Acct Theory- Mod 7 Flashcards
What is game theory?
Models behaviour of two or more players to predict their actions
What are the assumptions of game theory?
- Game takes place in an environment of uncertainty and information asymmetry
- Players are rational
- Players attempt to maximize their satisfaction (Utility)
- Players consider possible actions of other players when making their own decisions
What are the possible results of the game under Game Theory?
- Zero sum game
- Non zero sum game
What is a zero sum game in Game Theory?
When one players loss is another players gain.
One winner, everyone else loses
What is a non zero sum game in Game Theory?
Both players can win, but only if the cooperate
What is a cooperative game in Game Theory?
Players can enter into binding agreements. These agreements force each player to work together toward certain goals.
What is a non-cooperative game in Game Theory?
Player cannot (or choose to not) enter into binding agreements. As a result the players are not forced to work together.
What is the Nash Equilibrium?
The only choice possible to one player given a choice made by the other.
It’s not the best choice, just the one they will eventually agree to without any kind of binding agreement.
What are some conclusions of the Game Theory?
- It chooses a scenario where the two opposing players will agree
- The outcome is the only reasonable choice for one player given the choice made by the other (Nash Equilibrium)
- It is NOT the best choice, just the one they will come to without a binding agreement
What is agency theory?
How a contract motivates a rational agent to act on behalf of the principle
What are the two kinds of contracts under agency theory?
Employment Contracts
Lending Contracts
What is an employment contract?
Made between a company (Principle) and the top manager (Agent)
What is a lending contract?
Made between a company manager (agent) and the bond/debt holder (principal)
What is reservation utility? (under agency theory)
How much satisfaction you get from one job compared to another job
What is disutility of effort? (under agency theory)
The degree to which someone is effort-averse
how much they will shirk
What are some conclusions of agency theory?
- Managers are motivated by the highest utility
- There is often a lack of alignment between principal and agent
- Agents tend to put forward less effort if the compensation is the same no matter how much effort they put in
How can businesses control moral hazard with managers?
Best option is indirect monitoring. (Monitoring management efforts based on the results)
Other options such as direct monitoring are difficult and expensive
Is indirect monitoring practical in real life?
No
- Labour laws can prevent pay docking
- External factors can impact results (ex natural disasters)
What are some options for controlling moral hazard that are more practical than indirect monitoring?
-Rent the company to the manager:
Owner receives a fixed payoff and manager keeps the profits (similar to franchising)
-Share profits with the manager
What are some possible management bias that could occur in compensation contracts?
- management can bias the reported earnings
- Management can manipulate earnings to influence their own compensation
- Management controls the company’s accounting system
What is the Revelation Principle?
The concept that management can be motivated to tell the truth about financial results
How do we motivate managers to tell the truth? (3 Ways)
1) Do not use the truth against managers
2) No floor or ceiling to bonuses
3) No restrictions on a managers ability to communicate information
Why does profit sharing lead to alignment?
- Managers and company have the same goals
- Working toward same end result
- Both benefit from success
What is the main moral hazard in lending contracts?
Managers engage in activities that are not in the best interest of the creditor
(ex: paying dividends to owners before paying interest on loans)
What are the two options that a bank has for its money?
Loan it
Invest it
What is a restrictive covenant?
An agreement that the bank comes first.
Ex: no dividends paid until the bank is paid
Which is more realistic in real life: First best contracts or second best contracts
Second best contracts
What are the two characteristics of performance measurement? Describe each
Sensitivity:
Changes based on management performance. The more sensitive the measure the more it is changed by performance
(RELEVANCE)
Precision:
How accurately the measure can be predicted.
The more accurate, the more realistic the goals can be set.
(RELIABILITY)
