Agency Theory

Agency theory is a principle that is used to explain and resolve issues in the relationship between business principals and their agents. Most commonly, that relationship is the one between shareholders, as principals, and company executives, as agents.

An agency, in broad terms, is any relationship between two parties in which one, the agent, represents the other, the principal, in day-to-day transactions. The principal or principals have hired the agent to perform a service on their behalf.

Principals delegate decision-making authority to agents. Because many decisions that affect the principal financially are made by the agent, differences of opinion, and even differences in priorities and interests, can arise. Agency theory assumes that the interests of a principal and an agent are not always in alignment. This is sometimes referred to as the principal-agent problem.

Financial planners and portfolio managers are agents on behalf of their principals and are given responsibility for the principals’ assets. A lessee may be in charge of protecting and safeguarding assets that do not belong to them. Even though the lessee is tasked with the job of taking care of the assets, the lessee has less interest in protecting the goods than the actual owners.

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  • Agency theory attempts to explain and resolve disputes over priorities between principals and their agents.
  • Principals rely on agents to execute certain transactions, particularly financial, resulting in a difference in agreement on priorities and methods.
  • The difference in priorities and interests between agents and principals is known as the principal-agent problem.
  • Resolving the differences in expectations is called “reducing agency loss.”
  • Performance-based compensation is one way that is used to achieve a balance between principal and agent.
  • Common principal-agent relationships included in agency theory include shareholders and management, financial planners and their clients, and lessees and lessors.