TOPIC 6: THEORIES IN

CORPORATE
GOVERNANCE
DR. NOORAISAH KATMON@KATMUN
WEEK 8
CONTENTS

CORPORATE GOVERNANCE DEFINITION

THEORIES IN CORPORATE GOVERNANCE
AGENCY THEORY
STAKEHOLDER THEORY
STEWARDSHIP THEORY
RESOURCE DEPENDENCY THEORY
Definition on corporate
governance
According to Malaysian Code on Corporate Governance:

Corporate governance is defined as the process and structure used to

direct and manage the business and affairs of the company towards
promoting business prosperity and corporate accountability with the
ultimate objective of realising long-term shareholder value while taking
into account the interest of other stakeholders.
WHY WE NEED CORPORATE
GOVERNANCE?
To mitigate accounting scandal/ fraud/ earnings management
activities in the firms.
To avoid financial crisis.
As a monitoring and control systems in the firms.
To ensure that the resources in the firms are well governed.
To ensure the stability of the economy in general.
To cater for the need of globalization, where business complexities
have been increases, thus to cope with this expanding business
nature, firms need to develop sound governance structure in the
firms.
WHY WE NEED THEORIES IN
CORPORATE GOVERNANCE?
To understand the relationship between fraud, earnings
management, corporate governance and firm performance.
Theory is needed in understanding why managers behave like that?
Or what are the motives of managers decision/ action?
We can possibly found that there is a significant relationship
between the birth rate of the Kangaroo in Australia and the inflation
rate in Zambia for example, but what is the theory behind it? Only
the theory can explain on why such connection occurs. If there is no
theory that can explain such relationship, it means that there is no
connection between those two variables (i.e., kangaroo birth rate
and inflation rate in Zambia).
THEORIES IN CORPORATE
GOVERNANCE
AGENCY THEORY
STEWARDSHIP THEORY
STAKEHOLDER THEORY
RESOURCE DEPENDENCY THEORY
AGENCY THEORY

Jensen and Meckling (1976, p. 308) define the agency relationship

as a contract under which one or more persons (the principal(s))
engage another person (the agent) to perform some service on
their behalf which involves delegating some decision making
authority to the agent.
In this context, the agent refers to the managers and the principals
are the shareholders.
In the principal-agent relationship, agents are responsible for
making decisions on behalf of shareholders and they must exercise
their duty to the best of their ability in such a way as to maximize the
shareholders wealth and to fulfil their expectations.
 Agency problem
Conflict of interest
Conflict of interest occurs when an agent acts to fulfil their own personal
interest when making economic decisions while ignoring the implications
for shareholders.
 Information asymmetry
In essence, information asymmetry represents the gap between the
amount of information held by management and that held by market
participants (Fields et al., 2001, p. 257). With more information in their
hands, managers tend to make decision that benefit themselves.
While managers work in the firm every day and are knowledgeable about
all business transactions and affairs, stakeholders depend on periodic
sources of information, such as the annual reports and interim reports that
managers give to them to enable them to understand the firms activities.
Therefore, the degree of information asymmetry will be higher if the quality
of information is low and stakeholders will be poorly informed about the
business.
 Agency theory assumes that people in the market are rational.
Managers, shareholders, creditors, analysts, governments and all
other market players think rationally in making economic decisions
tend to make decisions that will enhance their welfare. Therefore,
managers tend to become involved in opportunistic behaviour (i.e.
earnings management and flawed disclosure) that potentially
increases a firms agency cost.
Agency costs

Monitoring cost cost of auditor

Bonding cost compensation/ remuneration cost to board of
directors.
Residual loss earnings management, fraud.
 Healy and Palepu (2001, p. 409) outline several solutions to the
agency problem.
First, appropriate contractual incentives must be developed to reduce
conflict of interests.
Second, the monitoring function of the board of directors is effective in
observing and controlling managerial behaviour on behalf of the
shareholders.
Third, capital market players, including financial analysts and rating
agencies, are responsible to act as whistleblowers in the case of any
wrongdoing.
This implies that collaboration and effort in internal and external
governance processes are important in solving agency problems.
Stewardship Theory

The roots of the stewardship theory are stemmed out from

organizational psychology and sociology and defined by Davis,
Schoorman, and Donaldson (1997) as a steward protects and
maximizes shareholders wealth through firm performance, because
by so doing, the stewards utility functions are maximized.
Stewardship theory articulates that managers are hired for handling
the firms operations in a well manner and a managers
achievement and success is measured by satisfaction he gets from
the performance of the firm; therefore the managers primary
objective is to maximize the firm value.
Stewardship Theory

Better firm performance is motivational spot for corporate managers

who are stewards of firm and consider the organizational objective
as their own.
Thus, managers choose pro-organizational behavior that is aligned
with wealth of shareholders rather than their self-serving objectives
(Davis, et al., 1997).
Major difference between agency theory and stewardship theory is
that the stewardship theory replaces the lack of trust on managers
whereas agency theory refers to authority and monitoring to
maintaining the inclination of ethical conduct.
 The main issue stewardship theory is ignorance of intrinsic nature of
man. Many studies showed that moral hazard problem is the main
cause explaining why mangers do not work with good faith and
honesty in order to increase wealth of owners (Acharya &
Viswanathan, 2011).
 In comparison with agency theory, stewardship theory argued that
managers and inside directors are best to serve and act in favor of
shareholders in any circumstances.
Inside directors have excessive knowledge of company matters due
to greater access of secret information as compare to independent
directors (L. Donaldson, 1990; L. Donaldson & Davis, 1991; Fama &
Jensen, 1983).
 Moreover, Daily, Dalton, and Cannella (2003) argued that
managers and directors safeguard shareholders interests by making
right decisions to increase performance of their organizations,
because they also want to protect their market reputations as good
decision makers.
Fama (1980) argued that managers and executives are also
managing their careers in order to be perceived as effective
stewards of their respective companies.
Stakeholder Theory

With the passage of time, both the agency and stewardship

theories showed their narrowness as these only focuses on the
shareholders, considering them the only source that would facilitate
the firm for further exploration.
On the other hand, by expanding the view regarding the interested
parties, stakeholder theory stipulates that a corporate firm or entity
works to improve a balance between the interests of its diverse
stakeholders in such a way that each stakeholder receives some
degree of satisfaction (Abrams, 1951).
 In addition, McDonald and Puxty (1979) laid emphasis that
companies have no longer sole responsibility towards their
shareholders only, but also to the society in which they resides and
operates in.
Accordingly, the stakeholder theory provides much better
explanation of role of corporate governance by clearing various
constituents of a firm than agency theory or stewardship theory.
Therefore, stakeholders of company consist of its employees,
customers, suppliers, shareholders, prospective investors, creditors,
governments, banks and society etc.
 Stakeholder theory proposed that organizations are separate
entities and they are connected with many parties while achieving
their targets (T. Donaldson & Preston, 1995).
Moreover, they explained that it is managements duty to make
sensible decisions and put their best efforts in attaining the benefits
that satisfy all stakeholders.
In addition, Wang and Dewhirst (1992) that highlighted board of
directors should not ignore their responsibilities towards protecting
interests of stakeholders.
Resource Dependency Theory

Above mentioned theories namely agency, stewardship and

stakeholder provide the insights to the shareholders, managers and
stakeholder perspectives while another theory of corporate
governance which emphasizes toward the need of different
resources for the success of business is named as resource
dependence theory.
 According to Pfeffer (1972), resource dependence theory argues
that companys success is dependent upon maximizing its power
over certain resources which are necessary for running smooth
operations.
Basically, the resource depending theory concentrates on role of
board that help to secure and acquire the crucial resources of the
organization by their external linkage to the environment.
 Through these linkages, it brings in different resources, such as
information, skills, access to key constituents like supplies of raw
material, buyer of outputs, public policy makers, social groups as
well as legitimacy (Hillman & Dalziel, 2003).
So, under this theory, board of directors is the key source of various
resources that different resources provision enhances organization
operation, firms performance and organizational life (Daily, et al.,
2003).
 Similar description was given by Ulrich and Barney (1984) who said
that organizational performance is highly reliant on the power of a
company to avail the required and scarce resources.
They gave further explanation of the resources that are required by
the company after making relationships with different parties who
have access of those required bulk resources.
 Corporate performance can be judged by the efficiency and
efficacy of the network and communication between contractual
parties of firms. Several prior studies provide evidence that
corporate boards played important role in accessing the desired
resources.
Likewise, Salancik and Pfeffer (1978) and Dalton, Daily, Johnson, and
Ellstrand (1999) found that without the help of corporate boards it is
difficult for organizations to acquire necessary resources. In this
theory, diversity of board members is seen as the essential element
which leads towards the broader business connections (Siciliano,
1996) and finally firms perform financially well (Waddock & Graves,
1997).
 Johnson, Daily, and Ellstrand (1996) highlighted the main feature of
resource dependence theory.
They said that independent directors on the boards provide more
assistance in gaining the desirable resources.
As an outside director who is related to a law firm will provide the legal
services and advises in the board meetings with executive directors
which is very costly for the firm to obtain otherwise.
Directors have more linkages with the outdoor environment that is
necessary for organizations survival and future growth (Hillman, et al.,
2001).
 They further explained that board of directors bring resources for the
firms namely necessary information, expertise, provide access to
business stakeholders in which key suppliers, customers, policy
makers, legal advisors and social groups are on the top.
 Therefore, board of directors can be classified into following
categories.
Firstly, inside directors that provides information regarding company
finance and regulation, make strategies and give direction for decision
making.
Secondly, business experts directors which are the present, former and
top analysts of the profit-oriented larger firms, they provide guidelines for
strategy making, problem solving and their professional opinion for
decision making.
Thirdly, specialists that provide support regarding their specific fields in
which bankers, lawyers, experts of public relations and representatives
of insurance companies etc. are included.
 Finally, type of directors is community influential that consisted upon
faculty members of different universities, political or social leaders
and organizational communities.
In addition, Ruigork, Peck, and Tacheva (2007) considered the
boards as the boundary guards that shelter the necessary firms
resources like capital, knowledge, skills and projects partnership
agreements.
SUMMARY

In summary, these theories provided the base for further understanding of

literature which is relevant to the corporate governance and study variables.
As agency theory suggests the relationship between owners and management
while introducing the several governance mechanisms to resolve the potential
agency conflict.
On the contrary stewardship theory provides evidence in favor of management
and put emphasis that managers work for the best interest of shareholders.
Both theories narrowed the concept of corporate governance to only two
parties, so stakeholder theory is noteworthy because of considering all the
parties that have some relationship with the firm. It explains that management
has responsibilities to all the companys stakeholders not only towards
shareholders.
Furthermore, the resource dependence theory explains that company needs
several resources for the completion of its operations successfully which is not
possible without the assistance of directors or board members.