Dynamic Moral Hazard and Optimal Accruals
61 Pages Posted: 3 Jun 2021 Last revised: 4 Jan 2022
Date Written: April 30, 2021
We derive optimal contracting and accrual accounting policies in a continuous-time moral hazard framework. An agent who takes actions to generate current and future cash flows is compensated via a contract written on cash flows, which contain timing errors, and accounting earnings, which correct these timing errors at the expense of introducing measurement errors. We show that deferred incentives and accruals are substitutes in solving the incentive problems created by cash flow timing errors. Late in the agency relationship, the optimal contract is short-term and the optimal accrual policy is standardized -- it is time invariant, accrual-heavy, and driven by measurability rather than agency-specific parameters. By contrast, early in the agency relationship the optimal contract is long-term and the optimal accrual policy is non-standardized -- it changes over time, corrects fewer timing errors than the standardized policy, and varies with agency-specific parameters. Our model sheds light on the relation between accruals and the timing of incentives, as well as the use of accounting-based performance measures over the manager's tenure.
Keywords: Accruals, dynamic contracting, long-term incentives, learning
JEL Classification: D86, M12, M41, M52
Suggested Citation: Suggested Citation