Agency theory focuses on the relationship between principals and their agents in a company. The agency theory revolves around two parties, the agent and the principal where the agent acts for the benefit of the principal and is expected to represent the best interest of the principal. The theory is based on having the agent acting without prioritizing on self-interest. However, there may arise conflicts between the agent and principal due to their different level of risk perspectives and company goals (Bosse and Phillips 2016). In listed companies, the agency theory exists between the shareholders and the executives who are appointed to act in the benefits of the shareholders of the company. Corporate governance is a setup in the public limited companies to make sure that the agent is working in the best interest of the principal.
Mechanisms of Corporate Governance
The two main categories include the internal and external mechanisms. The internal mechanisms comprise the board of directors, equity ownership structure, financial structure, and internal control systems. The board of directors is meant to oversee the conduct and supervise management. The board of directors, which is poised to act in the best interest of the principal, should be independent. The independent structure of the board consists of a separate chief finance officer and the majority of non-management directors. The assumption is that a well-composed board offers a diverse range of expertise and perspectives; hence a firm with a larger proportion of non-executive directors will outperform the board with a lower proportion (El-Faitouri 2014). The goal of the board is to strategize on the short and long term ambitions of the company and to ensure that the company remain a critical concern.
The equity ownership structure is critical in corporate governance as it affects the managerial incentives and, ultimately, the performance of the firm. Ownership structure can be distinguished into concentrated and managerial ownership. The concentrated ownership structure is owned by a large investor; hence, there is effective monitoring of the management, but this structure is susceptible to increased risks as there is no diversification in place. The manager ownership model brings in better monetary incentives to the managers and to the shareholders hence increasing performance (Misangyi and Acharya 2014). However, more equity ownership may reduce performance as it leads to the creation of powerful managers who may not consider other stakeholder’s interests.
Internal control systems are the policies and procedures that the company uses to ensure adherence to the expectations of the business. The systems utilized are either preventive or detective and serve to safeguard assets due to fraud, minimizing errors and risks, and promoting efficiency. Corporate governance sets the standards of the company to be followed while the internal control systems ensure those procedures are followed. The external corporate governance mechanisms comprise of legal systems, markets for corporates, and financial markets. The legal systems are included in the Sarbanes-Oxley Act of 2002, which listed the requirements that the management of publicly traded companies ought to observe and disclose to the investors. The requirements include transparency in reporting and accountability amongst those in executive positions. The management ought to disclose the true and fair view of the company’s accounts to the shareholders.
Market-based corporate systems are the main source of capital in a company. They rely on this to exert pressure on management to improve the business capital share. This mechanism tries to create an environment of market confidence in companies. Therefore, the company acquires the ability to put capital to use for long term investments (Panda and Leepsa 2017). The companies are able to respond dynamically to the changes in the short term and fix the issues that may have contributed to a dip in stocks. The financial market’s external mechanism refers to the company’s ability to access funds and its general financial performance. The financial markets play a huge role in ensuring that the economy; corporate governance standards are enhanced appropriately. Firm-level corporate governance has the capability to enhance the firm’s aptness to access finance and also improving financial performance, which ultimately leads to financial market development. This model is based on the economic approaches that the firm has adopted in regard to corporate governance.