Chapter 9

An Analysis of Conflict

9-1
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Chapter 9
An Analysis of Conflict

9-2
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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

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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

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9-4

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 riskaverse. Principal may be risk-averse, but assume
risk-neutral for simplicity
Principal wants agent to work hard, but
Agent is effort-averse

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9-5

Moral Hazard Problem of Information

Asymmetry
Principal cannot observe manager effort - call it a
Call managers 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?

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9-6

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

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9-7

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 managers
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

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9-8

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

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9-9

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

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9.4.2 Agency Contract Example

(continued)

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

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9.4.2 Agency Contract Example

(continued)

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Example 9.3 Agency Contract

Assumptions
Manager has 2 effort choices:
Work hard (a1 )
Shirk (a2 )

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

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Example 9.3 Agency Contract (continued)

Assumptions, contd
Managers contract (linear): c = ky, 0 k 1
y is net income
k is managers share of net income

Managers 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

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Example 9.3 Agency Contract (continued)

Managers utility
EUm(a1) = 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
EUm(a2) = 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

Owners utility (risk neutral)

EUO(a1) = 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

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Example 9.3 Agency Contract (continued)

Formal Statement of the Owners Problem
Find k to maximize
EUO(a)
Subject to:
Manager wants to take a1 (incentive compatibilityi.e.,
manager utility higher for a1 than a2)
manager receives reservation utility of R = 3

The result:
K = .3237

Continued

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Example 9.3 Agency Contract (continued)

Check
Managers utility
EUm(a1) = 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
EUm(a2) = 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

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Example 9.3 Agency Contract (continued)

Check, contd.
Owners utility
EUO(a1) = 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 owners utility of rental contract (Example
9.2) = 51
Contract based on net income is more efficient

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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

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Example 9.4 A More Efficient

Contract (continued)
Then
k = .3185 (compared with .3237 in previous contract)
EUm(a1) = 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
EUO(a1) = 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 owners utility of 55.4566 in Example 9.3

Less noisy net income increases contract efficiency
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9.5 Managers Information

Advantage
Post-decision information
Manager can observe unmanaged net income, but
owner cant
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

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9.5 Managers Information

Advantage (continued)
The revelation principle
If high net income is realized, manager will report high
net income
Raise managers 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

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9.5 Managers Information

Advantage (continued)
Example 9.5
Manager continues to shirk
Owners utility remains at 50.8165 as per example 9.5
But, manager reports truthfully
No adverse selection problem

Continued

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9.5 Managers 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

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9.5 Managers 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

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9.5 Managers 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
Owners utility now 55.4981, up from Examples 9.5 and
9.6 (50.8165)

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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

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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

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9.8.1 Holmstrms Agency Model

Basing managers compensation on 2 variables is
better than on 1 variable, unless the 2 variables
are perfectly correlated
Example 9.9

Holmstrms model implies that net income is in

competition with share price performance for
market share in compensation contracts
Continued

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9.8.1 Holmstrms 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

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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
Managers 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

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9.9 Reconciliation
Contract incompleteness and rigidity mean that
accounting policies matter
This argument does not conflict with efficient
securities market theory

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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

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