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Table of Contents
1.0 2.0 Learning Objective.........................................................................2 GAME THEORY...............................................................................3

2.1 Definition ............................................................................................................3 2.2 History of Game Theory.......................................................................................4 2.3 Game Requires....................................................................................................5 2.4 Types of Game Theory.........................................................................................5 2.5Function of Game Theory ..................................................................................11 3.0 AGENCY THEORY..........................................................................12

3.1 Introduction......................................................................................................12 3.2 Asymmetry Information.....................................................................................13 3.3 Agency Problems...............................................................................................13 3.4 Situation That Make Agency Problem Arise.......................................................14 3.5 Ways to Overcome Agency Problems................................................................15 3.6 Agency Costs.....................................................................................................16 4.0 TYPE OF CONTRACT.........................................................................18 4.1 Introduction.......................................................................................................18 4.2 Employment Contact.........................................................................................18 i. Self Interest Behavior.........................................................................................18 ii. Cost of Shareholder- Management Conflict.......................................................19 iii. Mechanisms for Dealing with Shareholder- Manager Conflicts.........................20 iv. Contract Design................................................................................................21 v. Earning Management.........................................................................................22 4.3 Lending Contract...............................................................................................23 5.0 IMPLICATION OF AGENCY THEORY FOR ACCOUNTING......................25

5.1 Holmstroms Agency Model...............................................................................25 5.2 Contract Incompleteness and Rigidity...............................................................26 6.0 EXECUTIVE COMPENSATION PLAN.................................................27

6.1 Introduction.......................................................................................................27 BKAF 3083 ACCOUNTING THEORY AND PRACTICE | 1

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6.2 Are Incentive Contracts Necessary....................................................................27 6.3 The Theory of Executive Compensation............................................................28 6.4 Type of Manager Effort......................................................................................29 6.5 The Role of Risk in Executive Compensation.....................................................30 7.0 8.0 CONCLUSION................................................................................33 BIBLIOGRAPHY..............................................................................34

1.0 Learning Objective


1. To introduce fundamental concepts of game theory 2. To introduce fundamental concepts of agency theory 3. Understanding the employment contract and lending contract 4. Understanding the executive compensation plan and incentive contract

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2.0 GAME THEORY 2.1 Definition


Game theory is the formal study of cooperation and conflict. It applies whenever the actions of several agents are independent. For instance, it Game theory is a method for analyzing decision making of conflict when the payoff to a participant depends upon the behaviors of others in the game. These agents include individuals, groups, firms, or any combination of these. Game theory came to prominence during the Cold War due to a particular interest in military application (the notion of winning and losing providing an attractive analogy). It remains a useful way of thinking about the decision making and it use in economic sector.
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Game theory attempts to mathematically capture behavior in strategic situations, in which an individual's success in making choices depends on the choices of others. Therefore, the concepts of game theory provide a language to formulate structure, analyze, and understand strategic scenarios. While initially developed to analyze competitions in which one individual does better at another's expense (zero sum games), it has been expanded to treat a wide class of interactions, which are classified according to several criteria.

2.2 History of Game Theory


In 1838, Antoine Cournot was developed the earliest example of a formal game- theoretic analysis, the study of a duopoly. In 1921, Emile Borel, the mathematician suggested a formal theory of games which furthered by the mathematician, John von Neumann in 1928 in a theory of parlor games. Game theory was established as a field in its own right which was developed by von Neumann and the economist Oskar Morgenstern after the year 1944 with the publication of the monumental volume Theory of Games and Economic Behavior. This game focused on cooperative game, which analyzes optimal strategies for groups of individuals, presuming that they can enforce agreements between them about proper strategies. This book provided much of the problem setup and the basic terminology which still in use today. After that, in 1950, John Nash developed a criterion for mutual consistency of players' strategies, known as Nash equilibrium, applicable to a wider variety of games than the criterion proposed by von Neumann and Morgenstern. This equilibrium is sufficiently general to allow for the analysis of non-cooperative game in addition to cooperative ones. That means this finite game have always have an equilibrium point, at which all players choose actions which are best for them as well as given their opponents choices. Since then, this central concept of non-cooperative game theory has been a focal point of analysis. This theory was developed extensively in the 1950s by many scholars and was broadened theoretically and applied to problems of war and politics in the 1950s and 1960s. Game theory was later explicitly driven a revolution in economic theory and it later has found apllications in sociology and psychology and established links with evolution and biology in the 1970s. applied to biology in the 1970s, although similar developments go back at least as far as the 1930s. Game theory has been widely recognized as an important tool in many fields after received special attention in 1994 where eight Eight game theorists have won the Nobel
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Memorial Prize in Economic Sciences, and John Maynard Smith was awarded the Crafoord Prize for his application of game theory to biology. A high-profile application of

game theory has been the design of auctions at the end of the 1990s. In the design of auctions, the prominent game theorists have been involved for allocating rights to the use of bands of the electromagnetic spectrum to the mobile telecommunication industry.

2.3 Game Requires


There are five game requires in the game theory. The first game require in the game theory is player. A player is an agent who makes decision in a game. In game theory, there must have at least two people participants or player because if there is only one person, then the game cant be played. Next, rules are also one of the game requires in the game theory. Every game must have rules, same with game theory, which in the game theory, every player must follow the rules. Besides that, the payoff or values that required in the game theory, defined as in a game, there is a payoff and associated values because all players want achieve their objective and strategies. Moreover, information availability also an important element in the game requires for the game theory. Each player must has complete information about the other to player content with own strategies and assumed to maximize his or her expected utility. The last game requires in the game theory is controllable moves which each player can make. All actions of other players can be extremely difficult to predict because the action chosen by one player will depend on what action that player thinks the other players will take and each player must control situation and be careful.

2.4 Types of Game Theory


There are two types of the game theory, cooperative game and non-cooperative game. The cooperative game can be defined as a game is cooperative if the players are able to form binding commitments. It is actually based mainly on agreements to allocate cooperative gains. The legal system requires them to adhere to their promises. This game ignores the strategic stages leading to coalition building and focuses on the possible results of the cooperation. Example non-zero sum game means a situation where one player gain (or loss) does not necessarily result in the other player loss (or gain). In other words, where the
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winnings or losses of all players do not add up to zero and everyone can gain or both players get same benefit like win-win situation. Next, for the non cooperative game, the game is able to model situations to the finest details, producing accurate results. Models situations where players see only their own strategic objectives and thus binding agreements among the players are not possible. Describe and take into account the strategic interaction among the players. Example zero sum game, a game is said to be zero-sum if for any outcome, the sum of the payoff to all players is zero. In a two-player zero-sum game, benefit gets from one player will as losses for the other player thus, their interests are diametrically opposed. Non-Cooperative Game Theory Non-cooperative game theory studies where a number of agents are involved in an interactive process. In this process, the outcome is determined by the agents individual decisions which sometimes in conjunction with chance, and affects the well-being of each agent in a possibly different way. In this area, the terminology will be used include: the entire situation is called a game; the agents are called players; their acts are called moves; their overall plans of action are called strategies; and their evaluations of the outcome are called payoffs. While the basic premise of the analysis is that players act rationally, meaning that they strive to maximize their payoffs. In the non-cooperative game theory, the players are normally assumed to maximize their own utility without caring the effort of their choices on other person. However, the outcomes of the game are usually jointly determined by the strategies chosen by all players in the game. Consequently, each players welfare depends, in part, on the decisions of other players in the game. Therefore, they need to take into account that the other players also act rationally. The qualification non-cooperative makes an assumption that players make their decision individually and are not enter into binding agreements with other players that stipulate the actions to be taken by the parties to the agreement. The players assumed that may be allowed to communicate with each other prior the game is play and discuss joint plans of action. However, during the game, they act as autonomous decision makers or they might follow previously made joint plans only if doing so is rational for them. This theory comprises three main ingredients. Firstly, the development of formal models of non-cooperative games that creates unified frameworks for representing games in a manner that lends itself to formal mathematical analysis. Secondly is formulation of concepts that capture the rational behavior idea in those models. Equilibrium is the main of such concept. The third ingredient of concept is the use of mathematical tools which to
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prove meaningful statements characterizations of equilibrium. Prisoners Dilemma Game

The prisoners dilemma is an aspect of game theory that shows why two individuals might not agree even though it is best for them to do so. It was developed and framed by Merrill Flood and Melvin Dresher in 1950. A classic example of prisoners dilemma is presented with prison sentence payoffs. The story begin with two men are arrested, howver, the police do not have enough and sufficient information for a conviction. Therefore, the police separate both men and offer them a similar deal. If one testifies against his partner, means defects or betrays or confess while the other remain silent which means cooperate or assist, the betrayer will goes free while the cooperator will receive a three month sentences in jail. However, if both of them keep silent, both will be sentenced to only one month in jail for a minor charge. But if each rat out the other, each of them will receive a three months sentence in jail. Therefore, the analysis shown that when you betray while the other party cooperates, you will win much in term of payoff and vice versa. But when you betray and so does the other party, you will get lose in the payoff. In the other hand, when you cooperate but the other party betray, you will lose much in term of payoff. PRISONER B SILENT (Cooperate) Each serves 1 month A: Goes free B: 1 year CONFESSES (Defect) A: 1 year B: Goes free Each serves 2 month

SILENT (Cooperate) PRISONER A CONFESSES (Defect)

Example 1: Manager and Investor Conflicts MANAGER HONEST (H) BUY (B) REFUSE TO BUY (R) 60, 40 35, 20 DISTORT (D) 20, 80 35, 30

INVESTOR

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Non-cooperative is very difficult to expert a binding agreement between manager and investor about what specific information is to be supplied. Agreement could be very costly and must have negotiated with all users because different users may have varied decision problem and different information needs. To settle this problem, both parties must cooperative at point (60, 40) and Nash equilibrium at point (35, 30).

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Example 2: Conflict between Standard Setter and Corporations STANDARD SETTER COOPERATE (C) COOPERATE (C) STRONG (S) 30, 30 20, 10 STRONG (S) 8, 40 12, 15

CORPORATION

Nash equilibrium is play (strong, strong). Each player has an incentive to play strong, given that the other player chooses strong. If the standard setter plays strong, the corporations receive a higher payoff from playing strong (12) than playing cooperates. Similarly, if corporations play strong, the standard setter is better off to also play strong since its payoff is lowered from 15 to 10 if it cooperates. Both parties would be better off if they cooperated, rather than each playing strong. However, if corporations plays cooperate, the standard setter will reason it would be better off to play strong thereby raising its payoff from 30 to 40. In the absence of a binding agreement or government legislation that would force the standard setter to cooperate, the (cooperate, cooperate) strategy is likely to break down.

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Example 3: Conflict between Investor and Auditor AUDITOR Work for investor (I) INVESTOR Invest (I) Not Invest (N) 5, 4 3, 1 Work for manager (M) 2, 6 3, 3

The Nash equilibrium is doing not invest, work for manager. This is only strategy pair such that, given the strategy choice of other player and player has an incentive to change strategies. The cooperative solution is invest, work for investor. The cooperative solution is unlikely in a single play because if the investor invests, the auditor will move to work to manager. Anticipating this strategy, the investor does not invest. The investor and auditor could enter into binding agreement to play the cooperative strategy.

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Example 4: Conflict between Both Countries COUNTRY A Keep (K) COUNTRY B Keep (K) Violate (V) 100, 100 200, 50 Violate (V) 50, 200 50, 50

Nash equilibrium is (violate, keep), (keep, violate) and (violate, violate) where both country Bs strategy. Country A could switch to violate, thereby punishing country B for not playing keep. When the game is repeated, each of the players realizes that it is to their mutual benefit to play (keep, keep). This is because each country will perceive that if it violate, the other county can punish it by switching to violate at the next opportunity in the next period. Both countries seem to have an incentive to play (keep, keep). At the beginning of the last period, both players realize that it will not be possible for the other party to punish a switch to violate. Thus they both have an incentive to switch strategies in the last period, in which case payoff is (50, 50). For the second-last period, each player will realize that it will not be possible for the other party to punish violation taking place in the second period, since both will be violating in the last period anyway. Thus, each party has an incentive to switch to violate in the second-last period.

2.5Function of Game Theory


Game theory can help us understand how manager, investors and other affected parties can rationally deal with economic consequences of financial reporting. Besides that, the game theory can help the user to see how the theory of efficient securities markets is not necessarily inconsistent with economic consequences and also help us to see why contacts frequently depend on financial reporting. Moreover, game theory is helping user to see why contacts frequently depend on financial reporting.
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3.0 AGENCY THEORY 3.1 Introduction


Jensen and Meckling (1976) define an agency relationship as a contract under which one or more persons (principals) engage another person (the agent) to perform some service on their behalf which involves delegating some decision-making authority to the agent. There are at least two agency relationships which cause corporate promoters and managers to bear agency costs. The first is relationship between shareholders (the principals) and manager (the agent) and the second is relationship between the bondholders (the principals) and the manager (the agent). As part of this arrangement, the principal will delegate some or all of the decision making authority to the agent. The principals roles are to supply capital, bear risk, and construct incentives while the roles of the agent are to make decisions on the principals behalf and also to bear risk (this is frequently of secondary concern). Agency theory focuses on the people within them and how they behave. Fama and Jensen used agency theory to investigate the survival of organizations when there was a separation of ownership (shareholders) and control (managers). They argued that agents and principals entered into these relationships because of the benefits of specialization and because of the ability to control agency problems by the separation of decision making and risk bearing parties. The agency theory suggest that the separation of ownership and control can give rise to agency cost because of the conflict of interest between the contracting parties which are management (agents) and shareholders (principals). This conflict is the result of information asymmetry between shareholders and management. In practice, shareholders from most corporations delegate the decision making authority to the board of director (BOD). In return, the BOD delegates power to the chief executive officers (CEO).

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3.2 Asymmetry Information


In general, all principal-agent relationships are affected by uncertainty. Uncertainty not only in the level of agents knowledge, skills and abilities but also in both the way the agents action get transformed into the output and whether or not the agent is acting in the principals best interest. The uncertainty is the result of the advantageous differential in knowledge held by the agent about his or her own actions in serving the principal. The difference of information between the agent and principal is called information asymmetry. This information asymmetry describes the inability of the principal to properly assess the extent to which the agent chooses an action that coincides with the principals best interests. Asymmetry information occurs when the principals ability to monitor the agents behaviors and work is limited, restrained, or interrupted by other factors known only to the agent. In such situations, agency theory argues that the agents may decrease their performance or may even shirk because of their ability to conceal such performance deficiencies from the principals.

3.3 Agency Problems


Two reasons that may lead to the divergence between self-interest and cooperative behavior are adverse selection and moral hazard as information-based problems. (1) Adverse selection: as an information problem, it arise when the agent uses private information that cannot be verified by the principal to implement successfully an input-action rule different from that desired by the principal and thereby rendering the principle incapable of determining if the agent made the appropriate choice. (2) Moral hazard: as an ex post information problem, it arise when there are motivational problems and conflicts as a result of basing contracts on imperfect surrogates of behavior. Moral hazard refers to the principals increased risk of suffering negative consequences resulting from problematical behavior of the agent.
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3.4 Situation That Make Agency Problem Arise


The agency problems arise because of the impossibility of perfectly contracting for every possible action of an agent whose decisions affect both his own welfare and the welfare of the principal. The problems also arise because managers will not solely act to maximize the shareholders wealth. They may protect their own interests or seek the goal of maximizing companies growth instead of earnings while making decision. The agency problem arises when (a) The two parties involved have different goals As we know, the principals (shareholders) hire the agent (manager) to perform some service on their behalf. But the aims or goals for each person are different where the agent is striving to maximize the contractual fees he receives subject to the necessary effort levels while principal is striving to maximize the returns from the use of his resources subject to the fee payable to the agent. For example, managers try to maximize their rewards from managing the firm but shareholders want to maximize their wealth in term of dividend. (b) When it is difficult or expensive for the principal to measure what the agent is actually doing Although the principal may be able to observe the agents action in some circumstances, the observation typically requires costly monitoring. Monitoring might obtain information on the agents ability, carefulness, laziness, reliability and trustworthiness. (c) Problems also arise due to differences in risk preferences, goal conflict among group and information availability Both principals and agents have their own risk to bear which lead to the agency problem. The information availability also different which the principal and agent do not share the same levels of information and as such, the agent can opportunistically

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take advantage of the situation. This situation is known as moral hazard problem and is often the result of asymmetry information. The principal can control an agent opportunistic behavior by Principals should have a high degree of involvement in the production of service products. Community reputation and third party evaluations should be used to audit the agent. Third party consultants with professional knowledge should be hired to audit the agent. Require agents to make investments in assets specific to the exchange. Engage in long-term relationship for the same or linked products or services.

3.5 Ways to Overcome Agency Problems


In order to overcome agency problem, managers interest and incentives must be aligned with those of the shareholders by for example, managers should hold significant amount of shares so that their interest and those of other shareholders converge. The higher the management interest, the more informative will be the accounting information because of less manipulation. Other than that, the agency problem can be reducing by reporting which means disclose full information and transparency. Transparent disclosures require the provision of material information. It is information which could influence the economic decisions made by the users of information. The issue of transparency can be explained by focusing on the concept of information asymmetry. A situation in which information asymmetry exists can be described as a lack of transparency. So that, the agency problem can be reduce by reporting reliable and transparent information.

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3.6 Agency Costs


Agency costs are arising because the managers (the agents) interests do not necessarily coincide with the interest of shareholders or bondholders (the principals). Agency costs are defined by Jensen and Meckling as the sum of monitoring costs, bonding costs and residual loss. Monitoring Costs Monitoring costs are expenditures paid by the principal to measure, observe and control an agents behavior. The economic impact of asymmetric information also results in various corporate agency problems. Firm managers (insiders) know more about their firm than shareholders and debt financiers (outsiders). When outsiders are unable to judge over the firms performance, they tend to qualify a firms performance as moderate. A result of this asymmetric information is that shares of a firm with a great performance are undervalued and vice versa. More specifically, information asymmetries between shareholders or bondholders and corporate executive management create the necessity of monitoring costs and complications for the structuring of financial contracts. They may include the costs of preparing reliable accounting information and audits, writing executive compensation contracts and even ultimately the cost of replacing managers. Effective monitoring is restricted to certain groups or individuals. Such monitors must have the necessary expertise and incentives to fully monitor manager. In addition, such monitors must provide a credible threat to managements control of the company. Bonding Costs Bonding refers to costs the owners (principals) incurred to provide incentives that the agent will act in the owners interest. To minimize monitoring costs, managers tend to set up the principles or structures and try to act in shareholders best interest. The costs of establishing and adhering to these systems are known as bonding costs. They may include the costs of additional information disclosures to shareholders, but management will obviously also have benefit of preparing these themselves. Agents
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will stop incurring bonding costs when the marginal reduction in monitoring equals the marginal increase in bonding costs. As suggested by the agency theory, the optimal bonding contract should aim to entice managers into making all decisions that are in the shareholders best interests. However, since managers cannot be made to do everything that shareholders would wish, bonding provides a means of making managers do some of the things that shareholders would like by writing a less than perfect contract. Residual Loss Despite monitoring and bonding, the interest of managers and shareholders are still unlikely to be fully aligned. Therefore, there are still agency losses arising from conflicts of interest. These are known as residual loss, which represent a trade-off between overly constraining management and enforcing contractual mechanisms designed to reduce agency problems.

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4.0TYPE OF CONTRACT 4.1 Introduction


In this reality world, we cannot trust other people. So, we need contract to deal with others. Contracts between principal and agent are written in order to reduce this agency costs. Only one way to reduce agency problem is by having reporting. By having a true and fair reporting and disclosure of necessary information, it will help to reduce the agency cost. There are two types of contract, that is employment contract and lending contract.

4.2 Employment Contact


The employment contract a contract that involved the firm owner and the manager. A good employment contract is beneficial to both the employee and the employer. It spells out the rights and obligations of each party, protects the job security of the employee and protects the employer from certain risks such as release of confidential employer information after the term of employment ends. For example, shareholders of Media Prima appoint Farid Ridzuan to manage the company. Shareholder of Media Prima is principal while Farid Ridzuan is agent. A corporations manager may have personal goals such as bonus and allowance that compete with the owners goal of maximization the wealth of the shareholders. Since the shareholders authorize managers to administer the firms assets, a potential conflict of interest exists between the two groups. i. Self Interest Behavior Agency theory suggests that, in imperfect labor and capital markets, manager will seek to maximize their own utility at the expense of corporate shareholders. Agents have the ability to operate in their own self- interest rather than in the best interests of the firm because of asymmetric information and uncertainty. Asymmetric information is where managers know better than shareholders whether they are capable of meeting the shareholders objectives because they are
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the one who managed the company. Manager knows well about the company strength and weaknesses in term of competition, revenue and sales. While uncertainty is where there are many factors contribute to the final outcomes, and it may not be evident whether the agent directly causes a given outcome, positive or negative. Evidence of self- interested managerial behavior includes the consumption of some corporate resources in the form of perquisites and the avoidance of optimal risk positions, whereby risk- adverse manager bypass profitable opportunities in which the firms shareholders would prefer they invest. Manager can be encouraged to act in the stockholders best interests through incentives, constraints and punishments. These methods however are effective only if stockholders can observe all of the actions taken by managers. A moral hazard problem, whereby agents take unobserved actions in their own selfinterests, originates because it is infeasible for shareholders to monitor all managerial actions. To reduce the moral hazard problem, stockholders must incur agency costs. ii. Cost of Shareholder- Management Conflict Agency costs are defined as those costs borne by shareholders to encourage managers to maximize shareholder wealth rather behave in their own selfinterests. There are three major types of agency costs which is expenditures to monitor managerial activities such as audit costs to audit financial statement and to detect whether fraud incurred or not on that company. Second are expenditures to structure the organization in a way that will limit undesirable managerial behavior such as appointing outside members to the board of directors or restructuring the companys business units and management hierarchy from top management to bottom line. Third are opportunity costs which are incurred when shareholders imposed restrictions such as requirement for shareholder votes on specific issues, limit the ability of managers to take actions that advance shareholders wealth.

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In dealing with shareholder- manager conflicts, where the executive compensation is tied to the performance but some of the monitoring is also undertaken. In addition to monitoring, the following mechanisms encourage managers to act in shareholders interests. First is a performance- based incentive plan. Most publicly traded firms now employ performance shares, which are shares of stock given to executives on the basis of the performances as defined by financial measures such as earnings per share, return on assets return on equity, and stock price exchange. If corporate performance is above the performance targets, the firms manager earns more shares. If performance is below the target, however they receive less than 100 percent of the shares. Incentive based compensation plans such as performance shares, are designed to satisfy two objectives. First, they offer executives incentives to take actions that will enhance shareholders wealth. Second, these plan helps companies attract and retain managers who have the confidence to risk their financial future on their own abilities, which should lead to better performance. Second is direct intervention by shareholders. An increasing percentage of common stock in corporation is owned by institutional investors such as insurance companies, pension funds and mutual funds. The institutional money managers have the clout, if they choose, to exert considerable influence over a firms operation. Institutional investors can influence a firms manager in two primary ways. First, they can meet with a firms management and offer suggestions regarding the firms operation. Second, institutional shareholders can sponsor a proposal to be voted on at the annual stockholders meeting even if the proposal is opposed by management. Although such shareholder- sponsored proposals are nonbinding and involve issues outside day to day operation, the results of these votes clearly influence management opinion.

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Third is the threat of firing. In the past, the likelihood of a large companys management being ousted by its stockholders was so remote that is posed little threat. This was true because the ownership of the most firms was so widely distributed, and managements control over the voting mechanism so strong, that is was almost impossible for dissident stockholders to obtain necessary votes required to remove the manager. In recent years, however the chief executive officer at American Express Co, General Motors Corp, IBM, and Kmart have all resigned in the midst of institutional opposition and speculation that their departures were associated with their companies poor operating performance. Fourth is the threat of takeover. Hostile takeovers which occur when management does not wish to sell the firm, are most likely to develop when a firms stock is undervalued relatives to its potential because of inadequate management. In a hostile takeover, the senior managers of the acquired firm are typically dismissed and those who are retained lose the independence they had prior to the acquisition. The threat of hostile takeover disciplines managerial behavior and induces managers to attempt to maximize shareholder value. iv. Contract Design Miligrom and Robert (1992) identify four principles of contract design. When perfect information is not available, Holmstrom (1979) developed the Informativeness Principle to solve this problem. This essentially states that any measure of performance that reveals information about the effort level chosen by the agent should be included in the compensation contract. This includes, for example Relative Performance Evaluation- measurement relative to other, similar agents, so as to filter out some common background noise factors such as fluctuation in demand. However, setting incentives as intense as possible is not necessarily optimal from the point of view of the employer. The incentive- intensity principle states that the optimal intensity of incentives depends on four factors which is the incremental profits created by additional effort, the precision with which the desired activities
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are assessed, the agents risk tolerance, and the agents responsiveness to incentives. The third principle is the monitoring intensity principle. It is complementary to the incentive- intensity principle. In that situations in which the optimal intensity of incentives is high correspond to situations in which the optimal level of monitoring is also high. Thus employers effectively choose from a menu of monitoring/ incentive intensities. This is because monitoring is a costly means of reducing the variance of employee performance, which makes more difference to profits in the kinds of situations where it is also optimal to make incentives intense. The fourth principle is the equal compensation principle, which essentially states that activities equally valued by the employer should be equally valuable (in terms of compensation, including non- financial aspects such as pleasantness of the workplace) to the employee. v. Earning Management Earning management is a strategy use by management of company to deliberately manipulate companys earning, so that figure match to pre determine target. Company keep the figure relatively stable by adding or remove cash from reserve account known as cookie jar account. Cookie jar account is where company use generous reserve from good year against loses that might incurred in bad years. There is a variety of forms that manager information advantage can take. One possibility is that 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). In the payoff information is sufficiently bad; the manager may resign unless this situation is
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allowed for in the contract. Yet, another possibility is that the manager receives information after the act is chosen (post decision information). For example, the manager may learn what net income is before reporting to the owner. If the owner cannot observe unmanaged net income, the manager may misreport earnings so as to maximize compensation. Controlling earning management is limit it by means of GAAP, to the point where the managers incentive to work hard is restored.

4.3 Lending Contract


This contract is between creditors and stockholders. Creditors have the primary claim on part of the firms earnings in the form of interest and principal payments on the debt as well as a claim on the firms assets in the event of bankruptcy. The stockholders however maintain control of the operation decisions (through the firms managers) that affect the firms cash flow and their corresponding risks. Creditors lend capital to the firm at rates that are based on the riskiness of the firms existing assets and on the firms existing capital structure of debt and equity financing as well as on expectations concerning changes in the riskiness of these two variables. The shareholders, acting through management, have an incentive to induce the firm to take on new projects that have a greater risk than was anticipated by the firms creditors. The increased risk will raise the required rate of return on the firms debt, which in turn will cause the value of the outstanding bonds to fall. If the risky capital investment project is successful, all of the benefits will go to the firms stockholders because the bondholders returns are fixed at the original low risk rate. If the project fails, however the bondholders are forced to shared in the losses. On the other hand, shareholders may be reluctant to finance beneficial investment projects. Shareholders of the firms undergoing financial distress are unwilling to raise additional funds to finance positive net present value projects because these actions will benefit bondholders more than shareholders by providing additional security for the creditors claim. Managers can also increase the firms level of debt, without altering its assets, in an effort to leverage up stockholders return on equity. If the old debt is not senior to the newly issued debt, its value will decrease, because a larger numbers of creditors will have claims
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against the firms cash flow and assets. Both the riskier assets and the increase leverage transactions have the effect of transferring wealth from the firms bondholders to the stockholders. Shareholder- creditor agency conflicts can result in situation in which a firms total value declines but its stock price rises. If stockholders attempt to expropriate wealth from the firms creditors, bondholders will protect themselves by placing restrictive covenants in future debt agreements. Furthermore, if creditors believe that a firms manager are trying to take advantage of them, they will either refuse to provide additional funds to the firm or will charge an above market interest rate to compensate for the risk are possible expropriate of their claims. Thus, firm which deal with creditors in an inequitable manner either lose access to the debt markets or face high interest rates and restrictive covenants, both of which are detrimental to shareholders.

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5.0 IMPLICATION OF AGENCY THEORY FOR ACCOUNTING 5.1 Holmstroms Agency Model
Holmstrom shows formally that a contract based on a performance measure such as net income is less efficient. It is more efficient by basing it on a second performance measure in addition to net income. For example, share price is also informative about manager performance. Rather than basing manager compensation solely on net income, basing the contract on both net income and share price reduce the agency costs. This is because provided that the second measure is also jointly observable, and conveys some information about manager effort. Besides, share price is also reflects the information content of net income and reflects other information. For example, it reflects expected future benefit of R&D, and expected future environmental and legal liabilities, sooner than the accounting system. Furthermore share price may be less subject to manager manipulation and bias than net income. Characteristics of performance measure that contribute to efficient compensation contract are sensitivity and precision. Sensitivity is the rate at which the expected value performance measure increases as the manager work harder or decreases the manager shirks. Sensitivity contributes to efficient compensation contracts by tightening up the connection between manager effort and the performance measure, thereby making it easier to motivate that effort. Another important characteristic of a performance measure is its precision in predicting the payoff from current manager effort. When a performance measure is precise, there is a relatively low probability that it will differ substantially from the payoff. Precision contributes to efficient compensation contracts by reducing the managers compensation risk. There is a tradeoff between sensitivity and precision. Attempts to increase sensitivity of net income by adopting fair value accounting may reduce precision, since fair value estimates tend to be imprecise. For example, precision may be serious problems if

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accountants were to adopt fair value accounting for R& D, due to problems of estimating its fair value.

5.2 Contract Incompleteness and Rigidity


Basic reason accounting policies can have economic consequences is because rigidity and incompleteness. Contracts tend to be rigid once signed. This is because it is generally impossible to anticipate all contingencies when entering into a contract. For example, unless the contract is of very short duration, it would be difficult to predict changes in GAAP that could affect the contract. Example is the firms ability to avoid debt covenant violation would be reduced if, say a new accounting standard restrict the firms ability to switch between amortization methods. Such a standard would preclude the manager from managing covenants ratio by changing amortization method. Consequently, the probability of covenants violation increases. It is unlikely that the contract anticipated the change in GAAP that causes this increase. Contracts that do not anticipate all possible state realizations are termed incomplete. Not all the information disclosed in the contract.

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6.0 EXECUTIVE COMPENSATION PLAN 6.1 Introduction


An executive compensation plan is an agency contract between the firm and its manager that attempts to align the interest of the owners and manager by basing the managers compensation on one or more measures of the managers performance in operating the firm. An executive compensation plans are real incentive plans that follow from the development of the agency theory, but are more complex and detailed because they involved a mix of incentive, risk, and decision horizontal considerations. There are many performance measures to measure the compensation plans, but many compensation plans are based on this two performance measures, that are net income and share price. The executive compensation is an important part of the corporate governance, and is often determined by a companys board of directors.

6.2 Are Incentive Contracts Necessary


In Fama (1980) arguement, he found that incentive contracts are not necessary because the managerial labour controls moral hazard. For example, if a manager can establish a reputation with superior performance for creating high payoffs for the shareholders, that managers market value will increase and generate a high wage offers. Fama argue that if a manager who is tempted to shirk looks ahead to future periods, the present value of reduced future compensation, which will be equal to or greater than the immediate benefits of shirking. Thus the manager will not shirk. Furthermore, in Fama argument, any shirking that done by the manager will be detected and reported by the employees that below them who want to get ahead. Therefore, internal control has been established to monitor the behaviour and the discipline of the manager. Moreover, if the manager is able to disguise the effects of shirking by willing to manage the earnings, Fama argues that GAAP limits and the reversing nature of accrual will discover the fraudulent behaviour and destroy the reputation of manager if and only if the expected costs of lost reputation are great to deter the manager from acting in this way. Therefore, an incentive contract is not necessary.
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In this regard, Wolfson (1985) have presented some empirical evidence on the markets ability to control the managers incentive to shirk. In the studies, Wolfson feels that the incentive contract is necessary because although the managers reputation can help to motivate the manager, but still it cannot eliminate the moral hazard, the manager still can do the earning management to cover up the shirking. Even though the internal monitoring and market forces may complement GAAP to control managers tendencies to shirk, it still cannot eliminate the moral hazard. Thus, effort incentives based on some measure of the payoff are still needed.

6.3 The Theory of Executive Compensation


In Holmstrom studies, if the compensation contract is based on two or more performance measures, it can increase the efficiency of the compensation contract, as it provides the additional performance measures that contain information about effort beyond that contained in the first performance measure. In Banker and Datar (1989) studies, linear mix of performance measures is depended on the sensitivity and precision of the measures. Sensitivity defined as the rate at which the expected value of the measure responds to manager effort, which means how sensitive the performance measure increase when the manager work hard and decrease when the manager shirks. For example, if the managers increase their effort for 10%, the expected value of the performance measure will increase 10% as well. However, normally this will not happen in reality because the performance measure does not currently capture all the aspect of the effort, it includes the short-run and long-run effort. Precision defined as the reciprocal of the variance of the noise in the measure, means the accuracy of the performance measure. Thus, the greater the sensitivity to manager effort and lower the noise, the greater the measure should be included in determining the managers performance. The performance measure of share price is high in sensitivity and low in precision. A main reason why the share price is low is precision is because of the effects of the economy-wide factors. For example, if the interest rate increases, the expected effects on future firm performance will show up in current share price, which is not really related to
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the current performance of the managers. For the performance measure of the net income, it is relatively high in precision and low in sensitivity. This is because majority of the information is recorded on the historical cost accounting. The decision horizon must be traded off with the sensitivity and precision of the performance measures. As we know, the net income performance measure is low in sensitivity. So there are several ways to increase the sensitivity of the net income. First, the sensitivity of the net income can be increase by reducing the recognition lag. Recognition lag means the time lag between when the actual economic shock and when the events are being recognised. We can use fair value accounting to reduce recognition lag and thus will increase the sensitivity since more of the payoffs from the manager effort are showed up in current net income. However, fair value accounting is a doubled-edged sword which will tend to reduce precision of net income. Thus, it is necessary determine the benefit out weight the cost involved before adoption. For instance, if the negative precision effect of fair value accounting outweighs its positive sensitivity effect, a bit of conservatism, such as historical cost accounting, is preferable to adopt fair value for compensating contract. Moreover, sensitivity of the net income can be increased through full disclosure, particularly of unusual and non-recurring items. Full disclosure can increase sensitivity of net income by enabling the compensation committee to better evaluate earning persistence. As a result, it is more difficult for the manager to disguise shirking by earning management since there is a use of GAAP in the reporting.

6.4 Type of Manager Effort


In the manager effort, we can divide the effort into short-run and long-run effort. Short run effort is effect devoted to activities, for example advertising, maintenance, cost control, and other day to day activities that can generate the current net income. For the long run effort, it includes the effort devoted to activities such as long-range planning, such as research and development. The shareholders of a company can adjust the relative proportions of the net income based or share price based compensation according to their focus and needs. For example, if the company want to encourage more research and development (long run effort), the shareholders can reduce the proportion of managers compensation based on net income and increase the effort on share price, which the share
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price based compensation can produces a longer decision horizon. If the share price and net income is congruent to the payoff, mix of short-run and long-run effort does not matter to the shareholders, because each effort type equally effective in generating the payoffs. However, if the share price and net income does not congruent to the payoff, short-run and long-run effort mix does matter to the investor. The shareholders may wish to control the managers effort mix, for example the length of the managers decision horizon.

6.5 The Role of Risk in Executive Compensation


Forcing managers to bear compensation risk is important because it affect how a manager operates the firm, if not enough risk is imposed, the firms will suffer from low manager effort while too much risk imposed, the manager may under invest in risky projects even the project will benefit the investors. Nevertheless, managers are assumed to be risk adverse but unlike shareholders they cannot diversify their compensation risk. Consequently, executive compensation plans are designed to control risk while still maintaining effort motivation. The risk in the executive compensation can go into downside risk and upside risk. Downside risk occur when the compensation may be less than expected; while upside risk occur when the compensation may be more than expected. There are several ways to control the compensation risk. First, the performance can be measured by using the relative performance evaluation that is the performance is measured by the difference between the firms net income or share price and the average performance relative to the average performance of similar firms in the same industry. Relative performance evaluation is a process of setting bonuses or other incentive awards in relation to the average performance of other firms in the industry. As a result, the common industry risk will be filtered out of the compensation plan, especially if the number of firms in the industry is large. For instance, some of the effects on share price and earnings of a downturn in the economy, such as a reduction in sales, will also affect other firms in the industry. The relative performance evaluation deducts the average earnings and share price performance, therefore, it is more highly correlated with manager effort than net income itself and therefore less risky. For example, the manager may still
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receive a bonus award even if the firm reported a loss but the loss are not lower than the industry average. Besides using the relative performance evaluation, the compensation risk can be reduced by having more than one performance measure. One major problem with compensation contract design is that full impact on net income of current manager effort. The compensation that measure by using the net income to measure the performance of manager usually is not observable in time to form the basis of incentive contract. The payoff observability problem will even become worse if the manager effort is recognized based on a set of activities, rather than a single activity. Some of these activities have longer-run implications than others do. Therefore, share price might be a better measure than current net income as a payoff measure. The share price will properly reflect all that is known about prospective payoff from current manager actions under efficient securities market. Although using share price will increase the sensitivity of the measure, but at the same time, reduce its precision which affected by economy-wide events such as interest rate charges, which impose risks beyond those inherent in the firm. In addition, the presence of noise traders means that share prices do not perfectly aggregate public information. Therefore, using share price as payoff measurement may impose excess risk on managers. To the extent that net income is relatively insensitive to economy-wide factors and to noise trading, therefore, the inclusion of both share price and net income in the compensation contract is vital in attaining an efficient contract. As Holmstrom studies, the efficiency of compensation contract can increase if it is based on two or more performance measures as it provide the additional information about effort. Moreover, the relative proportion of stock price-based and net income-based payoff measure will help management to having desirable risk-reduction properties. Moreover, the compensation risk can be reduced through the bogey of the compensation plan. A bogey exempts the manager from paying the company of the company suffer a loss. This can reduces the managers downside risk. For example, the stock option will reduce the manager downside risk because the lowest value of the stock option will be worth is zero. Besides that, fear of personal bankruptcy is not the best way to motivate the

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manager to work hard, this is because the manager may adopt only safe operating and investment strategies whereas shareholders interests may be better served by riskier ones. However, since the downside risk has been control, we also need to control the upside risk as well. Otherwise, the manager would have everything to gain and little to lose, and this will be too risky for the shareholders best interest. Therefore, compensation plan should impose a cap, whereby incentive compensation ceased beyond a certain level. For example, for the manager, no bonus may be given for the return on equity exceeding 25%. The last compensation risk control approach is to filter the managers incentive pay through a compensation committee. The committees are responsible to determine the cash and stock compensation as well. Besides that, the committee also has the flexibility to take special situation into account that a bonus formula could not. For example, if the company report a loss, the manager still can be awarded a bonus, as long as the committee feel that the loss is caused by some unusual event. As a result, this can reduce the managers compensation risk.

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7.0 CONCLUSION
Game theory enables to model conflict situation that often exists between different constituencies of financial statements users. Even a very simple game theories model show an accounting standard-setting body that fails to consider the interest of all constituencies affected by accounting policies choice is in danger of making policy recommendation that are difficult to implement. Conflict analysis can be used to examine conditions under which standard may or may not be needed, since under some conditions firms may be motivated to release even unfavorable information voluntarily. For the financial accounting which is based on the performance measures are important inputs into the executive compensation contracts. By having a full disclosure, it can help the compensation committee tie pay to performance, control the manager power, and increase contract efficiency as well. Moreover, the financial accounting which is based on performance measure can help to improve the operation of managerial labor markets. The working of managerial labor market can be improved by having a full disclosure.

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8.0 BIBLIOGRAPHY
1. Scott, W.R, (2009). Financial Accounting Theory, 5th ed, Pearson Prentice Hall International

Inc, Toronto 2. Cliff McCue, E. P. (2004). Using Agency Theory to Model Cooperative Public Purchasing. 46-70.
3. Fama, E. F. (1980). Agency Problems and the Theory of the Firm. Journal of Political

Economy , 288-307.
4. Ghoshal, S. (2005). Bad Mangement Theories are Destroying Good Management Practices.

Academy of Management Learning & Education , 75-91.


5. Lambert, R. A. (2007). Agency Theory and Management Accounting. Handbook of

Management Accounting Research , 247-248.


6. Logan, M. S. (2000). Using Agency Theory to Design Successful Outsourcing Relationships.

The International Journal of Logistics Management , 21-32. 7. M. Akhtaruddin, M. H. (2008). Investment Opportunity Set, Ownership Control and Voluntary Disclosures in Malaysia. 25-39. 8. Mesut Akdere, R. E. (2005). Organizational Development, Agency Theory and Efficient Contracts. 1-17.
9. Robert Bricker, N. C. (1998). On Applying Agency Theory in Historical Accounting

Research. Business and Economic History , 486-499.


10. Robert E. Hoskisson, M. W. (2009). Complementarity in Monitoring and Bonding: More

Intense Monitoring Leads to Higher Exevutive Compensation. Academy of Management Perspectives , 57-74. 11. Roberts, J. (2004). Agency Theory, Ethics and Corporate Governance. 1-18.
12. Ross L. Watts, J. L. (1979). The Demand for and Supply of Accounting Theories. The

Accounting Review , 273-305. 13. Sannikov, Y. (2007). Agency Problems, Screening and Increasing Credit Lines. 1-41. 14. Gavin Nicholson (2007). Topic 3.1 Agency Theory-The Board and Management. Retrieved on 10 October 2010 on 10am, from

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https://wiki.qut.edu.au/display/GM/Topic+3.1+Agency+theory+ +the+board+and+management 15. Wikipedia, The Free Encyclopedia. Retrieved on 10 October 2010 on 11.15am, from http://en.wikipedia.org/wiki/Principal-agent_problem 16. Ann Mathieu. (1997) Agency Theory Framework. Babson College, center for Entrepreneurial Studies. Retrieved on 13 October 2010, on 9pm, from http://www.babson.edu/entrep/fer/papers96/shane/shane3.htm#agency
17. M. Patrick. ( 2001). Agency Theory and Corporate Governance. Retrieved on 13 October

2010 on 4pm, from http://www.scribd.com/doc/8360273/Agency-Theory-UK


18. Turocy, T. L., & Stengel, B.V. (2001). Game theory. CDAM Research LSE-CDAM-

2001-09, 1-39.
19. Holzman, R. (n.d.) Foundations of non-cooperative games. Journal of Optimization and

Operations Research, (3), 1-7.

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