Semester 2, 2009 1

Seminar 7 – Contracting & Accounting Information

306-684 Financial

Accounting

Semester 2, 2009 2

Learning Objectives• To reinforce the existence of moral

hazard arising from information asymmetry;

• To formally model agency relationships as non-cooperative or co-operative games;

• To examine the role of accounting in performance measurement and efficient contracting.

Semester 2, 2009 3

The story so far (part (iii)) …

• Managers are agents who act on behalf of principals (shareholders and debtholders);

• Managers have an information advantage and hence may succumb to moral hazard;– Managers may shirk and still be rewarded above

their real performance;

• Managers are rationally maximising their own utility at the expense of principals

Semester 2, 2009 4

Moral Hazard Problem of Information Asymmetry• Principal wants agent to work hard, but

rational agents are likely to be effort-averse;

• Principal cannot observe manager effort;• Managers may experience disutility from

additional working/effort;– Greater effort, greater disutility

• Implies manager may shirk on effort– if paid a fixed salary, why work hard?

Semester 2, 2009 5

Game Theory

• Theory seeking to draw a parallel between the behaviour of participants in games of chance and strategy (such as chess) and behaviour of firms or people in small groups

• Use Game Theory to better understand accounting policy choices

• Non-cooperative v cooperative games

Semester 2, 2009 6

A Non-Cooperative Game

Manager

Utility payoffs to investor and manager

HONEST

(H)

DISTORT

(D)

Investor BUY 60 Inv, 40 Mgr 20 Inv, 80 Mgr

REFUSE 35 Inv,20 Mgr 35 Inv , 30 Mgr

Semester 2, 2009 7

A Non-Cooperative Game

• Manager– If manager chose H, investor would choose ……………,

therefore rule out…………– If manager chose D, investor would choose ……………,

therefore rule out…………• Investor

– If investor chose B, manager would choose ……………, therefore rule out…………

• Strategy pair not subject to this problem is ……………, – if manager chose D, investor would choose…….., if investor

chose R, manager would…………. (Nash equilibrium)• However the Nash equilibrium is not a completely

satisfactory outcome of the game.– Both parties would be better off if ……….were chosen. This is

called the cooperative solution

Semester 2, 2009 8

A Non-cooperative Game• Nash equilibrium – neither player can be better off,

given the other player’s strategy• A sub-optimal solution – both would be better off under

B, H– If investor chose to B, rational manager would prefer D, hence

investor would choose R, then market for the firm’s shares would not work very well

• A better solution– Long-run perspective

• If the game was repeated indefinitely, and the manager was always honest, then investors would choose B

– Change the payoffs• To work, the players must not have too high a discount rate• If investor chose B, the value to the manager of the immediate

payoff of $80 may exceed the PV off the $10 reduction in future period ($40 - $30) when the investor switches to R

– Enter a binding agreement (contract) → cooperative game

Semester 2, 2009 9

A model of Cooperative Game Theory - Agency Contract (an example)• Owner: rational, risk-neutral,

– Wants to max. expected firm payoff x

• Manager: rational, risk-averse and effort-averse– Wants to maximise expected utility of

compensation (c), net of disutility of effort– To overcome shirking, why not give manager

a share of payoff?

Semester 2, 2009 10

Cooperative Game - Agency Contract (an example cont.)• A problem arises:

– Firm payoff not known until after contract expires (single period contract). Why?

– Manager has be paid at contract expiry

• A solution:– Base manager compensation on a

performance measure (e.g. net income), which is available at period end

Semester 2, 2009 11

Cooperative Game - Agency Contract (an example cont.)

Semester 2, 2009 12

Cooperative Game - Agency Contract (an example cont.) • To motivate manager effort, give

manager a share of firm net income

• Concept of reservation utility– Call it R– If manager is to work for owner, must receive

expected utility of at least R– Assume reasonably efficient managerial

labour market

Semester 2, 2009 13

Cooperative Game - Agency Contract (an example cont.) • Manager has 2 effort choices

– Work hard (a1)

– Shirk (a2)

• Manager is effort-averse, so assume– Disutility of effort level a1 = 2

– Disutility of effort level a2 = 1.71

• Manager is risk-averse, so assume utility of remuneration is its square root

Semester 2, 2009 14

Cooperative Game - Agency Contract (an example cont.)

• If manager works hard, payoff is X1 = 100 with probability of 0.6

X2 = 55 with probability of 0.4

• If manager shirks, payoff is X1 = 100 with probability of 0.4

X2 = 55 with probability of 0.6

Semester 2, 2009 15

Cooperative Game - Agency Contract (an example cont.) • Manager’s reservation utility: R = 3• Quality of net income = y (noisy but unbiased measure

of payoff)If x is going to be 100

• Y = $115 with probability of 0.8• Y = $40 with probability of 0.2

If x is going to be 55• Y = $115 with probability of 0.2• Y = $40 with probability of 0.8

• Noise in Net Income can be due to– Failure of corporate governance, such as weak internal

controls, which allow random error or bias into net income– Recognition lag, that is several components of manager effort

may not fully pay off during the current period, e.g. R&D

Semester 2, 2009 16

Cooperative Game - Agency Contract (an example cont.) • Manager’s utility:

EUm(a1) = 0.6[0.8(k x 115)½ + 0.2(k x 40)½]

+ 0.4[0.2(k x 115)½ + 0.8(k x 40)½] – 2

EUm(a2) = 0.4[0.8(k x 115)½ + 0.2(k x 40)½ ]

+ 0.6[0.2(k x 115)½ + 0.8(k x 40)½] – 1.71

• Owner’s utility (risk neutral)

EUo(a1) = 0.6 [0.8((1 – k) x 115) + 0.2((1 – k) x 40)] + 0.4 [0.2((1 – k) x 115) + 0.8((1 – k) x 40)]

Semester 2, 2009 17

Cooperative Game - Agency Contract (an example cont.)

• Formal statement of owner’s problem:– Find k to maximise EUO(a)

– Subject to:• Manager wants to take a1 (incentive compatibility)

• Manager receives reservation utility of 3

• The result:– K = 0.3237

Semester 2, 2009 18

Cooperative Game - Agency Contract (cont.) Check: verify manager’s utility

EUm(a1) = 0.6[0.8 (0.3237 x 115)½ + 0.2 (0.3237 x 40)½] + 0.4[0.2 (0.3237 x 115)½ + 0.8 (0.3237 x 40)½]

- 2 = 3

EUm(a2) = 0.4[0.8(0.3237 x 115)½ + 0.2 (0.3237 x 40)½] + 0.6[0.2(0.3237 x 115)½ + 0.8 (0.3237 x 40)½]

- 1.7 = 2.96• So manager will work hard!

Semester 2, 2009 19

Cooperative Game - Agency Contract (an example cont.) Check owner’s utility:

EUO(a1) = 55.4566

Compare to situation [Ex 9.2] where:

1. Owner has all risk, manager has fixed salary

EUO (a1) = 57, EUO (a2) = 48

2. Manager has all risk, owner gets fixed rent of EUO $51

Thus, Risk & profit-sharing is an efficient contracting solution!!!

Semester 2, 2009 20

So far, so good………

• We can design efficient contracts to motivate manager performance

• See Ex 9.8 for debt contracts

• Both contracting parties are better off, relative to the non-cooperative solution

• BUT, we have a problem– Net income is noisy, AND– Net income is not necessarily unbiased!!!

Semester 2, 2009 21

Back to information asymmetry……..• Owner can only observe reported net

income

• Managers know actual net income

• But rational investors will assume managers may be biasing (managing) earnings

(More on earnings management in

forthcoming seminars)

Semester 2, 2009 22

Implications for Financial Accounting• Net income matters!!!

• The agency relationship is a contract.

–Contracts are incomplete (cannot foresee every possible state of nature realizable)

• Implies that some flexibility in accounting choice is essential

Semester 2, 2009 23

Implications for Financial Accounting• Implies that 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?)

Semester 2, 2009 24

Implications for Financial Accounting• Net income must be jointly observable by

manager and owner• Earnings management constraints :

– GAAP (including accounting standards)• Contracts based on the set of accepted

accounting choices• Conservative, to restrict earnings management• But some choice, as incomplete contracts

– Existence of audit• Indirect monitoring

Semester 2, 2009 25

Performance Measures

• Holmstrom’s agency model– Basing manager’s compensation on 2

variables is better than on 1 variable– Share price is informative about manager

effort (includes things not recognised in earnings, e.g. R&D)

– Share price also a noisy measure • Subject to economy-wide events

• The problem: proportion of compensation based on income versus share price???

Semester 2, 2009 26

Performance Measures• To be used in compensation contracts, net

income should be highly informative about manager effort– Properties: net income needs to be highly

informative1 Sensitivity

– Net income responds to changes in manager effort

2 Precision– Net income has low noise re effort

– Net Income cannot do both

Semester 2, 2009 27

Performance Measures

• BUT, sensitivity and precision must be traded off– Historical cost

• Lower sensitivity due to recognition lag• Higher precision, relatively unaffected by market-

wide factors

– Fair value accounting• Higher sensitivity – less recognition lag• Lower precision – affected by market-wide factors

Semester 2, 2009 28

The Fundamental Conflict

• We are back to the fundamental conflict in financial accounting theory– The most useful measure of net income for

investors is not necessarily the most informative about manager effort!

– The issue is to measure payoff from current manager effort versus providing information about future performance

Semester 2, 2009 29

Reconciliation with EMH

• Accounting policy choices/changes with no direct cash flows do matter (they have economic consequences) as they determine contractual payoffs;

• Rational explanation for conservatism:– A systematic bias relative to ideal fair value, BUT– Capital markets perspective – a signal of quality,

reliability;– Contracting perspective – a constraint on managers’

opportunistic earnings management.

Semester 2, 2009 30

Conclusions• Accounting choices matter as they

determine contractual payoffs• Efficient contracting increases the payoffs

for both contracting parties• Accounting income (and share price) are

used as measures of payoff from manager effort

• Incomplete contracts and indirect monitoring means opportunism could still occur.