Research Handbooks in Law and Economics series
Edited by Claire A. Hill and Brett H. McDonnell
Chapter 16: The Influence of Law and Economics on Law and Accounting: Two Steps Forward, One Step Back
Lawrence A. Cunningham 1. THEORY Models and their Limits Under agency theory, shareholders are treated as principals and corporate managers as agents. The theory, elaborated since the 1970s, notes how interests of principals and agents diverge. The cost of controlling that divergence and the cost of the part that cannot be controlled are called agency costs (Jensen & Meckling 1976; Tirole 2006). Agency costs are limited by various markets, especially capital and corporate control markets. In the law and accounting context, divergence of interests between managers and shareholders can be further reduced by investing in monitoring devices, such as internal controls, board oversight, and independent auditing, and bonding devices, principally transparent accounting and financial disclosure. To evaluate agency costs and ways to reduce them, scholars sought a proxy to express the shareholder interest and manager actions in relation to it. They found it in the efficient capital market hypothesis (ECMH), cornerstone of modern finance theory. For centuries, shareholders were seen to be interested in maximization of profits and managerial performance was measured in those terms. Beginning in the 1960s, theorists saw stock market price as a proxy for the shareholder interest. They developed the ECMH, a hypothesis that stock price incorporates all public information about a firm, including accounting measures of profits, and supplies a measure of value. The ECMH thus also suggests that stock price incorporated agency costs: companies with higher stock prices are better managed, posing lower agency costs, than those with lower prices (all other things being equal)...
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