Stewardship and agency theory – This part is a more detailed explanation of the revised Conceptual Framework for Financial Reporting 2018 (Conceptual Framework) issued by the International Accounting Standards Board (IASB) regarding Control as part of chapter 4 – The Elements of Financial Statements, section 4.25 on one party (a principal) engaging another party (an agent) to act on behalf of, and for the benefit of, the principal.
The view of ‘stewardship’ given in the current Conceptual Framework mentions that management are accountable to the entity’s capital providers for the custody and safekeeping of the entity’s economic resources and for their efficient and profitable use, including protecting them from unfavorable economic effects such as inflation and technological changes. Management are also responsible for ensuring compliance with laws, regulations and contractual provisions.
In the context of business entities, the need for accounting is often rationalised in terms of agency theory. Stewardship and agency theory
The main focus of the agency theory is the conflict that arises when ownership is different from management. Agency theory is concerned with resolving two problems that can occur in an agency relationship. The first problem arises when:
- the desires or goals of the principal and agent conflict; and Stewardship and agency theory
- it is difficult or expensive for the principal to verify what the agent is actually doing. Stewardship and agency theory
The problem here is that the principal cannot verify that the agent has behaved appropriately. The second problem is that of risk sharing when the principal and the agent have different attitudes towards risk and therefore prefer different actions.
When a company is listed (quoted) on the stock exchange, control and ownership are separated. The company is controlled, at least on a day-to-day basis, by its management (the directors or management board) but owned by its shareholders (or proprietors). This involves obvious benefits for both parties but also risks. These risks may be controlled or reduced by various means: one of the most obvious, and widely used, strategies is for a requirement on management to provide regular accounts that are available to the shareholders.
Financial statements therefore provide a key condition for the existence of a modern company: it is difficult to imagine how companies with widely held and traded shares would be managed if credible accounts were not generally prepared. A stewardship objective emphasises this role of financial reporting as explained below.
Shareholders, in their capacity as owners of the business, make decisions other than to buy, sell or hold. The other decisions include a consideration of whether they, as owners of the business, need to intervene in its management. The shareholders look to financial reporting to access information relating to management’s stewardship of the business.
Most accounts of agency theory stress the possibility of a divergence of interest between management and shareholders, both of which are assumed to be relentlessly pursuing their economic self-interest. Perhaps it is for this reason that stewardship is characterised as a demand for information on management’s safe custody of the assets, and compliance with laws and regulations. The stress is on whether management have behaved properly and not for example, unjustly enriched themselves at the company’s expense.
If owners assign stewardship of their company to management, they wish to have the ability to oversee management behaviour to ensure that:
- it is aligned to the owners’ objectives; Stewardship and agency theory
- management are devising strategies aimed at making the best use of company assets; and
- no misappropriation of the company assets takes place.
The owners attempt to ensure alignment to their objectives by monitoring the company against some criteria e.g. at its simplest the increase in profits and net assets over the year. However, they also need information that enables them to review the company’s performance in light of the risks management took in order to obtain the results and to assist them in making decisions about the future direction of the business.
Company law in many jurisdictions also interprets what is now commonly known as agency theory as discussed above. Stewardship was originally the primary objective of financial reporting which is why company law initially sought to ensure that management provide an account of their performance over a given period and show how they have utilised the resources entrusted to them by the owners. It was only after the development of capital markets that a further focus for financial reporting developed, i.e. on cash flow generation that would assist in buy, sell or hold decisions (the main focus of the resource allocation decision-usefulness objective).
For many investors in unlisted companies, selling the shares in a readily available, liquid market is not an option (due to a lack of capital markets or otherwise). The only alternatives available to such investors are intervention or removal of management. As a result, the main objective of financial reporting for these investors is stewardship. Such equity investors are interested in the following:
- how management have performed in the past so they can gauge their likely performance in the future;
- ability to gauge the extent to which transactions similar to those already undertaken might recur in the future; and
- how the management performance and transactions undertaken, including related party transactions, might affect the entity’s performance.
Thus, we consider stewardship as a separate objective of financial reporting. In fact, an investor first assesses how an entity has performed in a given period, and secondly to make a judgement about how it is likely to perform in the future (so that he can make resource-allocation decisions). Stewardship and agency theory
One of the first assessments an investor makes is to take a view on stewardship and as such this should have equal prominence with the resource-allocation decisions. Therefore, the stewardship objective that financial reporting has is broader than the resource-allocation decision-usefulness objective. Stewardship and agency theory
The stewardship objective is about providing information about the past (including, for example, the transactions entered into, the decisions taken and the policies adopted) at a level of detail and in a way that enables an entity’s past performance to be assessed in its own right, rather than just as part of an assessment about likely future performance. And it is about providing information about how an entity has been positioned for the future.
Stewardship and agency theory
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