The Chapter talks about the questions of manager/shareholder alignment that underlie economic

consequences and positive accounting theory. In order to clearly understand management’s

interests in financial reporting, it is however essential to include various models from game theory.
Game theory tries to model and predict the outcome of conflict between rational individuals.
Agency theory will also be considered. This is the version of game theory that models the process
of contracting between two or more persons.

Two particularly essential contracts are employment contracts between the firm and its managers
and lending contracts between the firm and its lenders. Both of these types of contracts often
depend on the firm’s reported earnings. Employment contacts usually base managerial bonuses
on net income, and lending contracts usually include protection for the lenders I the form of
covenants that, for example, bind the firm not go below a stated times-interest-earned ratio, or not
to pay dividends if working capital falls below a specified level.

Game level can help us understand how managers, investors, and other affected parties can
rationally deal with the economic consequences of financial reporting. Consequently game theory
and agency theory are relevant to accounting.

9.2 UNDERSTANDING GAME THEORY

Game theory models a conflict situation between rational players. It models an interaction of two
or more players. The interaction however takes place in the presence of information uncertainty
and information asymmetry. Each player is assumed to maximize his or her expected utility, just
as the investor did in the decision theory, in addition to taking into account many uncertainity
arising from random realization of states of nature, requires that the players formally take the
actions of the other players into account.. Actions of other players can be extremely difficult to
predict, since the action chosen by one player will depend on what action that player thinks the
other players will take, and vice versa. Game theory tends to be more complex than decision theory
and the theory of investment.

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Types of games

1. Cooperative

Binding agreement

2. Non-cooperative

No binding agreement

9.3 A NON-COOPERATIVE GAME MODEL OF MANAGERS-INVESTOR CONFLICT

A Single-Period game

In section 3.2 the concept of constituencies of financial statement users was introduced. Conflict
between constituencies can be modelled as a game, since the decision needs of different
constituencies may not coincide. Investors as discussed in chapter 3 desires a useful tradeoff
between relevant and reliable financial statement information to assist in assessing the expected
values and risks of their investments. Managers, on the other hand may not wish to reveal all he
information that investors desire. Game theory provides a formal framework for studying this
conflict situation and for predicting the decisions the parties will make. This situation is modeled
as a non-cooperative game, since it is difficult to envisage a binding agreement between manager
and investor about what specific information is to be supplied.

Non –cooperative game theory enables us to model the conflict situation that often exists between
different constituencies of financial statement users. Even a very simple game theoretic model
shows that an accounting standard setting body that fails to consider the interests of all
constituencies affected by accounting policy choice is in danger of making policy
recommendations that are difficult to implement.

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9.4 SOME MODELS OF COOPERATIVE GAME THEORY

Whereas the non-cooperative game shows some of the implications of conflict between user
constituencies, many other areas of accounting reflect cooperative behavior. The essence of
cooperation is that the players in a conflict situation can enter agreements that they perceive as
binding. Such agreements are often called contracts. These are employment contracts between
the firm and it’s to manager and lending contracts between the firm manager and the bondholder.
In these contracts there is one part acting as the principal and the other party as the agent. For
example, in an employment contract, the firm owner is the principal and the top manager is the
agent hired to run the firm on the owner’s behalf. This type of game theory is called agency theory.

Agency theory is a branch of game theory that studies the design of contacts to motivate a
rational agent to act on behalf of a principal when the agent’s interests would otherwise
conflict with those of the principal.

9.5 MANAGER’S INFORMATION ADVANTAGE

There are various forms that manager information advantage can take. One possibility is tht the
manager may have information about the payoff prior to signing the contract (called pre-contract
information). For example the manager may have information that the high payoff will occur, and
unless the owner can extract this information, may enter into the contract with the intention of
shirking, taking advantage of the high payoff to generate high earnings and compensation.
Alternatively, the manager may obtain payoff information after signing the contract but prior to
choosing an act (pre-decision information) if the payoffs information is sufficiently bad, the
managers may resign unless this situation is allowed for in the contract. Yet another possibility is
that the manager receives information after the act is chosen (post-decision information).

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9.6 AGENCY THEORY: A BONDHOLDER-MANAGER LENDING CONTRACT

Another moral hazard problem is a contract between a lender and a firm, such as a bondholder and
the firm manager. The bondholder can be regarded as the principal and the manager as the agent.
However the existence of moral hazard problem between lenders and firm managers-managers ma
act contrary to the best interests of the lenders. Rational lenders will anticipate this behavior,
however and raise the interest rates they demand for their loans. As a result the manager has an
incentive to commit not to act in a manner that is against the lender’s interests.

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.

9.8 CONCLUSION ON THE ANALYSIS OF CONFLICT

1. Accounting policies (even without cash flow effects) can have economic Consequences
but securities markets can still be efficient

Conflict theories enable a reconciliation of efficient securities markets and economic

consequences.

2. Role of net income in monitoring and motivating manager performance equally

important as informing investors

An Implication of the agency theory is that net income has a role to play in motivating and
monitoring manager performance.

3. Net income competes with share price as a performance measure

Net income competes with other performance measures, such as share price. If accountant
can improve the precision and sensitivity needed for a good performance measure, they
may expect to see an increase in the role of net income in manager compensation plans.

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4. Role of GAAP in controlling earnings management

If carried to the extreme, earnings management allows shirking, with resulting low payoffs
to owners. Complete elimination of earnings management is not cost effective. However,
by controlling earnings management through GAAP accountants can restore the manager’s
incentive to work hard, thereby increasing payoffs to owners.

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Reference

Scott, William R. 2012. “Financial Accounting Theory”. Sixth Edition. Person Canada.