Accounting Recognition, Moral Hazard, and Communication

Two complementary sources of information are studied in a multi-period agency model. One is an accounting source which partially but credibly conveys the agent’s private information through accounting recognition. The other is an unverified communication by the agent (i.e., a self-report). In a simple setting with no communication, alternative labor market frictions lead to alternative optimal recognition policies. When the agent is allowed to communicate his private information, accounting signals serve as a veracity check on the agent’s self-report. Finally, such communication sometimes makes delaying the recognition optimal. We see contracting and confirmatory roles of accounting as its comparative advantage. As a source of information, accounting is valuable because accounting reports are credible, comprehensive, and subject to careful and professional judgment. While other information sources may be more timely in providing valuation information about an entity, audited accounting information, when used in explicit or implicit contracts, ensures the accuracy of the reports from non-accounting sources. Suggestions from my dissertation committee chairman Professor Joel Demski and committee members Professor David Sappington, Professor Bipin Ajinkya, and Professor Karl Hackenbrack are gratefully acknowledged. Comments from Anwer Ahmed, Rick Antle, Sanjeev Bhojraj, Henry Cao, Hans Frimor, Jon Glover, Russ Lundholm, an anonymous referee, participants at 1999 Contemporary Accounting Research Conference and workshops at Columbia University, Carnegie Mellon University, University of Florida, and University of Texas at Dallas are appreciated. Financial support is partially provided by the Andersen Foundation Doctoral Dissertation Fellowship program. 1 FASB Statement of Financial Accounting Concepts No. 5, Recognition and Measurement in Financial Statements of Business Enterprises, paragraph 63. Essentially, accounting recognition may occur when the economic item in question has met the definition of an accounting element and is measurable, relevant, and reliable. All four criteria are subject to the pervasive cost-benefit constraint and a materiality threshold. 1 Accounting Recognition, Moral Hazard, and Communication Section