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2013 Chapter 09
2013 Chapter 09
Sixth Edition
William R. Scott
Chapter 9
An Analysis of Conflict
How Is This Chapter Different?
» Continued
A Single-Period Non-Cooperative Game (continued)
• 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)
>> Continued
Agency Theory (continued)
» Continued
Agency Theory (continued)
» Continued
Agency Theory (continued)
» Continued
Agency Theory (continued)
» Continued
Agency Theory (continued)
» Continued
Agency Theory (continued)
» Continued
Agency Theory (continued)
» Continued
Agency Theory (continued)
» Continued
Agency Theory (continued)
» Continued
Agency Theory (continued)
– 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)
• 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)
• 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)
» 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)
• 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