Dynamic Moral Hazard and Optimal Accruals

Abstract

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.