Game Theory

A normative theory what should be

Considers uncertainty and information asymmetry
Tries to model the interaction between two or more people
Every player is trying to maximize their expected utility, which causes conflicts as one party's attempt to maximize their utility will affect the other person
A small number of people whereby influences of one person influences the actions of another person
Game theory attempts to model and predict the outcome of conflict between rational individuals
Game theory can help us understand how managers, investors, and other affected parties can rationally deal with the economic consequences of financial
reporting

Contract based role for financial statements that emerges from game theory helps us to see how the theory of efficient securi ties markets is not
necessarily inconsistent with economic consequences

Game theory tends to be more complex than decision theory and the theory of investment because players need to take into cons ideration both
uncertainty and the other player's action

Description
Parties can enter into a binding agreement
Parties in a conflict situation can enter into agreements that they perceive as binding - contracts
Firm - principal; manager - agent hired
Contracts between the firm and its top manager
Employment contracts
Contracts between the firm manager and the bondholder
Lending contracts
Cooperative Games
Non-cooperative game model of manager-investor conflict
Difficult and costly as different users may have different need for information
It is difficult to envisage a binding agreement between managers and investors about what specific information is to be suppl ied
Investors will desire a useful tradeoff between relevant and reliable financial statement information, to assist in assessing the expected values and
risks of their investment

Mangers will also be aware of possible investor reaction when preparing the financial statements
Investors are aware of this possibility and will take into account when making an investment decision
Managers may not wish to reveal all the information that investors desire
Each party choose the option that maximizes their payoff
Nash equilibrium is an equilibrium where each player is content with his or her strategy
To achieve such a solution and not the unfortunate Nash equilibrium where no one party is better off or worst off, both parti es might enter
into a binding agreement on the cooperative solution

A reputation for honesty would be established and investors would start choosing the cooperative solution
Thus, the deviating player will be punished by receiving only the non-cooperative Nash equilibrium payoff for the remainder of the
game

Then, the Nash equilibrium will once again be returned to

Folk theorem: each player threatens that if the other player deviates from the cooperative solution, he/she will switch strat egy the next
time the game is played

Can also think on a long run perspective, where the game is repeated for more than one period and the manager always acted et hically by
choosing the cooperative solution

Cooperative solution is a strategy pair where both parties would be better off
The high or low payoffs are generated by some random mechanism called nature
Thus, a decision theory problem is sometimes called a game against nature, because some impartial force (nature) is assumed t o generate the
high or low payoffs with the probabilities as given

I.e., investor cant assign probability to a manager's action choice when the manager's action is not chosen probabilistically.
This assumption breaks down when the payoffs are generated by the actions of a thinking opponent rather than by nature
Assumes that the particular decision chosen by the investor would not affect what the probabilities are; does not affect "nat ure"
Single person decision theory
Enable us to better understand the process of accounting policy choice
The assumption of PAT that managers are rational, leading to the possibility of opportunistic behavior, makes it clear that m anagement
has its own interests at stake in accounting policy choice and cannot be assumed to necessarily adopt full disclosure or othe r accounting
policies solely on the ethical grounds that they will be useful to shareholders and other investors

Managers are unwilling to sit idly by and adopt whatever accounting policies are suggested by the standard setters
Game theory
Interest of the investor and manager constituencies may conflict
From an accounting perspective, the role of high quality financial reporting to maintain investor trust in manager is crucial
Single period game
Non-cooperative Games
Agency Theory
Agency theory is a branch of game theory that studies the design of contracts to motivate a rational agent to act on behalf of a principal when the agents
interests would otherwise conflict with those of the principal. (p. 340)

Principal wants to hire an agent to carry out some specialized task

Ownership - principal
Control - agent
Both the principal and the agent are rational
Agent is risk averse and effort averse
Principal is risk neutral
Agent can observe his/her effort while the principal cannot
There is information asymmetry - moral hazard
Assumptions
Single period
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Agent can observe his/her effort while the principal cannot
How the principal can design a contract to motivate the agent to make the appropriate decisions?
This market puts a value of the manager's services, where the value depends on the manager's ability, including training, exp erience, and
reputation

If the contract doesnt offer managers at least the reservation utility, the manager will go elsewhere to receive a utility greater than
the reservation utility

A fixed number on a single period

Good - higher reservation utility
Determined by the manager's reputation
Reservation utility
If the manager is to be willing to work for the owner for the current period, the compensation offered must be sufficiently l arge that his/her
expected utility is at least equal to its opportunity cost, that is, the utility that could be attained by the manager is the next best employment
opportunity - reservation utility

All parties want to maximize their own expected utility

There is a reasonably efficient managerial labour market
The manager dislike effort and that the greater the level of effort the greater the dislike
Disutility of effort is subtracted from the utility function
Manager is effort-averse
Bondholder-principal; manager-agent
Moral hazard problem, namely a contract between lender and a firm
Covenant may include pay no dividend if the interest coverage ratio is below a specified level
Do no take any additional borrowing if the D/E ratio is below a specified level
Write covenants into the lending agreement
Covenants are a legally binding contract component, the lender will change the assessed probabilities of the acts
To avoid a high nominal rate, manager may try to find some more efficient contractual arrangement that would lower the interest rate
Offer to bondholder an nominal rate that would make them indifferent from choosing between a rate elsewhere
Debt Contracts
Agency theory assumes that the courts have authority to costlessly enforce contract provisions and adjudicates disputes
Contracts tend to be rigid once signed
Difficult to predict change in GAAP that could affect the contract
Contracts that do not anticipate all possible state realizations are termed incomplete
Generally impossible to anticipate all contingencies when entering into a contract
Agreement would then be required from all of them, or at least a majority
The manager's compensation contract with the firm owner would be similarly difficult to amend
There are many bondholders
The party who suffered from change in standard will be worst off, and the party who is unaffected is better off.
Economic consequences: because these contracts have rigid terms, there is economic consequences where accounting policy now will affect
manager's behavior

Reasons
Contract Rigidity
Employment Contracts
Can help to control moral hazard
Risk neutral - we look at expected payoff
Principal/owner is rational and risk neutral, and would like the agent to maximize the payoff for the company
Risk averse - we look at expected utility
Agent/manager is rational and risk & effort averse, and the manager wants to maximize his/her expected utility of his/her compensation, net of the disutility of
effort

Pay the manager a fixed amount pay

Attractive to risk averse managers as having fixed salary imposes little risk
Managers would most likely not put in effort as the payoff is fixed with no variability
Fixed Salary
If the owner could costlessly observe the manager's chosen act, then the problem would be corrected as the owner can enforce the desired action
Gives the owner the maximum attainable utility and gives the agent his/her reservation utility
Has risk-sharing properties
Since manager is risk-averse, this is desirable
Since owners are risk neutral, they dont mind bearing risk
Managers bears none of the firm's risk, because a fixed salary is received regardless of the payoff
First-best: a contract where direct monitoring is possible
The managers knows the effort level, but the owner does not
Because first best contract is frequently unattainable, information asymmetry arises
Direct Monitoring of Effort
Given that managerial effort is not directly observable, it may be possible under some conditions to impute the effort
Moving support: the set of possible payoffs is different depending on which act is taken
Fixed support: the set of possible payoffs is fixed, regardless the action choice
The owner can observe what the actual payoff is, and derive from that which action was taken by the manager. Then the owner c an amend the
contract to include penalties that would make the managers select the desired action for to meet their reservation utility

Indirect monitoring will not work for the fixed support as payoffs might be consistent in desired and undesired actions, henc e it is difficult to derive
which action was taken that lead to the observable payoff

Indirect monitoring will not work even under moving support as legal and institutional factors may prevent the owner from penalizing the manager
sufficiently to force a desired action

Indirect monitoring
Firm rents to the manager and managers pays a rental fee, then the manager will receive all the residual income in the firm
Internalizing the manager's decision problem
Rental cost is taken out of expected payoff to determine utility for the manager
Agency cost - contracting cost. A cost imposed on the contract to the manager that brings the manager's action to a desired state
Manager is motivated to work hard, but is bearing all the risk
Owner Rents the Firm to the Manager
Type of contracts
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Owner ends up receiving less than desired
Assume manager is risk averse - must give manager sufficient/higher return for manager to meet reservation utility
Assume owner is risk neutral - not concerned about risk
Manager is motivated to work hard, but is bearing all the risk
Compensate the manager with a share of company profits
I.e., R&D costs results in profits spread over multiple periods in the future
Imposes a challenge in setting up a compensation plan at the end of the period due to the recognition lag
Solution: base the compensation on performance measure that is jointly observable at the end of the period
Very simple in a one period world, however the owner normally has a company that'll run for many periods into the future
Give the manager a share of firm performance in the form of bonus, which is evaluated on performance measures
May not perfectly measure the manager's performance due to recognition lag - income from R&D being spread over periods
Net income - noisy
I.e., net income; but may not be perfect if internal control is weak - management earnings manipulation
Performance measure, on some jointly observable variable that reflects the manager's performance and is available at the end of the first period
Incentive compatibility - agent's interest is compatible with principal's interest
This is a contract that motivates the manager to work hard; managers want to take the desired action
Second best: a contract short of being first best
Give the Manager a Share of the Profits
Net income tells us something about manager performance, since much of manager effort shows up in current earnings
GAAP/IFRS are setting standards as to how net income is to be calculated
A measure that both manager and owner agrees on
Fairly reliable
Provides assurance that this is a number can be used because it is audited
Reasons for using net income as a basis for performance measure
Poor corporate governance - weak internal control - random error or bias in income
Realization of revenue from R&D may be delayed until after the period that its written off as expenses
Several component of manager effort may not fully pay off during the current period, such as R&D
Recognition lag
However, since accruals are subject to error and bias, and since reliability concern prevents them from completely removing
recognition lag, net income does not tell the full story about current manager performance

Through accruals, net income anticipates at least some of the ultimate cash flows from current manager performance
Reasons
The greater noise in net income means that it predicts the payoff from current manager effort less precisely
Net income is noisy
Enhances the role of net income as a performance measure in managerial compensation plans
A less noisy net income will reduce compensation risk, enabling a lower profit-sharing proportion for the manager and increased contracting
efficiency

However, net income is not fully informative about effort

The rate at which the expected value of a performance measure increases as the manager works harder, or decreases as the mana ger
shirks

Links to the effort managers put in

Contributes to efficient compensation contracts by strengthening the connection between manager effort and the performance me asure,
thereby making it easier to motivate that effort

If manager changes effort, the expected value of the performance measure should change accordingly
Sensitivity
Measured as the reciprocal of the variance of the noise in the performance measure
When a performance measure is precise, there is a relatively low probability that it will differ substantially from the payof f
Contributes to efficient compensation contracts, by reducing the manager's compensation risk
Uncertainty is involved
Precision
I.e., RRA reflects manager effort devoted to proving oil and gas reserves sooner than historical cost accounting (sensitivity), but
decreases reliability through estimates (imprecise)

Attempts to increase sensitivity of net income by adopting current value accounting may reduce precision, since current value estimate
tend to be imprecise

When net income is biased, there is a tradeoff between sensitivity and precision
Characteristics of performance measures
Net Income as a Basis for Compensation
The source of efficiency loss is the necessity for the risk-averse agent to bear risk in order to overcome the tendency to take undesirable
actions

Contract based on a performance measure such as net income is less efficient than first best
Valid only if provided that second measure (share price) is also jointly observable and conveys some information about manage r effort beyond
that contained in the first measure (net income)

Second best contract could be made more efficient by basing it on a second performance measure in addition to net income, suc h as share price
Therefore, net income and share price can together better reflect current manager effort than either variable one
No matter how noisy the second variable (share price) is, it can increase the efficiency of the second best contract if it co ntains at least some
additional effort information

The greater efficiency arises because introduction of a second performance measure provides the manager with some diversifica tion of
compensation risk, enabling reservation utility to be attained with lower expected total compensation

Lower compensation shows up as higher expected utility for the owner as they dont have to incur that much more remuneration
Two performance-measure contract is more efficient
Multiple Performance Measures
Articles
Using net income as a measure of performance
Net income is closely related to earnings per share
As Companies Step Up Buybacks, Executives Benefit, Too
The issue with using EPS as a measure of management performance
Increase income
EPS can be manipulated by companies
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Increase income
Buy back shares
Decrease the number of shares
If paying managers based on EPS, most likely the EPS would be inflated by the manager through buying back shares
For investors to make a good decision
For contracts (debt, compensation, etc.)
Agency conflict
Hence conflicting purposes
Financial statements purposes
Capital gains
Unemployment rate is stubbornly high, yet corporations are profiting a lot
Conflict between workers and corporations
Corporate profit are taking a larger share of America's GDP than before the financial crisis
The first is that executives are worried about excessive regulation
The second is that firms are reluctant to invest in the face of weak demand
Managers are motivated by share options and share prices are driven by changes in earnings per share. Spending cash on share buy-backs boosts
earnings per share immediately, whereas a capital-investment program may actually reduce earnings in the short term

Incentives may be to blame

Three reasons for this cash mountain:
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