Accrual Accounting in a Dynamic Agency Setting

41 Pages Posted: 23 Feb 1999

See all articles by Sunil Dutta

Sunil Dutta

University of California, Berkeley - Haas School of Business

Stefan J. Reichelstein

Stanford University - Stanford Graduate School of Business; CESifo (Center for Economic Studies and Ifo Institute)

Date Written: January 1999

Abstract

This paper examines the choice of asset valuation rules from a managerial control perspective. A manager creates value for a firm through his effort choice each period. To support its operating activities, the firm also engages in financing transactions such as credit sales to its customers. These financing transactions merely change the pattern of cash flows across periods but have no effect on the value of the firm. An optimal compensation scheme must therefore shield the manager from the risk associated with such transactions. If the firm operates an accrual accounting system in which receivables are capitalized at their fair values, we show that residual income eliminates this risk and provides an optimal performance measure. On the other hand, compensation schemes based only on realized cash flows can be optimal only under exceptional circumstances.

The paper also considers a setting in which the principal can observe not only the aggregate cash flow, but also the amount of realized bad debt losses each period. In this setting, an optimal compensation scheme must also shield the manager from the default risk associated with credit transactions. We demonstrate that this can be achieved if receivables are valued according to the allowance method that leads to a proper matching of sales revenues and bad debt expenses each period.

JEL Classification: M41, M46

Suggested Citation

Dutta, Sunil and Reichelstein, Stefan J., Accrual Accounting in a Dynamic Agency Setting (January 1999). Available at SSRN: https://ssrn.com/abstract=149769 or http://dx.doi.org/10.2139/ssrn.149769

Sunil Dutta (Contact Author)

University of California, Berkeley - Haas School of Business ( email )

545 Student Services Building, #1900
2220 Piedmont Avenue
Berkeley, CA 94720
United States
510-643-1229 (Phone)
510-643-1412 (Fax)

Stefan J. Reichelstein

Stanford University - Stanford Graduate School of Business ( email )

655 Knight Way
Stanford, CA 94305-5015
United States
650-736-1129 (Phone)
650-725-7979 (Fax)

CESifo (Center for Economic Studies and Ifo Institute)

Poschinger Str. 5
Munich, DE-81679
Germany

HOME PAGE: http://www.CESifo.de

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