Chapter 9: An Analysis of Conflict

1. Vicki Curtis, Jeremy Wei, Jordan Hill, Cody Rice Chapter 9: An Analysis of Conflict

2. Agenda • Introduction to Game Theory • Non-Cooperative Game Theory • Cooperative Game Theory • Implications • Holmstrom • Reconciliation and Conclusion of Chapter 9 • Article: Project Earnings Manipulation: An Ethics Case Based on Agency Theory

3. Introduction to Game Theory • Underlies many current issues in financial accounting theory • Models the interaction of two or more players • Occurs in the presence of uncertainty and information asymmetry • Game theory is more complex than decision theory and the theory of investment

4. Another View • The number of players lies “in between” the number in single person decision theory and in markets. • In game theory the number of players is greater than one, but is sufficiently small

5. Types of Games • Many different types of games • Classified as cooperative or non-cooperative • Cooperative game: parties can enter into a binding agreement. • Non-cooperative game: an oligolopolistic industry is an example of a non-cooperative game

6. Non-Cooperative Game Theory

7. Single-Period Game • Constituencies of financial statement users • Both parties are aware of the other parties reactions in making their decisions • Game theory provides a framework for studying the conflict and predicting what decisions the other party will make • Classified as a non-cooperative game

8. Utility Payoffs in a Non-Cooperative Game

9. Answer • RD • Since both parties know the other parties strategy this is the only strategy pair that each party will be satisfied with his or her decision. • This is called the Nash Equilibrium

10. Trust-Based Multi-Period Game • Nash equilibrium suggests it is difficult to make longer-run conclusions from a single-period game • Single-period is repeated from an indefinite number of periods • Government intervention may change the pay-offs to enforce co-operation

11. Trust-Based Multi-Period Game

12. Answer • No • The manager will anticipate the investor’s move to sell at period 5 and as a result will distort at period 4. • At this point the manager’s payoff will be 200 rather than the 180 he would receive at period 5.

13. Trust-Based Multi-Period Game

14. Answer • Further to the strategy just explained, the game would continue to unravel as both parties anticipate that the other will end the game on their next turn. • This goes all the way back to period 1 where the investor will end the game and players receive the Nash equilibrium pay-offs of the single-period game

15. Co-operative Game Theory

16. Co-operative Theory • Involves two or more parties co-operating via binding contract • Two types of contracts • Employment contracts • Lending contracts

17. Agency Theory • A branch of game theory that studies the design of contracts to motivate a rational agent to act on behalf of a principal when the agent’s interest would otherwise conflict with those of a principal • Main concept is principal vs. agent

18. Game Inc. Agency Theory Illustration

19. Game Theory Outline • Owner • Maximize their payoff (expected cash flow) • First Best: option with highest pay off • Second Best: option with second highest pay off • Manager • Maximize their utility (expected benefit) • Agency Cost • Difference between first best and second best • Must minimize this cost

20. Game Inc. • Game Inc. is a company that has a single owner and single manager • Owner = principal • Manager = agent • Manager gets paid $25 per year • In this company, there are two possible payouts: • Good times (G) = $100 • Bad times (B) = $55

21. Payout and Utility • Payout • Represents the receipt of cash generated by the company • Measured by expected cashflows • E(cf) = p(x1) + p(x2)....p(xz) • Utility • Represents the net benefit for the manager’s effort • Measured by square root of monetary compensation net of disutility • E(u) = √(x) - D

22. Manager • The manager has two choices • Work hard • Slack off • If the manager works hard: • Probability of G = 0.6 • Probability of B = 0.4 • If the manager slacks off: • Probability of G = 0.4 • Probability of B = 0.6

23. Payoff Table

24. What the Owner Wants? • Managerial effort can increase the odds of a high payout (i.e. $100) • Therefore a rational owner would want the manager to work hard • Can be illustrated by their expected payoff: E(G) = 0.6(100-25) + 0.4 (55-25) = 57 E(B) = 0.4(100-25) + 0.4 (100-25) = 48

25. What the Manager wants? • A rational manager wants to maximize their utility • Remember: • Greater effort results in greater cost, therefore greater compensation must offset this EU(W) = √25 – 2 = 3 EU (S) = √25 – 1.71 = 3.29 • Manager will choose toslack off

26. What does this imply?

27. A Moral Hazard Exists! • Moral Hazard • Manager will choose to slack off despite the owner wanting them to work hard • Owner must find a way to overcome this moral hazard

28. What can the owner do? • Put up with manager slacking off • Direct monitoring of managerial performance • Indirect monitoring of managerial performance • Rent company to manager • Share pay off with manager • Remember: Must find the option that results in the highest pay off

29. Put up with slacking off • Owner allows manager to slack off • Evidently not ideal as this will not result in the highest expected pay off Agency Cost = 57 – 48 = 9

30. Direct Monitoring • Owner observes the actions of the manager to ensure they are working hard • Thus guarantee manager works hard (W) • Ideally, the best option as this guarantees the highest pay off (G) • Realistically, impossible as owners do not have the time or resources to do this • Results in an information asymmetry between manager and owner (moral hazard)

31. Indirect Monitoring • Owner were to determine the manager’s effort based on the ending payoff • If pay off = B, owner would know manager slacked off • Realistically impossible since there are external factors that could effect payoff • E.g. Recession, natural disaster, etc...

32. Owner rents the firm • Owner gives up the risks and rewards of Game Inc. in exchange for a guaranteed pay off of $51 • Manager will now be willing to work hard (W) since they take on risks and rewards • Not ideal since the pay off is below ideal Agency Cost = 57 – 51 = 6

33. Sharing profits with manager • Based on a performance measure, the owner could determine the pay of a manager • Net income is common measure • By sharing the risks, the manager becomes risk averse (rather than risk neutral) • Results in manager wanting to work hard • This is clearly most ideal option! 

34. Note about Net Income • Net Income does not represent pay off, it is an indicator of potential payoff • While it is the best indicator, it is not perfect • Imperfection due to: • Estimations • Accruals • As a result, there is a risk of noisy (imperfect) net income

35. Updated Probabilities • Due to imperfect net income, the probabilities are now updated: • If payoff is $100 – net income will be • 80% chance of $115 (correct) • 20% chance of $40 (incorrect) • If payoff is $55 – net income will be • 20% chance of $115 (incorrect) • 80% chance of $40 (correct)

36. What will Manager do? EU(W) = 0.6(0.8 √(0.3237 x 115) + 0.2 √(0.3237 x 40) + 0.4(0.2√(0.3237 x 115) + 0.2√(0.3237x40)) – 2 = 3 EU(S) = 0.4(0.8 √(0.3237 x 115) + 0.2 √(0.3237 x 40) + 0.6(0.2 √(0.3237 x 115) + 0.2 √(0.3237x40)) – 1.71 = 2.9896

37. What will the Owner get? E(W) = 0.6(0.8(100-0.3237 x 115)) + 0.2(100 – (0.3237 x 40)) + 0.4(0.2(55-(0.3237x115) + 0.8(0.3237x40)) = 55.456 Agency Cost = 57 – 55.456 = 1.544

38. Implications • Appears as though we have minimized the agency costs due to the moral hazard • If accountants can improve net income to better reflect pay off, imperfections can be reduced • Results in reduced compensation risk • Paying a manager for a high net income when the actual payoff will be low

39. Earnings Management • Example of Game Inc. assumed managers have no control over reporting process • Reality is that they do (positive accounting theory) • What does this mean? • Managers are able to manipulate numbers without the owner knowing

40. Controlling Earnings Management • Through regulations like GAAP, this can prevent absolute earnings management • Let’s now assume • Net income is a range • 115 = 111 – 116 • 40 = 36 – 41

41. What will the Manager do? EU(W) = 0.6(0.8√(0.3193x116) + 0.2 √(0.3193 x 41)) + 0.4(0.2 √(0.3193x116) + 0.8 √(0.3193 x 41) – 2 = 3 EU(S) = 0.4(0.8 √(0.3193x116) + 0.2 √(0.3193 x 41)) + 0.6(0.2 √(0.3193x116) + 0.8 √(0.3193 x 41) – 1.71 = 2.99 • As you can see, the owner will work hard

42. What happens to the Owner? E(W) = 0.6(0.8 (100- (0.3193 x 116) + 0.2(100 -(0.3193 x 41)) + 0.4(0.2(55- (0.3193 x 116) + 0.8(40 -(0.3193 x 41)) = 55.4981 Agency Cost – 57 – 55.4981 = 1.5091

43. Summary of Game Inc. • Evidently there will always be a moral hazard between managers and owners • Given the restrictions of owners ability to influence the managerial actions, there is an information asymmetry • Through accounting regulations (i.e. GAAP), accountants can influence managerial actions • Thus, reducing agency cost!

44. To summarize • Agency cost illustrates the role of accountants in financial reporting • Role 1: • Create accounting policies that can increase the accuracy of net income as a predictor • Role 2: • Create regulations that reduce a managers ability to manipulate net income

45. Bondholder-Manager Lending Contract

46. Bondholder-Manager Lending Contract • Principal cannot observe actions of manager • Moral hazard problem • Information Asymmetry • Conflict of interest

47. Bondholder-Manager Lending Contract • Divergence of Interests • Raising interest rates acts as a deterrent for managers • Reduce the cost of borrowing capital • Limit dividends • Limit additional borrowing

48. Implications of Agency Theory for Accounting • Recall: Agency theory • Compensate the managers as a part of the • Holmström Agency Model • Rigidity of Contracts

49. Holmström • Contributed to the agency model • Use of simultaneous performance measures • Net income • Share price performance • Performance Measure Characteristics

50. Performance Measure Characteristics • Sensitivity • Manager effort • Understand manager motivation • Reserve Recognition Accounting • Precision • A reciprocal of the variance of the noise • How good is it predicting payoff?