Contracting on Aggregated Accounting Estimates

46 Pages Posted: 14 Nov 2021 Last revised: 6 Sep 2023

See all articles by Jonathan Bonham

Jonathan Bonham

University of Illinois at Chicago

Amoray Riggs-Cragun

University of Chicago Booth School of Business

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

Bonham, Jonathan and Riggs-Cragun, Amoray, Contracting on Aggregated Accounting Estimates (September 4, 2023). Chicago Booth Research Paper No. 22-04, Available at SSRN: https://ssrn.com/abstract=3962557 or http://dx.doi.org/10.2139/ssrn.3962557

Jonathan Bonham

University of Illinois at Chicago ( email )

601 S. Morgan
Chicago, IL 60607

Amoray Riggs-Cragun (Contact Author)

University of Chicago Booth School of Business ( email )

5807 S Woodlawn Ave
Chicago, IL 60637
United States

HOME PAGE: http://www.riggscragun.com/

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