Advanced Financial Management · Corporate environmental, social, governance (ESG) and ethical issues

Corporate Governance and Agency Issues for ACCA AFM

Updated 11 October 2026 · Fact-checked

Corporate governance is the system of rules, structures and processes that directs and controls a company. The agency problem arises when managers (agents) act in their own interest rather than the shareholders' (principals). You solve AFM questions by spotting the conflict, linking it to a control (board, pay, code), and judging whether it works.

Understand Corporate Governance and Agency Issues

A company is owned by shareholders but run by directors. This separation of ownership and control is the root of the agency problem. Shareholders are the principals. Directors are the agents. Agents know more about the business than principals do (information asymmetry), and their interests may differ.

Typical conflicts: directors take excess pay and perks, avoid risk to protect their jobs, favour short-term profit to hit bonus targets, or build empires through acquisitions that do not add value. Shareholders may also conflict with lenders. Shareholders prefer riskier projects. Lenders want safety.

Agency costs are the costs of this conflict. They include monitoring costs (audit, reporting, non-executive directors), bonding costs (contracts, performance targets) and the residual loss (value lost because agents still do not act perfectly). You cannot remove them. You aim to reduce them at reasonable cost.

Corporate governance is the response. Key tools are a balanced board (independent non-executive directors, split chair and chief executive, board committees for audit, remuneration and nomination), transparent reporting, shareholder rights and votes, and well-designed pay.

Governance codes come in two styles. A rules-based approach sets mandatory rules, with penalties for breach (the US Sarbanes-Oxley Act is the usual example). A principles-based approach sets expected standards and lets companies comply or explain, as in the UK Corporate Governance Code. Principles-based codes are flexible but depend on shareholders to challenge weak explanations. Rules-based regimes are clearer to enforce but can lead to box-ticking and higher compliance cost.

Good governance also protects other stakeholders such as lenders, employees and society. It does so through risk management, internal control, ethics and honest disclosure.

Key rules to remember

Agency costs: Agency costs = monitoring costs + bonding costs + residual loss; Use this to structure any discussion of the cost of the agency problem.
Comply or explain: Comply with the code provision, or disclose and justify the departure; Core feature of principles-based codes. Do not describe it as optional to disclose.
Pay design test: Pay link = performance measure aligned to shareholder wealth, over a suitable time horizon; Use to judge bonuses, share options and long-term incentive plans.
Board balance rule of thumb: Independent NEDs, separate chair and CEO, committees chaired by independents; These are common code features, not a universal legal requirement in every country.

How to solve Corporate Governance and Agency Issues questions

Use this method for any governance or agency requirement, whether it asks you to explain, evaluate, advise or recommend.

1Read the requirement and note the verb. Explain, evaluate and recommend need different depth.
2Identify the principals and agents in the scenario. Include other conflicts, such as shareholders versus lenders.
3Pull out facts that show the problem: pay structure, board makeup, CEO duality, short-term targets, weak disclosure.
4Link each problem to the agency cost or behaviour it causes, for example excess risk-taking or short-termism.
5Propose controls: board changes, committees, pay redesign, monitoring, disclosure, code compliance.
6Evaluate each control. State its benefit, its cost and its limits, such as gaming of targets.
7Conclude with a clear recommendation that fits the scenario and the stakeholders. Show professional judgement and scepticism.

Quickest way: Problem – cause – fix – limit

When to use it: Use when time is short, such as a 5 to 8 mark governance part inside a larger case.

List two or three specific problems from the scenario, each with a fact.
For each, name the agency behaviour in a few words.
Give one fix per problem, tied to a board, pay or disclosure control.
Add one limitation or cost for each fix.
Finish with a one-line recommendation.

Common mistakes in Corporate Governance and Agency Issues

Writing a textbook list of governance features without using the scenario.
Students memorise code provisions and recite them.
Fix: Quote scenario facts first, then name the relevant control and say why it matters here.
Saying share options always align directors with shareholders.
It is the standard textbook answer.
Fix: Mention drawbacks: options reward upside only, can encourage excess risk or short-term share price manipulation, and may pay out for market rises unrelated to performance.
Treating principles-based codes as voluntary with no consequences.
Confusion between 'comply or explain' and 'optional'.
Fix: Explain that departures must be disclosed and justified, and shareholders can challenge them.
Ignoring stakeholders other than shareholders.
Agency theory is framed around shareholders.
Fix: Add lenders, employees and society. Note the shareholder versus lender risk conflict and the role of covenants.
Recommending a fix without its cost or limit.
Students think a one-sided answer is safer.
Fix: Give a balanced evaluation. Evaluation marks and professional skills marks depend on it.
Claiming that agency problems can be eliminated.
Overconfident wording in answers.
Fix: Say they can be reduced. Monitoring and bonding cost money and a residual loss always remains.

Worked examples

Example 1

Zenith plc has a CEO who is also chair. Her bonus is paid only on this year's earnings per share. She recently rejected a profitable long-term project because it would reduce current year EPS. Explain the agency problem and recommend two changes.

Show the solution

Principals are shareholders. The agent is the CEO.
Problem 1: the bonus is based on one-year EPS. This creates short-termism. The rejected project shows value was lost, which is residual loss.
Problem 2: CEO duality concentrates power, so the board cannot monitor her effectively.
Fix 1: redesign pay. Add a long-term incentive plan with measures linked to shareholder wealth, such as total shareholder return or economic profit, over three or more years, and defer part of the bonus.
Fix 2: split chair and CEO roles and appoint an independent chair, and ensure a remuneration committee of independent NEDs sets pay.
Limits: long-term measures cost more to design and can still be gamed. Splitting roles may slow decisions.
Recommendation: adopt both, because pay alone leaves weak board oversight.

Answer: The CEO is acting on a short-term bonus, causing short-termism and lost value. Move to long-term, shareholder-aligned pay and split the chair and CEO roles with an independent remuneration committee, accepting some design cost and gaming risk.

Example 2

A multinational is deciding whether to list in a country with a rules-based governance regime or stay under a principles-based code. Compare the two approaches for shareholder protection.

Show the solution

Define rules-based: mandatory requirements with legal penalties. Define principles-based: expected standards with comply or explain.
Rules-based strengths: clear, easy to enforce, strong deterrent against fraud.
Rules-based weaknesses: higher compliance cost, box-ticking, rules may not fit every company, and loopholes can be exploited.
Principles-based strengths: flexible, lets the board tailor governance to its business, focuses on the spirit of good practice.
Principles-based weaknesses: depends on shareholders reading and challenging explanations. Weak monitoring may let poor practice continue.
Conclude: protection depends on enforcement and investor activism, not on the label alone. A principles-based regime suits a market with engaged institutional investors.

Answer: Rules-based regimes give firmer protection and cost more. Principles-based regimes are flexible but rely on active shareholders. Choose based on the strength of enforcement and investor engagement in the market.

Exam tips

Always tie your points to scenario facts such as board composition, pay terms or ownership. Generic lists score poorly.
Evaluate every recommendation with a benefit and a limit. This earns evaluation and professional skills marks.
Link governance to the other parts of the case, such as dividend policy, risk appetite or an acquisition motive.
Keep answers structured with short headed points so a marker can find each mark quickly.
If the requirement asks for advice to the board, write in a professional tone and give a clear recommendation.

Practice questions from Corporate environmental, social, governance (ESG) and ethical issues

Corporate Governance and Agency Issues 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 and Agency Issues: frequently asked questions

What is the agency problem in ACCA AFM?

It is the conflict that arises when managers act in their own interest instead of the shareholders'. It is caused by separation of ownership and control and by information asymmetry. Questions expect you to show the behaviour and then suggest controls.

How can directors' remuneration reduce agency costs?

Pay can link rewards to shareholder wealth through bonuses, shares and long-term incentive plans. It works best with independent oversight, long-term measures and deferral. Poorly designed pay can encourage short-termism or excess risk.

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

Rules-based governance sets mandatory requirements with penalties. Principles-based governance sets standards that companies follow or explain why they do not. The first is stricter and clearer. The second is more flexible but needs engaged shareholders.

Do governance codes protect stakeholders other than shareholders?

Yes, indirectly. Risk management, internal control, transparency and ethical standards help lenders, employees and society too. Some conflicts, such as shareholders versus lenders, may still need covenants or other contractual protections.