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Chapter 9. An Analysis of Conflict. Chapter 9 An Analysis of Conflict. 9.3 A Non-Cooperative Game. Table 9.1 UTILITY PAYOFFS IN A NON-COOPERATIVE GAME Manager HONEST (H) DISTORT (D) BUY (B) 60, 40 20, 80 Investor REFUSE

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chapter 9

Chapter 9

An Analysis of Conflict

9 3 a non cooperative game
9.3 A Non-Cooperative Game

Table 9.1 UTILITY PAYOFFS IN A NON-COOPERATIVE GAME

Manager

HONEST (H) DISTORT (D)

BUY (B) 60, 40 20, 80

Investor

REFUSE

TO BUY (R) 35, 20 35, 30

  • Continued
9 3 a non cooperative game continued
9.3 A Non-Cooperative Game (continued)
  • Nash equilibrium solution
    • RD: payoffs 35,30
  • Cooperative solution
    • BH: payoffs 60, 40
  • Single play of the game
    • Why is BH unlikely?
  • Multiple plays: BH more likely
    • Manager reputation and ethical behaviour
    • Folk theorem
9 4 agency theory
9.4 Agency Theory
  • A principal wants to hire an agent for some specialized task
    • Assume single-period, for simplicity
    • Agency models separation of ownership and control
  • Principal and agent are rational. Agent is risk-averse. Principal may be risk-averse, but assume risk-neutral for simplicity
  • Principal wants agent to work hard, but
    • Agent is effort-averse
moral hazard problem of information asymmetry
Moral Hazard Problem of Information Asymmetry
  • Principal cannot observe manager effort - call it a
  • Call manager’s disutility of effort V(a)
    • More effort ---> greater disutility
  • Implies manager may shirk on effort
    • E.g., if paid a fixed salary, how hard will the manager work?
    • Analogy: if no final exam, how hard will students work?
examples of agency contracts
Examples of Agency Contracts
  • What gives the following agents an incentive to “work hard” for the principal?
    • Doctor, dentist
    • Lawyer
    • Auditor
    • Hockey player
    • Construction worker
    • Manager
9 4 2 agency contract example
9.4.2 Agency Contract Example
  • Owner: rational, risk-neutral
    • Wants manager to work hard, to max. expected firm payoff x
      • Think of x as the total cash flow to be realized from manager’s current-period effort
  • Manager: rational, risk-averse and effort-averse
    • Wants to max. expected utility of compensation c, net of disutility of effort V(a)
      • If manager works hard, V(a) = 2 units of disutility
      • If manager shirks, V(a) = 1.71
          • Continued
9 4 2 agency contract example continued
9.4.2 Agency Contract Example (continued)
  • Motivating the manager to work hard
    • Salary: manager will shirk
    • Direct monitoring of manager effort: unlikely in owner/manager context. Manager will shirk
    • Indirect monitoring: Unlikely in owner/manager context unless moving support. Manager will shirk
    • Owner rents firm to manager: Manager will work hard, but manager bears all the risk, requires low rent for manager to attain reservation utility
    • Give manager a share of the payoff
          • Continued
9 4 2 agency contract example continued1
9.4.2 Agency Contract Example (continued)
  • A problem arises if manager paid a share of payoff
    • Firm payoff x not known until after contract expires (single period contract).
      • Some manager effort does not pay of in current period
        • e.g., R&D, contingencies
    • Manager has to be paid at contract expiry
  • A solution
    • Base manager compensation on a performance measure (e.g., net income), which is available at period end
          • Continued
9 4 2 agency contract example continued2
9.4.2 Agency Contract Example (continued)
  • To motivate manager effort, most efficient contract may base manager compensation on a share of firm net income
  • Will manager be willing to accept contract?
    • Concept of reservation utility, call it R
      • If manager is to work for owner, must receive expected utility of at least R
        • Level of R depends on manager reputation
        • R treated as fixed in a single-period contract
          • Continued
example 9 3 agency contract
Example 9.3 Agency Contract
  • Assumptions
    • Manager has 2 effort choices:
      • Work hard (a1 )
      • Shirk (a2 )
    • If manager works hard

x = 100 with prob. 0.6

x = 55 with prob. 0.4

    • If manager shirks

x = 100 with prob. 0.4

x = 55 with prob. 0.6

Note fixed support

          • Continued
example 9 3 agency contract continued
Example 9.3 Agency Contract (continued)
  • Assumptions, cont’d
    • Manager’s contract (linear): c = ky, 0 ≤ k ≤ 1
      • y is net income
      • k is manager’s share of net income
    • Manager’s reservation utility: R = 3
    • Quality of net income y (noisy, but unbiased, e.g., fair value accounting)
      • If x is going to be $100
        • y = $115 with prob. 0.8
        • y = $40 with prob. 0.2
      • If x is going to be $55
        • y = $115 with prob. 0.2
        • y = $40 with prob. 0.8
          • Continued
example 9 3 agency contract continued1
Example 9.3 Agency Contract (continued)
  • Manager’s utility

EUm(a1) = 0.6[0.8(k × 115)1/2 + 0.2(k × 40)1/2]

+ 0.4[0.2(k × 115)1/2 + 0.8(k × 40)1/2] - 2

EUm(a2) = 0.4[0.8(k × 115)1/2 + 0.2(k × 40)1/2]

+ 0.6[0.2(k × 115)1/2 + 0.8(k × 40)1/2] – 1.71

  • Owner’s utility (risk neutral)

EUO(a1) = 0.6[0.8(100 - (1 – k) × 115) + 0.2(100 - (1 – k) ×40)]

+ 0.4[0.2(55 - (1 – k) ×115) + 0.8(55 - (1 – k) × 40)]

          • Continued
example 9 3 agency contract continued2
Example 9.3 Agency Contract (continued)
  • Formal Statement of the Owner’s Problem
    • Find k to maximize

EUO(a)

Subject to:

      • Manager wants to take a1 (incentive compatibility—i.e., manager utility higher for a1 than a2)
      • manager receives reservation utility of R = 3
  • The result:

K = .3237

          • Continued
example 9 3 agency contract continued3
Example 9.3 Agency Contract (continued)
  • Check
    • Manager’s utility

EUm(a1) = 0.6[0.8(.3237 × 115)1/2 + 0.2(.3237 × 40)1/2]

+ 0.4[0.2(.3237 × 115)1/2 + 0.8(.3237 × 40)1/2] – 2 = 3

EUm(a2) = 0.4[0.8(.3237 × 115)1/2 + 0.2(.3237 × 40)1/2]

+ 0.6[0.2(.3237 × 115)1/2 + 0.8(.3237 × 40)1/2] – 1.71 = 2.9896

    • Manager wants to “work hard” since his/her utility is higher
          • Continued
example 9 3 agency contract continued4
Example 9.3 Agency Contract (continued)
  • Check, cont’d.
    • Owner’s utility

EUO(a1) = 0.6[0.8(100 - .3237 × 115) + 0.2(100 - .3237 ×40)]

+ 0.4[0.2(55 - .3237 ×115) + 0.8(55 - .3237 × 40)]

= 55.4566

Compare with owner’s utility of rental contract (Example 9.2) = 51

Contract based on net income is more efficient

example 9 4 a more efficient contract
Example 9.4 A More Efficient Contract
  • Retain Example 9.3 assumptions, except
    • Higher quality of net income y (less noisy, still unbiased)
      • If x is going to be 100
        • y = $110 with prob. 0.8462
        • y = $45 with prob. 0.1538
      • If x is going to be 55
        • y = $110 with prob. 0.1538
        • y = $45 with prob. 0.8462
          • Continued
example 9 4 a more efficient contract continued
Example 9.4 A More Efficient Contract (continued)
  • Then

k = .3185 (compared with .3237 in previous contract)

EUm(a1) = 0.6[0.8462(.3185 × 110)1/2 + 0.1538(.3185 × 45)1/2]

+ 0.4[0.1538(.3185 × 110)1/2 + 0.8462(.3185 × 45)1/2] – 2 = 3

EUO(a1) = 0.6[.8462(100 – (.3185 × 110) + 0.1538(100 - .3185 ×45)]

+ 0.4[.1538(55 – (.3185 ×110) + 0.8462(55 - .3185 × 45)]

= 55.8829

Compare with owner’s utility of 55.4566 in Example 9.3

Less noisy net income increases contract efficiency

9 5 manager s information advantage
9.5 Manager’s Information Advantage
  • Post-decision information
    • Manager can observe unmanaged net income, but owner can’t
    • In a single-period contract, rational manager will shirk and report highest possible net income
    • Example 9.5: Owner utility falls to 50.8165
          • Continued
9 5 manager s information advantage continued
9.5 Manager’s Information Advantage (continued)
  • The revelation principle
    • If high net income is realized, manager will report high net income
    • Raise manager’s compensation if low net income is realized to the point where same compensation is received whether net income is high or low
    • Then, if low net income is realized, manager is indifferent between reporting high or low net income
    • Assume if indifferent, manager will report low net income if low net income is realized
    • Result: manager reports truthfully
          • Continued
9 5 manager s information advantage continued1
9.5 Manager’s Information Advantage (continued)
  • Example 9.5
    • Manager continues to shirk
    • Owner’s utility remains at 50.8165 as per example 9.5
    • But, manager reports truthfully
      • No adverse selection problem
          • Continued
9 5 manager s information advantage continued2
9.5 Manager’s Information Advantage (continued)
  • Problems in applying revelation principle in a financial reporting context
    • Manager may be punished for reporting the truth
      • May be fired if low net income reported
    • Contract restrictions
      • If compensation is capped, manager is effectively punished for reporting net income higher than cap
    • Restrictions on ability to communicate
      • Reporting the truth may impose legal liability and reputation loss on manager and owner, effectively blocking honest communication
          • Continued
9 5 manager s information advantage continued3
9.5 Manager’s Information Advantage (continued)
  • Result of these problems is that it may be more efficient to allow some upwards earnings management
  • But manager will then overdose on earnings management
    • i.e., back to example 9.5
  • A solution: restrict earnings management through GAAP
          • Continued
9 5 manager s information advantage continued4
9.5 Manager’s Information Advantage (continued)
  • Example 9.7
    • Illustrates how GAAP can restrict earnings management to point where manager must work hard to attain reservation utility
    • Some earnings management remains, but under control
    • Owner’s utility now 55.4981, up from Examples 9.5 and 9.6 (50.8165)
9 8 implications of agency theory for financial accounting
9.8 Implications of Agency Theory For Financial Accounting
  • The agency relationship is a contract. Contracts are rigid
    • Implies accounting policy choice and changes to accounting policy matter
      • Manager will usually object to new accounting standards that:
        • Lower reported net income (why?)
        • Increase its volatility (why?)
          • Continued
9 8 implications of agency theory for financial accounting continued
9.8 Implications of Agency Theory For Financial Accounting(continued)
  • Net income must be jointly observable (i.e., by manager and owner)
    • Role for GAAP, audit
9 8 1 holmstr m s agency model
9.8.1 Holmström’s Agency Model
  • Basing manager’s compensation on 2 variables is better than on 1 variable, unless the 2 variables are perfectly correlated
    • Example 9.9
  • Holmström’s model implies that net income is in competition with share price performance for “market share” in compensation contracts
          • Continued
9 8 1 holmstr m s agency model continued
9.8.1 Holmström’s Agency Model (continued)
  • To maintain market share in compensation contracts, net income must be informative about manager effort
  • To be informative, net income must have
    • Sensitivity
    • Precision
  • These 2 desirable qualities usually have to be traded off
    • Similar to, but not same as, tradeoff between relevance and reliability
9 8 2 contract incompleteness rigidity
9.8.2 Contract Incompleteness & Rigidity
  • Basic reasons why accounting policies can have economic consequences
    • Incompleteness
      • Contracts cannot anticipate all possible state realizations
        • e.g., New accounting standards may arise during contract term
        • Manager’s net-income-based compensation may be affected
        • Debt covenant ration may be affected
    • Rigidity
      • Once signed, contracts hard to change
  • Result: accounting policies matter since they can affect contracts
9 9 reconciliation
9.9 Reconciliation
  • Contract incompleteness and rigidity mean that accounting policies matter
  • This argument does not conflict with efficient securities market theory
9 10 conclusions
9.10 Conclusions
  • Accounting policies (even without cash flow effects) can have economic consequences and securities markets can still be efficient
  • Role of net income in monitoring and motivating manager performance equally important as informing investors
  • Net income competes with share price as a performance measure
  • Some earnings management can be “good” if controlled by GAAP
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