Equilibrium Earnings Management, Incentive Contracts, and Accounting Standards

In this paper, we model earnings management as a consequence of the interaction among self-interested economic agents -- namely, the managers, the shareholders, and the regulators. In our model, a manager controls a stochastic production technology and makes periodic accounting reports about his or her performance; an owner chooses a compensation contract to induce desirable managerial inputs and reporting choices by the manager; and a regulatory body selects and enforces accounting standards to achieve certain social objectives. We show that various economic trade-offs give rise to endogenous earnings management. Specifically, the owner may reduce agency costs by designing a compensation contract that tolerates some earnings management because such a contract allocates the compensation risk more efficiently. The earnings-management activity produces accounting reports that deviate from those prescribed by accounting standards. Given such reports, the valuation of the firm may be nonlinear and s-shaped, thereby recognizing the manager's reporting incentives. We also explore policy implications, noting that (1) the regulator may find enforcing a zero-tolerance policy -- no earnings management allowed -- economically undesirable; and (2) when selecting the optimal accounting standard, valuation concerns may conflict with stewardship concerns. We conclude that earnings management is better understood in a strategic context that involves various economic trade-offs

Accounting in Partnerships

In 1914, an accounting professor named Arthur Andersen founded a public accounting practice that became the world’s largest professional-services firm. For years preceding the Enron debacle and Andersen’s collapse, the firm had struggled to create incentives within the organization for partners to provide high-quality service, develop and sell new services, and meet the compensation expectations of various factions of partners. A years-long dispute over the division of profits between the firm’s consulting and accounting arms led to the 1998 separation of the consulting practice from the audit and tax practices. The rise, break-up and fall of Andersen underlines the importance of questions concerning incentive structures within public accounting firms in particular, and partnerships of professionals in general. This paper offers a perspective on partner compensation schemes and the accounting information systems that support them

Endogenous Precision of Performance Measures and Limited Managerial Attention

In this paper, we model two drivers which underlie the economic tradeoff shareholders face in designing incentives for optimal effort allocation by managers. The first driver is limited managerial attention, by which we mean that performing one task may have an adverse effect on the cost-efficiency of performing another. The second is the presence of a performance reporting task, by which we mean the manager’s ability to exert personally costly effort to improve the precision (or quality) of his/her performance measures. We show that the subtle interactions of the two drivers may alter the characteristics of incentive provision. First, we show the interaction may lead to a positive relation between the strength of the incentive and the variance of the performance measures. Second, the interaction may render an otherwise informative performance signal unused in equilibrium incentive contracts. In particular, we show that it is possible that the principal does not use the signal whose precision can be improved by the manager, in order to discourage the manager from diverting attention to the performance reporting task (which makes the productive effort more costly). Finally, we apply the model to a specific project-selection setting and show that in order to induce the agent to choose higher-risk-higher-return projects, the principal may need to raise the bonus rate when the project-selection choice is unobservable.</p

Accounting Measurement Basis, Market Mispricing, and Firm Investment Efficiency

In this paper, we investigate how the accounting measurement basis affects the capital market pricing of a firm's shares, which, in turn, affects the efficiency of the firm's investment decisions. We distinguish two broad bases for accounting measurements: input-based and output-based accounting. We argue that the structural difference in the two measurement bases leads to a systematic difference in the efficiency of the investment decisions. In particular, we show that an output-based measure has a natural advantage in aligning investment incentives because of its comprehensiveness. The (first-)best investment is achieved when the output-based measure is noiseless and manipulation free. In addition, under an output-based measure, more accounting noise/manipulation always leads to more inefficient investment choices. Therefore, if an output-based accounting measure is highly noisy and easy to manipulate in practice, the induced investment efficiency can be quite low. On the other hand, an input-based accounting measure, while not as comprehensive, may induce more efficient investment decisions than an output-based measure if some noise is unavoidable in either measure. The reason is twofold. First, input-based measures may be associated with less noise and limited manipulation in practice. Second, and more importantly, we show that under an input-based measure, a slight increase in accounting noise/manipulation may lead to more efficient investment choices. In fact, the (first-)best result is achieved when the noise/manipulability is small but positive. In other words, for an input-based measure, being less comprehensive makes small but positive accounting noise/manipulability desirable. Two extensions of the basic model are also explored

Informational Feedback Effect, Adverse Selection, and the Optimal Disclosure Policy

Trading in a secondary stock market not only redistributes wealth among investors but also generates information that guides subsequent real decisions. We provide a disclosure model that reflects both functions of the secondary market. By partially preempting traders' information advantage established from information acquisition, disclosure reduces incentives for private information acquisition. The resulting reduction in information acquisition has two opposite effects on firm value. On one hand, it narrows the information gap between informed and uninformed traders and improves the liquidity of firm shares. On the other hand, it reduces the informational feedback from the stock market to real decisions. The optimal disclosure policy is determined by the trade-off between liquidity enhancement and the investment efficiency. The model explains why the firm value could be higher in an environment that promotes disclosure and private information production at the same time and why growth firms are endogenously more opaque than value firms.</p

New Classical Income Measurement: A Choice-Theoretic Axiomatic Approach

At the fundamental level, the key challenge to a theory of income measurement is to resolve the problem caused by soft information, which leads to incomplete preferences within the entity (i.e. some alternatives are not always unambiguously ranked). This paper presents a formal axiomatic foundation for income measurement, building on several recent developments in the economic theory of choice. We first design a meaningful income measure for an entity with incomplete preferences. When there is enough hard information, this measure consists of finitely-many performance criteria (Line-Item Income Measure) which fully represent the incomplete decision problem of the entity. Second, a single-valued income measure (Summary Income Measure) is introduced, which extends classical income to incomplete preferences. Third, these measures can be operational and exhibit recognizable features such as linear aggregation over time and individual operating units

Voluntary Disclosure to Sustain Tacit Collusion

When facing repeated interactions, firms in an oligopoly can engage in tacit collusion, using the threat of a price war in future periods to sustain higher prices and industry profits in the current period. This paper explores how strategic voluntary disclosures can play an important role as part of a tacit collusion. In each period, one firm receives a signal on market size and must decide whether or not to publicly disclose the information before engaging in price competition in the product market. Two main forces in play are (1) nodisclosure makes it easier for the oligopoly to sustain higher prices because the uninformed firms are uncertain about the market size (and therefore the benefit of deviating from collusion is lower than otherwise); and (2) disclosure makes it easier to coordinate prices if and when the oligopoly wishes to condition equilibrium prices on the market size. We find that, when firms are sufficiently patient such that monopoly prices can be sustained as an equilibrium, no-disclosure is (weakly) preferable to any other disclosure policy. Otherwise and in contrast to the static model, a simple form of partial disclosure can be optimal: the informed firm does not disclose when market size is either too high or too low but discloses for intermediate market sizes, undercutting its competitors when its information is good

Information Economics and Accounting Measurement: A Blueprint for Scholarly Research

In this essay, we wish to make a single, simple argument. That is, if information problems are the primary root of the accounting problems, then modern information economics should be the center of accounting research. In making this argument, we plan to first revisit a somewhat elementary accounting question. Using the question as a spring-board, we retrace the rise of information economics in the accounting discipline. Finally, we argue that to answer similarly posed questions, accounting theory needs a (modern) information-economics core. It also needs to build accounting measurement structure based on the core. Such an accounting theory, hopefully, connects with the existing framework of accounting practice at a fundamental level and ought to guide accounting research, education, and policy-making

Contracting For Educational Achievement

We argue that the lack of academic proficiency in K-12 education is due to information asymmetry between the policy-maker, households and schools. The policy-maker is thus unable to write down contracts that ensure proficiency, and must incur agency costs which, in turn, generate other distortions. We develop a theoretical equilibrium model where schools and households choose their efforts in response to the policy-maker’s incentives. We model public schools as one possible response to informational failures. Unlike private schools, public schools separate the roles of financing and consuming education, thus creating rents for public schools. We develop a computational version of the model that allows us to illustrate the distortions and effects from alternative contracts

Information asymmetry and equilibrium monitoring in education

We develop a theoretical and computational model of school choice and achievement that embeds information asymmetries in the provision of education. Because school effort is unobservable to households and policymakers, schools have an incentive to under provide effort. This moral hazard affects both public and private schools, although public schools are subject to an additional distortion because of limited competition and fixed funding. Household monitoring of schools can mitigate moral hazard, but some households may free-ride on the monitoring of others. Using our calibrated model we simulate two policies aimed at raising achievement: public monitoring of public schools and private school vouchers. Our results indicate that in large scale settings no single tool may suffice. The reason is twofold: a) no tool raises achievement or welfare for all households; and b) since the extent of moral hazard is endogenous, the application of each tool has unintended consequences that limit its own effectiveness. Results also indicate that setting the policy parameters for public schools at the levels preferred by the majority of households may mitigate the distortions. Nonetheless, the current actual values of these parameters seem to match more closely the preferences of public schools than the preferences of parents.</p