Summary of Chapter #9: An Analysis of Conflict

Overview
Game theory, which models and predicts the outcome of conflict between rational people, is
necessary to fully understand economic consequences. Agency theory, a version of game theory that
looks at the process of contracting between two or more individuals, will also be considered.
Undoubtedly, economic consequences and agency theory contain conflict. Game theory can help us to
understand how managers, investors and other parties can deal with the economic consequences of
financial reporting and why contracts depend on financial statements.
Understanding Game Theory
Game theory is the basis of many current issues in accounting theory. It models the interactions
of two or more players in an environment of uncertainty and information asymmetry. As in decision
theory, each player is assumed to maximize their expected utility, however it requires that the players
consider the actions of other players. The action that one player chooses will depend on what action
that player thinks the other will take. Therefore, the actions of one player influence the others. This
defines the conflict aspect of the model.
There are many different types of games. One way to distinguish them is as cooperative and
non-cooperative games. In a cooperative game, the parties can enter into a binding agreement, such as
a cartel. However, if this type of agreement were not possible, it would be a non-cooperative game,
such as an oligopolistic industry.
A Non-Cooperative Game Theory Model of Manager-Investor Conflict
Since the decision needs of different parties may not coincide, conflict between parties can be
modeled as a game. One example of this conflict may exist between investors and managers. Investors
want relevant and reliable financial information to assist them in assessing the risks and expected
returns of an investment. However, managers may not wish to reveal all information.

Example 9.1: Manager-Investor Relations in a Non-Cooperative Game

The manager must chose between one of two strategies. He can choose distort (D) by under
investing in the internal control system or bias reported net income. The second choice is to choose
honest (H). The investor also has two strategies. He can either buy shares (B) in the managers firm
or refuse to buy shares (R).
Table 9.1 Utility Payoffs in a Non-Cooperative Game
Manager
HONEST (H)

DISTORT (D)

60, 40

20, 80

35, 20

35, 30

BUY (B)
Investor
REFUSE TO BUY (R)

Each party has complete information about the other. So, the investor knows the strategies and
payoffs available to the manager and vise versa. However, they must choose their strategy without
knowing the strategy the other party selected. Therefore, RD will be the strategy chosen. This is the
only pair in which each player is content with their strategy, even though both parties would be better
off if BH were chosen.
The fundamental point is that these models enable individuals to better understand the process
of accounting policy choice. Each party has their own interests at stake, which may conflict. Better
understanding of this conflict situation by accounting standard setters will result in more realistic
accounting policy choices.
Some Models of Cooperative Game Theory
Many areas of accounting exhibit cooperative behavior; players in a game situation can enter
into binding contracts. The two main types of contracts are employment contracts and lending
contracts. In these contracts one party is the agent and the other is the principal. For instance, in an

employment contract, the owner of the firm is the principal, and the manager running the firm is
considered to be the agent. This is an example of Agency theory
Agency theory contracts can have characteristics of both cooperative and non-cooperative
games. Each party must play by the rules and commit to the contract, however they do not specifically
agree to take certain actions.
Agency Theory: An Employment Contract between Owner and Manager
A firm consisting of a principal and an agent faces uncertainty, expressed in the form of random
states of nature. The agent has two possible actions; to work hard; or to slack off. The greater the
effort put into the operation by the agent, the higher the probability of the high payoff and the lower the
probability of the low payoff. However, it is unlikely the agents efforts could completely ensure the
high payoff, because some of the factors are beyond his or her control.
Effort is considered more than just the number of hours work; it is the care that the agent takes
in running the firm. The payoffs under each state of nature are assumed to be observable to both
parties.
It is important to note that in game theory, one player will not choose an act desired by another
player because the player says so. Each party will choose the act that maximizes their own expected
utility.
Designing a Contract to Control Moral Hazard
The tendency of an agent to slack off because they are paid a set salary is an example of moral
hazard. The owner has two choices, to run the business themselves or to go out of business.
The owner could observe the managers chosen act; the contract could be changed to pay the
manager a lower salary if an inferior action was chosen. This is an example of a first-best contract.
Unfortunately, this type of contract is often unattainable. Thus, there is a case of information
asymmetry, the manager knows the extent of their effort, but the owner does not.

It is possible for the owner to indirectly monitor the manager as well. This case could utilize
moving support, that is, the set of possible payoffs would move depending on which action is taken.
However, legal and institutional factors may prevent the owner from penalizing the manager to choose
a certain action.
The owner may be tempted to rent the firm to the manager, thus no longer caring which action
is chosen. This is referred to as internalizing the managers decision problem. The owner is riskneutral because a fixed rental is received. The manager is risk-averse and must bear all of the risk.
As an alternative, the owner could give the manager a share of the payoff. The contract
provides motivation for the manager to choose the better action; this is referred to as incentivecompatibility. Hence, the interests of the two parties are aligned, as they both wish for the firm to do
well.
In a second-best contract, the agency cost is the cost to the principal to motivate the agent by
means of a profit sharing contract. The manager would have to bear some risk to convince the owner
that the work-hard alternative would be chosen.
Lender-Manager Agency Problem
The lender-manager agency problem is the second source of the moral hazard problem. This
arises from the fact that creditors cant usually observe the actions of managers of the firm they have
contracts with. Both the manager and the creditor want to maximize their total expected utility. In order
to prevent managers from manipulating accounting figures lenders, include covenants in their contracts
requiring managers to keep their debt-equity ratio at a certain level for example.
The owner-manager and lender-manager agency examples illustrate that cooperation is better
for both parties involved. This feeds into the Positive Accounting Theory in that it provides an
incentive for managers to use accounting policies to manage their numbers, which in turn results in the
economic consequences discussed in chapter seven.

Implications of Agency Theory for Accounting

The two implications of agency theory for accounting are: measuring payoff and the rigidity of
contracts.
1. Measuring Payoff
Since the principal (creditor) cant observe the agent (manager) the first-best options
of the contract may not be possible and so the best way to compensate a manager may be with a
share of the payoff. The payoff has to be observable by both parties and net income is used
most often.
An alternative way of measuring payoffs is share price performance. However, this may
not be as reliable as net income because many factors that managers cant control, affect share
prices. According to the agency theory the more correlation there is between the payoff
measure and the managers amount of effort the better.
2. Rigidity of Contracts
This second implication of the rigidity of contracts is based on the fact that not all
possible state realizations can possibly be anticipated at the time contracts are written up. These
contracts are known as being incomplete. Managers have to face the fact that contracts are hard
to renegotiate. If contracts could easily be renegotiated we would be back to the efficient
market theory that states accounting standards dont matter.
Reconciliation of Efficient Securities Market Theory with Economic Consequences
As we saw with contracts, it is not the cash flow effect, but the incomplete contracts that cause
concern for managers. The covenants involved with these contracts are usually based on the
companys financial statement numbers, and hence they are concerned with accounting policies that
may affect these values.

So we see a reconciliation of the efficient securities market theory and the economic
consequences. Managers may very well intervene with accounting policies even if that would mean
better information for investors, hence creating a game between them.
Some other explanations for economic consequences other than game theory are:
1) Managers do not believe in security market efficiency
2) Managers do accept market efficiency but want to use accounting standard choices as a way
to convey inside information
3) Competitive disadvantage due to disclosures (Darrough & Stoughton)