ACCT10001 · Accounting Reports And Analysis
Agency Theory
Topic 9 explains the tension at the heart of corporate ownership: owners (principals) delegate to managers (agents) who hold more information, which can create agency problems. You learn how compensation aligns interests, how debt versus equity financing changes current shareholders' share of profit (and dilutes ownership), and how a debt covenant such as a debt-to-equity ceiling is tested and restored. It is a major source of marks in the exam's Case 4 (Integrated case, 33 marks), where the NPAT-by-financing and D/E covenant questions are recurring exact patterns.
What this chapter covers
- 011. The principal–agent relationship (Jensen & Meckling 1976): owners delegate to managers, creating information asymmetry and agency problems
- 022. Compensation to align interests: tie pay to performance, with trade-offs between gross-profit, NPAT and deferred shareholder-share measures
- 033. Debt financing: interest-only loan — interest is a fixed, tax-deductible expense and there is no dilution
- 044. Equity financing: sells an ownership percentage — no interest, but current shareholders are diluted
- 055. Current shareholders' share of NPAT: debt keeps 100%; equity keeps (1 − new ownership %) of NPAT, compared across success/failure scenarios
- 066. Debt covenants: e.g. maintain debt-to-equity ≤ a threshold; D/E = total liabilities ÷ total equity
- 077. The covenant test: debt funding raises the numerator (risks breach); equity funding raises the denominator (restores compliance)
- 088. Financial manipulation and ethics: how incentives can drive manipulation, and why ethics matter
Current shareholders' share of NPAT — debt versus equity (Case 4)
- 2 marksSuccessful, Debt: PBT = 120 − (5 + 5) = 110; tax 25% = 27.5; NPAT = 82.5; current shareholders keep 100% = 82.50.
- 2 marksSuccessful, Equity: PBT = 120 − 5 = 115; tax = 28.75; NPAT = 86.25; current shareholders keep 80% × 86.25 = 69.00.
- 2 marksUnsuccessful, Debt: PBT = 70 − 10 = 60; tax = 15; NPAT = 45; current shareholders keep 100% = 45.00.
- 2 marksUnsuccessful, Equity: PBT = 70 − 5 = 65; tax = 16.25; NPAT = 48.75; current shareholders keep 80% × 48.75 = 39.00.
Key terms
- Principal–agent relationship
- The relationship (Jensen & Meckling 1976) in which owners (principals) delegate decision-making to managers (agents). Because the agent typically knows more than the principal, it creates the conditions for agency problems.
- Information asymmetry
- The situation where one party (the manager/agent) has more or better information than another (the owner/principal), which can let managers act in their own interest rather than the owners' — the root of the agency problem.
- Debt vs equity financing
- Debt is an interest-only loan: interest is a fixed, tax-deductible expense and there is no dilution of ownership. Equity sells a percentage of the company: there is no interest, but current shareholders are diluted and share future profit with the new owners.
- Current shareholders' share of NPAT
- Net profit after tax attributable to the existing owners. Under debt they keep 100% of NPAT (after deducting all interest); under equity they keep (1 − new ownership %) of NPAT (after deducting only existing interest). Comparing the two across success and failure scenarios is the core Case 4 calculation.
- Debt covenant (debt-to-equity test)
- A lending condition, such as maintaining debt-to-equity ≤ a threshold, that aligns debt and equity holders. D/E = total liabilities ÷ total equity. Debt funding raises the numerator and can breach the covenant; equity funding raises the denominator and lowers the ratio.
- Compensation alignment
- Tying manager pay to performance measures so their interests match owners'. The choice of measure matters: a gross-profit bonus ignores opex and capital efficiency; an NPAT-linked component aligns with profitability; a deferred component linked to current shareholders' share of NPAT best aligns after dilution.
Agency Theory FAQ
How is Topic 9 examined in ACCT10001?
Agency theory is a major part of the exam's Case 4 (Integrated case, 33 marks). The two recurring exact patterns are computing current shareholders' share of NPAT under debt versus equity (Practice Exam Q12) and testing/restoring a debt-to-equity covenant (Practice Exam Q13–Q15), plus reasoning about compensation alignment and ethics.
How does debt versus equity affect current shareholders' share of profit?
Under debt, you deduct all finance costs (existing plus the new interest) before tax, but current shareholders keep 100% of the resulting NPAT and are not diluted. Under equity, you deduct only the existing finance costs (no new interest), but current shareholders keep only (1 − new ownership %) of NPAT because the new owners share in it. Which is better depends on EBIT, the interest rate, the equity percentage and tax.
How does the debt-to-equity covenant test work?
D/E = total liabilities ÷ total equity, and a covenant typically requires it to stay below a threshold. Funding with debt raises total liabilities (the numerator), pushing the ratio up and risking a breach; funding with new equity raises total equity (the denominator), pulling the ratio down. So to cut a breached ratio without repaying borrowings immediately, the firm issues equity, which directly lowers leverage.
What is the agency problem and how is it managed?
The agency problem arises because owners (principals) delegate to managers (agents) who, with more information, may act in their own interest. It is managed mainly by aligning incentives — tying management compensation to performance measures so that doing well for themselves means doing well for owners — and supported by monitoring, covenants and ethics. The choice of performance measure is critical to how well interests align.
Exam move
This topic carries serious Case 4 marks, so master its two calculations cold. For the NPAT comparison, lay out a 2×2 grid (success/failure × debt/equity) and apply the rule mechanically: debt subtracts all finance costs and keeps 100%; equity subtracts only old finance costs then multiplies by (1 − new ownership %); tax on PBT throughout. For the covenant, remember D/E = liabilities ÷ equity, that debt raises the numerator and equity raises the denominator, and that issuing equity is the move to fix a breach without repaying debt. Beyond the maths, be able to explain in a sentence or two how compensation aligns the principal and agent and why ethics matter — the discuss/explain marks reward clear reasoning, not just numbers.
