Optimal Contracting, Accounting Standards and Market Structures

Contempoary Accounting Research, Vol. 16, No. 2, Summer 1999, pp. 243-276

Posted: 24 Jun 2002

See all articles by Michael Kirschenheiter

Michael Kirschenheiter

College of Business Administration University of Illinois at Chicago

Abstract

In this study I use a principal-agent framework to analyze optimal contracting under two accounting standards, referred to as historical cost (HC) and market value (MV), and under differing asset market assumptions. I distinguish HC from MV by how revenue is recognized and in the reporting discretion allowed. The MV standard recognizes both realized and unrealized holding gains; HC recognizes only realized holding gains. MV allows the manager reporting discretion; the HC standard does not. Also, distinguishing an asset's value-in-use (VIU) from its net realizable value (NRV), I consider markets where the asset's VIU and NRV are always equal as well as markets where VIU and NRV differ. I show the following. If an asset's NRV and VIU are equal and if the manager's available reporting discretion is known, the principal prefers the MV standard because it provides better information about the manager's effort. However, the principal may prefer the HC standard if he is sufficiently uncertain about the manager's reporting discretion or if the asset's NRV exceeds its VIU, so that expected revenue is sufficiently enhanced by selling the asset earlier. Via an example (normal distribution and mean/variance preferences with linear contracts), I provide a case where the principal prefers the HC standard. Also, I compare the optimal effort and contract under each standard, and provide comparative static results which show how expected revenue, cost and net income change due to changes in certain model parameters.

JEL Classification: M41, M44, D82

Suggested Citation

Kirschenheiter, Michael, Optimal Contracting, Accounting Standards and Market Structures. Contempoary Accounting Research, Vol. 16, No. 2, Summer 1999, pp. 243-276, Available at SSRN: https://ssrn.com/abstract=316522

Michael Kirschenheiter (Contact Author)

College of Business Administration University of Illinois at Chicago ( email )

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