Financial Accounting Theory SeventhEdition William R. Scott. Chapter 9 An Analysis of Conflict

Transcription

1 Financial Accounting Theory SeventhEdition William R. Scott Chapter 9 An Analysis of Conflict

2 How Is This Chapter Different? BEFORE in CAPM we have the market meaning everyone else Market price is the consensus price of asset based on everyone else in the market Individuals take market info as given as no power to change the market Price taker Probability of events given by market / forecast

3 How Is This Chapter Different? But in this chapter, there is only a few parties involved Now each party can influence the other party by their action (no longer a price taker) Each party s decision making process must also take the other parties actions (or their potential actions) into account Interactivity Economic theory of games / game theory

4 How Is This Chapter Different? Like playing rock, scissors, paper Conflict / potential conflict Uncertainty higher due to INTERACTIVITY between the players Prisoner s Dilemma Cooperative vs non-cooperative game Binding agreement vs binding agreement not possible or available

5 Chapter 9 An Analysis of Conflict

6 9.2 Game Theory Game theory models a conflict situation between rational players Number of players More than 1 Few enough that each player takes the actions of other players into account Types of games Cooperative Binding agreement Non-cooperative No binding agreement

7 9.2Agency Theory A principal wants to hire an agent for some specialized task Assume single-period, for simplicity Agency models separation of ownership and control Principal and agent are rational. Agent is risk-averse. Principal may be risk-averse, but assume risk-neutral for simplicity Principal wants agent to work hard, but Agent is effort-averse >> Continued

8 Agency Theory (continued) Moral hazard problem of information asymmetry Principal cannot observe manager effort -call it a Call manager s disutility of effort V(a) More effort ---> greater disutility Effort aversion implies manager may shirk on effort E.g., if paid a fixed salary, how hard will the manager work? Analogy: if no final exam, how hard will students work? >> Continued

9 Agency Theory (continued) Examples of agency contracts What gives the following agents an incentive to work hard for the principal? Doctor, dentist Lawyer Auditor Hockey player Construction worker Manager

10 Agency Theory (continued) Agency contract example 9.1 Owner: rational, risk-neutral Wants manager to work hard, to max. expected firm payoff Think of payoff as the total cash flow to be realized from manager s currentperiod effort Manager: rational, risk-averse and effort-averse Wants to max. expected utility of compensation, net of disutility of effort V(a) More effort, less utility If manager works hard, V(a) = -2 If manager shirks, V(a) = -1.71» Continued

11 Agency Theory (continued) Agency contract example 9.1(continued) Motivating the manager to work hard Salary: manager will shirk Direct monitoring of manager effort: unlikely in owner/manager context. Manager will shirk Indirect monitoring: Unlikely in owner/manager context unless moving support. Manager will shirk Owner rents firm to manager: Manager will work hard, but managerbears all the risk, requires low rent for manager to attain reservation utility, reducing contract efficiency Give manager a share of the payoff» Continued

12 Agency Theory (continued) Agency contract example 9.1 (continued) A problem arises if manager paid a share of payoff Firm payoff not known until after contract expires (single period contract). Some manager effort does not pay of in current period e.g., R&D, contingencies Manager has to be paid at contract expiry A solution Base manager compensation on a performance measurewhich isavailable at period end Performance measure must be jointly observable and correlated with payoff» Continued

13 Agency Theory (continued) Agency contract example 9.1 (continued) Net income as a performance measure To motivate manager effort, an efficient contract may offer the manager compensation based on a share of firm net income Higher net income suggests higher payoff (but with noise) Will manager be willing to accept contract? Concept of reservation utility, call it R If manager is to work for owner, must receive expected utility of at least R» Level of R depends on manager reputation» R treated as fixed in a single-period contract» Continued

14 Agency Theory (continued) Agency contract example 9.2 Assumptions Manager has 2 effort choices: Work hard (a 1 ) Shirk (a 2 ) If manager works hard payoff = 100 with prob. 0.6 payoff = 55 with prob. 0.4 If manager shirks payoff= 100 with prob. 0.4 payoff = 55 with prob. 0.6 Note fixed support» Continued

15 Agency Theory (continued) Agency contract example 9.2 (continued) Assumptions, cont d Manager s contract : compensation = k net income, 0 k 1 Manager s reservation utility: R = 3 Quality of net income (noisy, but unbiased, e.g., fair value accounting) If payoff is going to be $100 Net income = $115 with prob. 0.8 Net income = $40 with prob. 0.2 If payoff is going to be $55 Net income = $115 with prob. 0.2 Net income = $40 with prob. 0.8» Continued

16 Agency Theory (continued) Agency contract example 9.2 (continued) Manager s utility EU m (a 1 ) = 0.6[0.8(k 115) 1/ (k 40) 1/2 ] + 0.4[0.2(k 115) 1/ (k 40) 1/2 ]-2 EU m (a 2 ) = 0.4[0.8(k 115) 1/ (k 40) 1/2 ] + 0.6[0.2(k 115) 1/ (k 40) 1/2 ] 1.71 Owner s utility (risk neutral) EU O (a 1 ) = 0.6[0.8(100 -(1 k) 115) + 0.2(100 -(1 k) 40)] + 0.4[0.2(55 -(1 k) 115) + 0.8(55 -(1 k) 40)]» Continued

17 Agency Theory (continued) Agency contract example 9.2 (continued0 Formal Statement of the Owner s Problem Find k to maximize EU O (a) Subject to: Manager wantsto take a 1 (incentive compatibility: i.e., manager utility higher for a 1 than a 2 ) Manager receives reservation utility of R = 3 The result: K =.3237» Continued

18 Agency Theory (continued) Agency contract example 9.2 (continued0 Check Manager s utility: EU m (a 1 ) = 0.6[0.8( ) 1/ ( ) 1/2 ] + 0.4[0.2( ) 1/ ( ) 1/2 ] 2 = 3 EU m (a 2 ) = 0.4[0.8( ) 1/ ( ) 1/2 ] + 0.6[0.2( ) 1/ ( ) 1/2 ] 1.71 = Incentive compatible: manager wants to work hard since his/her utility is higher» Continued

19 Agency Theory (continued) Agency contract example 9.2 (continued0 Owner s utility EU O (a 1 ) = 0.6[0.8( ) + 0.2( )] + 0.4[0.2( ) + 0.8( )] = Compare with owner s utility of rental contract (Example 9.3) = 51 Contract is more efficient

20 Agency Theory (continued) A more efficient contract, Example 9.3 Retain example 9.2 assumptions, except Higher quality of net income (less noisy, still unbiased) If payoff is going to be 100» Net income = $110 with prob » Net income = $45 with prob If payoff is going to be 55» Net income = $110 with prob » Net income = $45 with prob What share of net income does manager now require to attain reservation utility?» Continued

21 Agency Theory (continued) A more efficient contract, Example 9.3 (continued) k =.3185 (compared with.3237 in previous contract) EU m (a 1 ) = 0.6[0.8462( ) 1/ ( ) 1/2 ] + 0.4[0.1538( ) 1/ ( ) 1/2 ] 2 = 3 EU O (a 1 ) = 0.6[.8462(100 ( ) ( )] + 0.4[.1538(55 ( ) ( )] = Compare with owner s utility of in Example 9.4 Less noisy net income increases contract efficiency How can accountant decrease noise in net income?

22 9.3 Manager s Information Advantage In Examples 9.2 and 9.3, it was assumed manager could not control accounting system A more realistic assumption is that manager cancontrol accounting system Owner cannot observe unmanaged net income, only net income reported by manager Manager may then use this information advantage to bias (i.e., manage) reported net income Example 9.4 In a single-period contract, rational manager will shirk and report highest possible net income Owner utility falls to >> Continued

23 Manager s Information Advantage(continued) The revelation principle If high net income is realized, manager will report high net income Raise manager s compensation if low net income is realized to the point where same compensation is received whether net income is high or low Then, if low net income is realized, manager is indifferent between reporting high or low net income Assume if indifferent, manager will report low net income if lownet income is realized Result: manager reports truthfully» Continued

24 Manager s Information Advantage(continued) Section 9.5, Example 9.5 The revelation principle applied Manager continues to shirk Owner s utility remains at as per Example 9.6 But, manager reports truthfully No adverse selection problem» Continued

25 Manager s Information Advantage(continued) Section 9.5 Problems in applying revelation principle in a financial reporting context Manager may be punished for reporting the truth May be fired if low net income reported Contract restrictions If compensation is capped, manager is effectively punished for reporting net income higher than cap Restrictions on ability to communicate Reporting the truth may impose legal liability and reputation loss on manager and owner, effectively blocking honest communication» Continued

26 Manager s Information Advantage(continued) Result of these problems is that it may be more efficient to allow some upwards earnings management But manager will then overdose on earnings management i.e., back to example 9.6 A solution: restrict earnings management through GAAP: Example 9.8» Continued

27 Manager s Information Advantage(continued) Section 9.5 Example 9.6 Illustrateshow GAAP can restrict earnings management to point where manager must work hard to attain reservation utility Some earnings management remains, but under control Owner s utility now , up from Examples 9.4 and 9.5( ) Some earnings management can be good if controlled by GAAP

28 Section Agency Theory with Psychological Norms (optional section) An interesting model that combines rational decision making with behaviourial characteristics Personal norm: a personal belief (e.g., hard work is good, earnings management is bad ) Social norm: the average behaviourof a peer group such as other managers (e.g., earnings management is accepted) Effect of a personal norm for hard work is to reduce effort disutility Effect of a social norm that earnings management is acceptable may encourage manager to substitute earnings management effort >> Continued 9-28

29 Agency Theory with Psychological Norms (optional section) (continued) Extending Example 9.2 to incorporate norms Assume manager has personal norm for hard work Reduces effort aversion from 2 to 1.5 Assume manager now has an option to manage earnings, but has a personal norm against earnings management,with disutility of 3. However, a social norm accepts earnings management Disutility of earnings management reduced from 3 to 1 Revised Example 9.2 now gives manager required reservation utility of 3 with: Profit share of.2622 (down from.3237) No earnings management Contract is now more efficient 9-29

30 9.6Implications of Agency Theory for Accounting Holmström s agency model Basing manager s compensation on 2 variables is better than on 1 variable, unless the 2 variables are perfectly correlated Example 9.10 Holmström smodel implies that net income is in competition with share price performance for market share in compensation contracts» Continued

31 Implications of Agency Theory for Accounting (continued) Holmström s agency model(continued) To maintain market share in compensation contracts, net income must be informative about manager effort To be informative, net income must have Sensitivity Precision These two desirable qualities usually have to be traded off E.g., fair value accounting may be more sensitive than historical cost, but less precise. Why?

32 Implications of Agency Theory for Accounting (continued) Contract incompleteness All agency contracts in Chapter 9 are complete No possibility of unforeseen state realizations Realistically, contracts cannot anticipate all possible state realizations E.g., new accounting standards may arise during contract term» Manager s net-income-based compensation may be affected» Debt covenant ratios and probability of covenant violation may be affected Contract rigidity (Section 8.5) Contract rigidity prevents simply revising the contract when an unforeseen state realization occurs Result: agency theory implies economic consequences New accounting standards matter to managers since they can affect contracts, motivating managers to change accounting and/or operating policies to avoid effects of a new standard on reported net income and/or debt covenants

33 9.7Reconciliation of Economic Consequences and Securities Market Efficiency Contract incompleteness and rigidity mean that new accounting standards matter to managers This does not conflict with efficient securities market theory Market efficiency implies that new accounting standards with cash flow effects concern managers Contract and agency theories imply allnew standards concern managers (including ones with cash flow effects) Thus contract and agency theories explain why accounting standards matter to managers even when markets are efficient

34 9.10 Conclusions Accounting policies (even without cash flow effects) can have economic consequences but securities markets can still be efficient Role of net income in monitoring and motivating manager performance equally important as informing investors Net income competes with share price as a performance measure Role of GAAP in controlling earnings management