Strategic Business Leader · Agency

Managing Agency Problems: Monitoring and Incentives in ACCA SBL

Updated 11 October 2026 · Fact-checked

Agency problems arise when managers (agents) act in their own interest rather than shareholders' (principals'). You reduce them in two ways: **monitoring** (audit, non-executive directors, committees, disclosure) and **incentives** (performance-related pay, bonuses, share options). In SBL, recommend a mix and apply it to the scenario.

Understand Managing Agency Problems: Monitoring and Incentives

An agency problem exists when owners (principals) hire managers (agents) to run a business, and the managers' interests differ from the owners'. Managers may want high pay, perks, job security or empire building. Shareholders want long-term wealth. Shareholders cannot watch managers every day, so managers know more than they do. This is information asymmetry.

There are two broad ways to close the gap. The first is monitoring: checking what managers do, so that bad behaviour is found or discouraged. The second is incentives: designing rewards so that what is good for the manager is also good for the shareholder. This is often called aligning interests or goal congruence.

Monitoring tools include external audit, an independent audit committee, non-executive directors, internal audit, a separate chair and chief executive, mandatory disclosure of pay and results, shareholder voting on remuneration, and scrutiny by analysts, lenders and regulators. Each one costs money, so there is a trade-off. These are monitoring costs, and they form part of agency costs.

Incentive tools include a basic salary, annual bonuses linked to profit or other targets, long-term incentive plans (LTIPs) that pay out on multi-year results, share options and share awards, and pension or deferred pay. Share options give the holder a right to buy shares at a set price. Value rises only if the share price rises, so the manager shares in shareholder gains.

Incentives can backfire. Short-term bonuses can push managers to boost profit now at the cost of the future. Options can encourage excess risk-taking or manipulation of reported results, and they pay out on a general market rise that the manager did not cause. Targets that are too easy, or too hard, lose their effect. Good schemes balance fixed and variable pay, use several measures (financial and non-financial), look at the long term, and are set by an independent remuneration committee.

In SBL, you are expected to explain the mechanism, say whether it fits the scenario, and point out its limits.

Key rules to remember

Agency costs: Agency costs = monitoring costs + bonding costs + residual loss; Monitoring: paid by principal (audit, controls). Bonding: agent shows commitment (reports, contract terms). Residual loss: value still lost after both.
Goal congruence test for a reward scheme: Reward scheme works if: manager's pay rises when shareholder wealth rises; Use this to judge any pay package in a scenario. Ask what the manager is actually paid for.
Share option value to holder at exercise: Gain per option = market price at exercise − exercise price (only if positive); If the market price is below the exercise price, the option is not exercised and the gain is zero.
Balanced pay package: Total pay = fixed salary + short-term bonus + long-term incentive (options or shares) + benefits; Not a mathematical rule. It is the structure most governance codes expect: a significant part should be performance-linked and long term.

How to solve Managing Agency Problems: Monitoring and Incentives questions

Use this method for any question asking how to align directors with shareholders or how to reduce agency problems.

1Identify the principal and the agent in the scenario, and name the specific conflict (for example short-term bonus chasing, excess perks, risk avoidance).
2Split your answer into two headings: monitoring and incentives. Many students cover only one.
3For each mechanism, say what it is, then how it reduces the conflict in this case.
4Tie each point to scenario facts: the current pay structure, the board make-up, the ownership, the industry and the time horizon.
5Give limits or risks of each measure, such as manipulation, short-termism, cost, or pay not linked to effort.
6Add governance controls: independent remuneration committee, non-executive directors, shareholder vote, disclosure.
7Recommend a balanced package and say what you would change first.
8Finish with a short conclusion that answers the requirement directly, in the tone the task demands (report, memo or briefing).

Quickest way: Monitor, Motivate, Limit

When to use it: Use when time is short, or when you need a plan for a 10 to 15 mark requirement.

Write three headings: Monitor, Motivate, Limits.
Under Monitor, list 3 items: audit and audit committee, independent non-executives, disclosure and shareholder votes.
Under Motivate, list 3 items: performance bonus, long-term share-based pay, non-financial targets.
Under Limits, list 2 or 3 problems: short-termism, manipulation, cost.
Attach one scenario fact to each point before you write it up.
Finish with one clear recommendation.

Common mistakes in Managing Agency Problems: Monitoring and Incentives

Listing mechanisms without applying them to the scenario.
Students memorise the list from the text and treat it as a knowledge question.
Fix: Link each mechanism to a named fact: who the directors are, how they are paid, what has gone wrong.
Saying performance-related pay always solves the agency problem.
It sounds logical, so the downsides are skipped.
Fix: Always give a limit: short-termism, manipulation of profit, targets outside the manager's control, or excess risk.
Covering only incentives and ignoring monitoring, or the reverse.
Students recall pay schemes more easily than governance controls.
Fix: Use a Monitor and Motivate structure every time.
Confusing share options with shares.
Both give the holder a stake in the company.
Fix: Remember that options are a right to buy at a set price and have no value if the market price stays below it. Shares carry value and risk from day one.
Forgetting who sets pay.
Focus stays on the package, not on the process.
Fix: Mention an independent remuneration committee made up of non-executives, and shareholder approval and disclosure.
Ignoring cost and proportionality.
Students assume more controls are always better.
Fix: Note that monitoring costs money and should be weighed against the benefit. A small firm may not need a full set of committees.

Worked examples

Example 1

Zenith Retail plc's chief executive is paid a fixed salary and an annual bonus based only on this year's profit. Over three years, the CEO has cut staff training and store upkeep, and profit has risen while customer satisfaction has fallen. Advise the board on how the pay structure contributes to the agency problem and how to improve it. (10 marks)

Show the solution

Identify the conflict: the CEO (agent) gains from this year's profit. Shareholders (principals) want long-term value.
The bonus rewards short-term profit, so the CEO cuts discretionary spend. This raises profit now but harms future sales and brand.
Incentive fix 1: add a long-term incentive plan paying out over three to five years on measures such as total shareholder return or earnings growth.
Incentive fix 2: add non-financial targets such as customer satisfaction and staff retention, so quality is not sacrificed.
Incentive fix 3: consider share awards with a holding period, so the CEO bears the long-term effects of decisions.
Monitoring fix: the remuneration committee, made up of independent non-executives, should set targets and review them against performance.
Monitoring fix: disclose targets and results in the annual report and give shareholders a vote on pay.
Limits: long-term schemes can still be gamed, the share price may rise for reasons outside the CEO's control, and extra measures add complexity and cost.

Answer: The current bonus encourages short-termism. Zenith should add a long-term, multi-measure incentive (shares or LTIP with non-financial targets), have an independent remuneration committee set and disclose it, and give shareholders a vote. The board should recognise that no scheme removes the problem entirely.

Example 2

Marlowe Ltd offers its finance director 60,000 share options with an exercise price of $5.00. Over the vesting period the share price rises to $8.20. (a) Calculate the director's gain before tax if all options are exercised. (b) Explain how options help reduce the agency problem and one risk they create. (8 marks)

Show the solution

Gain per option = market price − exercise price = 8.20 − 5.00 = $3.20.
Total gain = 60,000 × $3.20 = $192,000.
How they help: the director gains only if the share price rises above $5.00. Their reward moves with shareholder wealth, which aligns interests.
Vesting over several years encourages a longer-term view than an annual bonus.
Risk 1: if the share price falls below $5.00, the options are worthless, which may encourage the director to take very risky decisions in the hope of a recovery.
Risk 2: the price may rise because of a general market rise, not the director's effort, so they are rewarded for luck. Director may also manipulate reported results to lift the price.

Answer: (a) The gain is $192,000 (60,000 × $3.20). (b) Options link pay to share price, so the director gains when shareholders gain. A key risk is excessive risk-taking or short-term manipulation to push the price up, and gains may reflect the market rather than performance.

Exam tips

In SBL, a list scores poorly. Always apply each mechanism to named facts from the case.
Cover both monitoring and incentives, then give limits. Examiners reward balance.
Link pay to governance: mention the remuneration committee, non-executive independence and shareholder voting.
Use professional skills: be sceptical of any scheme that rewards short-term numbers, and propose a practical recommendation in the format requested.
If a calculation appears, such as option gains or bonus, show your working briefly, then spend most of your time on the explanation.

Practice questions from Agency

Managing Agency Problems: Monitoring and Incentives in other exams

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

Managing Agency Problems: Monitoring and Incentives: frequently asked questions

How does performance-related pay reduce the agency problem?

It ties part of the manager's pay to results that shareholders care about, such as profit or share price. This makes the manager benefit when shareholders benefit. It works only if the measures are well chosen and hard to manipulate.

Why are share options used for directors?

Options reward directors only if the share price rises above the exercise price, so their gain follows shareholder wealth. They also usually vest over several years, which encourages a longer-term view. They can lead to excess risk-taking or reward market luck.

What is the difference between monitoring and incentives?

Monitoring checks and limits what managers do, through tools such as audit, non-executive directors and disclosure. Incentives change what managers want, by linking their rewards to shareholder interests. Strong answers use both.

Do these measures remove the agency problem completely?

No. Monitoring costs money and can miss things, and incentives can create new distortions such as short-termism. The aim is to reduce the problem to an acceptable level at reasonable cost.