Joel S. Demski, Hans Frimor, Performance Measure Garbling Under Renegotiation in Multi-Period Agencies, Journal of Accounting Research, Vol. 37, Studies on Credible Financial Reporting (1999), pp. 187-214

We emphasize the role of accounting policies, and their audit, in an earnings management setting. We use a two–period agency in which three frictions interact: the agent privately observes action (or effort) supply and output, and the initial contract is subject to renegotiation. This creates a setting in which both players’ behavior is of concern, and, importantly, information rationing is efficient. Moreover, this information rationing is directly interpretable as being produced by an accounting policy whose application is ensured by an auditor.

We analyze the optimal behavior of an organization when its employees can manipulate the organization's accounting system to their private advantage. We find that the organization may benefit by helping its employees manipulate the system. This help can reduce the employees' private returns from devoting effort to further manipulation of the accounting system, which reduces the cost of motivating the employees to devote their effort to improving the real (rather than the measured) performance of the organization.

We derive the optimal compensation contract in a principal–agent setting in which outcome is used to provide incentives for both effort and risky investments. To motivate investment, optimal compensation entails rewards for high as well as low outcomes, and it is increasing at the mean outcome to motivate effort. If rewarding low outcomes is infeasible, compensation consisting of stocks and options is a near‐efficient means of overcoming the manager's induced aversion to undertaking risky investments, whereas stock compensation is not. However, stock plus option compensation may induce excessively risky investments, and capping pay can be important in curbing such behavior.