Agency Cost - How Does It Relate to Fair Value and Historical Cost Accounting?

1) Agency theory

Agency theory is defined as a theory developed to explain and predict the actions of agents and principles. A common assumption of this theory is that both principle and agents are wealth maximizes whose interests are not aligned (Godfrey et al., 2006 p.665).

How does it relate to fair value and historical cost accounting?

Considering the current paradigm of shifting towards fair value accounting has resulted in increasing management efficiency and thus, decreasing principal-agent conflict. As suggest in many studies that to overcome principal-agent problem fair value accounting is the best approach. Furthermore, fair value accounting generates a need to report on the stewardship function of accounting. It is possible through fair value accounting to generate a report that centers on the stewardship function. This report will contain the changes to assets, liabilities and equity and the information on expense that serves as the stewardship function. It is also possible to include changes in the values of assets, liabilities and equities on statement of comprehensive income. By estimating and identifying the fair values of assets, the attention of the investors is directed towards the value of the asset placed in the hands of the principal.

On the other hand historical cost concept is seen as a concept that increases principal- agent problem. Historical cost concept is under so many controversies because it has been seen as concept that generates hidden reserves thereby contributing to agency problem. Historical cost concept overlooks the changes in the values of the assets which mangers may hide behind profitability. Investors regard this as a disadvantage of financial statement. To obtain high profit figures managers can take advantage of historical cost concept and select the method that is consistent with meeting the target profit figures. Following provisions suggest a number of ways management turns to take advantage of the historical cost concept.

* Manipulating depreciation figures

* Changing the estimation of doubtful debts

* Restating values of assets

* Selling undervalued assets

Usually the performance of the principal are calculated on the basis of ROA (rate of return on assets) and ROE (rate of return on equity). Under historical cost accounting both above two measures are subject to manipulation by mangers (BARLEV&HADDAD, 2003, pg.398)