Accounting for Compensation: Dynamic Moral Hazard and Optimal Accruals

Abstract

We investigate the impact of accrual accounting policies on contracting and productive efficiency in a continuous-time moral hazard framework. We allow an agent control over unobservable fundamental performance, and he is compensated via a contract written on cash flows, which contain timing errors, and accounting earnings, which correct timing errors at the expense of introducing estimation errors. The equilibrium incentive scheme is less stochastic and more short-term in nature as the accrual policy optimally corrects more timing errors in cash flows. We show that there exist two accrual policies that elicit the desired behavior from the agent. The stationary policy is standardized and does not depend on agency-specific parameters such as risk aversion or discount rates. On the other hand, the non-stationary policy changes over time as the nature of incentive provision changes and depends on such characteristics that are specific to the agency relationship. Neither accrual policy necessarily corrects all of the timing errors in cash flows. Moreover, the choice of accrual policy itself is a dynamic one: the principal will choose to implement the stationary accrual policy during times when the agent's incentives are more deferred, and the non-stationary policy when long-term incentives are closer to being fully vested.