AGENCY THEORY The Agency Theory (Jensen and Meckling, 1976) depicts a principal-agent relationship between a firms management

and its shareholders. Managers are considered as agents, and their personal interests may not coincide with the interest of the company and its shareholders, who are considered as the principal. This conflict of interest is then referred to as the principalagent problem. A companys performance is somehow parallel to the managements performance. They are the ones who take credit for when a company performs well. This is why the management is one of those factors in question when a companys performance deteriorates. One can conclude that the management style was ineffective, the strategies they used were not thought of properly or they were simply lacking in terms of immediate action to a problem. This immense pressure may cause the managers to tweak the firms numbers, even if it may prove to be harmful to the shareholders in the long run. Jensen, M.C. & Meckling, W.H. (1976). Theory of the firm: Managerial behavior, agency costs, and owner-ship structure. Journal of Financial Economics. 3, 305-360. Ittonen, K. (2010). A theoretical examination of the role of auditing and the relevance of audit reports. Vaasan Yliopisto, opetusjulkaisuja, 61. Diamond, D. & R. Verrecchia (1991). Disclosure, Liquidity and the cost of capital. Journal of Finance, 46(4), 13251359.

SIGNALLING THEORY The Signaling Theory is related to the Agency Theory in that the management has the advantage of power over the information that is to be released for external investors (Ittonen, 2010). This theory states that it is the managements responsibility to help investors distinguish between the good and the bad companies. If the bad companies are overvalued and the good companies undervalued, the market will become inefficient; and this is all due to the possibility of information asymmetry, or relevant information which may not be known to all involved parties. Because of such asymmetric information, an incentive may arise for the agent (management) to fulfill his personal interests, whether or not it will affect the shareholders. Managers disclose pertinent information to the investors to retain control over the investors opinion on that company, even if this relevant information may not be accurate. As the information released by a company become more symmetric, the liquidity of the companys stock rises and the cost of capital decreases (Diamond and Verrecchia, 1991), therefore proving that smoothening out reports can really entice potential investors.