The Effect of Risk Aversion on Optimal Bias in Incentive Contracts

Abstract

This paper analyzes the impact of agents' risk aversion and other agency parameters on optimal bias in the performance measures used for incentive contracts. Prior research has shown that the limited liability of the agent results in a demand for accounting systems that are stringent compared to the unobservable true outcome. This paper shows that risk aversion mitigates this preference for stringent accounting systems. Specifically, in a principal-agent model where the principal can choose between two accounting systems (ASs) with different biases, the optimal choice depends on the ranking of the overall information content (OIC) of these ASs and on the agent's level of risk aversion. The more stringent AS is always optimal if it has a higher OIC. When the more lenient AS has a higher OIC, it is optimal for high levels of risk aversion, the more stringent AS remaining optimal for low levels of risk aversion. This paper also analyzes the impact of the extent of the agent's possible liability and of the strength of the agency conflict. The paper contributes to the literature by identifying the role of the OIC, of agents' risk aversion, and of other agency parameters in the choice of an optimal reporting bias when accounting information is primarily used for stewardship.

Keywords: Reporting bias, limited liability, risk aversion, accounting conservatism, principal-agent theory, lower of market or cost rule

JEL Classification: D82, D86, M41, M52