MODULE 7 - AN ANALYSIS of CONFLICT
UNDERSTANDING GAME THEORY
GAME THEORY - attempts to model and predict the outcome of conflict between
rational individuals.
Characteristics:
- models interaction of 2 or more players
- occurs in presence of uncertainty and information asymmetry
- each player is assumed to maximize his/her expected utility
Contrast to:
* Decision theory that has single player, playing a game against the states of nature
* Market theory that has many players in which no one player's actions can influence
the market
In game theory 1 player does influence the other player(s)....leads to conflict aspect.
Co-operative game - parties can enter into a binding agreement (ex cartel)
Non co-operative game - no binding agreements to control actions of parties
NON –COOPERATIVE GAMES OF MANAGER- INVESTOR CONFLICT
Conflict occurs because investors & managers have differing objectives:
* Investors want relevant & reliable F/S
* Managers want to present firm in best light (could bias or manipulate F/S)
Typically considered a non-cooperative game since difficult to have binding contract:
 costly to prepare contracts (negotiating diff contracts w/ diff investors)
 costly & difficult to enforce (audit req'd for each user)
Nash Equilibrium - the only strategy pair such that given the strategy choice of the
other player, each player is content with his/her strategy (both chose same strategy
pair).
Initial choice of a non-cooperative solution is “unconstrained maximization”.
Other options to move towards a more satisfactory outcome (ie more co-operative):
1. Enter a binding agreement to choose that outcome
2. Change payoffs by introducing severe penalties for a specific choice
3. Develop sufficient trust that both parties are willing to choose the more cooperative outcome
Moral principles could be applied to enable parties to commit to a co-operative
solution.
 Help players realize the benefits of playing the moral strategy as well as the
costs of deviating
 Encourage transparency to generate trust between contracting parties
i.e. develop sufficient trust that both parties are willing to choose the more cooperative outcome”
Per Danielson:
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MODULE 7 - AN ANALYSIS of CONFLICT

Initial choice of a non-cooperative solution is “straight forward maximization”.
Moral principles could be applied to enable parties to commit to a co-operative
solution. Leads to:
 Constrained maximization - recognition of a longer term benefit (give up short
term benefits)
CO-OPERATIVE GAME THEORY MODELS
AGENCY THEORY - a version of game theory which models the process of
contracting between 2 or more persons. This involves conflict since each party in
the contract wants the best deal for him/herself.
Most common contracts for business firms:
1. Employment contracts - between the firm & its managers (firm is principal and
managers are agents)
2. Lending contracts - between the firm and its lenders (lender is principal and
firm manager is agent)
Contracts typically depend on reported NI:
* Employment contracts - managerial bonuses based on NI (incentive for managers)
* Lending contracts - inclusion of covenants (protection for lenders)
Co-operation comes in to play in a game situation when players enter agreements
they perceive as being binding. (Ex. employment contract; lending contracts)
Note that agency theory contracts have both cooperative and non-cooperative
characteristics:
- both parties choose their actions non-cooperatively
- but need to be able to commit to the contract
The action of the agent affects the distribution of the payoffs in that:
Greater effort put into the operation
=> higher probability of high payoff
=> lower probability of low payoff
Effort considered to be a range of activities that could include:
 work longer and harder
 be responsible for running firm prudently
 motivate employees and supervise them conscientiously
 not take advantages of opportunities at expense of firm
Note: payoff must be observable to both parties (onus on accountants to report
info fully & accurately so both players are willing to accept reported NI as measure of
the payoff).
Reservation utility - mgr has alternative opportunity for use of his/her time (this
represents the utility of the alternative opportunity. (Utility from remuneration must
be higher or the mgr goes elsewhere).
Effort averse - dislike of effort. Harder one works, the more one dislikes it.
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MODULE 7 - AN ANALYSIS of CONFLICT
Disutility of effort - dislike of effort reduces utility by X. The amount of this
reduction is the disutility. (Subtract the disutility from the utility derived from
remuneration)
Moral Hazard - tendency of agent to shirk.
Agency Theory works to control manager shirking by basing manager compensation
on a performance measure that is correlated with manager effort.
MANAGERS’ INFORMATION ADVANTAGE
EARNINGS MANAGEMENT
Managers frequently engage in earning management as predicted by Positive
Accounting Theory. Net income does have a role as a performance measure but we
need to recognize that the manager could bias or otherwise manage reported
earnings.
Manager information advantage:
 Manager could have information about the payoff prior to signing the
compensation contract (pre-contract information)
 Manager could obtain payoff information after signing the contract but prior to
choosing an act (pre-decision information)
 The manager receives information after the act is chosen (post-decision
information)
Typically means that the manager is more likely to shirk, having knowledge of the
payoff, and the owner’s expected utility will reflect the lower expected payoff.
Earnings management is possible since the manager controls the firm's accounting
system. When net income is the performance measure, the owner can only observe
an earnings number reported by the manager, which could be different than the
earnings number resulting from application of accounting policies that best inform
investors.
Revelation Principle
Definition: for any contract under which a manager has an incentive to lie about
his/her private information, an equivalent contract can be designed that motivates
truth-telling.
Several conditions must be met for this to hold:
 The owner must be able to commit that the truth will not be used against the
manager
 There must be no restrictions on the form of the contract
 There must not be any restrictions in the manager’s ability to communicate
his/her information
Overall – means we cannot rely on the revelation principle to assure us that the most
efficient compensation contract involves truth telling. It is unlikely that the revelation
principle can eliminate earnings management.
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MODULE 7 - AN ANALYSIS of CONFLICT
Note that GAAP (when accompanied by a credible audit) also fulfills a corporate
governance role. GAAP does allow some discretion in choice of accounting policies
but there is a structure to GAAP and it does limit the amount by which earnings can
be managed.
AGENCY THEORY: OWNER- MANAGER EMPLOYMENT CONTRACT
Separation of ownership & management; running organization requires skills.
Owner's options are:
1.Hire manager and put up with manager putting in less than desired effort
2.Directly monitor manager
First best - gives the owner the maximum
attainable utility and meets the agent's reservation utility; no risk imposed on agent
3.Indirectly monitor manager (changing payoffs - moving support)
4.Owner rents firm to manager (mgr internalizes the owner’s decision problem)
5.Manager gets a share of payoff Second best - ie best that can be achieved under
the circumstances but provides less utility to the owner than the first best contract;
imposes some risk on agent and agency costs on principal
Fixed Support - possible payoffs are fixed regardless of the action chosen
Moving Support - set of possible payoffs is different depending on which action is
taken.
Incentive compatibility - agent's incentive to take a specific action is compatible
with the owners’ best interests.
Agency Cost - represents cost to the owner of the information asymmetry b/w
owner & mgr (owner cannot observe mgr effort)
Note: if owner can observe manager’s effort, then the optimal compensation contract
is to pay a fixed salary (cost of manager compensation is typically lowest under this
option).
AGENCY THEORY: BONDHOLDER- MANAGER LENDING CONTRACT
Lending contracts - binding commitments in terms of debt covenants (legally
binding) where mgrs commit not to act in a manner that is against the lender's
interests.
Covenant is inserted into the lending agreement (ex limit dividends; additional
borrowing; maintain specific F/S ratios which relate to liquidity)
Lender changes the assessed probabilities of acts; thus firms are able to borrow at
lower rates.
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MODULE 7 - AN ANALYSIS of CONFLICT
IMPLICATIONS OF AGENCY THEORY FOR ACCOUNTING
Net income and key balance sheet ratios have desirable properties for
contracting -> correlation with effort
To use reported NI and balance sheet ratios as a basis for contracting
owners/lenders must have confidence that the number has not been biased or
manipulated. Hence, use of GAAP (provides structure to calculation of net income)
and auditing (adds credibility).
Use of two performance measures in a compensation contract
Given payoff observability, a contract based on payoff is less efficient than first best.
Holmström Agency Model (1997)
Holmström’s study asked whether the second best contract could be made more
efficient by basing it on a second variable in addition to payoff. (Does basing the
contract on both net income and share price reduce the agency costs of the second
best contract?)
Yes – if the second variable is also jointly observable and conveys some info about
mgr effort beyond that contained in the payoff measure itself. (This will be the case
for share price.)
Implies that both net income and share price can be useful payoff measures in
employment contracts, since each reveals different information about the manager’s
effort. Even if the second variable is noisy (ex. share price can be quite volatile) it
can increase efficiency of the second best contract if it does contain some additional
effort info.
(Implication is that net income also competes with other info sources for motivating
managers under agency theory.)
Characteristics of good performance measures
Sensitivity - strengthens the connection between manager effort and the
performance measure (makes it easier to motivate that effort).
Precision - reflects the probability that the performance measure will differ from the
payoff -> high precision means low probability of difference (precision reduces
manager’s compensation risk).
There is a trade-off between these two desirable characteristics.
Investors' interests are best served by earnings information that represents a tradeoff between relevance and reliability.
Managers' (and owners') legitimate interests are best served by earnings information
that represents an efficient trade-off between sensitivity and precision.
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MODULE 7 - AN ANALYSIS of CONFLICT
Note: earnings information that best meets investor interests does not always best
meets manager and owner interests – hence conflict between the interests of
manager and investors.
CONTRACTS – RIGID & INCOMPLETE
Contracts tend to be rigid once they are signed. This is a concern if a new accounting
standard impacts key calculations in the contract. Typically, a manager cannot
simply renegotiate affected contracts (hence accounting policies do matter)
It is generally impossible to anticipate all contingencies when entering into a contract
- thus would be an incomplete contract if it does not anticipate all possible state
realizations (hence will result in economic consequences.)
Reconciliation of Efficient Securities Market Theory with Economic
Consequences
* Agency theory enables a reconciliation of efficient market theory & economic
consequences. Economic consequences are rational result of constraints resulting
from binding contracts
* Financial statement variables (e.g. net income, balance sheet ratios) haev
desirable properties for contracting purposes
* Agency theory implies that GAAP & auditing are important in providing credibility to
NI (basis for contracting)
CALCULATIONS TO KNOW:
 Be able to identify Nash Equilibrium(s)
 Be able to calculate Owner Manager utility comparisons - fixed support; moving
support; rent; share of payoffs
 Be able to calculate Bondholder Manager expected returns
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