1. Copyright © 2009 by Pearson Education Canada 9 - 1 Chapter 9 An Analysis of Conflict

2. Copyright © 2009 by Pearson Education Canada 9 - 2 Chapter 9 An Analysis of Conflict

3. Copyright © 2009 by Pearson Education Canada 9 - 3 9.3 A Non-Cooperative Game Table 9.1 UTILITY PAYOFFS IN A NON-COOPERATIVE GAME Manager HONEST (H) DISTORT (D) BUY (B) 60, 40 20, 80 Investor REFUSE TO BUY (R) 35, 20 35, 30 »Continued

4. Copyright © 2009 by Pearson Education Canada 9 - 4 9.3 A Non-Cooperative Game (continued) Nash equilibrium solution –RD: payoffs 35,30 Cooperative solution –BH: payoffs 60, 40 Single play of the game –Why is BH unlikely? Multiple plays: BH more likely –Manager reputation and ethical behaviour –Folk theorem

5. Copyright © 2009 by Pearson Education Canada 9 - 5 9.4 Agency Theory A principal wants to hire an agent for some specialized task –Assume single-period, for simplicity –Agency models 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

6. Copyright © 2009 by Pearson Education Canada 9 - 6 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? –Analogy: if no final exam, how hard will students work?

7. Copyright © 2009 by Pearson Education Canada 9 - 7 Examples of Agency Contracts What gives the following agents an incentive to “work hard” for the principal? –Doctor, dentist –Lawyer –Auditor –Hockey player –Construction worker –Manager

8. Copyright © 2009 by Pearson Education Canada 9 - 8 9.4.2 Agency Contract Example Owner: rational, risk-neutral –Wants manager to work hard, to max. expected firm payoff x Think of x as the total cash flow to be realized from manager’s current-period effort Manager: rational, risk-averse and effort-averse –Wants to max. expected utility of compensation c, net of disutility of effort V(a) If manager works hard, V(a) = 2 units of disutility If manager shirks, V(a) = 1.71 »Continued

9. Copyright © 2009 by Pearson Education Canada 9 - 9 9.4.2 Agency Contract Example (continued) Motivating the manager to work hard –Salary: manager will shirk –Direct monitoring of manager effort: unlikely in owner/manager context. Manager will shirk –Indirect monitoring: Unlikely in owner/manager context unless moving support. Manager will shirk –Owner rents firm to manager: Manager will work hard, but manager bears all the risk, requires low rent for manager to attain reservation utility –Give manager a share of the payoff »Continued

10. Copyright © 2009 by Pearson Education Canada 9 - 10 9.4.2 Agency Contract Example (continued) A problem arises if manager paid a share of payoff –Firm payoff x not known until after contract expires (single period contract). Some manager effort does not pay of in current period –e.g., R&D, contingencies –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 »Continued

11. Copyright © 2009 by Pearson Education Canada 9 - 11 To motivate manager effort, most efficient contract may base manager compensation on a share of firm net income Will manager be willing to accept contract? –Concept of reservation utility, call it R If manager is to work for owner, must receive expected utility of at least R –Level of R depends on manager reputation –R treated as fixed in a single-period contract »Continued 9.4.2 Agency Contract Example (continued)

12. Copyright © 2009 by Pearson Education Canada 9 - 12 9.4.2 Agency Contract Example (continued)

13. Copyright © 2009 by Pearson Education Canada 9 - 13 Example 9.3 Agency Contract Assumptions –Manager has 2 effort choices: Work hard (a 1 ) Shirk (a 2 ) –If manager works hard x = 100 with prob. 0.6 x = 55 with prob. 0.4 –If manager shirks x = 100 with prob. 0.4 x = 55 with prob. 0.6 Note fixed support »Continued

14. Copyright © 2009 by Pearson Education Canada 9 - 14 Example 9.3 Agency Contract (continued) Assumptions, cont’d –Manager’s contract (linear): c = ky, 0 ≤ k ≤ 1 y is net income k is manager’s share of 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 = $115 with prob. 0.8 –y = $40 with prob. 0.2 If x is going to be $55 –y = $115 with prob. 0.2 –y = $40 with prob. 0.8 »Continued

15. Copyright © 2009 by Pearson Education Canada 9 - 15 Example 9.3 Agency Contract (continued) Manager’s utility EU m (a 1 ) = 0.6[0.8(k × 115) 1/2 + 0.2(k × 40) 1/2 ] + 0.4[0.2(k × 115) 1/2 + 0.8(k × 40) 1/2 ] - 2 EU m (a 2 ) = 0.4[0.8(k × 115) 1/2 + 0.2(k × 40) 1/2 ] + 0.6[0.2(k × 115) 1/2 + 0.8(k × 40) 1/2 ] – 1.71 Owner’s utility (risk neutral) EU O (a 1 ) = 0.6[0.8(100 - (1 – k) × 115) + 0.2(100 - (1 – k) × 40)] + 0.4[0.2(55 - (1 – k) × 115) + 0.8(55 - (1 – k) × 40)] »Continued

16. Copyright © 2009 by Pearson Education Canada 9 - 16 Example 9.3 Agency Contract (continued) Formal Statement of the Owner’s Problem –Find k to maximize EU O (a) Subject to: Manager wants to take a 1 (incentive compatibility—i.e., manager utility higher for a 1 than a 2 ) manager receives reservation utility of R = 3 The result: K =.3237 »Continued

17. Copyright © 2009 by Pearson Education Canada 9 - 17 Example 9.3 Agency Contract (continued) Check –Manager’s utility EU m (a 1 ) = 0.6[0.8(.3237 × 115) 1/2 + 0.2(.3237 × 40) 1/2 ] + 0.4[0.2(.3237 × 115) 1/2 + 0.8(.3237 × 40) 1/2 ] – 2 = 3 EU m (a 2 ) = 0.4[0.8(.3237 × 115) 1/2 + 0.2(.3237 × 40) 1/2 ] + 0.6[0.2(.3237 × 115) 1/2 + 0.8(.3237 × 40) 1/2 ] – 1.71 = 2.9896 –Manager wants to “work hard” since his/her utility is higher »Continued

18. Copyright © 2009 by Pearson Education Canada 9 - 18 Example 9.3 Agency Contract (continued) Check, cont’d. –Owner’s utility EU O (a 1 ) = 0.6[0.8(100 -.3237 × 115) + 0.2(100 -.3237 × 40)] + 0.4[0.2(55 -.3237 × 115) + 0.8(55 -.3237 × 40)] = 55.4566 Compare with owner’s utility of rental contract (Example 9.2) = 51 Contract based on net income is more efficient

19. Copyright © 2009 by Pearson Education Canada 9 - 19 Example 9.4 A More Efficient Contract Retain Example 9.3 assumptions, except –Higher quality of net income y (less noisy, still unbiased) If x is going to be 100 –y = $110 with prob. 0.8462 –y = $45 with prob. 0.1538 If x is going to be 55 –y = $110 with prob. 0.1538 –y = $45 with prob. 0.8462 »Continued

20. Copyright © 2009 by Pearson Education Canada 9 - 20 Example 9.4 A More Efficient Contract (continued) Then k =.3185 (compared with.3237 in previous contract) EU m (a 1 ) = 0.6[0.8462(.3185 × 110) 1/2 + 0.1538(.3185 × 45) 1/2 ] + 0.4[0.1538(.3185 × 110) 1/2 + 0.8462(.3185 × 45) 1/2 ] – 2 = 3 EU O (a 1 ) = 0.6[.8462(100 – (.3185 × 110) + 0.1538(100 -.3185 × 45)] + 0.4[.1538(55 – (.3185 × 110) + 0.8462(55 -.3185 × 45)] = 55.8829 Compare with owner’s utility of 55.4566 in Example 9.3 Less noisy net income increases contract efficiency

21. Copyright © 2009 by Pearson Education Canada 9 - 21 9.5 Manager’s Information Advantage Post-decision information –Manager can observe unmanaged net income, but owner can’t –In a single-period contract, rational manager will shirk and report highest possible net income –Example 9.5: Owner utility falls to 50.8165 »Continued

22. Copyright © 2009 by Pearson Education Canada 9 - 22 9.5 Manager’s Information Advantage (continued) The revelation principle –If high net income is realized, manager will report high net income –Raise manager’s compensation if low net income is realized to the point where same compensation is received whether net income is high or low –Then, if low net income is realized, manager is indifferent between reporting high or low net income –Assume if indifferent, manager will report low net income if low net income is realized –Result: manager reports truthfully »Continued

23. Copyright © 2009 by Pearson Education Canada 9 - 23 9.5 Manager’s Information Advantage (continued) Example 9.5 –Manager continues to shirk –Owner’s utility remains at 50.8165 as per example 9.5 –But, manager reports truthfully No adverse selection problem »Continued

24. Copyright © 2009 by Pearson Education Canada 9 - 24 9.5 Manager’s Information Advantage (continued) Problems in applying revelation principle in a financial reporting context –Manager may be punished for reporting the truth May be fired if low net income reported –Contract restrictions If compensation is capped, manager is effectively punished for reporting net income higher than cap –Restrictions on ability to communicate Reporting the truth may impose legal liability and reputation loss on manager and owner, effectively blocking honest communication »Continued

25. Copyright © 2009 by Pearson Education Canada 9 - 25 9.5 Manager’s Information Advantage (continued) Result of these problems is that it may be more efficient to allow some upwards earnings management But manager will then overdose on earnings management –i.e., back to example 9.5 A solution: restrict earnings management through GAAP »Continued

26. Copyright © 2009 by Pearson Education Canada 9 - 26 9.5 Manager’s Information Advantage (continued) Example 9.7 –Illustrates how GAAP can restrict earnings management to point where manager must work hard to attain reservation utility –Some earnings management remains, but under control –Owner’s utility now 55.4981, up from Examples 9.5 and 9.6 (50.8165)

27. Copyright © 2009 by Pearson Education Canada 9 - 27 9.8 Implications of Agency Theory For Financial Accounting 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?) »Continued

28. Copyright © 2009 by Pearson Education Canada 9 - 28 9.8 Implications of Agency Theory For Financial Accounting (continued) Net income must be jointly observable (i.e., by manager and owner) –Role for GAAP, audit

29. Copyright © 2009 by Pearson Education Canada 9 - 29 9.8.1 Holmström’s Agency Model Basing manager’s compensation on 2 variables is better than on 1 variable, unless the 2 variables are perfectly correlated –Example 9.9 Holmström’s model implies that net income is in competition with share price performance for “market share” in compensation contracts »Continued

30. Copyright © 2009 by Pearson Education Canada 9 - 30 9.8.1 Holmström’s Agency Model (continued) To maintain market share in compensation contracts, net income must be informative about manager effort To be informative, net income must have –Sensitivity –Precision These 2 desirable qualities usually have to be traded off –Similar to, but not same as, tradeoff between relevance and reliability

31. Copyright © 2009 by Pearson Education Canada 9 - 31 9.8.2 Contract Incompleteness & Rigidity Basic reasons why accounting policies can have economic consequences –Incompleteness Contracts cannot anticipate all possible state realizations –e.g., New accounting standards may arise during contract term –Manager’s net-income-based compensation may be affected –Debt covenant ration may be affected –Rigidity Once signed, contracts hard to change Result: accounting policies matter since they can affect contracts

32. Copyright © 2009 by Pearson Education Canada 9 - 32 9.9 Reconciliation Contract incompleteness and rigidity mean that accounting policies matter This argument does not conflict with efficient securities market theory

33. Copyright © 2009 by Pearson Education Canada 9 - 33 9.10 Conclusions Accounting policies (even without cash flow effects) can have economic consequences and securities markets can still be efficient Role of net income in monitoring and motivating manager performance equally important as informing investors Net income competes with share price as a performance measure Some earnings management can be “good” if controlled by GAAP