Accounting choice and optimal incentive contracts: A role of financial reporting in management performance evaluation

Three structural properties of accounting commonly embedded in Generally Accepted Accounting Principles are examined in a two-period principal-agent model. These structural properties are conservation of income, consistency, and selective recognition. The article illustrates that these properties are essential for the use of accounting information in management performance evaluation: they are necessary conditions for an accounting mechanism to be more efficient than a direct revelation mechanism. The trade-off between the gain from the information revelation and the incentive cost of discretion determines whether contracting is more efficient under the accounting mechanism or under the direct revelation mechanism.