Agency Loss: Definition & Examples

Instructor: Douglas Stockbridge

DJ Stockbridge is currently pursuing a Masters degree in Accounting.

In this lesson, you will learn about agency loss which arises when two parties in a relationship (an agent and a principal) have different goals/motivations.

You are the ''Cool'' Landlord

Imagine you are the landlord for this small apartment complex close to a college campus. The apartment complex is not owned by the school. In fact, it is owned by a multi-national apartment leasing company with headquarters in Paris, France. You were hired by that company to look after that apartment complex, and to make sure things did not get too ''rowdy.'' You started the job with the best of intentions, with a steely resolve, but your ''hard exterior'' is cracking.

Within the first week, you get invited to a party in one of the rooms. This is strictly prohibited. The company doesn't want the landlord to make an emotional connection to the tenants because they think the landlord will then unfairly favor those students. But on the other hand, how much harm can one party do? And no one at the company will ever know…

In this lesson, we'll ''unpack'' the example above. We'll define terms like who is the principal and agent. We'll describe what agency loss is, and then we'll give some examples in finance/accounting. Let's dive in!

Agency Loss

Before defining agency loss, we need to define some other terms, like a principal/agent relationship. The principal/agent relationship is when one party (principal) authorizes the other party (agent) to act on his or her behalf. In our example above, the multi-national apartment leasing company (principal) authorizes you (agent) to act on their behalf and monitor the property. Now, this relationship can get complicated and problems do arise when the two parties have misaligned goals and incentives.

For example, the multi-national company wants to keep the building, clean, free from needing renovations, and they want the lessees to have an enjoyable time. You (agent), have different goals. You may want to relive your college days, or appear to be cool in front of the tenants. To top it off, no one is monitoring your behavior. You can act however you want to act. This can create a big difference between how the principal wants you to act and how you actually act.

That difference is called agency loss. The formal definition for it is the difference between the best possible outcome for the principal and the actual actions of the agent. If the agent abides by what the principal wants, then agency loss is low. If the agent does not abide by those terms, then the difference between the two widens and agency loss increases.

Agency Loss Examples in Finance/Accounting

One of the most common agency relationship examples is that of the shareholder and the management team. Shareholders (principals) give money to finance a company. They bequeath the cash to management (agents) who are responsible for using the money to run the company, and if the company is successful enough, management will then give the shareholders a return on their investment through dividends or by buying back the company's shares. While there are some checks in place, like a Board of Directors who are responsible for monitoring the executive's actions, management often has the flexibility to do what it wants.

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