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Group B: Divya, Gloria, Melissa, Mohammed, Richard, Vivien
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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
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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
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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
Types of
Game Theory
Agency
Theory
Implications
for FAT
Case
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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
Types of
Game Theory
Agency
Theory
Implications
for FAT
Case
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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
Types of
Game Theory
Agency
Theory
Implications
for FAT
Case
Investors
Management
Honest (H)
Buy (B)
Refuse to Buy (R)
Game Theory
Basics
Types of
Game Theory
60,40
35,20
Agency
Theory
Distort (D)
20, 80
35, 30
Implications
for FAT
Case
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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
Types of
Game Theory
Agency
Theory
Implications
for FAT
Case
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Ex. Payoff to Manager is fixed amount of 25
Expected Utility for the Owner if Manager Works Hard (a1)
0.6(100-25) + 0.4(55-25) = 57
Expected Utility for the Owner if Manager Shirks (a2)
0.4(100-25) + 0.6(55-25) = 48
Game Theory
Basics
Types of
Game Theory
Agency
Theory
Implications
for FAT
Case
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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
Types of
Game Theory
Agency
Theory
Implications
for FAT
Case
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
Types of
Game Theory
Agency
Theory
Implications
for FAT
Case
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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
Types of
Game Theory
Agency
Theory
Implications
for FAT
Case
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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 well
Game Theory
Basics
Types of
Game Theory
Agency
Theory
Implications
for FAT
Case
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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
Types of
Game Theory
Agency
Theory
Implications
for FAT
Case
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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
Types of
Game Theory
Agency
Theory
Implications
for FAT
Case
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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
Types of
Game Theory
Agency
Theory
Implications
for FAT
Case
•
Variety of forms for managers to take advantage of
information
 Pre-contract information
 Pre-decision information
 Post-decision information
Game Theory
Basics
Types of
Game Theory
Agency
Theory
Implications
for FAT
Case
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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
Types of
Game Theory
Agency
Theory
Implications
for FAT
Case
•
Limit GAAP to the point where managers have a restored
sense to work hard rather than manipulate earnings
Game Theory
Basics
Types of
Game Theory
Agency
Theory
Implications
for FAT
Case
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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
Types of
Game Theory
Agency
Theory
Implications
for FAT
Case
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
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Question: Will the Lender be willing to lend $100 to the firm?
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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
Types of
Game Theory
Agency
Theory
Implications
for FAT
Case
• 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%)]
15.5
R=
= 16.40%
0.945
This rate is too high for the manager to offer, consequently the manager may try
to add Covenants into the agreement
Game Theory
Basics
Types of
Game Theory
Agency
Theory
Implications
for FAT
Case
• “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
Types of
Game Theory
Agency
Theory
Implications
for FAT
Case
• 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 loan
Game Theory
Basics
Types of
Game Theory
Agency
Theory
Implications
for FAT
Case
• 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
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As long as the second performance measure conveys additional information than
the first measure
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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
Types of
Game Theory
Agency
Theory
Implications
for FAT
Case
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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
Types of
Game Theory
Agency
Theory
Implications
for FAT
Case
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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
Types of
Game Theory
Agency
Theory
Implications
for FAT
Case
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
Types of
Game Theory
Agency
Theory
Implications
for FAT
Case
2. Net income has a very important role to play in motivating
and monitoring manager performance
o 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
Types of
Game Theory
Agency
Theory
Implications
for FAT
Case
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
Types of
Game Theory
Agency
Theory
Implications
for FAT
Case
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
Types of
Game Theory
Agency
Theory
Implications
for FAT
Case
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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
Types of
Game Theory
Agency
Theory
Implications
for FAT
Case
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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
Types of
Game Theory
Agency
Theory
Implications
for FAT
Case
CEO
VP, Division 2
VP, Division 1
VP, Division 3
Sue Davies
Game Theory
Basics
Types of
Game Theory
Agency
Theory
Implications
for FAT
Case
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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
Types of
Game Theory
Agency
Theory
Implications
for FAT
Case
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$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
Types of
Game Theory
Agency
Theory
Implications
for FAT
Case
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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
Types of
Game Theory
Agency
Theory
Implications
for FAT
Case
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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
Types of
Game Theory
Agency
Theory
Implications
for FAT
Case
Option 1: Allocate fully to K(3)
Option 2: Split costs between all 3
projects
Game Theory
Basics
Types of
Game Theory
Agency
Theory
Implications
for FAT
Case