Contracting on Aggregated Accounting Estimates

50 Pages Posted: 14 Nov 2021 Last revised: 4 Feb 2022

See all articles by Jonathan Bonham

Jonathan Bonham

The University of Chicago Booth School of Business

Amoray Riggs-Cragun

University of Chicago Booth School of Business

Date Written: December 22, 2021

Abstract

Using a principal-agent setting in which the agent has a rich action space, we provide a novel framework for studying accounting measurement and aggregation. We show that the optimal contracting process can be decomposed into three stages: constructing unbiased estimates of items that the principal values, aggregating those estimates using the weights in the principal's objective (as opposed to weighting by sensitivity or precision), and compensating the agent on the aggregated estimate. This decomposition provides a theoretical justification for contracting on highly-aggregated accounting metrics. Moreover, our results reconcile the conflict between the stewardship and valuation uses of information; when the agent has flexible control over firm performance, evaluating the manager and valuing the firm are one and the same. In a highly tractable specification of our model in which normal distributions arise endogenously, we show that optimal measurement rules are conservative yet produce unbiased estimates. Furthermore, we show that a weaker link between investment and future returns warrants more conservative treatment of expected future benefits, providing a rationale for the immediate expensing of R&D, the capitalization of PP&E and the accrual of credit sales.

Keywords: Optimal contracting, accounting measurement, aggregation, conservatism

JEL Classification: D86, J41

Suggested Citation

Bonham, Jonathan and Riggs-Cragun, Amoray, Contracting on Aggregated Accounting Estimates (December 22, 2021). Chicago Booth Research Paper No. 22-04, Available at SSRN: https://ssrn.com/abstract=3962557 or http://dx.doi.org/10.2139/ssrn.3962557

Jonathan Bonham

The University of Chicago Booth School of Business ( email )

1101 East 58th Street
Chicago, IL 60637-1561
United States
7738344748 (Phone)

HOME PAGE: http://https://www.chicagobooth.edu/faculty/directory/b/jonathan-bonham

Amoray Riggs-Cragun (Contact Author)

University of Chicago Booth School of Business ( email )

5807 S Woodlawn Ave
Chicago, IL 60637
United States

HOME PAGE: http://www.riggscragun.com/

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