Wealth is the long term view for the benefit of the owners of the corporation. Conversely, profit maximization is a short term view, which could indicate problems or potential problems. In light of the aforementioned, I thought about something I wrote several years ago (Ezelle, 2011) and provide parts of it verbatim:
In a perfect and complete market where there is a lack of information asymmetry and other barriers to a fair and efficient market operation, the asset and liability valuation of a firm is based on the expected present value of future cash flows. Under this ideal scenario the owners of a firm and the managers of a firm will have no conflict over the roles of financial reporting and no need for regulations (Scott, 2006, p. 14). However, ideal conditions do not exist in practice as the relationship between shareholders, principals, and corporate management, agents, is contentious with respect to conflicting interests (Jensen, 1986).
Scott (2006, p. 261) explains that owners of the firm are not able to directly observe the actions of management. Although management has in its’ possession the requisite skills necessary to direct the economic activities of a firm, the concern of owners is the preservation and growth of the firm with incipient returns they deem adequate. The concern for management is the preservation of the personal benefits contracted to them by the owners to be the caretakers of the firm. The conflict between management and owners results in the posturing of each party in an effort to gain a rational mutually beneficial economic outcome. The interaction between the owners and management is within the realm of an economic theory of games where there is a presence of uncertainty and information asymmetry wherein each party is desirous of gaining the maximum potential for their expected utility (Jensen & Meckling, 1976; Ross, 1973). The choices made by management may be difficult to determine since the action chosen by management will depend upon what action the owners think management may take. Likewise, the opposite exists when considering actions of the owners and what management may think the owners actions may be.
The owners of the firm will want relevant and reliable financial information to aid them in the determination of the risks and expected values of their investment. Management, however, may not necessarily provide the information to the owners or potential owners’ for a variety of reasons, including but not limited to; not reporting all liabilities on the balance sheet to be able to raise additional capital, not revealing the accounting policies used in order to manage profits, or not releasing information for fear of competitive reasons. In effect, the financial statements of the firm as released by management may be biased towards efficient contracting or for opportunistic purposes. The owner or investor considers the possibility of management actions and will react accordingly with their investment decision. In turn, management is aware of the investor considerations when the financial statements are prepared.
Management is generally viewed as having an information advantage as it is directly involved in the day to day operations of the firm, knowledge or information may not readily available to the owners. This information asymmetry may lead to two primary agency problems; moral hazard, and adverse selection (Subramaniam, 2006, p. 59). Moral hazard is concerned with the agent’s shirking or consuming perquisites due to the principal having restricted abilities to observe the manager directly and being only able to assess the manager’s performance outcome. Adverse selection occurs when the principal is able to observe the manager but is unable to discern if appropriate behavior is extended by the agent. Examples of adverse selection would include a manager choosing an accounting policy to maximize reported net income in order to increase bonuses, investors not receiving full disclosure of the firm where there is a beneficial gain to the managers, or the principal not being able to verify the agent’s abilities at the time of engagement or while working.
Lessening the effect of agency problems can be accomplished by offering incentives to the agent to align actions comparable to what is desired by the principal or by monitoring the behavior of the agent. Either effort to mitigate the agency problem has agency costs which are classified as bonding costs, agency costs, or residual costs (Eisenhardt, 1989; Jensen & Meckling, 1976; Ross, 1973). Monitoring costs would include those activities owners or lenders consider necessary to oversee the agent behaviors and control agent costs by means of auditing, implementation of internal controls, creation of various policies and procedures, and implementing budgeting so as to protect their investment. Bonding costs are those agency costs which provide the owners some form of security to curtail the agent acquiring benefits from the firm by auditing, requiring agent insurance, and contractually limiting the agent’s authority. The residual costs are the losses which will occur when incentives exist for the agent to consume perquisites of the firm which benefit the agent to the detriment of the principal.
The conflict between the owner as principal, and manager as agent, can be framed in a branch of the economic theory of games, agency theory. Agency theory is concerned with the design of contracts which are used in the motivation of rational agents to act on the behalf of the principal when the interests of the agent would conflict with that of the principal. In effect the modeling of a firm composed of a large number of owners and managers with conflicting interests is analogous to the separation of ownership and control of a firm which is composed of a single owner and a single manager.
Eisenhardt, K. M. (1989). Agency theory: An assessment and review. Academy of Management Review, 14(1), 57-74.
Ezelle, Jr., R. W. (2011). The impact of the Sarbanes Oxley Act on auditing fees: An empirical study of the oil and gas industry (3483923) (Doctoral dissertation). Retrieved from ProQuest Dissertations and Theses database. (3483923)
Jensen, M. C. (1986). Agency cost of free cash flow, corporate finance, and takeovers. The American Economic Review, 76(2), 323-329.
Jensen, M. C., & Meckling, W. H. (1976). Theory of the firm: Managerial behavior, agency costs and ownership structure. Journal of Financial Economics, 3(4), 305-360.
Ross, S. A. (1973). The economic theory of agency: The principal’s problem. The American Economic Review, 63(2), 134-139.
Scott, W. R. (2006). Financial Accounting Theory (4 ed.). Toronto: Pearson Prentice Hall.
Subramaniam, N. (2006). Agency theory and accounting research: An overview of some conceptual and empirical issues. In Z. Hoque (Ed.), Methodological Issues in Accounting Research: Theories and Methods (pp. 55-81). London: Spiramus Press Ltd.