Dynamic Moral Hazard and Optimal Accruals

Abstract

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 accounting earnings, which correct timing errors in cash flows at the expense of introducing measurement errors. Our model yields three main results. First, the optimal contract is generally short-term and the optimal accrual policy is standardized-it is time invariant, accrual-heavy, and driven by measurability rather than agency-specific parameters. Second, deferred incentives and accruals are substitutes: deferred incentives increase whereas accruals decrease in measurement error. Finally, if the agent is hired in conjunction with a shock to fundamentals, then early in the agent's tenure the optimal contract is long-term and the optimal accrual policy is non-standardized-it is time variant, accrual-light, and driven by agency-specific parameters.

Keywords: Accruals, dynamic contracting, long-term incentives, learning JEL Classification: D86, M12, M41, M52

JEL Classification: D86, M12, M41, M52