accounting theory

Topics: Game theory, Nash equilibrium, Utility Pages: 47 (10884 words) Published: October 13, 2014
Instructor’s Manual—Chapter 9

An Analysis of Conflict



Understanding Game Theory


A Non-Cooperative Game Model of Manager-Investor Conflict
9.3.1 Summary


Some Models of Cooperative Game Theory
9.4.1 Introduction

9.4.2 Agency Theory: An Employment Contract Between Firm Owner and Manager 9.5

Manager’s Information Advantage
9.5.1 Earnings Management
9.5.2 Controlling Earnings Management


Discussion and Summary


Agency Theory: A Bondholder-Manager Lending Contract


Implications of Agency Theory for Accounting
9.8.1 Is Two Better Than One?
9.8.2 Rigidity of Contracts


Reconciliation of Efficient Securities Market Theory with Economic Consequences


Conclusions on the Analysis of Conflict
Copyright © 2009 Pearson Education Canada


Instructor’s Manual—Chapter 9


To Introduce Fundamental Concepts of Non-Cooperative Game Theory

My objectives here are quite limited, being confined to developing the intuition underlying a simple, one-shot, prisoner’s dilemma type of game. I concentrate on the concept of strategic decision-making where, for each decision maker, the possible actions of a rational opponent need to be taken into account. Using the Nash equilibrium concept, I show how game theory can model and predict the outcome of conflict situations. The idea is to demonstrate that investors and managers are in a conflict situation since the manager’s interest in financial reporting can conflict with what is in the investor’s best interests. As a result, capital markets will not work as well as they could. This is captured in the game by the Nash equilibrium outcome leaving each party less well off than the cooperative solution.

To attain the cooperative solution, I suggest that a standard setting body, by controlling the payoffs of the game, can influence its outcome. Instructors may wish to motivate this suggestion by picking up on the brief interpretation of Example 9.1 into the Enron and WorldCom episodes, where these firms and investors ended up in the Nash equilibrium. Subsequent attempts by regulators and professional accounting bodies to restore investor confidence can be regarded (hopefully) as a move back to the cooperative outcome.

Instructors who wish to pursue what happens when game is repeated over time may be interested in the 2005 Nobel lecture by Robert Aumann referenced in Note 10 of Chapter 1. His lecture could be assigned for class discussion. I am grateful to a reviewer for suggesting this reference.

The purpose of the brief outline of Darrough and Stoughton (1990) in Section 9.3 is to further motivate the game theory topic by describing how it can be applied to predict the outcome of another type of financial reporting conflict, namely the tradeoff faced by a manager between the role of financial reporting to reduce cost of capital and its role in deterring entry into the industry.

Copyright © 2009 Pearson Education Canada


Instructor’s Manual—Chapter 9

I do not assign the Darrough and Stoughton paper itself. Instructors who wish to spend more time on game theory could usefully do so. Since Darrough and Stoughton, numerous researchers have studied the conflict between disclosure, threat of entry, and cost of capital. However, additional game theoretic concepts would need to be developed beyond the simple prisoner’s dilemma example in the text. The Darrough and Stoughton model is a 2-stage entry game with asymmetric information. For additional motivation, I usually hand out in class and discuss one or more articles from the financial press relating to game theory. Some interesting articles are: •

“It’s only a game,” The Economist, June 15, 1996, p. 57.

“Nobel in Economics is Awarded to Three for Pioneering Work in Game Theory,” The Wall Street Journal, October 12, 1994, p. B12.

“How game...
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