Advanced Financial Management · The role and responsibility of senior financial executive/advisor

Agency Theory and Corporate Governance for ACCA AFM

Updated 11 October 2026 · Fact-checked

Agency theory describes the conflict that arises when shareholders (principals) hire managers (agents) who may pursue their own interests. You solve it by naming the conflict, then recommending monitoring, governance structures and remuneration schemes whose benefits justify their agency costs. Always tie advice to the scenario.

Understand Agency Theory and Corporate Governance

A company is owned by shareholders but run by managers. The shareholders are the principals. The managers are the agents. Agents know more about the business than principals do. This is information asymmetry. Their goals may also differ from the shareholders' goals.

This gap creates the agency problem. Managers may take excess pay and perks, avoid risk to protect their jobs, build empires through acquisitions, or focus on short-term profit to hit bonus targets. Shareholders want long-term wealth. Managers may also have a different attitude to risk and a different time horizon. In a multinational, distance between head office and subsidiaries makes monitoring harder, and subsidiary managers may favour their own unit over group value.

Agency costs are the costs that arise from this conflict. They include monitoring costs (audits, reports, non-executive directors), bonding costs (contracts, incentive schemes) and the residual loss from decisions that still do not maximise shareholder wealth. The aim is not to remove agency costs. The aim is to keep the total sensible.

There are two broad solutions. The first is governance: a strong, independent board, separate chair and chief executive, non-executive directors, audit, remuneration and nomination committees, good disclosure, and shareholder voting rights. The second is remuneration design: link pay to results shareholders care about. Examples are performance-related bonuses, share options, long-term incentive plans (LTIPs) and shares with holding periods.

No scheme is perfect. Profit-based bonuses encourage short-termism and manipulation. Share options reward upside only, so they can encourage excess risk-taking, and the share price can rise or fall for market reasons outside management's control. Good answers weigh these points and use the scenario facts.

Key rules to remember

Agency costs (components): Total agency cost = monitoring costs + bonding costs + residual loss; Use this as a checklist. It is a classification, not a calculation.
Governance costs vs agency costs: Agency costs = cost of the conflict and of controlling it; governance costs = cost of running the board, committees, reporting and compliance; Governance spending is one way of reducing agency costs. The two overlap but are not the same.
Value test for a control or scheme: Adopt if reduction in agency loss > cost of the control; Use this as the decision rule when recommending a mechanism.
Good incentive scheme features: Aligned with shareholder wealth + measurable + controllable by managers + long-term + fair and transparent; Use these as criteria to evaluate any pay scheme in a scenario.

How to solve Agency Theory and Corporate Governance questions

Use this method for any written requirement on agency, governance or executive pay.

1Read the requirement and identify the verb: explain, discuss, evaluate or recommend. This sets the depth.
2Identify the principal and agent in the scenario, for example shareholders and directors, or head office and subsidiary managers.
3Pick the specific conflicts shown in the facts, such as excess pay, risk avoidance, short-termism or empire building. Do not list theory unconnected to the case.
4Link each conflict to a mechanism: monitoring and governance structures, or a remuneration scheme.
5Evaluate each mechanism: how well it aligns interests, what it costs, and how managers could game it.
6Use any figures given. For example, compare a bonus target with profit or share price movements and show how managers could reach it without creating value.
7Conclude with a clear recommendation and mention costs against benefits. Write in the style the requirement asks for, such as a report or briefing note, to earn professional skills marks.

Quickest way: Conflict, fix, flaw

When to use it: Use this when time is short and you need a structured answer to a discussion requirement.

Write three headings: Conflict, Fix, Flaw.
Under Conflict, give two scenario-based problems.
Under Fix, give one governance measure and one pay measure for each problem.
Under Flaw, give one weakness of each fix, such as cost, short-termism or gaming.
Finish with a one-line recommendation that compares cost with benefit.

Common mistakes in Agency Theory and Corporate Governance

Writing a generic list of governance rules with no link to the scenario.
Students memorise code provisions and reproduce them.
Fix: Quote scenario facts and say which problem each measure solves.
Treating agency costs and governance costs as identical.
Both involve spending to control managers.
Fix: Define agency costs as the whole cost of the conflict, including residual loss. Governance costs are the cost of the structures and reporting used to reduce it.
Recommending share options without criticism.
Options look like a perfect alignment tool.
Fix: Note that options reward upside only, may encourage excess risk, and depend on market movements outside management's control.
Assuming profit-based bonuses align interests with shareholders.
Profit seems close to shareholder wealth.
Fix: Point out that profit can be inflated by accounting choices or short-term cuts. Suggest long-term measures and clawback.
Ignoring the multinational dimension, such as subsidiary managers and distance from head office.
Students only think of directors and shareholders.
Fix: Add subsidiary-level conflicts, transfer pricing behaviour, and monitoring difficulty across time zones and regimes.
Giving no recommendation or conclusion.
Students run out of time after listing points.
Fix: Reserve the last minutes for a short, reasoned recommendation. This also supports professional skills marks.

Worked examples

Example 1

The directors of Zenith plc receive a bonus based only on this year's reported profit. Shareholders suspect the directors are cutting research spending to boost profit. Explain the agency problem and recommend two changes. (10 marks style)

Show the solution

Identify roles: shareholders are principals, directors are agents.
Explain the conflict: the bonus rewards short-term profit, while shareholders want long-term value. Cutting research raises current profit but may damage future cash flows.
Name the cause: information asymmetry. Shareholders cannot easily see whether research cuts are justified.
Recommend change one, a remuneration change: introduce an LTIP paid in shares that vest after several years and depend on long-term measures such as total shareholder return. Add a holding period so directors bear future consequences.
Recommend change two, a governance change: strengthen the remuneration committee with independent non-executive directors, and require disclosure of research spending so shareholders can monitor it.
Evaluate: long-term schemes cost more and share price may move for reasons outside directors' control, but they reduce the residual loss from short-termism.

Answer: The conflict is short-term profit bonuses versus long-term shareholder wealth. Recommend a share-based LTIP with vesting and holding periods, plus an independent remuneration committee and better disclosure. The benefit is better alignment, and the cost is higher scheme and monitoring cost plus some market noise.

Example 2

Distinguish agency costs from governance costs, giving one example of each, and state when a company should add a new control.

Show the solution

Define agency costs: the costs arising from the divergence between managers' and shareholders' interests, including monitoring costs, bonding costs and residual loss.
Give an example of agency cost: residual loss when a manager rejects a positive-NPV but risky project to protect their job.
Define governance costs: the costs of the structures and processes used to oversee the company, such as board and committee operation, audit, reporting and compliance.
Give an example of governance cost: fees and time of non-executive directors who sit on the audit committee.
Explain the link: governance spending is one way of reducing agency costs, but it is itself a cost.
State the decision rule: add a new control only if the expected reduction in agency loss is greater than its cost.

Answer: Agency costs are the total costs of the principal-agent conflict, including residual loss. Governance costs are the costs of running oversight structures. Add a control only where the reduction in agency loss exceeds its cost.

Exam tips

Always name the principal and the agent in your first sentence. It anchors the answer and is easy to mark.
Use the scenario's facts. A generic list of governance provisions earns few marks, and scenario application earns the professional skills marks.
For pay schemes, evaluate both sides: how it aligns interests and how it can be gamed or cause excess risk.
In multinational scenarios, discuss subsidiary managers and the difficulty of monitoring across countries as well as the main board.
Finish with a short recommendation. AFM written answers are marked on judgement as well as knowledge.

Practice questions from The role and responsibility of senior financial executive/advisor

Agency Theory and Corporate Governance in other exams

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

Agency Theory and Corporate Governance: frequently asked questions

What is the agency problem in ACCA AFM?

It is the conflict between shareholders, who own the company, and managers, who run it. Managers may pursue their own goals, such as higher pay or job security, instead of maximising shareholder wealth. You solve it with monitoring, governance structures and well-designed incentives.

What is the difference between agency costs and governance costs?

Agency costs are the total costs of the conflict between principals and agents, including monitoring, bonding and the residual loss from poor decisions. Governance costs are the costs of running the oversight structures such as boards, committees, audit and reporting. Governance spending is a way of reducing agency costs.

Which remuneration schemes align managers with shareholders?

Common schemes are performance-related bonuses, share options, LTIPs and shares with holding periods. Each has strengths and weaknesses. Bonuses can encourage short-termism, and options can encourage risk-taking, so evaluate them against the scenario.

How does agency theory apply to a multinational?

Distance, different regulations and local knowledge make it harder for head office to monitor subsidiary managers. Those managers may favour their own unit's results over group value. Group-wide targets, reporting systems and consistent governance help reduce the problem.