Kristen EicherMichael Pegutter

What is Game Theory? Agency Theory Game Theory in Action Types of Games Game Theory and Accounting Policy Employment Contracts Utility and Important Assumptions Dealing with Moral Hazard Manager’s Informative Advantage Earnings Management Within GAAP Bondholder-Manager Lending Contract Management Performance Measures Contract Rigidity Efficient Securities Market and Economic Consequences Conclusion

Attempts to model the outcome of conflict between rational individuals

Conflict: exists when one party has the motivation to act in manner which is not optimal to another party

Differs from investment theory because playing against an opponent who can think

Agency Theory: branch of game theory that studies the design of contracts to motivate a rational agent to act on behalf of the principal when the agent’s interests would otherwise conflict with those of the principal

To make a contract binding: Employment Contracts: between firm and top

manager Lending Contracts: between firm manager

and bondholder

http://www.youtube.com/watch?v=ED9gaAb2BEw&feature=fvwrel

Read your situation and determine your strategy

Cooperative Games Non-Cooperative Games

Existence of a binding contract

Cartel is an example; work together to maximize payout

Conflict exists

Nash Equilibrium: given the strategy choice of the other player, each player is satisfied with his or her strategy

Strategy pair: BH Built on trust Win-win situation and both parties

receive a higher payout Once trust is broken then will be

difficult to achieve BH again, will go to RD

Misused accrued liabilities in order to make the company appear profitable

Restatement of statements from 2000 to mid-2003 reduces losses by 505 million; restated twice and missed filing deadlines

Both SEC and RCMP launched formal investigations June 19, 2009 – RCMP lays fraudulent charges against

Dunn (former CEO) and two of his lieutenants

Policy needs to protect both short and long-term interests

Regulations can reduce the payoffs for certain actions; jail time and legal fees if caught distorting reduces the payout

Enron and Sarbanes-Oxley Act (2002) ◦ Senior management needs to certify accuracy of

statements ◦ Internal controls needs to be developed and

tested

Manager’s Effort

a1 (work hard) b1 (shirk)

Payoff

Probability

Payoff Probability

x1 (high payoff)

$100 0.6 $100 0.4

x2 (low payoff) $55 0.4 $55 0.6Why is the probability of a high payoff higher when the manager works hard?

Why is there still a probability that a low payoff will occur if the manager works hard?

Utility: degree of satisfaction towards a strategy

Disutility: degree of effort which needs to be put forth to receive payout – “the work you put in”

Reservation Utility: compensation offered must be sufficiently large that expected utility is at least equal to the opportunity cost

Manager is “effort-averse”

Assume manager is getting paid $25 Firm Owner’s EU

EUO(a1) = 0.6(100 – 25) + 0.4 (55 – 25) = 57EUO(a2) = 0.4(100 – 23) + 0.6 (55 – 25) = 48

Manager’s EU ◦ Assume disutility of effort for a1 = 2.0 and a2 = 1.71

EUm(a1) = (√25) – 2.0 = 3EUm(a2) = (√25) – 1.71 = 3.29

1. Let the manager shirk

2. Direct monitoring

3. Indirect monitoring

4. Owner rents firm to the manager

5. Give the manager a share of profits

2. Direct Monitoring 3. Indirect Monitoring

Observe the employee and reduce their pay when shirk

Working hard will increase manager’s EU, motivating to work hard

Observe at end of period

Adjust salary based on state achieved

Internalizing means the owner does not care what payout occurs because they will be paid fixed amount regardless◦ Onus to perform is on manager because incur all

the risk and benefit

What effect will this have on accounting practices used?

Owner needs to compensate manager when results not seen until next period◦ Performance Measure: results seen in same

period and reflect manager performance ◦ Net income often used

Noisy because of lag recognition and biased internal control

What is our role as accountants here?

Holding key employees to “financial measures” like net income, revenue and ROI

Regulators have pushed banks to design pay packages for top employees that would discourage excessive risk-taking

The payouts may be halted or reclaimed if the firm determines, for example, that an employee engaged in “materially improper risk analysis or failed sufficiently to raise concerns about risks”

Earnings Management

Managers have explicit information about earnings and can choose to manage results for their own benefit

Pre-Contract Information: manager has access to payoff information before signing the contract

Pre-Decision Information: manager obtains payoff information after signing the contract but before choosing an action

Post-Decision Information: manager receives information after action is chosen

Manager shirks, which decreases owner utility and results in lower Net Income

Revelation Principle

Can motivate truthful reporting by giving same compensation regardless of net income

Conditions for constant compensation contracts:◦ Owner commitment that the truth will not be used against the

manager◦ No restrictions of the form of the contract ◦ No restrictions on manager’s ability to honestly communicate

information

Increases investor confidence that reported Net Income is free from distortion and bias, reducing adverse selection and bettering the owner’s position

Controlling Earnings Management

GAAP allows discretion for choice among accounting policies but limits amount by which earnings can be management

Giving Net Income in a range of potential outcomes provides clearer idea of possible future state and ensures earnings management within GAAP measures

Identified Net Income Range: $110 - $115 Unmanaged Net Income: $112 Reported Net Income: $115

Earning’s Management Applied:◦ Changing amortization method◦ Accelerating revenue recognition◦ Asset reclassification

1. Owner unlikely to observe manager’s effort leading to moral hazard and manager shirking. Agency theory seeks the most efficient contract.

1. Most efficient contract depends on what can be jointly observed. May be effort, payoff, Net Income, or resort to rental contract.

1. Second best contract imposes lowest amount of risk on manager while maintaining incentive to work hard and reservation utility. Improve precision of Net Income as payoff predictor.

1. Manager controls accounting system and has information advantage leading to earnings management. Using GAAP to limit earnings management contracts can maintain manager’s incentive to work hard.

Payoff is conditional on manager’s actions

Manager may act contrary to best interest of lender depending on his/her own share of Net Income; bondholders will anticipate this risk and raise demanded interest rates or contract covenants

Holström discusses compensation based on more than one performance measure

Performance measure characteristics:◦ Sensitivity◦ Precision

Challenge to determine which measures are most useful, sensitivity and precision not necessarily align with investor requirements of relevance and reliability

How do you think an additional performance measure impacts the manager’s effort?

Eum(a1) = 3 Eum(a2) = 3 Euo(a1) = 55.552

Compensation packages based on net income and share price

Motivates management to commit to corporate goals and profits

Achieving ROE of >15% by 2015 as priority for operational objectives on 2010 financial reports

Virtually impossible to anticipate all contingencies and possible states of nature when enter into contracts

Renegotiation abilities can reduce manager motivation to act in the owner’s best interest

Unforeseen state realizations impose costs to firm and/or manager

IFRS changes treatment of specific items and acceptable accounting policies

May affect bottom line results, which may create violations of returns/covenants within a contract

Can lead to costly court fees and lengthy processes to change the terms of the agreement

High performance = high payoff = happy stakeholder

Efficient securities market theory measures economic consequences from accounting policies affecting expected cash flows

Contract agency model incorporates economic consequences caused by contract rigidities and binding obligations

Positive accounting theory reconciles the two with normative agency supporting why each party entered the contract

1. Agency model reconciles efficient securities market with economic consequences

1. Describes Net Income’s role in monitoring management performance as well as capital generation

1. Net Income competes with other performance measures for compensation and management effort

1. Earnings management allows for shirking, resulting in low payoffs for owner and investor. GAAP restores management’s incentive to work hard through controlling earnings management

Questions?

CBC News Online. (2006, October 23). From collapse to convictions: a timeline. Toronto, Ontario, Canada.

Eluta.ca. (2007). Canada's Top 100 Employers. Retrieved March 20, 2011, from Sun Life Financial Assurance Company of Canada Inc.: http://www.eluta.ca/einfo?en=Sun+Life+Financial+Assurance+Company+of+Canada+Inc.&ri=b2e76ed10653d0c1775ddb3a69f9e8b7&rk=1ff65a18c2159986d37e6f39ad7bff8b

Holström, B. (1979). Moral Hazard and Observability. The Bell Journal of Economics .

Investopedia. (2011). Sarbanes-Oxley Act 2002. Retrieved March 24, 2011, from Investopedia: http://www.investopedia.com/terms/s/sarbanesoxleyact.asp

Reader's Digest. (2010, April 21). CANADA’S MOST TRUSTED BRANDS REVEALED! Reader’s Digest Canada’s Annual Poll. Retrieved March 20, 2011, from Reader's Digest.ca: http://www.readersdigest.ca/canada%E2%80%99s-most-trusted-brands-revealed-reader%E2%80%99s-digest-canada%E2%80%99s-annual-poll

Scott, W. R. (2009). Financial Accounting Theory. Toronto: Pearson Canada Inc. Sun Life Financial Inc. (2010). Consolidated Financial Statements and Notes.

Retrieved March 20, 2011, from Sun Life Financial : http://cdn.sunlife.com/static/global/files/Year%20end%20reports/pa_e_Q410_2010_FinStats.pdf