Chapter 9 –
Summary and Review
An Analysis of Conflict
CHAPTER 9 – An Analysis of Conflict
Introduction
In the earlier sections of Accounting Theory, the course has focused on the
investor’s need for information on future cash flows. The measurement and decision usefulness
approach both support the notion that preparers and readers of financial statements should be
indifferent to the accounting policies used to arrive at income, as long as it does not affect the
cash flows. However, the previous section (chp.8) has shown us with the help of Positive
Accounting Theory, that firms are not indifferent to the accounting policy chosen. Rather, at
certain times certain types of accounting policies are preferred (ex. Earnings Management).
Chapter nine looks at the economic consequences of choosing policies. It also shows how
security markets can be efficient while at the same time allowing accounting policies to have
economic consequences.
Game Theory
Game Theory models the interaction between two or more players. The theory attempts
to create a model and to predict the outcome of a conflict between rational individuals, often
with uncertainty and information asymmetry. We assume that the players are rational and that
they all want to maximize their own expected utility. In game theory, each individual knows the
strategies and payoffs available to everyone. However, they do not know the other players’
choices of strategy. The outcome of one player affects all the other players. Game Theory can be
classified as either cooperative or non-cooperative. With a cooperative game, the players are in a
situation where there is a binding agreement between the players. In a non-cooperative game,
there is no binding agreement between the players.
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Non-Cooperative Game Model
The Scott text uses the example of an investor and a manager to demonstrate the noncooperative game theory of the conflict situation. A similar example of this model would be in
the used car industry. The buyer desires all the relevant and reliable information about the car to
aid her in assessing the car’s expected value and the risk of the purchase. The seller may not
wish to reveal all of the negative information about his car. The car may become harder to sell,
he may have to spend money repairing the car, or the buyer may purchase elsewhere. Both
parties are aware of the other’s strategies and possible reactions. This is a non-cooperative game
since there is not a binding agreement between the seller and the buyer.
The seller has two strategies. He can either lie about the quality of his used car, making it
sound better than it really is. Or, he can be honest about the quality of the vehicle and risk losing
the sale. The buyer can choose to either buy or refuse to buy the car. The expected utility payoffs
are:
SELLER
HONEST
LIE
BUY
70,40
30,70
REFUSE
35,10
35,30
The strategy pair chosen will not be Refuse/Honest or Buy/Lie. This is due to the fact that each
party has complete information about the other and knows their strategies and payoffs. For
example, if the seller chooses to Lie, the buyer would not choose to Buy because she would
receive a higher utility with Refuse. Lie/Refuse is the strategy pair chosen because given the
other player’s strategy, each player is content with his or her decision even though Buy/Honest
would give each player higher utilities. This is referred to as Nash Equilibrium.
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The Game Theory helps us to understand the process of choosing an accounting policy. It
aids us in understanding why in certain situations a company would choose to distort the
financial statements if it serves them to do so. The theory also aids in showing how difficult it
would be to try and implement new policies and procedures that have low payoffs to
management. The Game Theory can also be used to show accounting standard boards the danger
of not considering the interests of all parties affected by policy choices that are found to be
difficult to implement.
Models of Cooperative Game Theory
Contracts are agreements that are perceived to be binding by players in a game situation.
There are two types of contracts of particular importance in financial accounting theory:
employment contracts – between the firm and manager - and lending contracts – between the
manager and the bondholder, the principle and agent, respectively. The roles of these players are
studied with respect to agency theory, a branch of game theory that studies the design of
contracts to motivate a rational agent to act on behalf of a principal when the agent’s interests
would otherwise conflict with those of the principal.
Employment Contract
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. For example, the greater effort exerted by the manager, the greater the probability of a
high payoff, and vice versa.
Game theory, like decision theory, advocates a maximization of utility with one
exception. In the case of the manager, there is a reservation utility, which is the minimum utility
the manager will except before going elsewhere. They cannot seek to maximize their utility
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above the reservation utility since there is an excess supply of replacement workers that could
take their job. In many cases, the highest utility for one player is attached to the undesirable
action of the other. In particular, shirking their duties, therefore inducing the low payoff,
maximizes the manager’s utility, especially is they are remunerated on a fixed basis. This is an
example of a moral hazard. Managers must, therefore, design contracts to control moral hazard.
Contracts to control moral hazard
(1)
Hire the manager and put up with the shirking. This option is not usually put into
practice since owners can maximize their utility using other techniques.
(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. More practically, if the
manager works hard (= high payoff) he will be paid his normal wage. If the manager shirks (=
low payoff) he will be paid a reduced wage. This situation is effectively impossible since it is
hard to measure whether or not the manager is working hard due to the information asymmetry
involved; the manager knows his effort level while the owner does not.
(3)
Indirect Monitoring. Like direct monitoring, the wages earned by the manager are
dependent upon the payoff. However, indirect monitoring involves the issue of moving support
versus fixed support. Moving support is where the set of possible payoffs is different depending
on the action taken. Fixed support means the payoffs stay the same regardless of action taken.
Two problems with this approach are that penalizing the manager may be against the law and
that most contracts are based on fixed support where indirect monitoring does not work.
(4)
Owner rents firm to the manager. In this situation, the manager pays the owner a
fixed rental payment so that the owner no longer cares which actions the manager takes, since he
receives a percentage of the potential payoffs regardless.
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This is called internalizing the
manager’s decision problem. This is an inefficient option due to the high agency costs involved.
Agency costs are the lost utility to the owner of due to information asymmetry regarding efforts
to monitor, transfer risk, or adjust for the shirking.
(5)
Give the manager a share of the payoff. This is the most efficient alternative to a
first-best contract, called the second-best contract. The manager is given a percentage of the
payoff, thus he wants to work hard, which is also in the interest of the owner. This is called
incentive-compatibility. Agency costs are reduced compared to the rental contract and risk is
borne by both the manager and the owner. The measure of performance can be based either on
net income or share price depending on the nature of the firm’s structure. This implies a heavy
responsibility on the firm’s accounting systems and financial statements to report complete and
accurate information.
A Bondholder-Manager Lending Contract
This contract creates another moral hazard problem, where the actions of the agent
“manager” may not be consistent with the interests of the principle “bondholder.” A rational
lender will raise interest rates charged to the borrower. Instead, the rational borrower, not
wanting to pay excessive interest rates will agree to covenants in the lending agreement – like
not exceeding debt/equity ratios or not paying dividends if the interest coverage ratio is below a
specified level. Therefore, lenders are satisfied with their level of risk and managers are able to
borrow at lower rates.
Implications of Agency Theory for Accounting
An important aspect of agency theory is to develop a fair contract between the agent and
principal when the agent’s efforts are unobservable by the principal, but the payoff is jointly
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observable by both parties. There are a number of potential measures that can be used to
determine an agents pay, and one such measure Holmstrom examines is net income.
Both parties use net income to measure performance because it is observable; however
there are concerns that creative managers looking to maximize their pay often manipulate the
reported figure. Therefore, owners should use controls such as GAAP, audits, and historical cost
based accounting to limit adverse managerial behavior.
GAAP sets guidelines as to how net income is calculated, and it deters a manager’s
incentive to switch accounting policies to effect net income. Audits set up a control system
which limits the likelihood of fraud or error, and it ensures net income is calculated according to
the agreed upon terms set out in the GAAP. Auditors also reassure the owner that the audit is
independent and free from influence. Finally, if net income is used as a contract performance
measure, historical-cost-based net income should probably be used instead of current-valuebased net income because it is less susceptible to management manipulation, and therefore a
harder measure of net income.
Holmstrom also points out that a contract can be made even more efficient if a second
variable such as share price is used in addition to net income. According to Holmstrom, as long
as the second variable provides some additional information on effort, the overall efficiency of
the contract will increase.
Another important point to be made regarding agency theory is that contracts tend to be
quite rigid once signed. They are usually long term, and they cannot anticipate all possible state
realizations, which is termed incomplete.
This means they are not easily amended, and
unforeseen state realizations impose costs on the firm and/or its manager.
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Conclusions
Managers are not concerned over accounting policy because it affects the company’s cash
flow, but rather it can affect their own compensation.
The aforementioned rigidities in a
manager’s contract mean the changes in accounting policy affect net income and other financial
statement numbers on which their salary is based. Therefore, managers closely examine any
change in accounting policy because it affects their bottom line.
This raises the question; if managers are concerned over accounting policy should
investors be concerned, and if they are concerned does the theory of market efficiency still hold?
The answer to this isn’t clear (much like everything else in this class); however it is an important
topic to think about.
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Chapter 9 Review Questions
MULTIPLE CHOICE
1) According to the text, what are the two types of games in game theory?
a- cartels and oligopolistic
b- agency theory and economic theory
c- cooperative and non-cooperative
d- employment contracts and lending contracts
2) What term is used to identify the strategy chosen by each player in a game?
a- Strategy Pair
b- Nash equilibrium
c- Single-person decision theory
d- Utility function
3) In game theory, what is each player assumed to do?
a- minimize his or her expected utility
b- maximize his or her expected utility
c- know the other player’s choice of strategy
d- not take the other player’s actions into account.
4)
abcd-
What type of industry would best reflect the cooperative game theory?
a monopoly
an oligopoly
a cartel
none of the above
5) Contracts that do not anticipate all possible state realizations are called:
a- complete contracts
b- incomplete contracts
c- contingency contracts
d- short-term contracts
6)Managers tend to be concerned about changes in accounting policy because:
a- It affects the net cash flows of the firm
b- It can influence net income and other financial numbers that their remuneration is
dependent upon.
c- It causes the firms beta to increase to undesirable levels
d- It increases the amount of accounting information the manager has to disclose
7) Which of the following steps would not decrease a manager’s ability to manipulate the net
income figure?
a- Adhering to GAAP
b- Using current-value-based measures
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c- The use of an auditor
d- Using historical-cost-based measures
MULTIPLE CHOICE ANSWERS:
(1) C (2) A (3) B (4) C (5) B (6) B (7) B
SHORT ANSWER QUESTIONS:
(1)
Explain why game theory enables us to have a better understanding of the process of
accounting policy chosen?
Solution
We should never assume that managers are willing to accept any suggested accounting policy
that represents the interests of investors. Rather we should assume that management have their
own interests to contend with. Game theory allows us to model a conflict situation between
different parties with different interests. The theory takes into account everyone’s own interests.
Game theory aids standard setting bodies in showing them the danger of implementing policies
that will likely be met with resistance.
(2)
Sunflower Industries has been having problems with the accountability of their managers
not being what it should be. Company performance has been slack lately and Sunflower is
gearing up for the hire of a new manager. They, however, need to figure out an appropriate
manager compensation contract that will increase accountability of the manager.
If the manager works hard (a1), net income will be one of $200 or $450 (before manager
compensation) with the probability of 0.35, 0.65, respectively. If the manager shirks (a2), net
income will be one of $200 or $450 with probability 0.75, 0.25 respectively.
The interview with the potential new manager yields that he is rational, risk averse with
the utility for money equal to the square root of the amount of money received, and effort averse
with the disutility of effort of 2 if he works hard and 0.5 is he shirks.
Required
(a) Offered salary is $50 per period plus 20% of firm profits before manager compensation.
Will the manager take a1 or a2?
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(b) Instead, offer salary of $0 plus 30% of firm profits before manager compensation. Will
the manager take a1 or a2?
(c) Does the manager’s effort decision change between parts (a) and (b)? Why or why not?
Solution
Payoff Table
High Profit
Low Profit
(a)
(b)
Manager’s Act
A1 (work hard)
A2 (shirk)
Payoff
Probability
Payoff
Probability
$450
0.65
$450
0.25
$200
0.35
$200
0.75
The manager’s expected utility for each act is:
EU(a1) = 0.65(50 + 0.2 x 450)1/2 exponent + 0.35(50 + 0.2 x 200)1/2 exponent –2
= 0.65 x 11.83 + 0.35 x 9.49 – 2
= 7.69 + 3.3215 – 2
= 9.01
EU(a2)= 0.25 x 11.83 + 0.75 x 9.49 – 0.5
= 2.9575 + 7.1175 – 0.5
= 9.575
The manager would take a2.
EU(a1)= 0.65(0.3 x 450)1/2 exponent + 0.35(0.3 x 200)1/2 exponent - 2
= 0.65 x 11.62 + 0.35 x 7.75 – 2
= 7.55 + 2.7125 – 2
= 8.26
EU(a2)= 0.25 x 11.62 + 0.75 x 7.75 – 0.5
= 2.905 + 5.8125 – 0.5
= 8.22
Manager would now take a1.
(c)
Yes. The higher profit percentage in part (b) provides sufficiently more incentive that it
overcomes the disutility of working hard.
(3)
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What concerns would an agent and principal have when using net income as a measure of
payoff?
Solution
A principal would be concerned that the agent would be able to manipulate net income
figures from year to year to maximize their remuneration. In order to minimize this effect the
principal could require the manager to follow GAAP and hire an auditor to ensure the agent is
following the GAAP. The principal could also require income to be reported on a historicalcost-based as opposed to current-value-based, which would leave less room for manipulation.
The manager would be concerned that other factors could influence net income, which
are beyond his/her control. For example, a change in accounting policy could adversely affect
net income figures, and therefore be detrimental the managers overall compensation.
(4)
Give two reasons why net income and other financial statement numbers matter to managers?
Solution
One reason is that manager’s pay is usually based on net income. Another reason is that
contracts between lenders and borrower’s usually contain covenants that constrain managers
from taking actions that might not be in the best interest of the lender. These covenants are often
based on the firm’s financial statements. As a result, we would expect managers to look very
closely at accounting policy changes that may affect net income and other financial statement
numbers.
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