Presentation that their expected utility is at least

Presentation that their expected utility is at least

Presentation Summary Chapter 9 -­? An analysis of conflict 9. 1 & 9. 2 Understanding game theory Game theory: Attempts to model and predict the outcome between rational individuals. -­? Helps us understand how managers, investors and other affected parties can rationally deal with the economic consequences of financial reporting. • • • Presence of uncertainty and information asymmetry Each player is assumed to maximize his expected utility Each player takes the actions of the other players into account Types of games: -­? Cooperative game: The parties can enter in a binding agreement ( Ex:Cartel ) -­? Non-­? cooperative game: When a biding agreement is not possible ( Ex: Oligopolistic industry ) 9. 3 A non-­? cooperative game model Investor interests: • Relevant and reliable financial statements in order to assess risk for decision-­? making Manager interests: • • • Omit liabilities from balance sheet May prefer not to reveal accounting policies being used (Discretionary accruals) Present the firm in the best light (bias) = Conflicting interests Example 9.

1: Both parties would be better if BH (Investor buy, manager honest) were chosen = Cooperative solution Will end up at nash quilibrium= Investors refuse to buy, manager distort (RD) 9. 4 Some Models of Cooperative Game Theory 9. 4. 1 Introduction Essence of cooperation in game theory is that the players involved in a conflict situation can enter into agreements that they believe as binding. = called contracts 2 types of contracts with implications for financial accounting theory: 1.

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Employment contracts: between firm (principal) and top manager (agent) – focus of discussion 2. Lending contracts: between firm manager and bondholder Agency theory :A branch of game theory that studies the design of contracts to motivate rational agent to act on behalf of a principal when the agent’s interests would otherwise conflict with those of the principal. 9. 4. 2 Agency Theory: Employment Contract Between Firm Owner and Manager • States of nature are assigned to expected payoffs, which in turn are a function of the action the manager chooses. The action that the manager chooses affects the distribution of the payoffs. -­? > The greater effort exerted by the manager, the greater the probability of a high payoff, and vice versa.

Sometimes the full payoff is not observable until after current compensation contract has xpired. -­? -­? *Owner’s ultimate interest is maximizing expected payoff, net of manager compensation. • In the case of the manager, there is a reservation utility, which is the minimum utility the manager will except before going elsewhere. The compensation offered must be large enough that their expected utility is at least equal to if not greater to its opportunity cost. Each player chooses the act that maximizes his own expected utility.

-­? > Owner wants the manager to work harder but the manager is effort-­? averse. Contracts to Moral Hazard: (1) Hire the manager and put up with the hirking (2) Direct Monitoring: This type of contract is called first-­? best because the owner gains the maximum utility and the manager gains the reservation utility. (3) Indirect Monitoring: Involves moving support versus fixed support.

Moving support is where the set of possible payoffs is different depending on the action taken. (4) Owner rents firm to the manager: The manager pays the owner a fixed rental payment and the manager takes over 100% of the profit. Agency Cost problem. a. A component of contracting costs which the owner will want to minimize.

b. Agency costs: the lost utility o the owner of due to information asymmetry regarding efforts to monitor, transfer risk, or adjustments for the shirking. (5) Give the manager a share of the payoff: MOST EFFICIENT ALTERNATIVE to a first-­? best contract, called the second-­? best contract. Bases compensation on a performance measure that is observable variable that reflects managers’ performance and is available at the end of the first period = net income Control moral hazard Monitor effort Share profit (less noisy NI) Share profit (Noisy NI) Rent firm Fixed salary Sources of noise in net income include: 1. Random internal ontrol errors 2. Expensing the research component of R&D Owner’s expected utility 57 55.

88 55. 46 51 48 Agency cost 0 1. 12 1. 54 6 9 3.

Failure to accrue legal and environmental liabilities when estimates are too unreliable 9. 7 Bondholder manager relationship Example 9. 7 Manager is in a situation where the decision he makes does not affect his utility, therefore he may decide to act in a way that is unfavorable to the investor.

Investor is would be better off if manager decides not to pay dividends, however since the investor is unsure of how management will act, the investor will demand a igher expected rate of return Moral hazard: Manager is in a situation where he is indifferent between the decision he makes, therefore he might act in a way that is unfavorable to the investor. Information Asymmetry: Manager has access to superior information Solution: Debt covenant ratio, higher return 9. 8 Implications of Agency Theory Is Two Better Than One? ? Widely referenced paper by Holmstrom (1979) ? Assumes: 1) Agent’s effort is unobservable by the principle 2) But, the payoff is jointly observable at the end of the period Shows that a contract based on a performance measure such as et income is less efficient than first-­? best. A second variable can increase the efficiency of the second-­? best contract if it contains some additional effort information. (i. e Net Income AND Share Price) Characteristics of performance measures: 1) Sensitivity: The rate at which the expected value of a performance measure increases as the manager works harder, or decreases as the manager shirks.

2) Precision: (in predicting the payoff from current manager effort) Measured as the reciprocal of the variance of the noise in the performance measure. Incomplete Contracts: Contracts that do not nticipate all possible state realizations. 9. 9 Reconciliation of Efficient Securities Market Theory With Economic Consequences Agency Theory demonstrates that the best attainable compensation contract usually bases manager compensation on one or more measure of performance. ? Creates incentive to maximize performance ? Leads to higher expected payoff ? Aligns shareholders and managers on same goal Under efficient market theory, only accounting policy choices that affect expected cash flows create economic consequences.

Agency Theory suggests why firms enter into employment and debt contracts.

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