Relationship between Principle and Agents - Research Paper Example

Relationship between Principle and Agents Auditing Frame Work Auditing divided in many branches but the area of audit covered the business and accounting is defined as financial accounting. Autonomous bodies ask auditors to examine their financial transactions and statements. Its main purpose is to precisely account a company’s financial transaction. This process is performed to make sure that the entities are being traded justly and in accordance with the Accounting Standards so as their issued financial statements will not be deceptive for users.  Auditors play a role in serving public interests to ensure accountability and reinforce the trust and confidence in the reporting of financial issues. Audits enhance economic prosperity, expands the variety, number and the value of transactions that people are prepared to enter into. In recent years, however, in the light of corporate scandals, auditors are witnessing demands to improve audit quality, globally. The UK is seeing changes to promote greater transparency, but there are demands to further improve the system. The question is to how and to what extent this issue can be addressed (Bohren, Oyvind, 1998).  In order to understand all the outstanding queries, it is inevitable to have an understanding what audit means to all the parties involved in the dealings. We must ask ourselves as to what the sole purpose of an independent audit is and what are the elements that enclose the role of audit? The main reasons in the conflicts between the principles and the agents are, the principles lack trust in their agents because the information and motives are different of both parties, principles, whether rightly or wrongly, they think that the information that is being passed on by their agents is not accurate, and there is no uniformity of motives between the both parties. It is important to understand how this essential tool of audit has been developed over a period encompassing hundreds of years; it is important to understand its purpose and how useful it has become. In the domain of economy, the audits of financial data is publicly available nowadays, many factors and interests come into play. In this situation, a simple audit is not likely to be able to answer every question but it surely starts things up. The Agency Agency Theory defined the perception of connection for agreements which may reduce the conflicts between resources holders. Principle is the regulatory and the authoritative body to handle one or more agents at a time. The concept of Agency Theory come into being in early 70s, however it has the long diverse history behind this concept. The few theories clearly define the authority and responsibility of the principles includes the property rights theories, contract law, organization economics and philosophy. (Counting the Works, Locke and Hobbes, Zhang Qiuqiu 2010), Agency Theory. The Principal Principle is the boss, but does not take an active part in making the decisions. An agent is someone who participates in operations occurs in the agent organizations. The job of this individual is to make things easy for the principle. The mechanics or working of this relationship between the principle and the agent include making use of the skills and the insights of the agent by the principle whereas it is required that an agent effectively manages principle’s time. Problems face by Principle-Agent during Operation. The principal–agent problem is found in commonly employer/employee associations, for instance, when shareholders hire top executives of corporations. Political science has distinguished the problems innate in the allocation of legislative authority to intrusive agencies. The problems in the agency relationships are as follows: The agent is seen as someone who deflects risk and the principle is seen as someone who takes a risks. The agent might have spent less time in the organization than the principle. The agent’s income is fixed and the principle’s income is variable. Principle does not take part in the decisions taken in the organization directly. There is a di-synchronization of information between the principle and the agent; the principle ignores what the agent is doing. A research in 2002 identifies agency problem between these parties: shareholders and top management, controlling and minority shareholders, shareholders and creditors. The reasons of the problems are the dis- synchronization of information between the principle and the agent, different attitude towards risk. Agency problems between the shareholders and the management are due to synchronization of information and risk. Conflict of Interest Conflict of interests between the controlling and the minority shareholders are because, controlling shareholders can divert a part of the resources of the firm to benefit themselves, or to avoid unpleasant circumstances. On the other hand the minority shareholders have no power and influence; they are at the shear mercy of the controlling shareholders (Bohren, Oyvind, 1998). Problems face by Agent during Operation. Agency problems between the creditors and the shareholders are due to the fact that, creditors do not take part in high profit firms beyond to the agreed debt service, shares are lost in case things do not turn out as planned. Improper synchronization of information gives the incentive to the shareholders that the firm takes more risk that the creditors would like.  Bromwich (1992) divides the problem into four categories: Moral hazard with hidden action, which means that agent is the determining party in all of the decisions of the firm, and the principle, on the other hand, can’t keep an eye on the agent directly. Moral hazard with hidden information, which means that agent, knows about the things very much relevant to the transaction, which the principle does not know. Adverse selection, which means one of the parties cannot check whether the information they have given, is used in an ethical way. The problem arises for the uninformed party to give incentives to the other without having all of the information at hand, which goes for the detriment of the uninformed party. Signaling models are when a firm signals their quality by their actions. Their actions tell about the quality of their transactions. An investigation should take place in order for the problem to be solved. Auditors have a clear understanding once they have investigated the problem at hand, then and only then they can solve the problem. Both parties must go into the root of trust deficit and the varying motives, must find out why these problems are arising, it is difficult to work in an environment where both parties find it hard to trust each other. The only way to run everything smoothly is cohesion, trust and commonalities in work practices (Corentin M. Fontaine, Mark D. A. Rounsevell, 2008). Auditing Framework For Principle and Agent Relationship Auditors must have knowledge and understanding of what the process of audit really is. They should not just believe in each and everything others say. Auditors must study about this process and create their own solid personal knowledge and understanding regarding it. This is the only way to get the job done and turn the things in the right direction. Auditors must update their knowledge and understanding of the process of audit regularly. Reasoned arguments are essential to solve all the issues between the principle and the agent, as hostility will only bring about negative results. They should sit together with the intent of problem solving, rather than score settling, they need to have a positive approach to solve all the issues. Right approaches will bring good results. Analysis Based on Principle-Agent Model Principle conducts research on the agents operations and works for the betterment of agent’s operational processes which minimize the cost, save the labor, provide the guidelines and even arrange the training sessions for agents to work in secure and safety which minimize the costs, high the profitability as well as provide the productivity in limited resources. Principle is confined to issue the policy, procedures and the analysis under the regulations of the government laws, the principle re define the labor safety procedure for specifically agents operations and provide the guideline to agents to work under these procedures by following the government laws. (Zhang, Qiuqiu, 2010).  Principal Agent Model (PAM) In Accounting The current use of the Principal Agent Model (PAM) in accounting and finance is evaluated, focusing on the agents use of private information. The agents behavioral norms in the PAM deviate from frequently held ethical values in society, from models of man in conformist economic theory, and also from behavioral foundations of related business school fields like commercial strategy, business ethics, and human resource management. Still, it would be imprudent to reject the PAM solely because of its offensive ethical assumptions. The model does appear to have extrapolative power, but its descriptive or normative qualities remain unknown. The popularity of the PAM, with its extreme model of man, raises fundamental questions about the impact of this model on business school stakeholders and society at large. This paper extends the methodological literature on the PAM by evaluating the model as currently used in accounting and finance. The focus is exclusively on the PAMs implicit assumption about the agents indifference to dishonest use of private information, which has so far only been indirectly addressed in the economic literature. Role of Auditing to Ensure The Relationship The principal in the PAM delegates decisions to an agent who has private information about his abilities, efforts, and the outcomes of a stochastic process. The two parties have conflicting goals and possibly different risk attitudes, and the economic problem is to design contracts that maximize the principals expected utility of wealth, given that the agent will maximize his own expected utility and also never accept a contract that offers less than the best alternative. Even though the agent in the PAM feels no discomfort with dishonest use of private information, the concern with wealth and effort may still make an inherently dishonest agent act honestly. This happens because the agents preferences are well known to the principal, who may design a contract providing the agent with sufficient monetary and effort-based incentives to refrain from dishonesty. If such an honesty-ensuring contract is not optimal, then the principle will take the predictable dishonesty (e.g., overstated production figures) into account when remunerating the agent for the effort put into it. As the agent competes with other agents who have the same type of preferences, they must personally carry the anticipated costs of his dishonesty (Corentin M. Fontaine, Mark D. A. Rounsevell, 2008). The Principal-Agent model (PAM) is currently a very productive vehicle in the theory development process of accounting. The model involves a non-standard, pessimistic, and rather extreme model, which has been known in the theory of ethics for centuries. Given the popularity of the PAM, the lack of methodological discussions in the existing PAM literature, and also the increasing attention paid to ethics in both business schools and industries, three issues seem particularly important to address. First, the descriptive validity of the PAM should be explored in a much more extensive way. Second, principal-agent models should be developed which do not presuppose that agents are indifferent between being honest and dishonest, and which allow for the possibility that honesty makes sense even if it does not increase your wealth or reduce your effort. Third, accounting and finance professors should address the educational impact of the PAM in a more explicit and systematic way by pointing out the models implicit ethical assumptions, by addressing the externality costs to society caused by private dishonesty, and by clarifying alternative ways of modeling ethics in principal agent settings (Robert T. Kleiman, 2010). The agents behavioral norms in the PAM deviate from frequently held ethical values in society, from models of man in conformist economic theory, and also from behavioral foundations of related business school fields like commercial strategy, business ethics, and human resource management. Still, it would be imprudent to reject the PAM solely because of its offensive ethical assumptions. The model does appear to have extrapolative power, but its descriptive or normative qualities remain unknown. The popularity of the PAM, with its extreme model of man, raises fundamental questions about the impact of this model on business school stakeholders and society at large. This paper extends the methodological literature on the PAM by evaluating the model as currently used in accounting and finance. The focus is exclusively on the PAMs implicit assumption about the agents indifference to dishonest use of private information, which has so far only been indirectly addressed in the economic literature. The principal in the PAM delegates decisions to an agent who has private information about his abilities, efforts, and the outcomes of a stochastic process. The two parties have conflicting goals and possibly different risk attitudes, and the economic problem is to design contracts that maximize the principals expected utility of wealth, given that the agent will maximize his own expected utility and also never accept a contract that offers less than the best alternative. This topic can be concluded as follows: Audits are essential for keeping the general public at our side. They are essential for economic prosperity.  There are growing global needs to improve audit quality. Understand what it means to all the parties involved. Understand the sole reason of an independent audit and the elements that enclose the audit. There is a trust deficit between the parties involved and the motives are different of the principle and the agent. Principle thinks that the agent is lying. Understand the evolution of audit. Understand the purpose of audit. Understand the usefulness of audit. Audits of organizations are publicly available. Simple audits are not the answer they are just a starting point. Investigate why these issues are arising between the parties. Create cohesion, trust and commonalities in the environment. Have knowledge and understanding about audit. Need to update our knowledge and understanding regularly. Need an environment of reasoned argument between parties. References Bohren, Oyvind. (1998, May). The agents ethics in the principle-agent model. Retrieved March 6, 2012, from Journal of Business Ethics: http://search.proquest.com.esearch.ut.edu/docview/198121882/135581525DA53D52D9/3?accountid=14762  Corentin M. Fontaine, Mark D. A. Rounsevell. (2008, October 3). An agent-based approach to model future residential. Retrieved March 7, 2012, from Landscape Ecol: http://search.proquest.com.esearch.ut.edu/docview/216719683/135581525DA53D52D9/2?accountid=14762  Robert T. Kleiman. (2010). Agency Theory. Retrieved March 7, 2012, from eNotes: http://www.enotes.com/agency-theory-reference/agency-theory  Zhang, Qiuqiu. (2010, March). Analysis Based on Principle-Agent Model: the Application of Motivation Theories in Labor Safety Regulation. Retrieved March 7, 2012, from International Journal of Business and Management: http://search.proquest.com.esearch.ut.edu/docview/821544128/135581525DA53D52D9/1?accountid=14762  Read More