It is important to recognise that the firm is assumed to exist for the benefit of its owners who are assumed to be solely interested in the maximisation of their wealth. Managers, on the other hand, are the decision-makers in an organisation and they are implicitly assumed to automatically act in the best interests of owners, either because they are also the owners, or because they share the same interests. In other words, managers are assumed to make the same decisions that owners would make, irrespective of the effect on their personal interests.
Managers are, therefore, assumed to assess objectively alternative actions, and always select the option favored by the owners of the firm. The management accountant, therefore, is then concerned with providing the 'right' information combined with the 'right' decision-model which will help the manager make the 'right' decision. An obvious criticism of this approach, however, is that it fails to recognise that managers may not share the same interests as owners, and that this is likely to impact upon real-world decision-making. Agency theory attempts to address this problem, by providing a more realistic representation of decision-making.
Agency theory therefore recognises that people are unlikely to ignore their own self interest in making decisions; in other words people do not behave altruistically. It is a relatively new approach to analyzing decision-making which provides a framework within which the political and behavioral aspects of decision-making can be considered as part of the decision making process. The theory is therefore positive rather than normative as it seeks to understand and explain what happens in practice rather than seeking to prescribe what ought to happen. It recognises that the manager is an agent of the owners of the firm, whose actions the management accounting system seeks to influence.
Under Agency Theory both principal and agent are assumed to be rational economic persons: in other words they know what they are doing and they act consistently and rationally. They are both assumed to be motivated by self-interest alone, although the theory recognises that they possess different preferences, beliefs and information. Agency Theory provides a means of establishing a contract between the principal and the agent which will lead to optimal performance by the agent on behalf of the principal. The most important aspect is that information is not evenly distributed between managers and owners. This problem is known as 'information asymmetry' and has two separate, though related elements: moral hazard and adverse selection.
Moral hazard arises where it is difficult or costly for owners to observe or infer the amount of effort exerted by managers. In such a situation, there is an inevitable temptation for managers to avoid working to the terms of the agreed employment contract, since owners are unable to assess the 'true picture'. Managers may also have the incentive as well as the means to conceal the 'true picture' by misrepresenting the actual outcomes reported to the owners. Accounting provides one such means for misrepresentation through its ability to represent outcomes from any course of action in more than one way.
Whereas moral hazard relates to the 'post-decision' consequences of information asymmetry, adverse selection is concerned with the 'pre-decision' situation. Since all the information that is available to the manager at the time a decision is made is not also available to the owner, then the owner cannot be sure that the manager made the right decision in the circumstances. In addition, the manager has no incentive to reveal what he knows since this will then make it easier for the principal to properly assess his actions in the future. This is known as 'information expectedness.
The existence of 'information asymmetry' means that for owners to obtain relevant information concerning the manager's effort, they must either rely on the communications received from the managers themselves, or must incur monitoring costs. An example of monitoring costs would include the annual audit of the firm's financial statements; indeed such auditing of financial statements was instituted as a means of safeguarding such investments in firms made by those who had no part in the operational activity of the firm. In the context of the agency relationship between top management and divisional management, such monitoring costs would include the cost of employing head office staff to monitor the performance of divisions.