Optimal Incentive Contracts with Accounting Method Choice

Abstract

I present a two-period principal-agent model in which the principal chooses between two information regimes, one in which he directly observes outputs and the other in which the agent has reporting discretion through an accounting method choice. I show that reporting discretion through an accounting method choice can be optimal from the principal's perspective. I formally distinguish between the use of discretion through accounting method choices and through other means, e.g., accounting estimates, by incorporating two characteristics of accounting method choices found in Generally Accepted Accounting Principles. First, accounting methods selectively utilize some information and disregard other information in order to determine revenues or expenses. Second, accounting methods are used consistently across periods. Both characteristics are necessary for the accounting method choice in the model to be optimal for the principal. The results emphasize the importance of institutional mechanisms. Reporting discretion, granted with a well-designed control mechanism, can help reduce agency costs.

Keywords: accounting choice, earnings management, managerial incentive, reporting discretion

JEL Classification: M41, M43, J33, D82