1. Kristen Eicher Michael Pegutter

2.  What is Game Theory?  Agency Theory  Game Theory in Action  Types of Games  Game Theory and Accounting Policy  Employment Contracts  Utility and Important Assumptions  Dealing with Moral Hazard  Manager’s Informative Advantage  Earnings Management Within GAAP  Bondholder-Manager Lending Contract  Management Performance Measures  Contract Rigidity  Efficient Securities Market and Economic Consequences  Conclusion

3.  Attempts to model the outcome of conflict between rational individuals  Conflict: exists when one party has the motivation to act in manner which is not optimal to another party  Differs from investment theory because playing against an opponent who can think

4.  Agency Theory: branch of game theory that studies the design of contracts to motivate a rational agent to act on behalf of the principal when the agent’s interests would otherwise conflict with those of the principal To make a contract binding:  Employment Contracts: between firm and top manager  Lending Contracts: between firm manager and bondholder

5. Manager Investor Honest (H)Distort (D) Buy (B)60,4020,80 Refuse (R)35,2035,30

6.  http://www.youtube.com/watch?v=ED9gaAb 2BEw&feature=fvwrel http://www.youtube.com/watch?v=ED9gaAb 2BEw&feature=fvwrel

7.  Read your situation and determine your strategy

8. Cooperative GamesNon-Cooperative Games  Existence of a binding contract  Cartel is an example; work together to maximize payout  Conflict exists

9. Manager Investor Honest (H)Distort (D) Buy (B)60,4020,80 Refuse (R)35,2035,30 Nash Equilibrium: given the strategy choice of the other player, each player is satisfied with his or her strategy

10. Manager Investor Honest (H)Distort (D) Buy (B)60,4020,80 Refuse (R)35,2035,30  Strategy pair: BH  Built on trust  Win-win situation and both parties receive a higher payout  Once trust is broken then will be difficult to achieve BH again, will go to RD

11.  Misused accrued liabilities in order to make the company appear profitable  Restatement of statements from 2000 to mid-2003 reduces losses by 505 million; restated twice and missed filing deadlines  Both SEC and RCMP launched formal investigations  June 19, 2009 – RCMP lays fraudulent charges against Dunn (former CEO) and two of his lieutenants Manager Investor Honest (H)Distort (D) Buy (B)60,4020,80 Refuse (R)35,2035,30

12.  Policy needs to protect both short and long- term interests  Regulations can reduce the payoffs for certain actions; jail time and legal fees if caught distorting reduces the payout  Enron and Sarbanes-Oxley Act (2002) ◦ Senior management needs to certify accuracy of statements ◦ Internal controls needs to be developed and tested

13. Manager’s Effort a 1 (work hard)b 1 (shirk) PayoffProbabilityPayoffProbability x 1 (high payoff)$1000.6$1000.4 x 2 (low payoff)$550.4$550.6 Why is the probability of a high payoff higher when the manager works hard? Why is there still a probability that a low payoff will occur if the manager works hard?

14.  Utility: degree of satisfaction towards a strategy  Disutility: degree of effort which needs to be put forth to receive payout – “the work you put in”  Reservation Utility: compensation offered must be sufficiently large that expected utility is at least equal to the opportunity cost  Manager is “effort-averse”

15. Assume manager is getting paid $25  Firm Owner’s EU EU O (a 1 ) = 0.6(100 – 25) + 0.4 (55 – 25) = 57 EU O (a 2 ) = 0.4(100 – 23) + 0.6 (55 – 25) = 48  Manager’s EU ◦ Assume disutility of effort for a 1 = 2.0 and a 2 = 1.71 EU m (a 1 ) = (√25) – 2.0 = 3 EU m (a 2 ) = (√25) – 1.71 = 3.29

16. 1. Let the manager shirk 2. Direct monitoring 3. Indirect monitoring 4. Owner rents firm to the manager 5. Give the manager a share of profits

17. 2. Direct Monitoring3. Indirect Monitoring  Observe the employee and reduce their pay when shirk  Working hard will increase manager’s EU, motivating to work hard  Observe at end of period  Adjust salary based on state achieved

18.  Internalizing means the owner does not care what payout occurs because they will be paid fixed amount regardless ◦ Onus to perform is on manager because incur all the risk and benefit  What effect will this have on accounting practices used?

19.  Owner needs to compensate manager when results not seen until next period ◦ Performance Measure: results seen in same period and reflect manager performance ◦ Net income often used  Noisy because of lag recognition and biased internal control What is our role as accountants here?

20.  Holding key employees to “financial measures” like net income, revenue and ROI  Regulators have pushed banks to design pay packages for top employees that would discourage excessive risk-taking  The payouts may be halted or reclaimed if the firm determines, for example, that an employee engaged in “materially improper risk analysis or failed sufficiently to raise concerns about risks ”

21. Earnings Management  Managers have explicit information about earnings and can choose to manage results for their own benefit  Pre-Contract Information: manager has access to payoff information before signing the contract  Pre-Decision Information: manager obtains payoff information after signing the contract but before choosing an action  Post-Decision Information: manager receives information after action is chosen  Manager shirks, which decreases owner utility and results in lower Net Income

22. Revelation Principle  Can motivate truthful reporting by giving same compensation regardless of net income  Conditions for constant compensation contracts: ◦ Owner commitment that the truth will not be used against the manager ◦ No restrictions of the form of the contract ◦ No restrictions on manager’s ability to honestly communicate information  Increases investor confidence that reported Net Income is free from distortion and bias, reducing adverse selection and bettering the owner’s position

23. Controlling Earnings Management  GAAP allows discretion for choice among accounting policies but limits amount by which earnings can be management  Giving Net Income in a range of potential outcomes provides clearer idea of possible future state and ensures earnings management within GAAP measures

24.  Identified Net Income Range: $110 - $115  Unmanaged Net Income: $112  Reported Net Income: $115  Earning’s Management Applied: ◦ Changing amortization method ◦ Accelerating revenue recognition ◦ Asset reclassification

25. 1. Owner unlikely to observe manager’s effort leading to moral hazard and manager shirking. Agency theory seeks the most efficient contract. 1. Most efficient contract depends on what can be jointly observed. May be effort, payoff, Net Income, or resort to rental contract. 1. Second best contract imposes lowest amount of risk on manager while maintaining incentive to work hard and reservation utility. Improve precision of Net Income as payoff predictor. 1. Manager controls accounting system and has information advantage leading to earnings management. Using GAAP to limit earnings management contracts can maintain manager’s incentive to work hard.

26.  Payoff is conditional on manager’s actions  Manager may act contrary to best interest of lender depending on his/her own share of Net Income; bondholders will anticipate this risk and raise demanded interest rates or contract covenants

27.  Holström discusses compensation based on more than one performance measure  Performance measure characteristics: ◦ Sensitivity ◦ Precision  Challenge to determine which measures are most useful, sensitivity and precision not necessarily align with investor requirements of relevance and reliability  How do you think an additional performance measure impacts the manager’s effort?

28.  Eu m (a 1 ) = 3  Eu m (a 2 ) = 3  Eu o (a 1 ) = 55.552

29.  Compensation packages based on net income and share price  Motivates management to commit to corporate goals and profits  Achieving ROE of >15% by 2015 as priority for operational objectives on 2010 financial reports

30.  Virtually impossible to anticipate all contingencies and possible states of nature when enter into contracts  Renegotiation abilities can reduce manager motivation to act in the owner’s best interest  Unforeseen state realizations impose costs to firm and/or manager

31.  IFRS changes treatment of specific items and acceptable accounting policies  May affect bottom line results, which may create violations of returns/covenants within a contract  Can lead to costly court fees and lengthy processes to change the terms of the agreement

32.  High performance = high payoff = happy stakeholder  Efficient securities market theory measures economic consequences from accounting policies affecting expected cash flows  Contract agency model incorporates economic consequences caused by contract rigidities and binding obligations  Positive accounting theory reconciles the two with normative agency supporting why each party entered the contract

33. 1. Agency model reconciles efficient securities market with economic consequences 1. Describes Net Income’s role in monitoring management performance as well as capital generation 1. Net Income competes with other performance measures for compensation and management effort 1. Earnings management allows for shirking, resulting in low payoffs for owner and investor. GAAP restores management’s incentive to work hard through controlling earnings management

34. Questions?

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