Contracting in Peer Networks

We consider multiagent multifirm contracting when agents benchmark their wages to those of their peers, using weights that vary within and across firms. When a single principal commits to a public contract, optimal contracts hedge relative wage risk without sacrificing efficiency. But compensation benchmarking undoes performance benchmarking, causing wages to load positively on peer output, and asymmetries in peer effects can be exploited to enhance profits. With multiple principals, a “rat race” emerges: agents are more productive, with effort that can exceed the first best, but higher wages reduce profits and undermine efficiency. Wage transparency and disclosure requirements exacerbate these effects.     

Optimal Contracts with Performance Manipulation

We study optimal compensation contracts that (1) are designed to address a joint moral hazard and adverse selection problem and that (2) are based on performance measures, which may be manipulated by the agent at a cost. In the model, a manager is privately informed about his productivity prior to being hired by a firm. In order to incentivize the manager to exert productive effort, the firm designs a compensation contract that is based on reported earnings, which can be manipulated by the manager. Our model predicts that (1) the optimal compensation contract is convex in reported earnings; (2) the optimal contract is less sensitive to reported earnings than it would be absent the manager's ability to manipulate earnings; and (3) higher costs of manipulating reported earnings (e.g., due to higher governance quality) are associated with higher firm value, lower expected level of earnings management, and higher output.     

Implementing high‐powered contracts to motivate intertemporal effort supply

We characterize the optimal contract between a principal and a risk‐neutral, wealth‐constrained agent when an adverse selection problem follows a moral hazard problem. The optimal contract in this setting often is more steeply sloped for the largest output levels than is the optimal contract in either the standard moral hazard setting or the standard adverse selection setting. The large incremental rewards for exceptional performance motivate the agent to deliver substantial effort both before and after he acquires privileged information about the production environment.     

Optimal securitization with moral hazard

We consider the optimal design of mortgage-backed securities (MBS) in a dynamic setting in which a mortgage underwriter with limited liability can engage in costly hidden effort to screen borrowers and can sell loans to investors. We show that (i) the timing of payments to the underwriter is the key incentive mechanism, (ii) the maturity of the optimal contract can be short, and that (iii) bundling mortgages is efficient as it allows investors to learn about underwriter effort more quickly, an information enhancement effect. Finally, we demonstrate that the optimal contract can be closely approximated by the “first loss piece.”     

Public Reports, Information Acquisition by Investors, and Management Incentives

This paper initially provides a general characterization of the relative weight assigned to two performance measures in an optimal linear compensation contract in a two-task principal/agent setting. This characterization is applied to a setting in which the measures are a public report about the firm's performance (e.g., accounting earnings) and its market price. The latter reflects the public report and non-contractible investor information, whose costly acquisition is endogenously determined. The analysis considers both the gross observed price and the filtered price, which excludes the effect of the public report and represents a contractible noisy measure of the investors' non-contractible information.     

Earnings management,incentive contracts and private information acquisition

This paper analyzes the optimal design of compensation contracts in the presence of earnings management incentives, and its interplay with investors’ information acquisition decisions. We consider a setting in which compensation contract is based on both accounting earnings and stock price when an agent engages in predictable, pernicious earnings management and stock price is endogenously determined in a Noisy Rational Expectations Equilibrium (NREE) that reflects both the public information from reported earnings and a costly, noisy signal privately acquired by investors. We show that an increase in the precision of the firm’s financial reporting system could reduce the informativeness of stock price and exacerbate the agency problem by inducing lower productive effort and higher earnings management, implying that the firm may not choose a more precise financial reporting system.     

The affect heuristic and stock ownership: A theoretical perspective

We consider asset prices and informational efficiency in a setting where owning stock confers direct utility due to an affect heuristic. Specifically, holding equity in brand name companies or those indulging in “socially desirable” activities (e.g., environmental consciousness) confers positive consumption benefits, whereas investing in “sin stocks” yields the reverse. In contrast to settings based on wealth considerations alone, expected stock prices deviate from expected fundamentals even when assets are in zero net supply. Stocks that yield high direct utility are, on average, more informationally efficient as they stimulate more entry into the market for these stocks and, consequently, more information collection. The analysis also accords with a value effect, high valuations of brand‐name stocks, abnormally positive returns on “sin stocks,” volume premia in the cross‐section of returns, proliferation of mutual funds and ETFs, and yields untested implications. If, as psychological literature suggests, agents derive greater utility from successful companies by “basking in reflected glory,” then asset prices react to public signals non‐linearly, leading to booms and busts, as well as crashes and recoveries.     

Performance evaluation inflation and compression

We provide a behavioral account of subjective performance evaluation inflation (i.e., leniency bias) and compression (i.e., centrality bias). When a manager observes noisy signals of employee performance and the manager strives to produce accurate ratings but feels worse about unfavorable errors than about favorable errors, the manager’s selfishly optimal ratings will be biased upwards. Both the uncertainty about performance and the asymmetry in the manager’s utility are necessary conditions for performance evaluation inflation. Moreover, the extent of the bias is increasing in the variance of the performance signal and in the asymmetry in aversion to unfair ratings. Uncertainty about performance also leads to compressed ratings. These results suggest that performance appraisals based on well-defined unambiguous criteria will have less bias. Additionally, we demonstrate that employer and employee can account for biased performance evaluations when they agree to a contract, and thus, to the extent leniency bias and centrality bias persist, these biases hurt employee performance and lower firm productivity.     

Implicit racial prejudice against African-Americans in balanced scorecard performance evaluations

A dominant theme in critical accounting theory concerns the relation between human identities and accounting discourse and practices. Though this theme has strong antecedents in Marxist-inspired critique of ideology, research into this theme has employed diverse approaches; among them, genealogical studies (e.g., Miller and O’Leary, 1987), deconstructive studies (e.g., Shearer and Arrington, 1993), psychoanalytic studies (Roberts, 1991, Roberts, 2009) and critical-rational studies (e.g., Power and Laughlin, 1996). We offer a different approach grounded in social-cognitive concerns with how implicit attitudes about race influence evaluation of others. We report on the results of an empirical, lab-based study of balanced scorecard evaluations and bonus allocations where race is a treatment effect and where the well-established tenets of Implicit Association Testing (IAT) are used to reveal that there are, indeed, propensities to unwillingly let racial prejudice intervene into our accounting-based evaluations of others. That intervention influences identity in ways that are morally unacceptable, degrading to black workers, and loaded with potential for negative material consequences for workers (e.g., less compensation due to racially determined and irrational performance evaluations). The paper illustrates one area of research in which methodologies adapted from conventional empirical, statistical approaches can enhance the emancipatory potential of critical accounting research.     

Carrot or Stick? Contract Frame and Use of Decision‐Influencing Information in a Principal‐Agent Setting

A fundamental management accounting issue is how to incorporate decision‐influencing information (e.g., an ex post state signal) into employment contracts. Our experiment examines the effects of contract framing on such information use in a principal‐agent setting. In each of 40 rounds, participants (as employer and worker) negotiate a contract that specifies pay depending on an ex post state signal. State‐signal pay is framed as either a bonus or a penalty over two groups. The results show that the bonus frame facilitates information use, because of worker loss aversion. Although both groups initially underweigh the state signal, the bonus group quickly converges toward the optimal weight, whereas the penalty group persistently underweighs the state signal.     

Information disclosure quality: correlation versus precision

We investigate how a multidimensional disclosure quality (i.e., correlation and precision) determines an optimal information disclosure strategy. We find that, for an infinitely lived, unlevered firm with market perfection, a truth‐telling disclosure is optimal at increasing the expected firm value. However, for a finitely lived, levered firm in the presence of market imperfections (e.g., bankruptcy cost), the optimal disclosure quality depends negatively on the level of imperfections. Once we consider the agency problem, such dependence can become positive, thereby highlighting the importance of a proper managerial‐incentive scheme to align the information disclosure interests of managers and shareholders.     

Balanced Scorecards: A Relational Contract Approach

Reward systems based on balanced scorecards often connect pay to an index, that is, a weighted sum of multiple performance measures. We show that such an index contract may indeed be optimal if performance measures are nonverifiable so that the contracting parties must rely on self-enforcement. Under commonly invoked assumptions (including normally distributed measurements), we show that the weights in the index reflect a tradeoff between distortion and precision for the measures. The efficiency of the contract improves with higher precision of the index measure, because this strengthens incentives, and correlations between measurements may for this reason be beneficial. There is a caveat, however, because the index contract is not necessarily optimal for very precise measurements, although it is shown to be asymptotically optimal. We also consider hybrid measurements, and show that the principal may want to include verifiable performance measures in the relational index contract in order to improve incentives, and that this has noteworthy implications for the formal contract.     

Leading indicator variables and managerial incentives in a dynamic agency setting

This paper studies, in a dynamic agency setting, how incentives and contractual efficiency are affected by leading indicators of firms’ future financial performance. In our two-period model, a leading indicator variable provides a noisy forecast of the uncertain return from the manager’s long-term effort, and both contracting parties cannot refrain from renegotiating contract terms based on updated information. We find that the leading indicator can reduce the manager’s long-term effort incentive, as it allows the firm owner to capture more of the resulting return through renegotiated wages (i.e., the manager is held up). By reducing the uncertainty about future aggregate cash flows, the leading indicator also exacerbates the “ratchet” effect and discourages the manager’s short-term effort. In equilibrium, as the leading indicator becomes more accurate in forecasting future cash flows, the first-period contract attaches higher explicit weights to both the forward-looking leading indicator and backward-looking cash flow, and yet the manager may find it optimal to reduce both the short- and long-term efforts. We further show that with a more accurate leading indicator variable, the explicit incentive on the lagging cash flow may increase more than that on the leading indicator, and the equilibrium firm profit may decrease and diverge from the manager’s equilibrium efforts.     

Contracting with private knowledge of signal quality

We characterize the optimal procurement contract in a setting where a supplier has privileged knowledge of the quality of a public signal about his production costs. The optimal contract exhibits important differences with standard contracts in adverse selection settings. For instance, the contract induces output both above and below first‐best levels. Furthermore, the induced output may not vary with the realized public signal unless the signal quality is sufficiently pronounced. In addition, output may increase as expected costs increase.     

Model Secrecy and Stress Tests

Should regulators reveal the models they use to stress-test banks? In our setting, revealing leads to gaming, but secrecy can induce banks to underinvest in socially desirable assets for fear of failing the test. We show that although the regulator can solve this underinvestment problem by making the test easier, some disclosure may still be optimal (e.g., if banks have high appetite for risk or if capital shortfalls are not very costly). Cutoff rules are optimal within monotone disclosure rules, but more generally optimal disclosure is single-peaked. We discuss policy implications and offer applications beyond stress tests.     

Managerial Incentives and Stock Price Manipulation

We present a rational expectations model of optimal executive compensation in a setting where managers are in a position to manipulate short‐term stock prices and the manipulation propensity is uncertain. We analyze the tradeoffs involved in conditioning pay on long‐ versus short‐term performance and show how manipulation, and investors' uncertainty about it, affects the equilibrium pay contract and the informativeness of prices. Firm and manager characteristics determine the optimal compensation scheme: the strength of incentives, the pay horizon, and the use of options. We consider how corporate governance and disclosure regulations can help create an environment that enables better contracting.     

Accounting comparability and relative performance evaluation in CEO compensation

We investigate whether accounting comparability is associated with the likelihood that CEO compensation is tied to relative accounting performance (e.g., return on assets). We predict that higher accounting comparability increases the risk-sharing benefit of accounting-based RPE because peer firm performance better controls for common risk in RPE firm performance. Thus, firms that have higher accounting comparability with potential performance peers will be more likely to include accounting-based RPE as a component of the total CEO compensation contract. We find support for this prediction using (1) an explicit test design that relies on the ex ante terms of CEO compensation contracts obtained from proxy disclosures, and (2) an implicit design that relies on the actual realizations of CEO compensation. To provide further evidence, we examine the association between accounting comparability and the selection of performance peers when the CEO compensation contract includes an accounting-based RPE component. We find that higher comparability between the RPE firm and a potential peer firm increases (decreases) the potential peer firm’s likelihood of being selected into (dropped from) the peer group. Cross-sectional analyses show that this association is less pronounced, or not present, when the relative performance measure is price-based (as opposed to accounting-based), indicating that these results do not merely reflect a more general role of comparability in all RPE contracts.     

The form of incentive contracts: agency with moral hazard,risk neutrality,and limited liability

The analysis obtains a complete characterization of the optimal agency contract with moral hazard, risk neutrality, and limited liability. We introduce a “critical ratio” that indicates the returns to providing the agent with incentives for effort in each random state. The form of the contract is debt (a capped bonus) when the critical ratio is increasing (decreasing) in the state. An increasing critical ratio in the state‐space setting corresponds to the hazard rate order for the reduced‐form distribution of output, which we term the “decreasing hazard rate in effort property” (DHREP). The critical ratio also yields insights into agency with adverse selection.     

Options in Compensation: Promises and Pitfalls

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.     

Insurance law and incomplete contracts

We analyze how insurance law can mitigate moral hazard by allowing insurers to reduce or cancel coverage in some circumstances. We consider an incomplete contract setting in which the insurer may obtain information related to the policyholder's behavior through a costly audit of the circumstances of the loss. Court decisions are based on a standard of proof such as the balance of probabilities. We show that an optimal insurance law brings efficiency gains compared to the no-audit case. We also highlight the conditions under which the burden of proof should be on the insured, provided that insurers are threatened with sanctions for bad faith.