Acct Theory- Mod 7

Question 1

What is game theory?

Answer 1

Models behaviour of two or more players to predict their actions

Question 2

What are the assumptions of game theory?

Answer 2

• 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

Question 3

What are the possible results of the game under Game Theory?

Answer 3

• Zero sum game

- Non zero sum game

Question 4

What is a zero sum game in Game Theory?

Answer 4

When one players loss is another players gain.

One winner, everyone else loses

Question 5

What is a non zero sum game in Game Theory?

Answer 5

Both players can win, but only if the cooperate

Question 6

What is a cooperative game in Game Theory?

Answer 6

Players can enter into binding agreements. These agreements force each player to work together toward certain goals.

Question 7

What is a non-cooperative game in Game Theory?

Answer 7

Player cannot (or choose to not) enter into binding agreements. As a result the players are not forced to work together.

Question 8

What is the Nash Equilibrium?

Answer 8

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.

Question 9

What are some conclusions of the Game Theory?

Answer 9

• 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

Question 10

What is agency theory?

Answer 10

How a contract motivates a rational agent to act on behalf of the principle

Question 11

What are the two kinds of contracts under agency theory?

Answer 11

Employment Contracts

Lending Contracts

Question 12

What is an employment contract?

Answer 12

Made between a company (Principle) and the top manager (Agent)

Question 13

What is a lending contract?

Answer 13

Made between a company manager (agent) and the bond/debt holder (principal)

Question 14

What is reservation utility? (under agency theory)

Answer 14

How much satisfaction you get from one job compared to another job

Question 15

What is disutility of effort? (under agency theory)

Answer 15

The degree to which someone is effort-averse

how much they will shirk

Question 16

What are some conclusions of agency theory?

Answer 16

• 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

Question 17

How can businesses control moral hazard with managers?

Answer 17

Best option is indirect monitoring. (Monitoring management efforts based on the results)

Other options such as direct monitoring are difficult and expensive

Question 18

Is indirect monitoring practical in real life?

Answer 18

No

• Labour laws can prevent pay docking
• External factors can impact results (ex natural disasters)

Question 19

What are some options for controlling moral hazard that are more practical than indirect monitoring?

Answer 19

-Rent the company to the manager:
Owner receives a fixed payoff and manager keeps the profits (similar to franchising)

-Share profits with the manager

Question 20

What are some possible management bias that could occur in compensation contracts?

Answer 20

• management can bias the reported earnings
• Management can manipulate earnings to influence their own compensation
• Management controls the company’s accounting system

Question 21

What is the Revelation Principle?

Answer 21

The concept that management can be motivated to tell the truth about financial results

Question 22

How do we motivate managers to tell the truth? (3 Ways)

Answer 22

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

Question 23

Why does profit sharing lead to alignment?

Answer 23

• Managers and company have the same goals
• Working toward same end result
• Both benefit from success

Question 24

What is the main moral hazard in lending contracts?

Answer 24

Managers engage in activities that are not in the best interest of the creditor
(ex: paying dividends to owners before paying interest on loans)

Question 25

What are the two options that a bank has for its money?

Answer 25

Loan it

Invest it

Question 26

What is a restrictive covenant?

Answer 26

An agreement that the bank comes first.

Ex: no dividends paid until the bank is paid

Question 27

Which is more realistic in real life: First best contracts or second best contracts

Answer 27

Second best contracts

Question 28

What are the two characteristics of performance measurement? Describe each

Answer 28

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)