Contracting and Income Smoothing in an Infinite Agency Model

Richard T. Boylan and Bente Villadsen - Washington University in St. Louis

The paper describes accrual accounting and managerial compensation choices for a firm that potentially lives infinitely. Specifically, we incorporate a basic accrual accounting system in an infinitely repeated agency model, derive a dynamic program that characterizes the equilibrium contract, and obtain numerical results for the model. Thus, the approach allows us to study the interaction of a variety of accrual accounting procedures in a setting with optimal contracting. Previous studies of accrual accounting have derived their results from either a very parsimonious model of the accounting system or empirical data. Empirical studies necessarily rely on observable information only and therefore cannot determine whether reported income was the result of an optimal contracting arrangement or other phenomena.

Scheduled for Session 2.5 Dynamic Contracting