Early versus late accounting information in a limited commitment setting

Abstract

We consider a two period principal-agent problem in a LEN setting. Stock prices as well as accounting measures are available for incentive contracting. The principal needs to implement one out of two accounting systems. While the early accounting information system reports an accounting signal in the period it is produced, the late accounting system reports this information with one period delay. As accounting information is considered contractible if and only if it is reported within the two period horizon of the game, the late system ends up providing less contractible information than the early one. Accounting information is supposed to be effort informative and value relevant. Stock prices reflect all value relevant information. This includes accounting information along with further information that is value relevant but not effort informative. We derive optimal compensation contracts in a full commitment setting and in a limited commitment setting for both, the early and the late accounting information system. With full commitment the early system dominates the late one. If the early system is implemented stock prices are not used for contracting at all. In contrast, if the late system is present, stock prices are required to incentivice second period effort at all. However, contracting on them results in an inferior risk-incentive trade-off as compared to contracting on early accounting information only. With limited commitment implementing the late accounting information system may bene.t the principal. If accounting signals are positively correlated, limited commitment causes excessive second period incentive rates. Using the late system in combination with stock prices serves as a commitment device. Noise immanent in the stock prices reduces optimal incentive rates and thus counteracts the over-incentives. Second period benefits may more than outweigh the cost related to using stock prices in the first period.