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Group B: Divya, Gloria, Melissa, Mohammed, Richard, Vivien

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Game Theory Basics Cooperative Game Theory Non-cooperative Game Theory Agency Theory and the Bondholder-Manager Lending Contract Example Implications for Financial Accounting Theory Project Earnings Manipulation Case & Discussion

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Game theory helps understand managers, investors, and other parties to rationally deal with economic consequences of financial reporting Agency theory: is a branch of game theory that studies the process of contracting between 2 or more persons Game Theory Basics Types of Game Theory Agency Theory Implications for FAT Case

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Attempts to model and predict the outcome of a conflict between rational individuals Models the interactions between 2 or more players where there is uncertainty and information asymmetry Must take the actions of the other players into account Two types of games Cooperative Non-cooperative Game Theory Basics Types of Game Theory Agency Theory Implications for FAT Case

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Framework for studying conflict situations and predicting decisions parties will make when managers and investors do not have a binding agreement about what specific information is to be supplied Agreement can be costly since users have various decision problems and information needs Agreements can be illegal (e.g. cartels) Game Theory Basics Types of Game Theory Agency Theory Implications for FAT Case

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Managers may not wish to reveal all information that investors want E.g. omitting liabilities so it will be easier to raise capital by facilitating contracts with lenders E.g. management believes that releasing too much information will benefit competitors Investors are aware of this and will take it into account when making their investment decisions Game Theory Basics Types of Game Theory Agency Theory Implications for FAT Case

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Management Investors Honest (H)Distort (D) Buy (B)60,4020, 80 Refuse to Buy (R)35,2035, 30 Game Theory Basics Types of Game Theory Agency Theory Implications for FAT Case

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Strategy decision with which both parties will be content given the strategy choice of the other player Not necessarily the best outcome of the game Auditing scandals in the early 2000s – managers saw that the immediate payoff by departing from a cooperative solution outweighed the longer-run costs of investor and regulator reaction Central authorities have been trying to regain investor confidence in financial reporting (e.g. introducing new regulations and/or threaten penalties for distortion) – change payoff ratios for situations so that managers will not deviate from the cooperative solution Game Theory Basics Types of Game Theory Agency Theory Implications for FAT Case

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Ex. Payoff to Manager is fixed amount of 25 Expected Utility for the Owner if Manager Works Hard (a 1 ) 0.6(100-25) + 0.4(55-25) = 57 Expected Utility for the Owner if Manager Shirks (a 2 ) 0.4(100-25) + 0.6(55-25) = 48 Game Theory Basics Types of Game Theory Agency Theory Implications for FAT Case

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Assume Manager is effort-averse (a 1 ) if manager works hard, a manager will experience a disutility of 2 (a 2 ) if manager works hard, a manager will experience a disutility of 1.71 Expected Utility for Hard working manager (a 1 ) Sqrt(25) – 2 = 3 Expected Utility if Manager Shirks (a 2 ) Sqrt(25) – 1.71 = 3.29 Game Theory Basics Types of Game Theory Agency Theory Implications for FAT Case

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Designing a Contract to Control Moral Hazard Alternatives Hire the manager and put up with a 2 essentially do nothing Direct Monitoring Indirect Monitoring Rent the firm to manager Profit Sharing Game Theory Basics Types of Game Theory Agency Theory Implications for FAT Case

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Owner could observe the managers efforts closely Salary would be dependent on firm profits Called first-best contract Owner bears all risk whereas the manager bears no risk Often unattainable – nature of managerial effort is so complex that it would be ineffective for a remote owner to establish whether the manager is working hard Game Theory Basics Types of Game Theory Agency Theory Implications for FAT Case

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Effort cannot be directly observable but can be imputed – this would occur if there is a moving support, a case where the return of the firm would differ whether a manager exhibits high efforts or shirks Would penalize a manager when the payoffs are low, since now it is easy for the firm to determine if the manager had worked hard Will not work if there is a fixed-support, where payoffs are same regardless of state of natures Legal and institutional factors may prevent the owner from penalizing the manager as well Game Theory Basics Types of Game Theory Agency Theory Implications for FAT Case

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Owner gives manager rights to 100% of payoff after paying a fixed rental price to the owner Not a common relationship Owner is often worse off, contracting arrangement has inefficient risk-sharing Game Theory Basics Types of Game Theory Agency Theory Implications for FAT Case

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Final and most widely used tool to align interest Give managers a share of the profits Aligns managers incentives with the owners and maximize utility for both Disadvantages: Payoffs are not fully recognizable until the future but compensation is due at the end of the year; realization of R&D returns Net income not always informative; poor corporate governance, weak internal controls, bias in net income Then lag of some management efforts such as net income as well as accrual bias, which will affect Net Income. Game Theory Basics Types of Game Theory Agency Theory Implications for FAT Case

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Firms choose accounting policies to achieve a certain management objective Increase earnings Increase revenue Capital asset purchases Previous motivation was assumed on net income noise where managers had no control Game Theory Basics Types of Game Theory Agency Theory Implications for FAT Case

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Variety of forms for managers to take advantage of information Pre-contract information Pre-decision information Post-decision information Game Theory Basics Types of Game Theory Agency Theory Implications for FAT Case

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For any contract that a manager could have an incentive to manipulate earnings an equivalent contract can be designed to motivate the truth Conditions: Truth not held against the manager No restrictions on contract No restrictions on information communication Game Theory Basics Types of Game Theory Agency Theory Implications for FAT Case

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Limit GAAP to the point where managers have a restored sense to work hard rather than manipulate earnings Game Theory Basics Types of Game Theory Agency Theory Implications for FAT Case

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Consider another moral hazard scenario of Agency Theory; A contract between a Bond-Holder (Principal) and a Firm Manager (Agent) Bondholder has a choice of lending $100 to a Firm offering 12% interest or to the Government at 10% interest Risks of investing in the Firm would be possibility of bankruptcylose both principal and interest Manager can choose one of two situations: To pay no dividends while the loan is outstanding and to pay high dividends Game Theory Basics Types of Game Theory Agency Theory Implications for FAT Case

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Assume that Manager is paid a salary plus a bonus based on the firms Net Income. Then since Dividends are Not charged against net Income the manager is unaffected between the 2 acts; the manager is Indifferent between the 2 acts Question: Will the Lender be willing to lend $100 to the firm? Solving for the expected ETR (expected rate of return): ETR = 50%[(12 x 99%) – (100 x 1%)] + 0.5[(12 x 90%) – (100 x 10%)] = 5.84% ($5.84) Therefore, lender will not make the loan Game Theory Basics Types of Game Theory Agency Theory Implications for FAT Case

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Game Theory Basics Types of Game Theory Agency Theory Implications for FAT Case

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A promise in an indenture, or any other formal debt agreement, that certain activities will or will not be carried out Examples: Non-Payment of Dividends: conditional if the interest coverage ratio is below a specified level No Additional Borrowing: conditional if the debt-to-equity ratio is below a specified level Since covenants are legally binding, the lender will change the assessed probabilities of the managers decisions Game Theory Basics Types of Game Theory Agency Theory Implications for FAT Case

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Assume probability that the manager will take a1 (No Dividends) is now assessed by the lender as 100% and 0% for a2 (High Dividends) Thus, if the firm offers a nominal rate of 12%, then the lenders ETR is: ETR = 1[(12 x 99%) – (100 x 1%)] + 0[(12 x 90%) – (100 x 10%)] = 10.88% > 10% Since this exceeds the required 10% from risk-free government bonds, the lender would make the loan Game Theory Basics Types of Game Theory Agency Theory Implications for FAT Case

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Holmstrom provides an extension of the agency model to allow more than one performance measure (i.e: Net Income) Example: Basing compensation based on Both Net Income and Share Price may reduce agency costs As long as the second performance measure conveys additional information than the first measure Example: Share price also reflects future benefits of R&D and expected future liabilities sooner through the market How do performance measures contribute to efficient compensation? Sensitivity – rate that the performance measure reflects how hard the manager works Example: Performance measure Increases when the manager works Hard, Decreases when the manager Does not. Precision – measures how precise the performance measure is (Noise Reduction) Example: If the performance measure is precise, the expected payoff should be relatively the same as the one predicted Game Theory Basics Types of Game Theory Agency Theory Implications for FAT Case

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Agency Theory assumes that courts have the authority to enforce contract provisions without cost and resolve disputes if breach of contract occurs However, if an unforeseen realization of the state of nature occurs it is difficult amend contract provisions because of a contracts Rigidity It is not possible to anticipate all contingencies when entering into a contract Example: New GAAP accounting policy lowers reported net income and increases its volatility Implications: Manager asks Bondholder to reduce the coverage ratio from 3:1 to 2:1 Still maintains the Bondholder protection as before, but may ask for a higher interest Problem is further complicated when there are thousands of Bondholders Thus, unforeseen state realizations (Contract Incompleteness) impose costs on the firm & other parties Game Theory Basics Types of Game Theory Agency Theory Implications for FAT Case

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It is best to base managers compensation on one or more measures of performance The alignment between manager and shareholder interest explains how accounting policies have economic consequences Rigidities provided by signing contracts causes managers to intervene in standard setting processes Game Theory Basics Types of Game Theory Agency Theory Implications for FAT Case

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1. Conflict theory enables reconciliation between efficient security markets and economic consequences Accounting policies can affect contracts that companies enter into, therefore affecting manager utility and welfare of the firm Alignment of manager and shareholder interest will motivate managers intervene in standards Game Theory Basics Types of Game Theory Agency Theory Implications for FAT Case

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2. Net income has a very important role to play in motivating and monitoring manager performance o Ability for net income to fulfill its income enhancing role depends on its sensitivity and precision as a measure of payoff o Ability for net income to provide useful information to investors depends on how it can provide reliable and relevant information about future performance Game Theory Basics Types of Game Theory Agency Theory Implications for FAT Case

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3. Net income competes with other forms of performance measures (i.e. share price) If accountants can make net income a better measure of performance, then it may have a greater role in manager compensation Game Theory Basics Types of Game Theory Agency Theory Implications for FAT Case

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4. Earnings management allows management shirking, resulting low payoff to shareholders By controlling earnings management through GAAP, accountants can restore managements incentive to work hard Game Theory Basics Types of Game Theory Agency Theory Implications for FAT Case

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Sue Davies, Project Manager at Pure Marine – Membrane and Related Equipment Group Background on Sue: single mom with 2 kids, salary = $97,500 Managing a major project, K(3) as well as 2 other projects Responsible for approving and allocating costs to projects Past history of incorrectly estimating costs Game Theory Basics Types of Game Theory Agency Theory Implications for FAT Case

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Company in growth stage with aggressive earnings targets Require 10% profitability for projects Top management places heavy emphasis on meeting these targets and uses bonus system to get middle management on board Historically, poor cost allocation system leading to cost overruns because of bad estimates Recently, new allocation system in place to more accurately predict costs Game Theory Basics Types of Game Theory Agency Theory Implications for FAT Case

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Game Theory Basics Types of Game Theory Agency Theory Implications for FAT Case CEO VP, Division 1 VP, Division 2 VP, Division 3 Sue Davies

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To be completed over 18 months Price charged to customer depends on the allocation of costs done by Sue Profits from project = $7 million Cost to date = $8.2 million Environmental problems and additional insurance not anticipated at the beginning of the project, leading to cost overruns Game Theory Basics Types of Game Theory Agency Theory Implications for FAT Case

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$2 million in R&D costs 2 options: o Allocate fully to K(3) Outcome = 30% over budget losses Unhappy boss No bonus for Sue o Share among all 3 projects Profitable project Happy boss and bonus for Sue Incorrectly allocated costs If discovered, could lose her job Game Theory Basics Types of Game Theory Agency Theory Implications for FAT Case

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Sue Davies Sues Boss, VP of Division K(3) customer Customers of the other 2 projects Shareholders Employees Sues successor Game Theory Basics Types of Game Theory Agency Theory Implications for FAT Case

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Sues utility Does the project meet managements targets? Accurate method of cost allocation Is it the best decision for shareholders? Are customers hurt due to the cost allocation? Game Theory Basics Types of Game Theory Agency Theory Implications for FAT Case

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Game Theory Basics Types of Game Theory Agency Theory Implications for FAT Case Option 1: Allocate fully to K(3) Option 2: Split costs between all 3 projects

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