Topics: Performance measurement, dynamic contracting, accounting rules, dynamic games, real options, information disclosure
Methodologies: Analytical, archival
I develop a dynamic principal-agent framework to examine the role of accounting information in a long-term contracting relationship with uncertainty over fundamental performance in which intertemporal incentives and termination are jointly determined. Learning and the reversal property embedded in the accounting performance measurement system gives rise to an accounting-driven demand for long-term incentives. Measurement precision directly influences the performance-based vesting behavior of these incentives over the course of the contracting relationship. Furthermore, equilibrium manipulation of the accounting report becomes increasingly positive as the agency approaches termination because such a policy reduces the chance of inefficient termination. My framework allows for falsifiable predictions regarding the relationship between the properties of accounting measurement and the evolving nature of incentives over the manager’s tenure, managerial risk-taking activity, and managerial turnover.
with Jonathan Bonham
We investigate the impact of accrual accounting on contracting and the characteristics of optimal accrual policies in a continuous-time moral hazard framework. An agent who controls unobservable fundamental performance 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 measurement errors. Deferred incentives and accruals are substitutes in solving the incentive problems created by cash flow timing errors, and accruals dominate deferred incentives as measurement becomes more precise. If cash flows and earnings are sufficiently informative, then accruals are the primary control mechanism late in the agency relationship when the most efficient accrual policy is time-invariant and standardized — it is driven by measurability rather than agency-specific parameters. By contrast, deferred incentives are the primary control mechanism early in the agency relationship, when the most efficient accrual policy changes over time, is non-standardized, and corrects fewer timing errors than the standardized policy. Overall, our model links optimal long-term incentives to accrual accounting policies and generates novel predictions about dynamic contracting and accounting practices.
Selected Works in Progress
Uncertainty, Performance Measurement, and the Provision of Dynamic Incentives: Theory and Evidence
In this paper, I examine how the interaction between performance measurement and uncertainty affects the provision of long-term incentives. Guided by a stochastic filtering model where stock prices and earnings provide noisy measures of the same underlying economic construct, unobservable firm fundamentals, I develop a novel empirical measure of intertemporal information asymmetry between the principal and the agent, the rate at which the principal’s beliefs over underlying fundamentals match those of the agent’s. It represents the degree to which stock price and earnings information alleviate the moral hazard problem. This measure helps explain variation in executive pay duration and the use of performance-vesting incentive provisions in long-term compensation contracts. The dynamics of incentives are thus driven primarily by informational concerns, in contrast to the managerial entrenchment view of the executive pay process.
Dynamic Information Acquisition and Disclosure
with Iván Marinovic
Accounting Aggregation in Long-Term Incentive Contracts
with Amoray Riggs-Cragun
The construction of accounting-based performance measures entails two primary forms of aggregation. First, the occurrence of like transactions or events are aggregated over time into distinct accounts as dictated by Generally Accepted Accounting Principles (GAAP). Second, accounts are aggregated together in specific ways to construct relevant accounting measures. We develop a fully dynamic principal-agent model which captures both types of aggregation. In our model, a manager controls the intensity of the firm’s revenue and expense accounts, which we model as Poisson processes. These accounts can be aggregated into earnings, which we model as a Skellam process. We study how the second-best levels of revenue-generating effort versus cost-cutting effort evolve over the course of the contracting relationship, as well as how optimal incentives change over time. We also explore conditions under which contracting on aggregated measures may be desirable.
Continuous Measurement with Periodic Reporting: The Economic Effects of Disclosure Frequency
In this paper, I examine the relation between disclosure frequency and the properties of incentives in executive compensation contracts in a setting where periodic financial reports measure unobservable fundamental performance. I develop a continuous-time framework of periodic financial reports that are released at discrete points in time to capture the fact that, while transactions take place continuously, financial statements are only released at predetermined points in time. I explicitly model the financial reporting process as a stochastic jump process where the agent controls the mean jump size at each reporting time. The earnings release times are deterministic at a given frequency level. When financial statements are the only source of information regarding fundamental performance, the optimal compensation contract exhibits jumps for low frequency levels, but gets smoother as disclosure frequency increases. If there is another source of information that is observed continuously, such as cash flows or voluntary disclosures, the contract contains both smooth and discontinuous incentive components.
Trade Under Asymmetric Information: A Reader’s Companion
with Thomas Hemmer
There are plenty of good books available that provide summaries and overviews of key contributions of information economics to our understanding of the role of rules and contracts for the functioning of markets. Writing another book of this form makes little sense, and this is not our aim. Rather than providing a substitute for reading the fundamental papers we cover, our goal is to help facilitate the reading of the underlying papers. As such, although entirely feasible, this monograph is not meant to be read as a stand-alone document, but instead read in conjunction with the papers that we cover. The individual notes are structured to help readers through some of the technicalities that, in our experience, stand between readers new to this literature and the important insights that these papers contain. While technically rigorous, we also provide intuition and tie the papers together to help the user better “see the forest for the trees.” Although the monograph spans both classical so-called “Disclosure” and “Contracting” papers, we avoid this segmentation and instead emphasize the commonalities to help readers better explore the links between the individual papers and particular market structures and circumstances.