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

2. © 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

3. © 2006 Pearson Education Canada Inc.9-3 Moral Hazard Problem of Information Asymmetry Principal cannot observe manager effort - \ 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?

4. © 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?

5. © 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

6. © 2006 Pearson Education Canada Inc.9-6 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

7. © 2006 Pearson Education Canada Inc.9-7 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?)

8. © 2006 Pearson Education Canada Inc.9-8 Implications, Cont’d. Net income must be jointly observable (i.e., by manager and owner) –Role for GAAP, audit

9. © 2006 Pearson Education Canada Inc.9-9 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