Financial Accounting Theory

Sixth Edition
William R. Scott

Chapter 9
An Analysis of Conflict
 How Is This Chapter Different?

• BEFORE in CAPM we have the “market” meaning everyone

else
• Market price is the consensus price of asset based on
everyone else in the market
• Individuals take market info as given as no power to change
the market
– Price taker
– Probability of events given by market / forecast
 How Is This Chapter Different?

• But in this chapter, there is only a few parties involved

• Now each party can influence the other party by their action
(no longer a price taker)
• Each party’s decision making process must also take the other
parties’ actions (or their potential actions) into account
– Interactivity
• Economic theory of games / game theory
 How Is This Chapter Different?

• Like playing rock, scissors, paper

• Conflict / potential conflict
• Uncertainty higher due to INTERACTIVITY between the
players
• Prisoner’s Dilemma
• Cooperative vs non-cooperative game
– Binding agreement vs binding agreement not possible or available
 Chapter 9
An Analysis of Conflict
 9.2 Game Theory

• Models a conflict situation between rational players

• Number of players
– More than 1
– Few enough that each player takes the actions of other players into
account
• Types of games
– Cooperative
• Binding agreement
– Non-cooperative
• No binding agreement
 9.3.1 A Single-Period 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
 A Single-Period 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
 9.3.2 A Multi-Period Game (optional section)

• Example 9.2
– A 5-period game
– If parties do not trust each other, game unravels to single-period
– If parties trust each other, game continues with probabilities shown.
• Note: trust is not complete but depends on difference between a player’s
expected payoff from continuing and payoff from ending the game
– How is trust maintained?
• Ethics
• Legal liability
• GAAP
 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

>> Continued
 Agency Theory (continued)

• 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?

>> Continued
 Agency Theory (continued)

• 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
 Agency Theory (continued)

• Agency contract example 9.3

– Owner: rational, risk-neutral
• Wants manager to work hard, to max. expected firm payoff
• Think of payoff 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 , net of disutility of effort V(a)
• More effort, less utility
– If manager works hard, V(a) = -2
– If manager shirks, V(a) = -1.71

» Continued
 Agency Theory (continued)

• Agency contract example 9.3 (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,
reducing contract efficiency
• Give manager a share of the payoff

» Continued
 Agency Theory (continued)

• Agency contract example 9.3 (continued)

– A problem arises if manager paid a share of payoff
• Firm payoff 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 which is available
at period end
– Performance measure must be jointly observable

» Continued
 Agency Theory (continued)

• Agency contract example 9.3 (continued)

– Net income as a performance measure
• To motivate manager effort, an efficient contract may offer the manager
compensation based 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
 Agency Theory (continued)

• Agency contract example 9.4

– Assumptions
• Manager has 2 effort choices:
– Work hard (a1 )
– Shirk (a2 )
• If manager works hard
payoff = 100 with prob. 0.6
payoff = 55 with prob. 0.4
• If manager shirks
payoff = 100 with prob. 0.4
payoff = 55 with prob. 0.6

Note fixed support

» Continued
 Agency Theory (continued)

• Agency contract example 9.4 (continued)

• Assumptions, cont’d
– Manager’s contract : compensation = k × net income, 0 ≤ k ≤ 1
– Manager’s reservation utility: R = 3
– Quality of net income (noisy, but unbiased, e.g., fair value accounting)
• If payoff is going to be $100
– Net income = $115 with prob. 0.8
– Net income = $40 with prob. 0.2

• If payoff is going to be $55

– Net income = $115 with prob. 0.2
– Net income = $40 with prob. 0.8

» Continued
 Agency Theory (continued)

• Agency contract example 9.4 (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
 Agency Theory (continued)

• Agency contract example 9.4 (continued0

– 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
 Agency Theory (continued)

• Agency contract example 9.4 (continued0

– 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
 Agency Theory (continued)

• Agency contract example 9.4 (continued0

– 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 9.3) = 51

 Agency Theory (continued)

• A more efficient contract, Example 9.5

– Retain example 9.4 assumptions, except
• Higher quality of net income (less noisy, still unbiased)
– If payoff is going to be 100
» Net income = $110 with prob. 0.8462
» Net income = $45 with prob. 0.1538

– If payoff is going to be 55
» Net income = $110 with prob. 0.1538
» Net income = $45 with prob. 0.8462

• What share of net income does manager now require to attain reservation
utility?

» Continued
 Agency Theory (continued)
• A more efficient contract, Example 9.5 (continued)
– 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 9.4
Less noisy net income increases contract efficiency
How can accountant decrease noise in net income?
 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 9.6: owner utility falls to 50.8165

» Continued
 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
 Manager’s Information Advantage (continued)

• Example 9.7
– Manager continues to shirk
– Owner’s utility remains at 50.8165 as per Example 9.6
– But, manager reports truthfully
• No adverse selection problem

» Continued
 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
 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 9.6
• A solution: restrict earnings management through GAAP:
Example 9.8

» Continued
 Manager’s Information Advantage (continued)

• Example 9.8 (optional)

– 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 9.6 and 9.7 (50.8165)
– Some earnings management can be “good” if controlled by GAAP
 9.8 Implications of Agency Theory for
Accounting
• 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 9.10
– Holmström’s model implies that net income is in competition with
share price performance for “market share” in compensation contracts

» Continued
 Implications of Agency Theory for
Accounting (continued)
• 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 two desirable qualities usually have to be traded off
• E.g., fair value accounting may be more sensitive than historical cost, but
less precise. Why?
 Implications of Agency Theory for Accounting
(continued)

• Contract incompleteness & rigidity

– These are 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: economic consequences
• I.e., accounting policies matter since they can affect contracts
 9.9 Reconciliation of Economic Consequences
and Securities Market Efficiency

• Contract incompleteness and rigidity mean that accounting

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

• Accounting policies (even without cash flow effects) can have

economic consequences but 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
• Role of GAAP in controlling earnings management