Chapter 9

An Analysis of Conflict

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

9-2
Copyright © 2009 by Pearson Education Canada
 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

Copyright © 2009 by Pearson Education Canada 9-3

 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

Copyright © 2009 by Pearson Education Canada 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 risk-
averse. Principal may be risk-averse, but assume
risk-neutral for simplicity
• Principal wants agent to work hard, but
– Agent is effort-averse

Copyright © 2009 by Pearson Education Canada 9-5

 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?

Copyright © 2009 by Pearson Education Canada 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

Copyright © 2009 by Pearson Education Canada 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 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

Copyright © 2009 by Pearson Education Canada 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

Copyright © 2009 by Pearson Education Canada 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

Copyright © 2009 by Pearson Education Canada 9 - 10

 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

Copyright © 2009 by Pearson Education Canada 9 - 11

 9.4.2 Agency Contract Example
(continued)

Copyright © 2009 by Pearson Education Canada 9 - 12

 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

Copyright © 2009 by Pearson Education Canada 9 - 13

 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

Copyright © 2009 by Pearson Education Canada 9 - 14

 Example 9.3 Agency Contract (continued)

• Manager’s 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
• Owner’s 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

Copyright © 2009 by Pearson Education Canada 9 - 15

 Example 9.3 Agency Contract (continued)

• Formal Statement of the Owner’s Problem

– Find k to maximize
EUO(a)
Subject to:
• Manager wants to take a1 (incentive compatibility—i.e.,
manager utility higher for a1 than a2)
• manager receives reservation utility of R = 3
• The result:
K = .3237

» Continued

Copyright © 2009 by Pearson Education Canada 9 - 16

 Example 9.3 Agency Contract (continued)

• Check
– Manager’s 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

Copyright © 2009 by Pearson Education Canada 9 - 17

 Example 9.3 Agency Contract (continued)

• Check, cont’d.
– Owner’s 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 owner’s utility of rental contract (Example

9.2) = 51
Contract based on net income is more efficient

Copyright © 2009 by Pearson Education Canada 9 - 18

 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

Copyright © 2009 by Pearson Education Canada 9 - 19

 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 owner’s utility of 55.4566 in Example 9.3

Less noisy net income increases contract efficiency

Copyright © 2009 by Pearson Education Canada 9 - 20

 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

Copyright © 2009 by Pearson Education Canada 9 - 21

 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

Copyright © 2009 by Pearson Education Canada 9 - 22

 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

Copyright © 2009 by Pearson Education Canada 9 - 23

 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

Copyright © 2009 by Pearson Education Canada 9 - 24

 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

Copyright © 2009 by Pearson Education Canada 9 - 25

 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)

Copyright © 2009 by Pearson Education Canada 9 - 26

 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

Copyright © 2009 by Pearson Education Canada 9 - 27

 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

Copyright © 2009 by Pearson Education Canada 9 - 28

 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

Copyright © 2009 by Pearson Education Canada 9 - 29

 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

Copyright © 2009 by Pearson Education Canada 9 - 30

 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

Copyright © 2009 by Pearson Education Canada 9 - 31

 9.9 Reconciliation

• Contract incompleteness and rigidity mean that

accounting policies matter
• This argument does not conflict with efficient
securities market theory

Copyright © 2009 by Pearson Education Canada 9 - 32

 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

Copyright © 2009 by Pearson Education Canada 9 - 33