Advanced Performance Management · Performance and reward

Principal-Agent Theory and Agency Problems in ACCA APM

Updated 11 October 2026 · Fact-checked

Principal-agent theory explains the conflict that arises when owners (principals) hire managers (agents) to act for them. Agents have their own goals and know more than owners do. In APM you identify the conflict, name the problem (moral hazard or information asymmetry), then recommend monitoring or reward schemes that align interests.

Understand Principal-Agent Theory and Agency Problems

A principal is the party who delegates work and decision-making. In a company, the shareholders are the principals. An agent is the party who acts on the principal's behalf. In a company, the directors and managers are the agents.

The problem is that the two sides want different things. Shareholders usually want long-term growth in wealth. Managers may want higher pay, job security, status, a quieter life or a bigger empire. When managers pursue these goals at the owners' expense, you have an agency problem. The cost of dealing with it is the agency cost. It includes monitoring costs, bonding costs and the loss of value from decisions that are not ideal.

Information asymmetry means the agent knows more than the principal. Managers see daily operations, forecasts and risks. Shareholders see only the published reports. This gap lets managers present results in a favourable way, and the principal cannot easily check.

Moral hazard arises when the agent's actions cannot be fully observed, and the agent does not bear the full consequences. A manager on a bonus may take excessive risk, because the gain is shared with them but the loss falls on the owners. A manager on a fixed salary may put in less effort, because owners cannot see how hard they work. Related to this is adverse selection, where the principal cannot judge an agent's true skill or honesty before hiring.

Owners respond in three broad ways. They monitor (audit, board oversight, non-executive directors, reporting). They bind the agent through contracts and governance rules. And they incentivise through reward schemes that tie pay to outcomes the owners value. This is called goal congruence. Rewards can themselves create new problems, such as short-termism and manipulation of targets. APM often asks you to weigh both sides.

Key rules to remember

Agency cost (components): Agency cost = monitoring costs + bonding costs + residual loss; Residual loss is the value lost because the agent's decisions still differ from what the principal would choose. This is a framework to list, not a calculation.
Goal congruence test: Reward is effective if agent's gain rises only when principal's wealth rises; Use this as a quick check on any reward scheme in a scenario.
Typical agency problem types: Moral hazard (hidden action) | Adverse selection (hidden information before hiring) | Information asymmetry (general gap); Name the correct type. Do not use the terms as if they mean the same thing.

How to solve Principal-Agent Theory and Agency Problems questions

Use this sequence for any written requirement on agency theory, whether it asks you to explain, assess or recommend.

1Read the requirement verb. Explain, evaluate and recommend need different depth.
2Identify the principal and the agent in the scenario. They are not always shareholders and directors. They could be head office and divisional managers.
3State what each party wants. Use scenario facts, such as bonus bases, short contracts or ownership structure.
4Name the specific problem: moral hazard, information asymmetry, adverse selection or short-termism. Link it to evidence from the case.
5Explain the harm to the principal, for example excess risk, cut spending to hit profit or misreporting.
6Recommend mitigation: monitoring, governance, and a reward design linked to long-term measures. Match each fix to the problem.
7Evaluate the fix. Note costs, how easily it can be manipulated and any new behaviour it encourages.
8Close with a clear recommendation. Write it in the form asked (report, memo or email) to earn professional skills marks.

Quickest way: P-A-P-F: Parties, Aims, Problem, Fix

When to use it: Use it when you have about 10 minutes for a mark-heavy part and must plan fast.

Parties: write who is the principal and who is the agent in one line.
Aims: write one goal for each side, taken from the scenario.
Problem: label it (moral hazard or information asymmetry) and give a case fact as proof.
Fix: give two mitigations, one monitoring and one reward, and add one drawback for each.
Write one paragraph per letter. Keep sentences short and tied to the scenario.

Common mistakes in Principal-Agent Theory and Agency Problems

Treating principal-agent theory as only a shareholder and director issue.
Textbook examples always use that pair.
Fix: Check the scenario. Divisional managers and head office, or government and a public body, can also be the pair.
Using moral hazard and information asymmetry as if they mean the same thing.
Both involve the agent knowing more or acting unseen.
Fix: Information asymmetry is the knowledge gap. Moral hazard is the behaviour it allows, such as taking risk or shirking, because the agent does not bear the cost.
Listing theory without applying it to the case.
Students memorise definitions and run short of time.
Fix: Every point needs a scenario fact: a figure, a bonus rule, a contract length or a named manager.
Recommending bonuses or share options as a complete cure.
Pay-for-performance feels like the obvious answer.
Fix: Show the downside too: short-termism, target manipulation, excessive risk or windfall gains. Suggest long-term, balanced measures and clawback.
Assuming all managers act selfishly.
The theory is built on self-interest, so students overstate it.
Fix: Say the theory assumes self-interest. Mention that other views, such as stewardship theory, expect managers to act in the owners' interest.
Giving a generic answer without a clear recommendation.
Students describe the issues and forget to advise.
Fix: End with a specific, justified recommendation that matches the requirement. That also supports the professional skills marks.

Worked examples

Example 1

Zenith Retail Ltd's board pays its chief executive a bonus based only on this year's reported profit. The CEO has just delayed a store refurbishment and cut staff training. Shareholders say profit is up, but customer satisfaction is falling. Explain the agency problem and recommend how the reward scheme should change. (10 marks)

Show the solution

Parties: shareholders are principals. The CEO is the agent.
Aims: shareholders want long-term wealth. The CEO wants a larger bonus, which depends on this year's profit.
Problem: this is moral hazard with information asymmetry. The CEO takes actions that boost short-term profit but harm future value. Shareholders cannot see these trade-offs clearly in the profit figure.
Evidence: the refurbishment delay and training cuts raise profit now. Falling customer satisfaction signals future loss of revenue.
Harm: long-term value is destroyed while the CEO is paid for a short-term gain. This is short-termism.
Fix 1: add non-financial measures such as customer satisfaction and staff retention, perhaps through a balanced scorecard.
Fix 2: defer part of the bonus into shares or a long-term incentive plan over several years, so the CEO shares in the long-term result. Add clawback for results later restated.
Fix 3: improve monitoring through a remuneration committee of independent non-executive directors and clearer reporting on capital and training spend.
Evaluate: long-term plans cost more and are harder to design. The CEO may see them as unfair if factors outside their control affect the measures. Targets must be controllable and clear.

Answer: The problem is a short-term profit bonus that leads the CEO to cut investment, which is moral hazard supported by information asymmetry. Recommend a mix of financial and non-financial measures, deferred share-based pay with clawback, and stronger board oversight, while acknowledging cost and manipulation risk.

Example 2

Karan Industries is a listed group with a cost of capital of 12%. Its divisional managers are paid a bonus only if divisional ROI is at least 20%. Division A has ROI of 20% on assets of $50m. It rejects a project costing $10m that would earn $1.9m a year. Explain why this happens and what it says about agency problems. (6 marks)

Show the solution

Current Division A profit: 20% × $50m = $10m. The manager is exactly at the bonus threshold.
Project return: $1.9m ÷ $10m = 19%.
Combined: profit = $10m + $1.9m = $11.9m. Assets = $50m + $10m = $60m. New ROI = 11.9 ÷ 60 = 19.83%, which is below the 20% bonus threshold.
So accepting the project would push divisional ROI below 20% and the manager would lose the bonus. The manager (agent) therefore rejects it to protect the measure on which they are paid.
From the group's view, the project return of 19% is above the 12% cost of capital. Its residual income is $1.9m − (12% × $10m) = $1.9m − $1.2m = $0.7m, which is positive. The group (principal) would want it accepted.
Agency link: the manager's interest (the bonus) conflicts with the group's interest (higher value). This is a goal congruence failure caused by the reward measure, because ROI favours rejecting any project that earns less than the current ROI, even if it earns more than the cost of capital.
Fix: use residual income or EVA with a capital charge. Division A's residual income would rise from $10m − (12% × $50m) = $4.0m to $11.9m − (12% × $60m) = $4.7m, so the manager would accept the project. Set the bonus on that measure and add long-term and non-financial measures.

Answer: The project lowers divisional ROI from 20% to about 19.83%, below the 20% bonus threshold, so the manager rejects it even though its 19% return exceeds the group's 12% cost of capital (residual income +$0.7m). This is an agency problem caused by the measure. Use residual income or EVA to align divisional decisions with group value.

Exam tips

Always name the principal and agent from the scenario in your first sentence. It shows application at once.
Use the exact terms moral hazard, information asymmetry and goal congruence. Examiners look for them.
For reward questions, give one benefit and one risk of each scheme. Balanced answers score better than one-sided ones.
If the scenario has numbers, such as bonus thresholds or ROI, calculate with them and say what the manager would do. Do not leave the figures unused.
Match the format asked. A short, clear memo or email with a recommendation earns professional skills marks.

Practice questions from Performance and reward

Principal-Agent Theory and Agency Problems in other exams

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

Principal-Agent Theory and Agency Problems: frequently asked questions

What is the difference between principal and agent goals in APM?

The principal, usually the shareholder, wants long-term wealth and a good return for the risk taken. The agent, usually a manager, may want higher pay, security, status or an easy life. Agency problems arise where those goals differ.

How do I explain moral hazard in the APM exam?

Say that the agent's actions cannot be fully seen by the principal and the agent does not bear all the cost of those actions. Then give a case example, such as a manager taking excess risk to earn a bonus. Finish by naming a control, such as deferred pay or stronger oversight.

Is information asymmetry the same as an agency problem?

No. Information asymmetry is one cause: the agent knows more than the principal. The agency problem is the resulting conflict of interest and the poor decisions or behaviour that follow.

Can reward schemes remove agency problems completely?

No. They reduce the gap by tying the agent's gain to the principal's, but they cost money and can be manipulated. They can also encourage short-term or risky behaviour, so combine them with monitoring and governance.