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Copyright 2009 by Pearson Education Canada9 - 1

Chapter 9An Analysis of Conflict

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Copyright 2009 by Pearson Education Canada9 - 2

Chapter 9An Analysis of Conflict

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Copyright 2009 by Pearson Education Canada 9 - 3

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, 80Investor

REFUSE

TO BUY (R) 35, 20 35, 30

Continued

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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

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9.4 Agency Theory

A principal wants to hire an agent for somespecialized task Assume single-period, for simplicity

Agency models separation of ownership and control

Principal and agent arerat ional

. Agent is risk-averse. Principal may be risk-averse, but assumerisk-neutral for simplicity

Principal wants agent to work hard, but Agent is effort-averse

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Moral Hazard Problem of Information

Asymmetry Principal cannot observe manager effort - call it a

Call managers 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?

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Examples of Agency Contracts

What gives the following agents an incentive to workhard for the principal? Doctor, dentist

Lawyer Auditor

Hockey player

Construction worker

Manager

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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 managerscurrent-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

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9.4.2 Agency Contract Example(continued)

Motivating the manager to work hard

Salary: manager will shirk

Direct monitoring of manager effort: unlikely inowner/manager context. Manager will shirk

Indirect monitoring: Unlikely in owner/manager contextunless 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

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A problem arises if manager paid a share ofpayoff 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 isavailable at period end

Continued

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To motivate manager effort, most efficient contractmay base manager compensation on a share of firmnet 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 utilityof at least R

Level of R depends on manager reputation

R treated as fixed in a single-period contract

Continued


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Example 9.3 Agency Contract

Assumptions Manager has 2 effort choices:

Work hard (a1) Shirk (a2)

If manager works hardx = 100 with prob. 0.6x = 55 with prob. 0.4

If manager shirksx = 100 with prob. 0.4x = 55 with prob. 0.6

Note fixed support

Continued

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Example 9.3 Agency Contract(continued)

Assumptions, contd

Managers contract (linear): c = ky, 0 k 1

y is net income

k is managers share of net income

Managers reservation utility: R = 3

Quality of net income y (noisy, but unbiased, e.g., fair valueaccounting)

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

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Managers utilityEUm(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

Owners utility (risk neutral)EUO(a1) = 0.6[0.8(100 - (1k) 115) + 0.2(100 - (1k) 40)]

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

Continued

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Formal Statement of the Owners Problem Find k to maximize

EUO(a)

Subject to: Manager wantsto take a1 (incentive compatibilityi.e.,

manager utility higher for a1 than a2)

manager receives reservation utility of R = 3

The result:K = .3237

Continued

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Check

Managers 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

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Check, contd.

Owners 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 owners utility of rental contract (Example

9.2) = 51

Contract based on net income is more efficient

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Example 9.4 A More EfficientContract

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

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Example 9.4 A More EfficientContract(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 owners utility of 55.4566 in Example 9.3

Less noisy net income increases contract efficiency

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9.5 Managers Information

Advantage

Post-decision information

Manager can observe unmanaged net income, butowner cant

In a single-period contract, rational manager will shirkand report highest possible net income

Example 9.5: Owner utility falls to 50.8165

Continued

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Advantage(continued)

The revelation principle If high net income is realized, manager will report high

net income

Raise managers compensation if low net income is

realized to the point where same compensation isreceived whether net income is high or low

Then, if low net income is realized, manager isindifferent between reporting high or low net income

Assume if indifferent, manager will report low netincome if low net income is realized

Result: manager reports truthfully

Continued

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Example 9.5

Manager continues to shirk

Owners utility remains at 50.8165 as per example 9.5

But, manager reports truthfully No adverse selection problem

Continued

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Problems in applying revelation principle in afinancial 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 effectivelypunished for reporting net income higher than cap

Restrictions on ability to communicate

Reporting the truth may impose legal liability andreputation loss on manager and owner, effectivelyblocking honest communication

Continued

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Result of these problems is that it may be moreefficient to allow some upwards earningsmanagement

But manager will then overdose on earningsmanagement

i.e., back to example 9.5

A solution: restrict earnings management

through GAAP

Continued

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Example 9.7

Illustrates how GAAP can restrict earnings managementto point where manager must work hard to attainreservation utility

Some earnings management remains, but under control

Owners utility now 55.4981, up from Examples 9.5 and

9.6 (50.8165)

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9.8 Implications of Agency TheoryFor Financial Accounting

The agency relationship is a contract. Contractsare rigid

Implies accounting policy choice and changes toaccounting policy matter

Manager will usually object to new accounting standardsthat:

Lower reported net income (why?)

Increase its volatility (why?)

Continued

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9.8 Implications of Agency TheoryFor Financial Accounting(continued)

Net income must be jointly observable (i.e., bymanager and owner)

Role for GAAP, audit

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9.8.1 Holmstrms Agency Model

Basing managers compensation on 2 variables is

better than on 1 variable, unless the 2 variablesare perfectly correlated

Example 9.9

Holmstrms model implies that net income is in

competition with share price performance formarket share in compensation contracts

Continued

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9.8.1 Holmstrms Agency Model(continued)

To maintain market share in compensationcontracts, net income must be informative aboutmanager effort

To be informative, net income must have Sensitivity

Precision

These 2 desirable qualities usually have to betraded off

Similar to, but not same as, tradeoff between relevanceand reliability

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9.8.2 Contract Incompleteness &Rigidity

Basic reasons why accounting policies can haveeconomic consequences Incompleteness

Contracts cannot anticipate all possible state realizations

e.g., New accounting standards may arise during contract term

Managers 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 canaffect contracts

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9.9 Reconciliation

Contract incompleteness and rigidity mean thataccounting policies matter

This argument does not conflict with efficient

securities market theory

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C i ht 2009 b P Ed ti C d 9 - 33

9.10 Conclusions

Accounting policies (even without cash floweffects) can have economic consequences andsecurities markets can still be efficient

Role of net income in monitoring and motivatingmanager performance equally important asinforming investors

Net income competes with share price as aperformance measure

Some earnings management can be good if

controlled by GAAP

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