Chapter 9

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# Chapter 9 - PowerPoint PPT Presentation

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

An Analysis of Conflict

### Chapter 9An 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

TO BUY (R) 35, 20 35, 30

• 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
• 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
• 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
• 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
• 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)
• 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 (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 (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
• 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)
• 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 (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 (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 (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 (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
• 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)
• 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

• 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
• 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
• Example 9.5
• Manager continues to shirk
• Owner’s utility remains at 50.8165 as per example 9.5
• But, manager reports truthfully
• 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
• 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
• 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
• 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)
• Net income must be jointly observable (i.e., by manager and owner)
• Role for GAAP, audit
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 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
• 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
• Contract incompleteness and rigidity mean that accounting policies matter
• This argument does not conflict with efficient securities market theory
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