The relevance of agency conflicts in small and medium enterprises

Yahya et al/ International Journal of Advanced and Applied Sciences, 3(7) 2016, Pages: 41‐45 42 It has been previously argued that agency theory is not relevant in the context of small businesses because owners and managers in small enterprises are same (Emery et al., 2004). However, it is purported that although the main agency conflicts in small enterprise is not usually between managers and owners but between outside and inside capitalists (Hand et al., 1982). Possible agency conflicts in small and medium enterprises are aggravated by information asymmetries emerging from lack of uniform, publicly available detailed accounting information. The main purpose of this study is to identify the agency conflicts and explore the agency theory in perspective of SMEs. Previous studies have focused less on the relevance of agency theory in small and medium businesses. 2. Literature review and hypothesis development In the initial phases of the foundation of an SME, the attention of its administration tends to be narrow, for instance, building associations with regulatory bodies, customers, suppliers and investors, final alterations to a product or service in preparation of its preliminary launch. A more sophisticated firm structure will be necessary, business will expand in the context of complexity, managerial scope and scale and eventually the SME will continue to grow if these primary stages are successful. SME does not function in a vacuity so it is influenced by external forces which need to be controlled by separate departments. Organizational sophistication requires adequate formulating and monitoring which newly developed SMEs usually do not possess. Therefore, business angels, financial institutions and private investors feel hesitate in providing external funding. SMEs are also deficient in the areas of financial and accounting reporting systems which is required for organizational sophistication. Moreover, when monitoring and managing SMEs become more complicated, it leads to separation of managerial control and ownership. With this separation, there is possibility that not all parties may share the objective of revenue generation leading to the adverse effect on SME performance (Berle and Means, 1932; Fama and Jensen, 1985; Jensen and Meckling, 1976). The conflict of objectives between owners and managers is not relevant in small businesses because ownership and management is not separated in these firms, however, it can be arisen in Medium enterprises if these are not owner-managed. Nonowner managers could work in their own best interest due to different priorities like power, personal prestige, firm’s valuation ratio, market share, risk taking, sales revenue, growth maximization and other related factors. Nevertheless, in most of the markets, the principalagent conflicts in SMEs are less prominent due to higher influence of owners in this sector. However, the conflicts between debt capital providers and managers are noticeable in small and medium enterprises. Conflicts in SME sector emerge between outsiders and insiders, i.e. providers of debt capital and agents. Mainly these conflicts arise due to information asymmetries. Managers in SME generally hold comparatively superior firm-specific information but they could conceal it from lenders or investors. Substantial information asymmetries can develop due to cultural factors, local disclosure requirements, and legal status of the SME, causing the debt provider to become the victim of moral hazard and adverse selection. 2.1. Debt maturity structure Researchers have addressed almost three agency conflicts between lenders and owners in determining the SMEs’ debt maturity. Myers (1977) has identified the problem of underinvestment in SMEs. Financial markets feel tentative in term of providing equity to SMEs because they are usually very much in debt. SMEs possess less fixed assets so due to their young nature, they enjoy greater growth opportunities. Therefore, it is suggested that underinvestment issue can be resolved by issuing debt with a shorter maturity with the settings of growth opportunities and debt. Secondly, as small businesses possess less fixed assets on their financial statements so the issue related to risk-shifting and asset substitution can also be observed in these businesses (Jensen and Meckling, 1976). In this case, monitoring the success of small ventures by debt provider become challenging. Thus, providing shortterm debt could also solve this problem as debt provider can evaluate the success of firm through utilization of borrowed funds. Thirdly, the issue of free cash flow or overinvestment has been identified by Jensen (1986). SMEs become increasingly complicated with their growth which also leads to separation of ownership and management (Schulze et al., 2001). Consistent with this argument, Stulz (1990) postulated that managers can be restricted from the exploitation of owner’s resources by utilizing financing policies. To mitigate this type of agency conflict or to restrict managers from overinvestment, debt payments (usually long-term debts) can also be used as a control mechanism. Prior studies suggested that agency conflicts stemming from debt contracts can be mitigated through an optimum policy for debt maturity (Lopez-Gracia and Mestre-Barberá, 2015). Debt overhang or underinvestment issue emerges when managers or owners in SMEs who obtain loan renounce positive NPV investments. In this scenario, the owner recognize that he or she will undertake all the risk of the investment with lower gain in business and higher benefits to creditor. Consequently, debt contracting in the present to invest current opportunities can cause an underinvestment issue in the future. This issue is specifically prominent in SMEs because usually there are highly in debt. Many researchers have suggested that this agency problem can be mitigated with the reduction in debt maturity as before the investment is made, the debt will be matured (Barnea et al., Yahya et al/ International Journal of Advanced and Applied Sciences, 3(7) 2016, Pages: 41‐45 43 1977; Smith, 2007). Thus, considering the postulations of previous studies, the hypothesis can be formulated as follows: H1: Underinvestment agency problem in SMEs is likely to be mitigated by reducing the debt maturity. The second agency problem face by SMEs is riskshifting or asset substitution problem as evaluated by Jensen and Meckling (1976). The problem arises when SME debt holders try to invest in risky projects instead of low risk ventures. At the expense of lender, SME owners make an attempt to enhance their wealth. This problem is mostly observed in small business ventures where owner realize that most of the risk burden has to face by creditor in case of business failure. Moreover, small business is already indebted so high risk-taking or venture failure will adversely affect creditor more than debtor. Therefore, to reduce this risk, creditors specify some rules and clauses while contracting debt. Moreover, Barnea et al. (1980) suggested that short-term debt policy can be utilized to mitigate this issue of moral hazard. Short-term debt financing will also allow the creditor to monitor the risk-taking behavior and firm performance on regular intervals (Jun and Jen, 2003). Myers (1977) also posited that this issue can also be resolved by matching the economic life of assets to debt maturity. The problem of asset substitution is more prominent in small firms due to the greater proportion of current assets rather than fixed asset. Therefore, it is hypothesized that: H2: Risk-shifting agency problem in SMEs is likely to be mitigated by aligning the economic life of assets to debt maturity. Free cash flow or overinvestment problem has not been viewed in small businesses where management and ownership remain in the hand of one person. However, with the expansion in business, owner allow someone else (agent) to take decision on his behalf to enhance profitability but it is possible that the agent will work in his own best interest. Moreover, the new decision makers could misuse the available free cash flows by investing them in unsuccessful ventures. There are less control structures and concentrated ownership in small firms; therefore, the issue of overinvestment becomes more prevalent in these firms (Danielson and Scott, 2007). Probably, small businesses renounce (foster) growth if the agency costs derived from overinvestment are higher (lower) than the benefits gained. However, it is suggested that agency costs can be minimized by investing in decision hierarchies. Despite of its prominence, there is lack of evidence in the perspective of SMEs’ ownershipmanagement separation. Moreover, the views regarding the solution to this agency problem are contrary. For instance, Kaplan (1999) suggested utilizing short-term debts for the superior monitoring, on the other hand, Hart and Moore (1995) have recommended that long-term debts can mitigate the overinvestment issue as it restricts managers from investment in less profitable projects by borrowing against future earnings. In the same lines, through evidence from Finish SMEs, LopezGracia and Mestre-Barberá (2015) also revealed that long-term debts could mitigate the overinvestment problem. Thus, considering all the arguments, following hypothesis has been generated: H3: Overinvestment agency problem in SMEs is likely to be mitigated by increasing the debt maturity. 2.2. Demand for audit Owing to the fact that agency conflicts emerge in SMEs with their growth and with the separation of ownership and management, the demand for audit service increase. Efficient auditing can mitigate the potential agency conflicts as it acts as monitoring mechanism (Niskanen et al., 2010). In developing countries, only large and public listed companies demand for the auditing of their financial statements. Most of the small and medium enterprises do not invest in the auditing of t