Chapter 9 An Analysis of Conflict Copyright

Chapter 9 An Analysis of Conflict Copyright © 2009 by Pearson Education Canada 9 -1

Chapter 9 An Analysis of Conflict Copyright © 2009 by Pearson Education Canada 9 -2

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 Copyright © 2009 by Pearson Education Canada 3

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 Copyright © 2009 by Pearson Education Canada 4

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 riskaverse. Principal may be risk-averse, but assume risk-neutral for simplicity • Principal wants agent to work hard, but – Agent is effort-averse Copyright © 2009 by Pearson Education Canada 5

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? Copyright © 2009 by Pearson Education Canada 6

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 Copyright © 2009 by Pearson Education Canada 7

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 Copyright © 2009 by Pearson Education Canada 8

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 Copyright © 2009 by Pearson Education Canada 9

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 Copyright © 2009 by Pearson Education Canada 10

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 Copyright © 2009 by Pearson Education Canada 11

9. 4. 2 Agency Contract Example (continued) 12

Example 9. 3 Agency Contract • Assumptions – Manager has 2 effort choices: • Work hard (a 1 ) • Shirk (a 2 ) – 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 Copyright © 2009 by Pearson Education Canada 13

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 Copyright © 2009 by Pearson Education Canada 14

Example 9. 3 Agency Contract (continued) • Manager’s utility EUm(a 1) = 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(a 2) = 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(a 1) = 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 Copyright © 2009 by Pearson Education Canada 15

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 a 1 (incentive compatibility—i. e. , manager utility higher for a 1 than a 2) • manager receives reservation utility of R = 3 • The result: K =. 3237 » Continued Copyright © 2009 by Pearson Education Canada 16

Example 9. 3 Agency Contract (continued) • Check – Manager’s utility EUm(a 1) = 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(a 2) = 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 Copyright © 2009 by Pearson Education Canada 17

Example 9. 3 Agency Contract (continued) • Check, cont’d. – Owner’s utility EUO(a 1) = 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 Copyright © 2009 by Pearson Education Canada 18

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 Copyright © 2009 by Pearson Education Canada 19

Example 9. 4 A More Efficient Contract (continued) • Then k =. 3185 (compared with. 3237 in previous contract) EUm(a 1) = 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(a 1) = 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 Copyright © 2009 by Pearson Education Canada 20

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 Copyright © 2009 by Pearson Education Canada 21

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 Copyright © 2009 by Pearson Education Canada 22

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 Copyright © 2009 by Pearson Education Canada 23

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 Copyright © 2009 by Pearson Education Canada 24

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 Copyright © 2009 by Pearson Education Canada 25

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) Copyright © 2009 by Pearson Education Canada 26

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 Copyright © 2009 by Pearson Education Canada 27

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 Copyright © 2009 by Pearson Education Canada 28

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 Copyright © 2009 by Pearson Education Canada 29

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 Copyright © 2009 by Pearson Education Canada 30

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 Copyright © 2009 by Pearson Education Canada 31

9. 9 Reconciliation • Contract incompleteness and rigidity mean that accounting policies matter • This argument does not conflict with efficient securities market theory Copyright © 2009 by Pearson Education Canada 32

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 Copyright © 2009 by Pearson Education Canada 33