Group B: Divya, Gloria, Melissa, Mohammed, Richard, Vivien.

Agency TheoryGroup B: Divya, Gloria, Melissa, Mohammed, Richard, Vivien

Table of Contents

Game Theory Basics Cooperative Game Theory Non-cooperative Game Theory Agency Theory and the Bondholder-Manager

Lending Contract Example Implications for Financial Accounting Theory Project Earnings Manipulation Case & Discussion

Game Theory Basics

An Analysis of Conflict

• Game theory helps understand managers, investors, and other parties to rationally deal with economic consequences of financial reporting

• Agency theory: is a branch of game theory that studies the process of contracting between 2 or more persons

Game Theory Basics

Types of Game Theory

Agency Theory

Implications for FAT Case

Game Theory 101

• Attempts to model and predict the outcome of a conflict between rational individuals

• Models the interactions between 2 or more players where there is uncertainty and information asymmetry

• Must take the actions of the other players into account

• Two types of games Cooperative Non-cooperative

Game Theory Basics


Agency Theory


Non-cooperative Game Theory

Non-Cooperative Game Model

• Framework for studying conflict situations and predicting decisions parties will make when managers and investors do not have a binding agreement about what specific information is to be supplied Agreement can be costly since users have

various decision problems and information needs

Agreements can be illegal (e.g. cartels)

Game Theory Basics


Agency Theory


Non-Cooperative Game Model

• Managers may not wish to reveal all information that investors want E.g. omitting liabilities so it will be easier to

raise capital by facilitating contracts with lenders

E.g. management believes that releasing too much information will benefit competitors

• Investors are aware of this and will take it into account when making their investment decisions

Game Theory Basics


Agency Theory


Single-Period Game

Management

Investors

Honest (H) Distort (D)

Buy (B) 60,40 20, 80

Refuse to Buy (R) 35,20 35, 30

Game Theory Basics


Agency Theory


Nash Equilibrium

• Strategy decision with which both parties will be content given the strategy choice of the other player

• Not necessarily the best outcome of the game• Auditing scandals in the early 2000’s – managers saw

that the immediate payoff by departing from a cooperative solution outweighed the longer-run costs of investor and regulator reaction

• Central authorities have been trying to regain investor confidence in financial reporting (e.g. introducing new regulations and/or threaten penalties for distortion) – change payoff ratios for situations so that managers will not deviate from the cooperative solution

Game Theory Basics


Agency Theory


Cooperative Game Theory & Agency Theory

Agency Theory: An Employment Contract between Firm Owner and Manger

Ex. Payoff to Manager is fixed amount of 25Expected Utility for the Owner if Manager Works Hard (a1)0.6(100-25) + 0.4(55-25) = 57Expected Utility for the Owner if Manager Shirks (a2)0.4(100-25) + 0.6(55-25) = 48

Game Theory Basics


Agency Theory


Agency Theory

• Assume Manager is effort-averse• (a1) if manager works hard, a manager will

experience a disutility of 2• (a2) if manager works hard, a manager will

experience a disutility of 1.71• Expected Utility for Hard working manager

(a1)• Sqrt(25) – 2 = 3• Expected Utility if Manager Shirks (a2)• Sqrt(25) – 1.71 = 3.29

Game Theory Basics


Agency Theory


Dealing with Agency Problems

Designing a Contract to Control Moral Hazard

Alternatives• Hire the manager and put up with a2

• essentially do nothing• Direct Monitoring• Indirect Monitoring• Rent the firm to manager• Profit Sharing

Game Theory Basics


Agency Theory


Direct Monitoring

• Owner could observe the manager’s efforts closely

• Salary would be dependent on firm profits• Called first-best contract• Owner bears all risk whereas the manager bears

no risk• Often unattainable – nature of managerial effort is

so complex that it would be ineffective for a remote owner to establish whether the manager is working hard

Game Theory Basics


Agency Theory


Indirect Monitoring

• Effort cannot be directly observable but can be imputed – this would occur if there is a moving support, a case where the return of the firm would differ whether a manager exhibits high efforts or shirks

• Would penalize a manager when the payoffs are low, since now it is easy for the firm to determine if the manager had worked hard

• Will not work if there is a fixed-support, where payoffs are same regardless of state of natures

• Legal and institutional factors may prevent the owner from penalizing the manager as wellGame Theory Basics


Agency Theory


Owner Rents firm to Manager

• Owner gives manager rights to 100% of payoff after paying a fixed rental price to the owner

• Not a common relationship• Owner is often worse off, contracting

arrangement has inefficient risk-sharing

Game Theory Basics


Agency Theory


Profit Sharing

• Final and most widely used tool to align interest• Give managers a share of the profits• Aligns manager’s incentives with the owners and

maximize utility for both• Disadvantages:

Payoffs are not fully recognizable until the future but compensation is due at the end of the year; realization of R&D returns

Net income not always informative; poor corporate governance, weak internal controls, bias in net income

Then lag of some management efforts such as net income as well as accrual bias, which will affect Net Income.

Game Theory Basics


Agency Theory


Earnings Management

• Firms choose accounting policies to achieve a certain management objective Increase earnings Increase revenue Capital asset purchases

• Previous motivation was assumed on net income noise where managers had no control

Game Theory Basics


Agency Theory


Information Advantage

• Variety of forms for managers to take advantage of information Pre-contract information Pre-decision information Post-decision information

Game Theory Basics


Agency Theory


Revelation Principle

• For any contract that a manager could have an incentive to manipulate earnings an equivalent contract can be designed to motivate the truth

• Conditions: Truth not held against the manager No restrictions on contract No restrictions on information communication

Game Theory Basics


Agency Theory


Controlling Earnings Management

• Limit GAAP to the point where managers have a restored sense to work hard rather than manipulate earnings

Game Theory Basics


Agency Theory


Agency Theory Example

Agency Theory: A Bondholder-Manager Lending Contract

• Consider another moral hazard scenario of Agency Theory; A contract between a Bond-Holder (Principal) and a Firm Manager (Agent)

• Bondholder has a choice of lending $100 to a Firm offering 12% interest or to the Government at 10% interest

• Risks of investing in the Firm would be possibility of bankruptcy—lose both principal and interest

• Manager can choose one of two situations: To pay no dividends while the loan is outstanding and to pay high dividends

Game Theory Basics


Agency Theory



• Assume that Manager is paid a salary plus a bonus based on the firm’s Net Income. Then since Dividends are Not charged against net Income the manager is unaffected between the 2 acts; the manager is Indifferent between the 2 acts

• Question: Will the Lender be willing to lend $100 to the firm?• Solving for the expected ETR (expected rate of return): ETR = 50%[(12 x 99%) – (100 x 1%)] + 0.5[(12 x 90%) – (100 x 10%)] = 5.84% ($5.84)Therefore, lender will not make the loan

Game Theory Basics


Agency Theory



• What nominal rate would the firm have to offer in order to attract the lender?

Solving for “R”: (Where “R” is the required nominal rate)10.00 = 50%[(R x 99%) – (100 x 1%)] + 0.5[(R x 90%) –

(100 x 10%)]R =

This rate is too high for the manager to offer, consequently the manager may try to add Covenants into the agreement

Game Theory Basics


Agency Theory


Covenants & Their Implications

• “A promise in an indenture, or any other formal debt agreement, that certain activities will or will not be carried out”

• Examples:• Non-Payment of Dividends: conditional if the

interest coverage ratio is below a specified level• No Additional Borrowing: conditional if the

debt-to-equity ratio is below a specified level• Since covenants are legally binding, the lender will

change the assessed probabilities of the manager’s decisions

Game Theory Basics


Agency Theory



• Assume probability that the manager will take a1 (No Dividends) is now assessed by the lender as 100% and 0% for a2 (High Dividends)

• Thus, if the firm offers a nominal rate of 12%, then the lenders ETR is:

ETR = 1[(12 x 99%) – (100 x 1%)] + 0[(12 x 90%) – (100 x 10%)] = 10.88% > 10%Since this exceeds the required 10% from risk-free government bonds, the lender would make the loanGame

Theory Basics


Agency Theory


Implications Of Agency Theory For Accounting: Is Two Better Than One?

• Holmstrom provides an extension of the agency model to allow more than one performance measure (i.e: Net Income)• Example: Basing compensation based on Both Net Income and

Share Price may reduce agency costs• As long as the second performance measure conveys additional

information than the first measure• Example: Share price also reflects future benefits of R&D and

expected future liabilities sooner through the market• How do performance measures contribute to efficient

compensation?• Sensitivity – rate that the performance measure reflects how

hard the manager works• Example: Performance measure Increases when the

manager works Hard, Decreases when the manager Does not.

• Precision – measures how precise the performance measure is (Noise Reduction)• Example: If the performance measure is precise, the

expected payoff should be relatively the same as the one predicted

Game Theory Basics


Agency Theory


Rigidity Of Contracts

• Agency Theory assumes that courts have the authority to enforce contract provisions without cost and resolve disputes if breach of contract occurs

• However, if an unforeseen realization of the state of nature occurs it is difficult amend contract provisions because of a contracts Rigidity

• It is not possible to anticipate all contingencies when entering into a contract

• Example: New GAAP accounting policy lowers reported net income and increases its volatility• Implications: Manager asks Bondholder to reduce the coverage ratio

from 3:1 to 2:1• Still maintains the Bondholder protection as before, but may ask for a

higher interest• Problem is further complicated when there are thousands of Bondholders

• Thus, unforeseen state realizations (Contract Incompleteness) impose costs on the firm & other parties

Game Theory Basics


Agency Theory


Implications for FAT

Efficient Securities Markets

• It is best to base managers compensation on one or more measures of performance

• The alignment between manager and shareholder interest explains how accounting policies have economic consequences

• Rigidities provided by signing contracts causes managers to intervene in standard setting processes

Game Theory Basics


Agency Theory



1. Conflict theory enables reconciliation between efficient security markets and economic consequences Accounting policies can affect contracts that

companies enter into, therefore affecting manager utility and welfare of the firm

Alignment of manager and shareholder interest will motivate managers intervene in standards

Game Theory Basics


Agency Theory



2. Net income has a very important role to play in motivating and monitoring manager performanceo Ability for net income to fulfill its income

enhancing role depends on its sensitivity and precision as a measure of payoff

o Ability for net income to provide useful information to investors depends on how it can provide reliable and relevant information about future performance

Game Theory Basics


Agency Theory



3. Net income competes with other forms of performance measures (i.e. share price) If accountants can make net income a better

measure of performance, then it may have a greater role in manager compensation

Game Theory Basics


Agency Theory



4. Earnings management allows management shirking, resulting low payoff to shareholders By controlling earnings management through

GAAP, accountants can restore management’s incentive to work hard

Game Theory Basics


Agency Theory


Case & Discussion

Project Earnings Manipulation

• Sue Davies, Project Manager at Pure Marine – Membrane and Related Equipment Group

• Background on Sue: single mom with 2 kids, salary = $97,500 Managing a major project, K(3) as well as 2

other projects Responsible for approving and allocating costs

to projects Past history of incorrectly estimating costs

Game Theory Basics


Agency Theory


Pure Marine

• Company in growth stage with aggressive earnings targets

• Require 10% profitability for projects• Top management places heavy emphasis on

meeting these targets and uses bonus system to get middle management on board

• Historically, poor cost allocation system leading to cost overruns because of bad estimates

• Recently, new allocation system in place to more accurately predict costs

Game Theory Basics


Agency Theory


Organizational Structure

Game Theory Basics


Agency Theory


CEO

VP, Division 1

VP, Division 2

VP, Division 3

Sue Davies

The Project, K(3)

• To be completed over 18 months• Price charged to customer depends on the

allocation of costs done by Sue• Profits from project = $7 million• Cost to date = $8.2 million• Environmental problems and additional insurance

not anticipated at the beginning of the project, leading to cost overruns

Game Theory Basics


Agency Theory


The Problem

• $2 million in R&D costs• 2 options:

o Allocate fully to K(3) • Outcome = 30% over budget losses• Unhappy boss• No bonus for Sue

o Share among all 3 projects• Profitable project• Happy boss and bonus for Sue• Incorrectly allocated costs• If discovered, could lose her job

Game Theory Basics


Agency Theory


Who are the stakeholders involved?

• Sue Davies• Sue’s Boss, VP of Division• K(3) customer• Customers of the other 2 projects• Shareholders • Employees• Sue’s successor

Game Theory Basics


Agency Theory


Decision Criteria

• Sue’s utility• Does the project meet management’s targets?• Accurate method of cost allocation• Is it the best decision for shareholders?• Are customers hurt due to the cost allocation?

Game Theory Basics


Agency Theory


What would YOU do?

Game Theory Basics


Agency Theory


Option 1: Allocate fully to K(3)

Option 2: Split costs between all 3 projects

Group B: Divya, Gloria, Melissa, Mohammed, Richard, Vivien.

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