1. Semester 2, 20091 Seminar 7 – Contracting & Accounting Information 306-684 Financial Accounting

2. Semester 2, 20092 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.

3. Semester 2, 20093 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

4. Semester 2, 20094 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?

5. Semester 2, 20095 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

6. Semester 2, 20096 A Non-Cooperative Game Manager Utility payoffs to investor and manager HONEST (H) DISTORT (D) Investor BUY60 Inv, 40 Mgr20 Inv, 80 Mgr REFUSE35 Inv,20 Mgr35 Inv, 30 Mgr

7. Semester 2, 20097 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

8. Semester 2, 20098 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

9. Semester 2, 20099 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?

10. Semester 2, 200910 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

11. Semester 2, 200911 Cooperative Game - Agency Contract (an example cont.)

12. Semester 2, 200912 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

13. Semester 2, 200913 Cooperative Game - Agency Contract (an example cont.) Manager has 2 effort choices –Work hard (a 1 ) –Shirk (a 2 ) Manager is effort-averse, so assume –Disutility of effort level a 1 = 2 –Disutility of effort level a 2 = 1.71 Manager is risk-averse, so assume utility of remuneration is its square root

14. Semester 2, 200914 Cooperative Game - Agency Contract (an example cont.) If manager works hard, payoff is X 1 = 100 with probability of 0.6 X 2 = 55 with probability of 0.4 If manager shirks, payoff is X 1 = 100 with probability of 0.4 X 2 = 55 with probability of 0.6

15. Semester 2, 200915 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

16. Semester 2, 200916 Cooperative Game - Agency Contract (an example cont.) Manager’s utility: EU m (a 1 ) = 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 EU m (a 2 ) = 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) EU o (a 1 ) = 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)]

17. Semester 2, 200917 Cooperative Game - Agency Contract (an example cont.) Formal statement of owner’s problem: –Find k to maximise EU O (a) –Subject to: Manager wants to take a 1 (incentive compatibility) Manager receives reservation utility of 3 The result: –K = 0.3237

18. Semester 2, 200918 Cooperative Game - Agency Contract (cont.) Check: verify manager’s utility EU m (a 1 ) = 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 EU m (a 2 ) = 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!

19. Semester 2, 200919 Cooperative Game - Agency Contract (an example cont.) Check owner’s utility: EU O (a 1 ) = 55.4566 Compare to situation [Ex 9.2] where: 1.Owner has all risk, manager has fixed salary EU O (a 1 ) = 57, EU O (a 2 ) = 48 2. Manager has all risk, owner gets fixed rent of EU O $51 Thus, Risk & profit-sharing is an efficient contracting solution!!!

20. Semester 2, 200920 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!!!

21. Semester 2, 200921 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)

22. Semester 2, 200922 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

23. Semester 2, 200923 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?)

24. Semester 2, 200924 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

25. Semester 2, 200925 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???

26. Semester 2, 200926 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 income responds to changes in manager effort 2 Precision –Net income has low noise re effort –Net Income cannot do both

27. Semester 2, 200927 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

28. Semester 2, 200928 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 to measure payoff from current manager effort versus providing information about future performance

29. Semester 2, 200929 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.

30. Semester 2, 200930 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.