seventh edition william r. scott chapter 9 · pdf filefinancial accounting theory...
Post on 16-Feb-2018
274 Views
Preview:
TRANSCRIPT
Financial Accounting Theory
Seventh Edition
William R. Scott
Chapter 9 An Analysis of Conflict
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
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
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
Chapter 9
An Analysis of Conflict
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
9.2 Agency 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
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
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
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 current-period 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
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 manager bears
all the risk, requires low rent for manager to attain reservation utility,
reducing contract efficiency
• Give manager a share of the payoff
» Continued
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 measure which is available
at period end
– Performance measure must be jointly observable and correlated with payoff
» 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
Agency Theory (continued)
Agency Theory (continued)
• Agency contract example 9.2– Assumptions
• Manager has 2 effort choices:– Work hard (a1 )
– Shirk (a2 )
• 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
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
Agency Theory (continued)
• Agency contract example 9.2 (continued)
– Manager’s utility
EUm(a1) = 0.6[0.8(k ×××× 115)1/2 + 0.2(k ×××× 40)1/2]
+ 0.4[0.2(k ×××× 115)1/2 + 0.8(k ×××× 40)1/2] - 2
EUm(a2) = 0.4[0.8(k ×××× 115)1/2 + 0.2(k ×××× 40)1/2]
+ 0.6[0.2(k ×××× 115)1/2 + 0.8(k ×××× 40)1/2] – 1.71
– Owner’s utility (risk neutral)
EUO(a1) = 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
Agency Theory (continued)
• Agency contract example 9.2 (continued0
– Formal Statement of the Owner’s Problem
• Find k to maximize EUO(a)
Subject to:
Manager wants to take a1 (incentive compatibility: i.e.,
manager utility higher for a1 than a2)
Manager receives reservation utility of R = 3
– The result:
K = .3237
» Continued
Agency Theory (continued)
• Agency contract example 9.2 (continued0
– Check
• Manager’s utility:
EUm(a1) = 0.6[0.8(.3237 ×××× 115)1/2 + 0.2(.3237 ×××× 40)1/2]
+ 0.4[0.2(.3237 ×××× 115)1/2 + 0.8(.3237 ×××× 40)1/2] – 2 = 3
EUm(a2) = 0.4[0.8(.3237 ×××× 115)1/2 + 0.2(.3237 ×××× 40)1/2]
+ 0.6[0.2(.3237 ×××× 115)1/2 + 0.8(.3237 ×××× 40)1/2] – 1.71 = 2.9896
• Incentive compatible: manager wants to “work hard” since his/her utility is higher
» Continued
Agency Theory (continued)
• Agency contract example 9.2 (continued0
– Owner’s utility
EUO(a1) = 0.6[0.8(100 - .3237 ×××× 115) + 0.2(100 - .3237 ×××× 40)]
+ 0.4[0.2(55 - .3237 ××××115) + 0.8(55 - .3237 ×××× 40)]
= 55.4566
Compare with owner’s utility of rental contract (Example 9.3) = 51
Contract is more efficient
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. 0.8462
» Net income = $45 with prob. 0.1538
– If payoff is going to be 55» Net income = $110 with prob. 0.1538
» Net income = $45 with prob. 0.8462
• What share of net income does manager now require to attain reservation utility?
» Continued
Agency Theory (continued)
• A more efficient contract, Example 9.3 (continued)
– k = .3185 (compared with .3237 in previous contract)
EUm(a1) = 0.6[0.8462(.3185 ×××× 110)1/2 + 0.1538(.3185 ×××× 45)1/2]
+ 0.4[0.1538(.3185 ×××× 110)1/2 + 0.8462(.3185 ×××× 45)1/2] – 2 = 3
EUO(a1) = 0.6[.8462(100 – (.3185 ×××× 110) + 0.1538(100 - .3185 ×××× 45)]
+ 0.4[.1538(55 – (.3185 ×××× 110) + 0.8462(55 - .3185 ×××× 45)]
= 55.8829
Compare with owner’s utility of 55.4566 in Example 9.4
Less noisy net income increases contract efficiency
How can accountant decrease noise in net income?
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 can control 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 50.8165
>> Continued
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 low net
income is realized
– Result: manager reports truthfully
» Continued
Manager’s Information Advantage (continued)
• Section 9.5, Example 9.5 The revelation principle applied
– Manager continues to shirk
– Owner’s utility remains at 50.8165 as per Example 9.6
– But, manager reports truthfully
• No adverse selection problem
» Continued
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
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
Manager’s Information Advantage (continued)
• Section 9.5 Example 9.6
– Illustrates how 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 55.4981, up from Examples 9.4 and 9.5 (50.8165)
– Some earnings management can be “good” if controlled by GAAP
Section 9.3.4 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 behaviour of 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
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
9.6 Implications 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’s model implies that net income is in competition with
share price performance for “market share” in compensation contracts
» Continued
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?
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
9.7 Reconciliation 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 all new 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
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
top related