Game Theory, Principal-Agent Problem & Arthur Andersen

“As the firm grew from a close-knit partnership to a globe-spanning behemoth, pressure to boost profits became intense. Andersen leaders responded by pushing partners to become salesmen — upsetting the delicate balancing act any auditor must perform between pleasing a client and looking out for the public investor.”

-Ken Brown, The Wall Street Journal

In game theory there is interesting concept of Principal- Agent Problem, which is also called as Agency Theory.

It belongs to the category of games with imperfect information in which one player (the principal) attempts to offer incentives to the other (the agent) to encourage the agent to act in the principal’s best interest.

An agency is the relationship between two parties, where one is a principal and the other is an agent who represents the principal in transactions with a third party. Agency relationships occur when the principals hire the agent to perform a service on the principals’ behalf. Principals commonly delegate decision-making authority to the agent’s ex. relationship between shareholders (Principals) and Managers (Agents).

P1_Ch2New_040

 

The problem arises where the two parties have different interests and asymmetric information (the agent having more information); such that the principal cannot directly ensure that the agent is always acting in its (the principal’s) best interests.

Agency-modelA

The principal-agent problem also develops when a principal creates an environment in which an agent has incentives to align its interests with those of the principal, typically through incentives.

“Waste Management paid Andersen $17.8 million in fees unrelated to the audit between 1991 and 1997, against audit fees of $7.5 million.”

-The Wall Street Journal

conflict

 

 

A good example of this is relationship between auditing firm Arthur Andersen (agent) and its clients like Enron, Waste Management, and WorldCom (principal). The principal had hired agent for auditing their books. But soon Andersen also started given non audit services to the clients ex. consulting services. The principal designed incentive structure in such a way that agent was more interested in non audit related services than doing their actual job. This created conflict of interest and soon Andersen was helping clients in committing financial frauds.

enronandersen

“The quiet dilution of standards and the rise of auditor-salesmen at Andersen are central to the scandals that have cost investors billions of dollars, eliminated thousands of jobs and threatened the retirement security of millions of citizens.”

-Chicago Tribune

Advertisements

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s