Lecture 10

ACCT 332 Accounting Thought and Practice

An Analysis of Conflict and Executive Compensation

- Chapters
p
9-10
- Singtel CEO Compensation

Objectives for Todays Class

Introduce Fundamentals of Non-Cooperative Game Theory

Textbook Problem #8-17

Introduce Fundamentals of Agency Theory (Cooperative Game

Theory)

Compensation / Debt Contracts

Role of Income in this Agency Theory Framework
Practice Problem

Design of Executive Incentive-based Compensation and the

Stewardship Role of Accounting Information

Non-Cooperative Game Theory

What is Game Theory?

Advantage of game theory over single person decision theory:

- Takes into account the other partys actions as their actions will affect your own
decisions.

An economic representation of decision

decision-making
making involving
two or more players

What are the key features?

Two or more parties are in conflict.

Nash Equilibrium make decision conditional on other

Definition: Given the other players strategy choice, each player is content his/her own
player
p
y actions strategy.

Strategies / payoffs for each player are known.

known
Predict outcomes based on certain assumptions about
wealth maximizing behavior

Usually not the 1st best

Textbook Problem #8-17

The shareholders of X Ltd. will vote at the forthcoming annual
meeting on a proposal to establish a bonus plan for the CEO
CEO,
based on firm earnings. There is some debate over whether to
include a bonus plan (why?). Assume you estimate that if the
b
bonus
plan
l iis granted,
t d expected
t d future
f t
cash
h flows
fl
will
ill b
be $150 if
the CEO doesnt manage earnings, and $140 if he does, before
g the bonus,, would be
remuneration. CEO remuneration,, including
$50 if he doesnt manage earnings, and $60 if he does manage
earnings. If the bonus plan is not granted, expected cash flows
will be $140 before remuneration if the CEO does not manage
earnings, and $100 if he does. The CEO would be paid a fixed
salary of $30 in either case.
*The remaining cash flows go to the shareholders in all cases.

Textbook Problem #8-17 (contd)

What is the payoff table?

What is the Nash Equilibrium?

Management
Does Not Manage
Earnings

M
Manage
E
Earnings
i
Nash Equilibrium A

Shareholders

Bonus Plan

(100, 50)

(80, 60)

Nash Equilibrium B

No Bonus Plan

(110, 30)

(70, 30)

SH:
A: If mgmt chooses to manage earnings, SH would choose bonus plan
B: If mgmt chooses not to manage earnings, SH would choose no bonus plan
Mgmt:
A: If SH choose bonus plan, Mgmt would choose to manage earnings
B: If SH choose no bonus plan, Mgmt is indifferent to managing earnings*.
*Note, however, that in B we assume in the concept of manager indifference that managers suffer no disutility from exerting effort.
In real life, however, managers do experience disutility from exerting effort, and so B is no longer a Nash Equilibrium as managers
may find it easier to manage earnings even if their financial payoffs remain the same. There is thus agency conflict.

Non-Cooperative Game Theory

- Implications for Accounting

Accounting choices

Managers: make
M
k th
the choice
h i tto maximize
i i th
their
i own
utility

Regulators/owners: factor managers

managers decision
during the regulation process and when making
investment decision

Negative aspects of non-cooperation

Everybody
y
y is worse off
Worse, the market breaks down

Non-Cooperative Game Theory

- Implications for Accounting (contd)

How could they cooperate to get a better result?

C
Commit
it tto nott pursue a particular
ti l action.
ti
Problem: the commitment might not be credible

Mechanisms to help managers to work hard and report

truthfully

Regulators:
R
l t
to
t reduce
d
the
th potential
t ti l abuse
b
off accounting
ti
choices

Corporate governance
Audit: to increase the credibility of reporting

All off the

th above
b
come with
ith costs
t

E.g. Compliance, monitoring, enforcement, agency

(for directors hired by SH to monitor mgmt) costs.

Alternatively, we can design the contract to motivate the

desirable behavior

Agency Theory

Fundamentals

All parties
ti are self-interested
lf i t
t d and
d expectt other
th
parties to act similarly.

Parties contract to get better results than in non

noncooperative game

To address moral hazard problem

Agent is (experiences
effort averse
and risk averse
disutility from
exerting effort)

Mgmt:
- capped upside, high downside
- unable to diversify risk

Note that we assume here that SH are risk-neutral for simplicity. However, this has no effect
on the outcomes.

All risk borne

by owners

All risk borne by

owners, as
managers still
earn fixed salary
(albeit based on
output).

All risk borne

by managers

Risk and
profit shared
by both
owners and
managers

Agency Theory
Different Types of Contracts
Direct monitoring (first best)

Fixed salary with penalty for shirking

Manager bears no risk
Impossible unless in ideal situation

Indirect monitoring

I
Impute
t manager effort
ff t ffrom payoff
ff

But still fixed salary with penalty for shirking

(shirking imputed based off performance)

the same for different effort levels). An example of this

Not ideal if fixed support (payoff
may be macro-factors result in good outcomes for SH, although
managers are in fact performing poorly

Rental agreement

Cannot observe behaviour, but can observe output

(owners get a fixed amount, whereas managers receive salaries dependent on

their performance)

Inefficient b/c agent bears all risk, hence owner will be

Owners will have to incentivize
to agree to such an
worse off
ff tto compensate
t for
f managers
risk
i k managers
arrangement, making owners

Profit sharing, or incentive-based compensation

Need a measure of performance

(Second best solution)

worse off.

Agency Theory The Model

Principal and agent are rational.

P i i l iis assumed
Principal
d tto be
b risk-neutral
i k
t l ffor simplicity
i li it
Agent is risk-averse and effort averse

More effort

greater disutility

Owners Problem

Managers compensation = salary + k net income, 0

Exercise: Problem 9-15

Find k to maximize the owners utility

Subject to: Manager wants to work hard and manager
receives the reservation utility minimum amount of utility to be received for managers to work

Practice Problem
Henry owns and operates a small sporting goods store. He has decided to negotiate
p
the store while he is away.
y The stores earnings
g are highly
g y
with Marie to operate
dependent on how hard the manager works, as per the following table:
A1: Work Hard

A2: Shirk

Net Income

Probability

Net Income

Probability

X1: High Earnings

$300

0.7

$300

0.2

X2: Low Earnings

$80

0.3

$80

0.8

Marie is risk- and effort-averse. Her utility is equal to the square root of the amount of
money received. If she works hard, her effort disutility is 2. If she shirks, her effort
disutility is 1.6.
Marie informs Henri that she is willing to accept the manager position but that she must
receive at least an expected utility of 3.41, or she would be better off to work
somewhere else. Henri, who is not an agency theory expert, offers Marie a salary of $20
plus 5% of the store earnings (after deducting $20 salary from the earnings in the table).
Marie immediately accepts.

Practice Problem (contd)

1) Why did Marie accept the offer immediately? If Henry
hires Marie
Marie, which action will she take?
2) Henrys friend suggests that he should hire an auditor if
Auditor provides ex-post confirmation that Marie is
hard (verification), providing assurance for
g
Why?
y working
he chooses to hire an agent.
Henry.
3) Assume that Henry hires Marie under the contract
proposed. Shortly after he leaves, a new accounting
rule requires that estimated customer liability be
accrued. This lowers the high earnings to $286 and the
low earnings to $40 in the table above (i
(i.e.,
e before
salary). The payoff probabilities are unaffected. Which
act will Marie take now? Why?
1)
A1: 0.7(20 + 0.05 * 280) + 0.3 (20 + 0.05 * 60) - 2 3.52

3)
A1: 0.7(20 + 0.05 * 266) + 0.3(20 + 0.05 * 20) - 2 3.41

A2: 0.2(20 + 0.05 * 280) + 0.8 (20 + 0.05 * 60) - 1.6 3.41

A2: 0.2(20 + 0.05 * 266) + 0.8(20 + 0.05 * 20) - 1.6 3.22.

Accepts immediately as even if she shirks, she will still receive

her requisite utility.

Marie will work hard, given that it is the solution that gives
her her requisite utility

Agency Theory Implications

Compensation = salary + incentive-based

compensation

The key is the performance measure

the
stewardship
p role of accounting
g information

Pros and cons of incentive-based compensation?

Work hard to improve firm performance

Net income
Stock price

Drawbacks of using incentive-based compensation

Pay risk premium

Premium paid to management in order to compensate them for the risk

they undertake

Earnings management

Role of performance measures

The desirable properties

S
Sensitivity
iti it

How relevant is this measure at gauging performance?

How sensitive the performance is to manager

effort
More Informative of managers effort

Precision
P
i i How reliable is this measure at gauging performance?

Less noise in the measure

Tradeoff?

Lower sensitivity but higher precision

Higher sensitivity but lower precision

Accounting earnings vs. stock price

Tradeoff b/w sensitivity and precision

Accounting earnings typically

have recognition lag (lower
sensitivity), but higher
precision given conservatism,
regulation, etc.

Managers
g
decision horizon
Need to design compensation plans to incentivize
managers to focus on LT performance

Whenever there is noise, >1 performance

measure is preferred (even if individually they
each have noise)

Executive Compensation
- SingTel CEO Compensation

Objectives

Develop
D
l understanding
d t di off specific
ifi ffeatures
t
off
Compensation Plans and how they fit into the theory
developed.
p

Implications of Agency Theory for Compensation

Key Features of a Typical Compensation Plan

Role of Income in Compensation Plans in Relation

to Stock-based Measures

Group Questions

40 minutes to complete group questions

A i
Assignment
t off di
discussion-leading
i l di groups

Week 10 Group Questions

1) Identify the compensation structure for Singtels
Senior Management.
Management
2) What are the different performance measures used?
3) What are the characteristics (pros/cons) of each
performance measure?
4) What is the horizon of the different performance
measures?
5)) How do the features of the p
plan fit with the theory?
y
1.
2.
3.
4.
5. Profit-sharing contract. Fits with theory as there is a mix of fixed and variable components in their remuneration plans. Also
have > 1 performance measure, which is better given noise. Benchmarking against industry reduces noise, which reduces the
risk managers take.