Agency Theory
The theory that explains why managers may not always act in the best interests of shareholders.
What is Agency Theory?
Managers often know more about a company’s performance than these people.
Who are investors?
Lenders give companies money, but they want this in return.
What is repayment?
When managers make small changes to the financial statements to look better.
What is earnings management?
The main parties involved in the agency problem.
Who are shareholders and managers?
When managers hide information, this problem occurs.
What is information asymmetry?
A rule that forces companies to keep a certain level of financial health.
What are debt covenants?
The rules and guidelines that limit how much managers can manipulate earnings.
What are GAAP (Generally Accepted Accounting Principles)?
The reason why agency problems arise between managers and shareholders.
What is conflicting interests?
One way managers can misuse their advantage over shareholders.
What is earnings manipulation?
Lenders use this type of agreement to protect their money.
What is a loan contract?
A reason why managers might manage earnings?
What are performance bonuses?
A solution to reduce agency problems through monitoring and incentives.
What are performance-based bonuses?
Financial statements help reduce this problem by providing public data.
What is transparency?
Lenders protect themselves by setting limits on this ratio.
What is debt-to-equity ratio?
A financial statement item managers might change to make earnings look better.
What is net income?
A document that aligns manager actions with shareholder interests.
What is a contract?
The rule that requires managers to share important information with shareholders.
What is full disclosure?
When a company fails to meet its debt covenants, it is said to be in this situation.
What is default?
The main reason why we can't fully stop earnings management—it’s not worth this.
What is the cost?