This paper reviews agency theory and its application to accounting issues. I discuss the formulation of models of incentive problems caused by moral hazard and adverse selection problems. I review theoretical research on the role of performance measures in compensation contracts, and I compare how information is aggregated for compensation purposes versus valuation purposes. I also review the literature on communication, including models where the revelation principle does not apply so that nontruthful reporting and earnings management can take place. The paper also discusses capital allocation within firms, including transfer pricing and cost allocation problems.

It is commonly observed that the compensation paid to senior level executives depends on both accounting and security price measures of performance. The articles by Kim and Suh, Bushman and Indjejikian, and Sloan, which I have been invited to discuss, examine the issue of how much weight to place on these two measures in the contract. The first two papers analyze the role that earnings can play in removing the ‘noise’ in stock price in a rational expectations pricing model. The Sloan paper analytically and empirically examines the role that earnings can play in removing macroeconomic factors from stock price.

Richard A. Lambert, Customer Satisfaction and Future Financial Performance Discussion of are Nonfinancial Measures Leading Indicators of Financial Performance? An Analysis of Customer Satisfaction, Journal of Accounting Research, Vol. 36, Studies on Enhancing the Financial Reporting Model (1998), pp. 37-46

Cost variance, Auditing, Agency Theory

ABSTRACT This paper responds to Hemmer's (2020) critique of Lambert's (1984) paper on income smoothing. Lambert develops and analyzes a two-period agency model in which he shows income smoothing, defined as the second-period action being a decreasing function of the first-period outcome, is part of the equilibrium. Hemmer claims Lambert's analysis contains errors, and that income smoothing does not occur in the model for the reasons Lambert claims. Here, I confirm the Lambert results, show why Hemmer's results appear different than mine, and make clearer the economic forces behind why income smoothing occurs.

Abstract ABSTRACT: This paper uses agency theory to examine the phenomenon of "real" income smoothing. The analysis suggests that incentive problems caused by the unobservability of a manager's actions can lead to the manager selecting actions at the end of a period to smooth the period's income toward its ex ante expected value. An important feature of the analysis is that both the principal and the manager are modeled as rational parties. In particular, the principal can predict what actions the manager will choose in response to any compensation scheme, and he takes this into consideration in deciding what compensation plan to offer. The analysis shows that the optimal compensation scheme offered by the principal causes the manager to smooth the firm's income. Income smoothing can therefore arise as optimal equilibrium behavior.

[This paper uses agency theory to examine the phenomenon of "real" income smoothing. The analysis suggests that incentive problems caused by the unobservability of a manager's actions can lead to the manager selecting actions at the end of a period to smooth the period's income toward its ex ante expected value. An important feature of the analysis is that both the principal and the manager are modeled as rational parties. In particular, the principal can predict what actions the manager will choose in response to any compensation scheme, and he takes this into consideration in deciding what compensation plan to offer. The analysis shows that the optimal compensation scheme offered by the principal causes the manager to smooth the firm's income. Income smoothing can therefore arise as optimal equilibrium behavior.]

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This paper uses an agency theory model in which the agent's actions are multi‐dimensional to analyze the optimal weights to apply to performance measures in a compensation contract. We show how the optimal contract trades off the congruity of the overall performance measure with the desire to minimize the risk imposed upon the agent. In contrast to the single action case, we find that an increase in the sensitivity of a performance measure to an agent's action does not necessarily increase the weight placed on that performance measure, even if that measure is perfectly congruent with the firm's outcome.

[Prior work has examined models in which the reciprocal cost allocation method yields allocation rates that are equal to the marginal costs of operating service departments. We extend this work by analyzing more general production functions for service departments and by incorporating uncertainty. The results demonstrate that the allocation rates derived from the reciprocal cost allocation method are random variables that, in general, are not equal to the expected marginal costs of operating the service departments. In particular, the reciprocal cost allocation rates are biased estimates of these expected marginal costs if any of the service departments operate at a point on their production functions at which the marginal physical product is not equal to the average physical product of their inputs. We also analyze three econometric procedures that provide consistent estimates of the marginal costs. The simulation results indicate that the standard deviations of these estimators are considerably larger than those of the reciprocal cost allocation rates. Because the estimates of the marginal costs provided by the reciprocal cost allocation method have a greater degree of bias, but a lower standard deviation than the estimates provided by the other methods, none of the methods provide estimators that are unambiguously best. Factors that affect the magnitudes of the bias and relative efficiency of the reciprocal cost allocation rates are also discussed.]