Four theories of corporate governance — study companion

Accounting Ahead | Original study resource | accountingahead.com.au

Four lenses on governance

MODULE 3 | PART A.4 | STUDENT COMPANION

Each theory starts from an assumption about how people with power behave. The assumption decides which

safeguards make sense.

Theory Assumption about people Whose relationship Governance response

Stewardship (inside

view)

Stewards naturally act for

the owners

Directors and

shareholders

Trust and freedom to act;

financial reports as the

stewards' account

Agency (inside view) Self-interested, and they

know more than the owners

Principals and agents Monitoring, bonding and pay

design to align interests

Stakeholder (outside

view)

Managers must balance

many groups' claims

Everyone affected,

inside and out

Engage, prioritise and

account publicly to each

group

Corporate social

responsibility (outside

view)

Entities should contribute to

society

The community and its

causes

Programs that benefit the

community and engage

employees

Why it matters. Audits, audit committees, independent directors and long-term pay design are agency

theory in practice: each one reduces information asymmetry or lines up the agent's interests with the

owners' interests.

Agency costs: who bears them?

Monitoring costs

Borne by the principal

Spent watching the agent:

compulsory annual reporting and

audit, plus optional reviews and

scorecards.

Bonding costs

Borne by the agent

Commitments the agent accepts to

show alignment: deferred bonuses,

shareholding requirements,

disclosures.

Residual loss

Borne by the principal

Value still lost despite monitoring

and bonding: excessive perks,

empire building, risk avoidance,

short horizons.

What causes agency costs?

Information asymmetry | poor communication | poor understanding | innocent self-interest | deliberate but legal self-interest | illegal

self-interest such as fraud

ETHICS & GOVERNANCE | M3 PART A.4 | STUDENT COMPANION

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Residual loss in four forms

MODULE 3 | PART A.4 | IMAGINED EXAMPLES AT SUMMIT LOGISTICS LTD

Form What it looks like Why shareholders lose

Excessive perks Lavish offices, cars and memberships charged to

the company

Lower profit and less cash available for

owners

Empire building Buying a rival mainly for status and a bigger

salary

Growth that adds size but not value

Risk avoidance Managers on fixed salaries reject good but risky

projects

Higher returns that diversified owners

wanted are forgone

Short time

horizons

A retiring CEO cuts maintenance to lift this year's

bonus profit

Long-term damage arrives after the

agent has left

Real case - Tyco International. Former chief executive Dennis Kozlowski was convicted in 2005 after

using company money for extravagant personal spending. Perks became crime, but the agency problem

was the same: the agent's interests displaced the owners' interests.

Real case - Patagonia, 2022. The founder's family transferred the company: voting shares to a trust that

protects its values, and non-voting shares (the vast majority) to a non-profit that uses profits not reinvested

to fight the environmental crisis. Stakeholder and social responsibility thinking built into ownership.

ETHICS & GOVERNANCE | M3 PART A.4 | STUDENT COMPANION

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Accounting Ahead | Original study resource | accountingahead.com.au

Practice questions

MODULE 3 | PART A.4 | TRY THESE BEFORE THE WORKED ANSWERS

Question 1 - label the agency cost

Imagine a listed company called Harbourside Wind Ltd. Label each event as a monitoring cost, a bonding cost

or residual loss, and say who bears it.

Event Your label and who bears it

(a) Shareholders pay for the annual external audit.

(b) The CEO agrees that 40% of her bonus is paid in shares she can't

sell for three years.

(c) A 'leadership retreat' for the CEO and two friends at a luxury

resort is charged to the company.

(d) The board pays consultants to build a dashboard tracking the

CEO's targets.

(e) Managers on fixed salaries reject a promising but risky turbine

project to protect their jobs.

(f) The CFO publishes a register of her outside interests and accepts

a clawback of bonuses if results are restated.

Question 2 - which theory explains it?

Name the theory that best explains each choice: (a) a board gives its long-serving founder-CEO wide authority

and relies mainly on the annual report; (b) a company forms an audit committee and links bonuses to three-year

shareholder returns; (c) a mining company consults landholders, Traditional Owners, employees and councils

before approving a new site; (d) a bank gives every employee two paid volunteering days a year with local

charities.

Harbourside Wind, Summit Logistics and the apartment-sale illustration are imagined examples. Real cases: Tyco International

(conviction of former CEO, 2005); Patagonia ownership transfer (September 2022). Study guide reference: Module 3, Part A, section 3.4.

ETHICS & GOVERNANCE | M3 PART A.4 | STUDENT COMPANION

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Accounting Ahead | Original study resource | accountingahead.com.au

Worked answers

MODULE 3 | PART A.4 | WORKED ANSWERS - ATTEMPT THE QUESTIONS FIRST

Question 1 - Harbourside Wind Ltd

Event Label Who bears it and why

(a) External audit Monitoring (compulsory) Principal: the owners pay to check the agent's

reporting.

(b) Bonus paid in locked

shares

Bonding Agent: she accepts a restriction that ties her

wealth to the shareholders'.

(c) Resort 'retreat' with friends Residual loss (excessive

perks)

Principal: company money funds personal

benefit.

(d) Target dashboard Monitoring (discretionary) Principal: an optional tool for watching

performance.

(e) Risky project rejected Residual loss (risk avoidance) Principal: returns that diversified owners would

accept are forgone.

(f) Interests register and

clawback

Bonding Agent: voluntary commitments that signal

alignment.

Tip: ask who bears the cost. Principals pay for monitoring and suffer residual loss; agents bear bonding

costs, and many bonding costs are restrictions rather than dollars.

Question 2 - which theory?

(a) Stewardship theory: the founder is trusted as a steward, and the annual report is the formal account to

owners.

(b) Agency theory: an audit committee reduces information asymmetry, and long-term pay builds goal

congruence.

(c) Stakeholder theory: managing relationships with many affected groups and balancing their interests.

(d) Corporate social responsibility theory: supporting community causes and engaging employees beyond

their work.

Answers apply the theories as explained in the lesson. Other defensible answers are possible where a choice reflects more than one

theory, provided the reasoning links to the theory's assumption about people.

ETHICS & GOVERNANCE | M3 PART A.4 | WORKED ANSWERS

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