, the stakeholders
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have insufficient information as to each other’s actions, knowledge, and preference (Imam & Malik, 2007; Vaez et al., 2010).
Ward, Brown, and Rodriguez (2009) reiterate that the basis for corporate governance exists in an environment of incomplete contracts. Incomplete contracts entail agents/managers having more information than the principals/shareholders and, as such, this leads to a divergent of interest between the two parties. In highlighting the relevance of agency theory in corporate governance, Christopher, Sarens, and Leung (2009), noted that the essential concern of corporate governance arises from the separation of ownership and control in modern public corporations. Imam and Malik (2007) observed that corporate governance arises from the potential for agency conflict.
It is similar to the opinion expressed by Vaez et al. (2010) that it also leads to an agency relationship. Jensen and Meckling (2004) define agency relationship as a contract under which the principal engages the agent to act on his/her behalf.
The literature on earnings manipulations has shown that agency theory is an underpinning theory that can clearly explain the reasons behind this unethical practice which is the basis for all the conflicts and problems mentioned earlier (Ali & Kamardin, 2018). For example, the Enron financial saga was a result of managers’ intentions to increase their benefits at the cost of other stakeholders (Arnold & De Lange, 2004). The flexibility of accounting standards and discretionary expenses provides managers with the opportunity to manipulate earnings (Dechow & Skinner, 2000). As such, managers tend to affect reported earnings which assist them in directing the reported earnings in such a way that they reflect their desires instead of the shareholders’ desires (Ali &
Kamardin, 2018). Such opportunistic behaviour provides a basis for numerous studies to use agency theory as the underpinning concept in the investigation of earnings manipulations (Alexander, 2010), such as in this study.
Close monitoring is possible when owners themselves can actively participate in this monitoring process. However, because of high-cost involvement and in some cases due to lack of expertise, knowledge, and dispersion (especially with public firms), they cannot be actively involved in this process. Nevertheless, the board has to put in place a monitoring mechanism because of its oversight responsibilities to shareholders (Johnson, Daily, & Ellstrand, 1996). DeZoort, Hermanson, Archambeault, and Reed (2002) argued that in order to deal with the problem arising from agency relationship, the board has to assume the oversight role of monitoring the CEO and other managers,
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approving the firm’s strategies and evaluating the control systems. The board usually hires an expert and knowledgeable body to oversee management activities on its behalf.
The audit committee is such a committee under the corporate governance framework to which the board delegates some of its oversight responsibilities. Chen et al. (2008) studied non-US companies trading shares in US market and argued that a competent audit committee could resolve the agency problems of foreign companies no matter which corporate governance model is in place in the company’s home country. Dey (2008) found that the level and intensity of the agency problem is less in those firms where the audit committee is more effective in terms of composition and functioning.
Abbott and Parker (2000) are of the view that once the audit committee is composed of independent, qualified members, the ability of management to manipulate such committee is limited if not eliminated thereby reducing agency costs and information asymmetry. It further informs the choice of agency theory as one of the theories underpinning this study.
Watts and Zimmerman (1990),several decades earlier, explained positive agency theory to mean linking managerial incentives to voluntary financial disclosure. Good financial reporting practices ensure more managerial disclosures (Choudhury, 2014). Thus, the financial reporting system has a role in resolving the agency problem. Since managers usually do not have to interact frequently with shareholders, it is appropriate for the communication gap to exist which will affect the level of trust between the parties. The audit committee can act as a bridge to such gaps (Islam et al., 2010). Hay, Knechel, and Ling (2008) assert that the audit committee serves in a complementary capacity to an external auditor in monitoring management activities. Chen et al. (2008) argued that an audit committee could help to maintain a healthy relationship in the contract between management and shareholders. The moment this is achieved, the practice of RAM may decrease while accountability and good corporate governance will become a culture in the corporate environment.