seventh edition william r. scott chapter 9 · pdf filefinancial accounting theory...

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


• 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


• 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


• 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 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 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



– 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


– 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 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


• If manager shirks



Note fixed support

» 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


• If payoff is going to be $55



» 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 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



– 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



– 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


• 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


• 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


• 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


• 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


• 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


• 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

seventh edition william r. scott chapter 9 · pdf filefinancial accounting theory...

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