Audit and Assurance · Corporate governance

Corporate Governance Principles and Agency Theory Explained

Updated 11 October 2026 · Fact-checked

Corporate governance is the system by which a company is directed and controlled. Agency theory says directors (agents) may act in their own interest rather than shareholders' (principals). Good governance reduces this conflict through accountability, transparency, fairness, independence and responsibility, backed by oversight, disclosure and aligned incentives.

Understand Corporate Governance Principles and Agency Theory

Corporate governance is the set of systems, processes and relationships by which a company is directed and controlled. It decides who holds power in the company, how decisions are made and how those in power are held to account. In AA you meet it because governance affects control risk, the auditor's reporting duties and the audit committee.

Most large companies separate ownership from control. Shareholders own the company. Directors run it day to day. This separation creates the agency problem. Under agency theory, shareholders are the principals and directors are their agents. Agents have more information than principals and may pursue their own goals, such as higher pay, bonuses, status, job security or empire building, rather than maximising shareholder value.

This conflict creates agency costs. These include the cost of monitoring (audits, board committees, reporting), the cost of bonding (contracts and incentives that tie the agent to the principal) and the residual loss when agents still act against the principals' interest. Governance mechanisms exist to keep these costs down. Examples: independent non-executive directors, audit and remuneration committees, external audit, share-based incentives, and disclosure requirements.

The main principles of good governance are: accountability (directors answer for their actions to shareholders), transparency (open, timely, accurate disclosure), fairness (equal treatment of shareholders and consideration of other stakeholders), integrity, independence (judgement free from undue influence), responsibility (directors accept duties and act in the company's long-term interest) and probity (honest, straightforward conduct).

Two approaches exist for codes. A rules-based approach sets mandatory requirements that must be met, with penalties for breach. It is clear and easy to enforce, but can encourage box-ticking and loopholes. A principles-based approach sets out broad principles and expects companies to apply them or explain why they have not, often called 'comply or explain'. It is flexible and suits different company sizes, but depends on honest explanations and on shareholders challenging weak ones.

An alternative view is stewardship theory. It assumes directors are motivated to do a good job and act as stewards of the company's assets, so they are best left with wide authority and trust. Agency theory assumes self-interest and calls for monitoring. Stewardship theory assumes alignment and calls for empowerment.

Key rules to remember

Agency relationship: Principals (shareholders) → appoint → Agents (directors); The agency problem arises from separation of ownership and control and from information asymmetry.
Agency costs: Agency costs = monitoring costs + bonding costs + residual loss; Use this list when asked what the costs of the agency problem are.
Core governance principles: Accountability, transparency, fairness, independence, integrity, responsibility, probity; Learn at least five and be able to apply each to a scenario. Do not just list them.
Rules-based vs principles-based: Rules-based = mandatory, compliance enforced; Principles-based = 'comply or explain', flexible; Give an advantage and a disadvantage of each when comparing.
Agency vs stewardship: Agency: directors self-interested → monitor; Stewardship: directors trustworthy → empower; Contrast the assumption about director motivation, then the governance consequence.

How to solve Corporate Governance Principles and Agency Theory questions

Use this method for scenario questions asking you to identify governance weaknesses, explain agency theory or recommend improvements.

1Read the requirement and note whether it asks you to explain, identify, evaluate or recommend. Match your answer style to that verb.
2Identify the principals and agents in the scenario. Usually shareholders and directors, but it may be lenders and management.
3Scan for signs of conflict: one person as chair and CEO, high bonuses linked to short-term profit, no non-executive directors, no audit committee, poor disclosure.
4Link each sign to a governance principle that is breached, such as accountability, transparency, fairness or independence.
5Explain the consequence in one sentence, for example risk of misstated results, weak control or loss of shareholder trust.
6Give a specific recommendation for each weakness, such as appoint independent non-executive directors, set up an audit committee or link pay to long-term performance.
7Where relevant, add the audit link: effect on control environment, risk of fraud or the auditor's communication with those charged with governance.

Quickest way: Weakness – principle – consequence – fix

When to use it: Use this in Section A and OT case questions with limited time, and as a skeleton for Section C written answers.

Underline each governance fact in the scenario.
Name the principle breached in one or two words.
State the risk it creates.
Write the fix.
For objective questions, eliminate options that confuse agency theory (self-interest, monitor) with stewardship theory (trust, empower).

Common mistakes in Corporate Governance Principles and Agency Theory

Describing agency theory as a conflict between directors and auditors.
Students link governance to audit and mix up the parties.
Fix: The principals are shareholders and the agents are directors. Auditors are one monitoring mechanism, not a party to the conflict.
Listing principles without applying them to the scenario.
Students memorise lists and write them out.
Fix: Tie each principle to a fact in the scenario, then say what has gone wrong and how to fix it.
Confusing rules-based and principles-based approaches, for example saying principles-based codes are always weaker.
Students assume mandatory means better.
Fix: State that each has strengths and weaknesses. Principles-based is flexible but depends on honest explanation. Rules-based is clear but can encourage box-ticking.
Mixing up agency theory and stewardship theory.
Both deal with directors and shareholders, so the names blur.
Fix: Agency assumes self-interest and calls for monitoring. Stewardship assumes directors act in the company's interest and calls for empowerment.
Saying governance is only about financial reporting.
The topic sits in an audit paper.
Fix: Governance covers board structure, remuneration, risk management, internal control, shareholder relations and ethics, as well as reporting.
Recommending vague fixes such as 'improve governance'.
Students run out of time or ideas.
Fix: Name the action: separate chair and CEO, appoint independent non-executive directors, form an audit committee, set up a remuneration committee.

Worked examples

Example 1

Explain the agency problem in a listed company and describe two ways in which it can be reduced. (6 marks)

Show the solution

Define the relationship: shareholders (principals) own the company and appoint directors (agents) to run it.
Explain the problem: ownership and control are separated and directors know more than shareholders. Directors may pursue their own interests, such as high pay, status or avoiding risk, instead of maximising shareholder wealth.
Mention the result: agency costs, including monitoring costs, bonding costs and residual loss.
Way one: link part of directors' pay to long-term performance, such as share options or shares with holding periods. This aligns directors' interests with shareholders'.
Way two: appoint independent non-executive directors and an audit committee to monitor management and review financial reporting, supported by external audit.

Answer: The agency problem arises because directors (agents) may act in their own interest rather than shareholders' (principals), helped by separation of ownership and control and by information gaps. It can be reduced by aligning pay with long-term shareholder returns and by independent oversight through non-executive directors, an audit committee and external audit.

Example 2

Zenith Ltd's founder is both chair and chief executive. The board has four executive directors and no non-executive directors. Executive bonuses depend only on this year's profit. The company has no audit committee. Identify the governance weaknesses and recommend improvements. (8 marks)

Show the solution

Weakness 1: the chair and CEO roles are combined. This concentrates power in one person and breaches independence and accountability, because no one challenges the CEO. Fix: separate the roles.
Weakness 2: no non-executive directors. The board lacks independent judgement and there is no one to protect shareholders' interests. Fix: appoint independent non-executive directors.
Weakness 3: bonuses depend on current-year profit only. This encourages short-term decisions and possible manipulation of results, which is an agency problem. Fix: add long-term performance measures, with a remuneration committee of non-executives setting pay.
Weakness 4: no audit committee. Oversight of financial reporting, internal control and the external auditor is weak, and transparency is reduced. Fix: set up an audit committee of independent non-executives.
Audit link: these weaknesses weaken the control environment and raise the risk of misstatement. The auditor would treat them as increasing audit risk and communicate them to those charged with governance.

Answer: Weaknesses: combined chair/CEO, no non-executive directors, short-term profit-based bonuses and no audit committee. Improvements: separate the chair and CEO roles, appoint independent non-executive directors, set up a remuneration committee and link bonuses to long-term performance, and establish an audit committee. The weaknesses raise audit risk.

Exam tips

Always name the principals and agents when you mention agency theory. It is an easy mark.
In scenario questions, use the scenario's facts. Generic lists of principles score poorly.
Know a clear contrast between rules-based and principles-based approaches, with one strength and one weakness of each.
Link governance weaknesses to audit risk and the control environment. AA examiners reward the audit angle.
In objective questions, watch the wording: 'self-interest and monitoring' points to agency theory, 'trust and empowerment' points to stewardship theory.

Corporate Governance Principles and Agency Theory in other exams

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

Corporate Governance Principles and Agency Theory: frequently asked questions

What is corporate governance in ACCA Audit and Assurance?

It is the system by which a company is directed and controlled, including board structure, accountability to shareholders, remuneration, risk management and disclosure. In AA you use it to assess control environment weaknesses and the auditor's communication with those charged with governance.

What is the agency problem?

It is the conflict that arises when directors, who run the company, act in their own interest instead of shareholders' interest. It exists because ownership and control are separate and directors hold more information. Governance mechanisms aim to reduce it.

What is the difference between agency theory and stewardship theory?

Agency theory assumes directors are self-interested and need monitoring and incentives. Stewardship theory assumes directors want to act in the company's interest and should be given authority and trust. They lead to different views on how tightly to control the board.

What is the difference between principles-based and rules-based governance?

Rules-based codes set mandatory requirements with penalties for breach. Principles-based codes set broad principles and use 'comply or explain', so companies may depart from them if they give reasons. The first is clearer to enforce, the second is more flexible.