Contracting on Aggregated Accounting Estimates
46 Pages Posted: 14 Nov 2021 Last revised: 6 Sep 2023
Date Written: September 4, 2023
Abstract
In a model where the agent has a very rich action space, we show that optimal contracting can be decomposed into three stages: constructing unbiased estimates of revenues and expenses, aggregating those estimates with weights of 1 and -1 (as opposed to weighting by sensitivity or precision), and compensating the agent on the aggregated estimate (net income). Unbiased estimates are produced by measurement that tends toward conservatism as the agent manipulates transaction characteristics. Taken together, our results provide a theoretical justification for tying executive pay to highly-aggregated GAAP accounting metrics like net income, a practice unexplained by conventional agency models.
Keywords: Optimal contracting, accounting measurement, aggregation, conservatism
JEL Classification: D86, J41
Suggested Citation: Suggested Citation