© 2006 Pearson Education Canada Inc.9-1 Conflict Resolution Game Theory Agency Theory

© 2006 Pearson Education Canada Inc.9-2 Agency Theory A principal wants to hire an agent for some specialized task –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

© 2006 Pearson Education Canada Inc.9-3 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?

© 2006 Pearson Education Canada Inc.9-4 Agency Contract Example 9.3 Owner: rational, risk-neutral –Wants to max. expected firm payoff x Manager: rational, risk-averse and effort- averse –Wants to max. expected utility of compensation c, net of disutility of effort V(a) –To overcome shirking, why not give manager a share of payoff?

© 2006 Pearson Education Canada Inc.9-5 Agency Contract Example 9.3 A problem arises: –Firm payoff not known until after contract expires (single period contract). Why? –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

© 2006 Pearson Education Canada Inc.9-6 Timeline for Agency Example

© 2006 Pearson Education Canada Inc.9-7 Motivation of Manager Effort 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

© 2006 Pearson Education Canada Inc.9-8 Assumptions for Agency Contract Example 9.3 Manager has 2 effort choices: –Work hard (a 1 ) –Shirk (a 2 ) If manager works hard, payoff is x = 100 with prob. 0.6 x = 50 with prob. 0.4 If manager shirks, payoff is x = 100 with prob. 0.4 x = 50 with prob. 0.6

© 2006 Pearson Education Canada Inc.9-9 Assumptions, cont’d. Manager’s contract (linear): c = ky, 0 ≤ k ≤ 1, where y is 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 = $125 with prob. 0.5 y = $75 with prob. 0.5 –If x is going to be 50 y = $62.50 with prob. 0.5 y = $37.50 with prob. 0.5

© 2006 Pearson Education Canada Inc.9-10 Assumptions, cont’d. Manager’s utility EU m (a 1 ) = 0.6[0.5(k × 125) 1/ (k × 75) 1/2 ] + 0.4[0.5(k × 62.50) 1/ (k × 37.50) 1/2 ] - 2 EU m (a 2 ) = 0.4[0.5(k × 125) 1/ (k × 75) 1/2 ] + 0.6[0.5(k × 62.50) 1/ (k × 37.50) 1/2 ] – 1.7 Owner’s utility (risk neutral) EU O (a 1 ) = 0.6[0.5((1 – k) × 125) + 0.5((1 – k) × 75)] + 0.4[0.5((1 – k) × 62.50) + 0.5((1 – k) × 37.50)]

© 2006 Pearson Education Canada Inc.9-11 Formal Statement of the Owner’s Problem Find k to maximize EU O (a) Subject to: Manager wants to take a 1 (incentive compatibility) manager receives reservation utility of R = 3 The result: K =.326

© 2006 Pearson Education Canada Inc.9-12 Check Manager’s utility EU m (a 1 ) = 0.6[0.5(.326 × 125) 1/ (.326 × 75) 1/2 ] + 0.4[0.5(.326 × 62.50) 1/ (.326 × 37.50) 1/2 ] – 2 = 3 EU m (a 2 ) = 0.4[0.5(.326 × 125) 1/ (.326 × 75) 1/2 ] + 0.6[0.5(.326 × 62.50) 1/ (.326 × 37.50) 1/2 ] – 1.7 = 2.96 Manager will work hard, (i. e., incentive compatible)

© 2006 Pearson Education Canada Inc.9-13 Check, cont’d Owner’s utility EU O (a 1 ) = 0.6{100 – [0.5(.326 × 125) + 0.5(.326 × 75)]} + 0.4{50 – [0.5(.326 × 62.50) + 0.5(.326 × 37.50)]} = 53.92

© 2006 Pearson Education Canada Inc.9-14 A More Efficient Contract, Example 9.4 Retain previous assumptions, except –Quality of net income y (less noisy, still unbiased) If x is going to be 100 y = $110 with prob. 0.5 y = $90 with prob. 0.5 If x is going to be 50 y = $55 with prob. 0.5 y = $45 with prob. 0.5

© 2006 Pearson Education Canada Inc.9-15 A More Efficient Contract, cont’d. Then k =.322 (compared with.326 in previous contract) EU m (a 1 ) = 0.6[0.5(.322 × 110) 1/ (.322 × 90) 1/2 ] + 0.4[0.5(.322 × 55) 1/ (.322 × 45) 1/2 ] – 2 = 3 EU m (a 2 ) < 3 can be verified EU O (a 1 ) = 0.6{100 – [0.5(.322 × 125) + 0.5(.322 × 75)]} + 0.4{50 – [0.5(.322 × 62.50) + 0.5(.322 × 37.50)]} = Owners utility g reater than previous contract

© 2006 Pearson Education Canada Inc.9-16 Implications of Agency Theory For Financial Accounting Net income matters 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?)

© 2006 Pearson Education Canada Inc.9-17 Implications, Cont’d. Net income must be jointly observable (i.e., by manager and owner) –Role for GAAP, audit

© 2006 Pearson Education Canada Inc.9-18 Implications, Cont’d. Holmström’s agency model –Basing manager’s compensation on 2 variables is better than on 1 variable, unless the 2 variables are perfectly correlated –This implies that net income is in competition with share price performance for “market share” in compensation contracts

© 2006 Pearson Education Canada Inc.9-19 Implications, Concl. To maintain market share, net income should be highly informative about manager effort –Properties net income needs to be highly informative Sensitivity –Net income responds to changes in manager effort Precision –Net income has low noise re effort

© 2006 Pearson Education Canada Inc.9-20 Implications, Concl. Unfortunately, sensitivity and precision must be traded off –Historical cost accounting Low sensitivity due to recognition lag High precision since relatively unaffected by market-wide factors –Fair value accounting High sensitivity due less recognition lag Low precision since affected by market-wide factors Fundamental problem of financial accounting theory –Most useful net income for investors is not necessarily the most informative about manager effort

© 2006 Pearson Education Canada Inc.9-21 Multi-Period Considerations Manager reputation and resulting value of manager on managerial labour market motivates effort Net income provides information to market about manager value Is agency contract still needed?

© 2006 Pearson Education Canada Inc.9-22 Multi-Period Considerations, Concl. Answer: yes Reason: managerial labour market does not fully operate properly, due to information asymmetry (moral hazard) For example, manager may disguise shirking by earnings management