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CHAPTER 8
THE EFFICIENT CONTRACTING APPROACH TO DECISION USEFULNESS
8.1 Overview
8.2 What is Efficient Contract Theory?
8.3 Sources of Efficient Contracting Demand for Financial Accounting Information
8.3.1 Lenders
8.3.2 Shareholders
8.4 Accounting Policies for Efficient Contracting
8.4.1 Reliability
8.4.2 Conservatism
8.5 Contract Rigidity
8.6 Employee Stock Options
8.7 Discussion and Summary of ESO Expensing
8.8 Distinguishing Efficiency and Opportunism in Accounting
8.9 Summary of Efficient Contracting for Debt and Stewardship
8.10 Implicit Contracts
8.10.1 Definition and Empirical Evidence
8.10.2 A Single–Period Non–Cooperative Game
8.10.3 A Trust–Based Non–Cooperative Game*
8.10.4 Summary of Implicit Contracting
8.11 Summary of Efficient Contracting
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LEARNING OBJECTIVES AND SUGGESTED TEACHING APPROACHES
1. To Understand what Contract Theory is, and What it Wants to Accomplish
This chapter begins the second major component of the text, namely to consider
management’s role in financial reporting, and how managers can be motivated to
manage in the interests of firm investors.
Suggested points to consider;
• Managers, like investors, are assumed to be rational, that is, to act in their own
best interests.
• The moral hazard problem. In our context, this arises because manager effort in
running the firm cannot be observed by outside investors. As a result, the
interests of rational managers conflict with the interests of investors, since the
manager may shirk on effort at investors’ expense. The question then is, how is
this conflict resolved so that investors have reasonable trust that the manager is
working on their behalf.
• A manager who shirks on effort may cover up by managing earnings so as to
hide or delay the effects of his/her shirking on firm profitability This unfairly
increases the manager’s reputation and compensation beyond what he/she
deserves. Concept of an efficient contract. Firms enter into many contracts, in
particular, debt contracts with lenders and compensation contracts with
managers. By basing these contracts on accounting information, the manager’s
temptation to act only in his/her own interests can be controlled. However,
contracts can be costly to the firm (covenants in debt contracts, compensation
paid to managers). An efficient contract motivates the manager to act on
investors’ best interests at lowest cost to the firm.
• Corporate governance. Efficient contracting is an important component of
corporate governance.
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2. What Accounting Policies Support Efficient Contracting?
Contract theory gives considerable attention to lenders to the firm, since they are
important sources of capital, and since debt contracts usually depend in some manner
on accounting variables. To understand accounting policies desired by debtholders, the
main point to realize is their payoff asymmetry. Debtholders do not share directly if firm
profitability increases, but stand to lose if profitability decreases. From this, it follows
naturally that debtholders prefer accounting policies that are reliable and (conditionally)
conservative. They reward firms using such policies with lower interest rates. The most
efficient debt contract balances the lower interest rate with the expected costs imposed
by the debt covenants.
With respect to shareholders, reliable and conservative accounting policies make it
more difficult for the manager to record unrealized gains, thereby making it more difficult
to hide shirking by inflating reported earnings so as to increase reputation and
compensation.
3. To Illustrate Economic Consequences
The text uses the saga of accounting for ESOs as an example of economic
consequences, whereby managers expressed extreme concerns about an accounting
policy that does not directly affect cash flows. Also illustrated are several of the
opportunistic tactics used by managers to increase compensation by manipulating stock
price so as to increase the value of their ESOs. Expensing of ESOs can then be viewed
as a way to increase compensation contract efficiency.
4 To Review the Research on Manager Opportunism versus Efficient
Contracting
Given the importance of efficient contracting to corporate governance, the question
arises whether actual debt and compensation contracts are efficient or whether they
bear evidence of manager opportunistic behaviour. This question has received
considerable empirical research, much of which, but not all, suggests that on average,
contracts are efficient.
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Instructors may wish to point out the parallel between this question and the question
examined in Chapter 5 whether securities prices behave as predicted by rational
investor theory and efficient capital markets. While the two concepts of efficiency are
different, there is substantial empirical support for the respective theories. This leads
into the argument in Section 8.7 that even though managers care about accounting
policy choice even if it does not affect cash flow (contrary to market efficiency theory),
the two theories are not inconsistent.
However, some of the empirical evidence in Section 8.8, as well as the ESO saga,
suggests that manager opportunism (i.e., inefficient contracts) is mixed in with the
efficient contracts. The text uses this dichotomy to remind students that accountants
have a responsibility to reduce the extent of manager opportunism by ethical behaviour
leading to high quality financial reporting.
5. To Introduce the Theory of Non–Cooperative Games
The text pushes the theme of contract efficiency a bit further by introducing a simple
non–cooperative game example (by definition, no formal contract exists, therefore an
implicit contract). This introduces the concept of a Nash equilibrium, and serves to
illustrate nicely the basic conflict between investor and manager interests.
Instructors who wish to pursue what happens when the 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.
Instructors who wish to consider non–cooperative games a bit further may be interested
in the optional multi–period game illustrated in Section 8.10.3. I use this game
demonstrate how important mutual trust is if cooperation between investors and
managers is to be maintained (i.e., a more efficient implicit contract) over time. The role
of accountants to help generate and maintain this trust is pointed out.
To be honest, I have a reservation about this game. My reservation arises in the final
period, where the investor must trust that the manager will play honest with some
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probability even though it is to his advantage to distort. If the investor feels he will distort
for sure (rather than with probability 0.9 in this example), the game will unravel. This
implies that the manager must value his reputation after the game is over. While this
seems reasonable, it does go “outside the model” to some extent. Going outside the
model for support does raise eyebrows in analytical modeling.
The text returns briefly to game theory in Section 12.9.1, where the model of Darrough
and Stoughton (1990) is discussed in the context of the trade–off faced by a manager
between the role of full disclosure to reduce cost of capital and less disclosure in order
to deter entry into the industry. Since Darrough and Stoughton, numerous researchers
have studied the conflict between disclosure, threat of entry, and cost of capital.
However, to pursue this literature, 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 theory rewrote all the rules, “Business Week, October 24,
1994, p. 44.
• “Businessman’s Dilemma,” Forbes, October 11, 1993, pp. 107–109.
• Economics Focus: “War games,” The Economist, October 13, 2005, pp.
82–83.
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SUGGESTED SOLUTIONS TO QUESTIONS AND PROBLEMS
1. Maintaining a specified level of working capital generates lender trust by helping
to ensure that the firm has the cash needed to pay interest and principal, since
the firm is constrained from paying excessive dividends and manager
compensation. To the extent that this covenant discourages additional borrowing
2. Lenders benefit if the firm does well because the better the firm performs the
greater is the probability that it will be able to pay interest and principal on its
debts.
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3. a. Lev selected the date of the exposure draft because of efficient securities
market theory, which predicts that if the market is going to react to the imposition
of successful-efforts accounting, it will do so at the earliest moment it becomes
b. The prospect of lower and more volatile reported profits for the concerned
firms increased the likelihood of violation of debt covenants. Alternatively, or in
addition, lower and more volatile reported earnings threatened to reduce the
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affected firms. Share prices would also be bid down by diversified investors if the
manager avoids risky exploration programs, since the effect is to lower expected
returns without decreasing investor risk (since diversified investors have already
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5. The following accounting policy choices are suggestive of what could be done to
lower the probability of technical violation:
(i) Increase equity by increasing current reported (comprehensive) earnings.
This can be done by managing accruals. Possibilities include:
• Minimize provisions for doubtful accounts receivable and for warranties.
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• Delay adoption of new income–decreasing accounting standards, or speed
up adoption of income–increasing ones, to extent allowed by the standard.
(ii) Reclassify long–term liabilities as equity:
Note: This tactic may increase future net income volatility.
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