Seminar 7 – Contracting & Accounting Information

1. Seminar 7 – Contracting & Accounting Information 306-684 Financial Accounting Semester 2, 2009

2. Learning Objectives • To reinforce the existence of moral hazard arising from information asymmetry; • To formally model agency relationships as non-cooperative or co-operative games; • To examine the role of accounting in performance measurement and efficient contracting. Semester 2, 2009

3. The story so far (part (iii)) … • Managers are agents who act on behalf of principals (shareholders and debtholders); • Managers have an information advantage and hence may succumb to moral hazard; • Managers may shirk and still be rewarded above their real performance; • Managers are rationally maximising their own utility at the expense of principals Semester 2, 2009

4. Moral Hazard Problem of Information Asymmetry • Principal wants agent to work hard, but rational agents are likely to be effort-averse; • Principal cannot observe manager effort; • Managers may experience disutility from additional working/effort; • Greater effort, greater disutility • Implies manager may shirk on effort • if paid a fixed salary, why work hard? Semester 2, 2009

5. Game Theory • Theory seeking to draw a parallel between the behaviour of participants in games of chance and strategy (such as chess) and behaviour of firms or people in small groups • Use Game Theory to better understand accounting policy choices • Non-cooperative v cooperative games Semester 2, 2009

6. A Non-Cooperative Game Manager Semester 2, 2009

7. A Non-Cooperative Game • Manager • If manager chose H, investor would choose ……………, therefore rule out………… • If manager chose D, investor would choose ……………, therefore rule out………… • Investor • If investor chose B, manager would choose ……………, therefore rule out………… • Strategy pair not subject to this problem is ……………, • if manager chose D, investor would choose…….., if investor chose R, manager would…………. (Nash equilibrium) • However the Nash equilibrium is not a completely satisfactory outcome of the game. • Both parties would be better off if ……….were chosen. This is called the cooperative solution Semester 2, 2009

8. A Non-cooperative Game • Nash equilibrium – neither player can be better off, given the other player’s strategy • A sub-optimal solution – both would be better off under B, H • If investor chose to B, rational manager would prefer D, hence investor would choose R, then market for the firm’s shares would not work very well • A better solution • Long-run perspective • If the game was repeated indefinitely, and the manager was always honest, then investors would choose B • Change the payoffs • To work, the players must not have too high a discount rate • If investor chose B, the value to the manager of the immediate payoff of $80 may exceed the PV off the $10 reduction in future period ($40 - $30) when the investor switches to R • Enter a binding agreement (contract) → cooperative game Semester 2, 2009

9. A model of Cooperative Game Theory - Agency Contract (an example) • Owner: rational, risk-neutral, • Wants to max. expected firm payoff x • Manager: rational, risk-averse and effort-averse • Wants to maximise expected utility of compensation (c), net of disutility of effort • To overcome shirking, why not give manager a share of payoff? Semester 2, 2009

10. Cooperative Game - Agency Contract (an example cont.) • A problem arises: • Firm payoff not known until after contract expires (single period contract). Why? • Manager has be paid at contract expiry • A solution: • Base manager compensation on a performance measure (e.g. net income), which is available at period end Semester 2, 2009

11. Cooperative Game - Agency Contract (an example cont.) Semester 2, 2009

12. Cooperative Game - Agency Contract (an example cont.) • To motivate manager effort, give manager a share of firm net income • Concept of reservation utility • Call it R • If manager is to work for owner, must receive expected utility of at least R • Assume reasonably efficient managerial labour market Semester 2, 2009

13. Cooperative Game - Agency Contract (an example cont.) • Manager has 2 effort choices • Work hard (a1) • Shirk (a2) • Manager is effort-averse, so assume • Disutility of effort level a1 = 2 • Disutility of effort level a2 = 1.71 • Manager is risk-averse, so assume utility of remuneration is its square root Semester 2, 2009

14. Cooperative Game - Agency Contract (an example cont.) • If manager works hard, payoff is X1 = 100 with probability of 0.6 X2 = 55 with probability of 0.4 • If manager shirks, payoff is X1 = 100 with probability of 0.4 X2 = 55 with probability of 0.6 Semester 2, 2009

15. Cooperative Game - Agency Contract (an example cont.) • Manager’s reservation utility: R = 3 • Quality of net income = y (noisy but unbiased measure of payoff) If x is going to be 100 • Y = $115 with probability of 0.8 • Y = $40 with probability of 0.2 If x is going to be 55 • Y = $115 with probability of 0.2 • Y = $40 with probability of 0.8 • Noise in Net Income can be due to • Failure of corporate governance, such as weak internal controls, which allow random error or bias into net income • Recognition lag, that is several components of manager effort may not fully pay off during the current period, e.g. R&D Semester 2, 2009

16. Cooperative Game - Agency Contract (an example cont.) • Manager’s utility: EUm(a1) = 0.6[0.8(k x 115)½ + 0.2(k x 40)½] + 0.4[0.2(k x 115)½ + 0.8(k x 40)½] – 2 EUm(a2) = 0.4[0.8(k x 115)½ + 0.2(k x 40)½ ] + 0.6[0.2(k x 115)½ + 0.8(k x 40)½] – 1.71 • Owner’s utility (risk neutral) EUo(a1) = 0.6 [0.8((1 – k) x 115) + 0.2((1 – k) x 40)] + 0.4 [0.2((1 – k) x 115) + 0.8((1 – k) x 40)] Semester 2, 2009

17. Cooperative Game - Agency Contract (an example cont.) • Formal statement of owner’s problem: • Find k to maximise EUO(a) • Subject to: • Manager wants to take a1 (incentive compatibility) • Manager receives reservation utility of 3 • The result: • K = 0.3237 Semester 2, 2009

18. Cooperative Game - Agency Contract (cont.) Check: verify manager’s utility EUm(a1) = 0.6[0.8 (0.3237 x 115)½ + 0.2 (0.3237 x 40)½] + 0.4[0.2 (0.3237 x 115)½ + 0.8 (0.3237 x 40)½] - 2 = 3 EUm(a2) = 0.4[0.8(0.3237 x 115)½ + 0.2 (0.3237 x 40)½] + 0.6[0.2(0.3237 x 115)½ + 0.8 (0.3237 x 40)½] - 1.7 = 2.96 • So manager will work hard! Semester 2, 2009

19. Cooperative Game - Agency Contract (an example cont.) Check owner’s utility: EUO(a1) = 55.4566 Compare to situation [Ex 9.2] where: • Owner has all risk, manager has fixed salary EUO (a1) = 57, EUO (a2) = 48 2. Manager has all risk, owner gets fixed rent of EUO $51 Thus, Risk & profit-sharing is an efficient contracting solution!!! Semester 2, 2009

20. So far, so good……… • We can design efficient contracts to motivate manager performance • See Ex 9.8 for debt contracts • Both contracting parties are better off, relative to the non-cooperative solution • BUT, we have a problem • Net income is noisy, AND • Net income is not necessarily unbiased!!! Semester 2, 2009

21. Back to information asymmetry…….. • Owner can only observe reported net income • Managers know actual net income • But rational investors will assume managers may be biasing (managing) earnings (More on earnings management in forthcoming seminars) Semester 2, 2009

22. Implications for Financial Accounting • Net income matters!!! • The agency relationship is a contract. • Contracts are incomplete (cannot foresee every possible state of nature realizable) • Implies that some flexibility in accounting choice is essential Semester 2, 2009

23. Implications for Financial Accounting • Implies that 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?) Semester 2, 2009

24. Implications for Financial Accounting • Net income must be jointly observable by manager and owner • Earnings management constraints : • GAAP (including accounting standards) • Contracts based on the set of accepted accounting choices • Conservative, to restrict earnings management • But some choice, as incomplete contracts • Existence of audit • Indirect monitoring Semester 2, 2009

25. Performance Measures • Holmstrom’s agency model • Basing manager’s compensation on 2 variables is better than on 1 variable • Share price is informative about manager effort (includes things not recognised in earnings, e.g. R&D) • Share price also a noisy measure • Subject to economy-wide events • The problem: proportion of compensation based on income versus share price??? Semester 2, 2009

26. Performance Measures • To be used in compensation contracts, net income should be highly informative about manager effort • Properties: net income needs to be highly informative 1 Sensitivity • Net incomeresponds to changes in manager effort 2 Precision • Net incomehas low noise re effort • Net Income cannot do both Semester 2, 2009

27. Performance Measures • BUT, sensitivity and precision must be traded off • Historical cost • Lower sensitivity due to recognition lag • Higher precision, relatively unaffected by market-wide factors • Fair value accounting • Higher sensitivity – less recognition lag • Lower precision – affected by market-wide factors Semester 2, 2009

28. The Fundamental Conflict • We are back to the fundamental conflict in financial accounting theory • The most useful measure of net income for investors is not necessarily the most informative about manager effort! • The issue is tomeasure payoff from current manager effort versus providing information about future performance Semester 2, 2009

29. Reconciliation with EMH • Accounting policy choices/changes with no direct cash flows do matter (they have economic consequences) as they determine contractual payoffs; • Rational explanation for conservatism: • A systematic bias relative to ideal fair value, BUT • Capital markets perspective – a signal of quality, reliability; • Contracting perspective – a constraint on managers’ opportunistic earnings management. Semester 2, 2009

30. Conclusions • Accounting choices matter as they determine contractual payoffs • Efficient contracting increases the payoffs for both contracting parties • Accounting income (and share price) are used as measures of payoff from manager effort • Incomplete contracts and indirect monitoring means opportunism could still occur. Semester 2, 2009