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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


Chapter 9 an analysis of conflict

Chapter 9An 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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