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Chapter 9

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

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  1. Chapter 9 An Analysis of Conflict

  2. Chapter 9An Analysis of Conflict

  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, 80 Investor REFUSE TO BUY (R) 35, 20 35, 30 • Continued

  4. 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

  5. 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

  6. 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?

  7. 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

  8. 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. 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

  10. 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

  11. 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

  12. 9.4.2 Agency Contract Example (continued)

  13. 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

  14. 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

  15. 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

  16. 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

  17. 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

  18. 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

  19. 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

  20. 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

  21. 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

  22. 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

  23. 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

  24. 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

  25. 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

  26. 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)

  27. 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

  28. 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

  29. 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

  30. 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

  31. 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

  32. 9.9 Reconciliation • Contract incompleteness and rigidity mean that accounting policies matter • This argument does not conflict with efficient securities market theory

  33. 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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