Professional Documents
Culture Documents
Sixth Edition
William R. Scott
Chapter 9
An Analysis of Conflict
9-1
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Chapter 9
An Analysis of Conflict
9-2
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9.2 Game Theory
9-3
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9.3.1 A Single-Period Non-
Cooperative Game
Table 9.1 UTILITY PAYOFFS IN A NON-COOPERATIVE GAME
Manager
HONEST (H) DISTORT (D)
BUY (B) 60, 40 20, 80
Investor
REFUSE
TO BUY (R) 35, 20 35, 30
» Continued
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A Single-Period Non-Cooperative
Game (continued)
• Nash equilibrium solution
– RD: payoffs 35,30
• Cooperative solution
– BH: payoffs 60, 40
• Single play of the game
– Why is BH unlikely?
• Multiple plays: BH more likely
– Manager reputation and ethical behaviour
– Folk theorem
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9.3.2 A Multi-Period Game (optional section)
• Example 9.2
– A 5-period game
– If parties do not trust each other, game unravels to
single-period
– If parties trust each other, game continues with
probabilities shown.
• Note: trust is not complete but depends on difference
between a player’s expected payoff from continuing and
payoff from ending the game
– How is trust maintained?
• Ethics
• Legal liability
• GAAP
9-6
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9.4 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
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Agency Theory (continued)
>> Continued
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Agency Theory (continued)
9-9
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Agency Theory (continued)
» Continued
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Agency Theory (continued)
» Continued
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Agency Theory (continued)
» Continued
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Agency Theory (continued)
» Continued
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Agency Theory (continued)
» Continued
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Agency Theory (continued)
» Continued
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Agency Theory (continued)
» Continued
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Agency Theory (continued)
» Continued
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Agency Theory (continued)
» Continued
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Agency Theory (continued)
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Agency Theory (continued)
– If payoff is going to be 55
» Net income = $110 with prob. 0.1538
» Net income = $45 with prob. 0.8462
» Continued
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Agency Theory (continued)
• A more efficient contract, Example 9.5 (continued)
– k = .3185 (compared with .3237 in previous contract)
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9.5 Manager’s Information
Advantage
• Post-decision information
– Manager can observe unmanaged net income, but
owner can’t
– In a single-period contract, rational manager will shirk
and report highest possible net income
– Example 9.6: owner utility falls to 50.8165
» Continued
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Manager’s Information Advantage
(continued)
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Manager’s Information Advantage
(continued)
• Example 9.7
– 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
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Manager’s Information Advantage
(continued)
» Continued
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Manager’s Information Advantage
(continued)
» Continued
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Manager’s Information Advantage
(continued)
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9.8 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
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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?
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Implications of Agency Theory for
Accounting (continued)
• Contract incompleteness & rigidity
– These are basic reasons why accounting policies can have
economic consequences
• Incompleteness
– 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 ration may be affected
• Rigidity
– Once signed, contracts hard to change
– Result: economic consequences
• I.e., accounting policies matter since they can affect contracts
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9.9 Reconciliation of Economic
Consequences and Securities
Market Efficiency
• Contract incompleteness and rigidity mean that
accounting policies matter
• This argument does not conflict with efficient
securities market theory
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9.10 Conclusions
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