Financial Accounting · Duties and responsibilities of those charged with governance

Agency Problem and Governance Codes Explained

Updated 11 October 2026 · Fact-checked

The agency problem arises when managers (agents) run a company for its owners (principals) but act in their own interests. Governance codes reduce this conflict through board structure, independent directors, committees and disclosure. Many codes use comply or explain: follow the rule, or publicly state why you did not.

Understand Agency Problem and Governance Codes

A company is owned by shareholders but run by directors and managers. This is an agency relationship. The shareholders are the principals. The directors are the agents, who act on their behalf.

The agency problem appears because the two groups want different things. Shareholders want long-term growth in value and dividends. Managers may want high pay, bonuses, job security, perks and a bigger business to run. Managers also know far more about the business than shareholders do. This gap is called information asymmetry.

Examples of agency conflicts: a director takes an expensive company jet, a manager boosts short-term profit to earn a bonus, or a board refuses a good takeover to keep their jobs. Shareholders bear the cost of such behaviour. Money spent to control it, such as audit fees and monitoring, is called an agency cost.

Corporate governance is the system by which companies are directed and controlled. Governance codes set out good practice to narrow the conflict. Typical themes: a balance of executive and non-executive directors, a separate chair and chief executive, audit, remuneration and nomination committees, regular re-election of directors, and clear reporting to shareholders.

Many codes work on a comply or explain basis. A company either follows each provision or tells shareholders which it did not follow and why. This is flexible, but it relies on shareholders reading and challenging the explanations. Some countries make rules mandatory by law, or through stock exchange listing rules. The ACCA exam tests the ideas, not the detail of one national code.

Key formulas to remember

Agency relationship: Principal (shareholders) → appoints → Agent (directors/managers); Agents must act in the principal's interests. The conflict between the two is the agency problem.
Source of the problem: Conflict of interests + information asymmetry = agency problem; Both parts matter. Managers want personal benefit and know more than owners.
Agency cost: Agency costs = monitoring costs + incentive costs + residual loss; Examples: audit fees, bonus schemes, and value lost despite controls.
Comply or explain: Follow the provision OR disclose non-compliance with reasons; Used in many codes. It is not the same as a legal requirement.
Typical board safeguards: Independent non-executives + separate chair and CEO + audit, remuneration and nomination committees; Common features of governance codes. Details differ by country.

How to solve Agency Problem and Governance Codes questions

Use this method for any question on agency or governance codes, whether multiple choice, multiple response or a short scenario.

1Identify who is the principal (usually shareholders) and who is the agent (directors or managers).
2Spot the behaviour in the scenario. Ask: whose interest does it serve, the owners' or the managers'?
3If it favours managers at the owners' expense, name it as an agency problem or conflict of interest.
4Check the wording for information asymmetry, short-term bonus focus or excessive pay.
5Match the control to the problem: independence for oversight, remuneration committee for pay, audit committee for reporting, disclosure for transparency.
6Check whether the question asks about a code (voluntary, comply or explain) or about law (mandatory).
7Read all options, remove those that reverse the roles or confuse voluntary with mandatory, then pick the best fit.

Quickest way: Principal, agent, safeguard

When to use it: Use for objective test questions where you have about a minute per question.

Underline the actor: shareholders are principals, directors are agents.
Ask what the agent gains and what the owner loses.
Pick the safeguard that directly targets that gap: independent directors for oversight, remuneration committee for pay, audit committee for reporting.
If you see 'explain', think comply or explain, so non-compliance is allowed if disclosed.

Common mistakes in Agency Problem and Governance Codes

Reversing principal and agent, calling directors the principals.
Directors seem to be in charge, so students assume they are the 'principal'.
Fix: Remember the owners appoint the directors. Owners are principals; directors act on their behalf as agents.
Saying comply or explain means a company can ignore a code.
The word 'explain' sounds like a free choice.
Fix: A company may depart from a provision only if it discloses the departure and gives reasons. Shareholders can then challenge it.
Treating every governance code as law.
Codes sound official and rule-like.
Fix: Many codes are voluntary or apply through listing rules. Law and listing rules may make some parts mandatory. Read the question for which source it means.
Confusing agency problems with fraud only.
Students link conflicts of interest to illegal acts.
Fix: Agency problems include legal but self-serving behaviour, such as excessive pay or short-term bonus chasing.
Matching the wrong safeguard to the problem.
Students memorise committee names but not their purpose.
Fix: Link each: audit committee to reporting and control, remuneration committee to pay, nomination committee to board appointments.

Worked examples

Example 1

A listed company's chief executive receives a bonus based only on this year's profit. To increase it, the chief executive cuts research spending, which will harm profits in future years. Which statement best describes this situation? A) Principal acting against the agent B) An agency problem C) Compliance with comply or explain D) Information symmetry

Show the solution

The shareholders are the principals; the chief executive is the agent.
The chief executive gains a higher bonus now.
Shareholders lose because long-term value falls.
The agent's interest conflicts with the owners', so this is an agency problem.
A is wrong because the roles are reversed. C is unrelated. D is wrong because the managers know more, so there is asymmetry.

Answer: B) An agency problem

Example 2

Select the TWO measures that most directly reduce the risk that directors set their own pay too high. A) Appointing a remuneration committee of independent non-executive directors B) Increasing the number of executive directors C) Requiring disclosure of directors' pay to shareholders D) Merging the chair and chief executive roles E) Reducing the frequency of reporting

Show the solution

The risk is directors setting their own pay, a conflict of interest.
A fixes who decides: independent people without a personal stake.
C adds transparency, so shareholders can see and challenge pay.
B adds more people who benefit from higher pay, so it does not help.
D concentrates power, which weakens oversight.
E reduces information to owners, which worsens the gap.

Answer: A and C

Exam tips

Always identify principal and agent first. Many wrong options reverse them.
Expect the words 'comply or explain'. Link them to voluntary codes with disclosure, not to a legal ban.
For multiple response, select exactly the number requested and match each to the risk named.
Learn what each committee is for, not just its name.
Do not rely on one national code's details. Answer with general principles unless the question names a specific provision.

Practice questions from Duties and responsibilities of those charged with governance

Agency Problem and Governance Codes in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Agency Problem and Governance Codes: frequently asked questions

What is the agency problem in corporate governance?

It is the conflict between shareholders, who own the company, and directors or managers, who run it. Managers may pursue their own interests, such as high pay or job security, instead of maximising shareholder value. Owners also know less than managers, which makes monitoring harder.

What does comply or explain mean?

A company should follow each provision of the governance code. If it does not, it must disclose which provision it did not follow and give reasons. Shareholders then judge whether the explanation is acceptable.

How do governance codes reduce the agency problem?

They set good practice on board balance, independent non-executive directors, committees, director re-election and disclosure. These measures increase oversight and transparency. They do not remove the conflict, but they reduce its impact.

Are governance codes the same as law?

Not usually. Many codes are voluntary or operate through stock exchange listing rules. Some jurisdictions make certain requirements legally binding, so check the source named in the question.