Pierre Jinghong Liang

Equilibrium Earnings Management, Incentive Contracts, and Accounting Standards

In this paper, we model earnings management as a consequence of the interaction among self-interested economic agents, namely the managers, the shareholders, and the regulators. In our model, a manager controls a stochastic production technology and makes periodic accounting reports about his performance; an owner chooses a compensation contract to induce desirable managerial inputs and reporting choices by the manager; and a regulatory body selects and enforces accounting standards to achieve certain social objectives. We show various economic trade-offs give rise to endogenous earnings management. Specifically, the owner may reduce agency costs by designing a compensation contract that tolerates some earnings management because such a contract allocates the compensation risk more efficiently. The earnings management activity produces accounting reports that deviate from what is prescribed by accounting standards. Given such reports, the valuation of the firm may be nonlinear and S-shaped, recognizing the managers reporting incentives. We also explore policy implications, noting (i) the regulator may find enforcing a zero-tolerance policy - no earnings management is allowed - economically undesirable; and (ii) when selecting the optimal accounting standard, valuation concerns may conflict with stewardship concerns. We conclude earnings management is better understood in a strategic context involving various economic trade-offs.

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 agents 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 agents 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.

Intertemporal aggregation and incentives

Intertemporal aggregation results in a summarization of information and a natural delay in the release of information. We study a principal–agent model and show that intertemporal aggregation can be an optimal feature of a performance evaluation system. We then highlight subtleties associated with valuing additional information as the level of aggregation of existing information is varied.

Optimal Team Size and Monitoring in Organizations

We formulate and analyze a model of team structure and monitoring within a LEN agency framework. We incorporate three key instruments in the internal design of an organization involving team production: team size, monitoring activities, and incentive contracts. We show that the complex trade-offs among these instruments lead to surprisingly simple implications. One such result is that the equilibrium level of pay-for-performance for workers is attenuated, and is at times invariant to most environmental variables of interest. As such, our model helps explain the empirical puzzle of the lack of a tradeoff for risk/incentives shown in standard agency models. Our work also demonstrates the presence of complementarities between team size and monitoring, and between worker talent and managerial monitoring ability. Finally, we derive predictions about the impact of environmental variables on the choice of optimal team size, incentives and employee quality, even in the presence of an external marketplace for talent.

Accounting Measurement Basis, Market Mispricing, and Firm Investment Efficiency

In this paper, we investigate how the accounting measurement basis affects the capital market pricing of a firms shares, which, in turn, affects the efficiency of the firms investment decisions. We distinguish two broad bases for accounting measurements: input-based and output-based accounting. We argue that the structural difference in the two measurement bases leads to a systematic difference in the efficiency of the investment decisions. In particular, we show that an output-based measure has a natural advantage in aligning investment incentives because of its comprehensiveness. The (first-)best investment is achieved when the output-based measure is noiseless and manipulation free. In addition, under an output-based measure, more accounting noise/manipulation always leads to more inefficient investment choices. Therefore, if an output-based accounting measure is highly noisy and easy to manipulate in practice, the induced investment efficiency can be quite low. On the other hand, an input-based accounting measure, while not as comprehensive, may induce more efficient investment decisions than an output-based measure if some noise is unavoidable in either measure. The reason is twofold. First, input-based measures may be associated with less noise and limited manipulation in practice. Second, and more importantly, we show that under an input-based measure, a slight increase in accounting noise/manipulation may lead to more efficient investment choices. In fact, the (first-)best result is achieved when the noise/manipulability is small but positive. In other words, for an input-based measure, being less comprehensive makes small but positive accounting noise/manipulability desirable. Two extensions of the basic model are also explored.

Accounting in Partnerships

In 1914, an accounting professor named Arthur Andersen founded a public accounting practice that became the world’s largest professional-services firm. For years preceding the Enron debacle and Andersen’s collapse, the firm had struggled to create incentives within the organization for partners to provide highquality service, develop and sell new services, and meet the compensation expectations of various factions of partners. A years-long dispute over the division of profits between the firm’s consulting and accounting arms led to the 1998 separation of the consulting practice from the audit and tax practices. The rise, break-up, and fall of Andersen underlines the importance of questions concerning incentive structures within public accounting firms in particular, and partnerships of professionals in general. This paper offers a perspective on partner compensation schemes and the accounting information systems that support them. In partnerships, ownership and control lie with the partners. Furthermore, each member of a partnership is endowed with human capital that may be employed either within the firm or without. Every partner is simultaneously a principal (who shares in the net output of the partnership) and an agent (who produces output). Ownership and control are diffused among many persons, and partners are subject to moral hazard. Each must be motivated by his peers. It is intuitive that the structure of professional partnerships is a function of the production and monitoring technologies available to the partners. As Oliver Williamson (1975 p. 43) points out: Group affiliation ... can provide income guarantees to buffer the effects of unanticipated contingencies on terms superior to that which market insurance can provide ... . A group will have an advantage over the market to the extent it is better able to ... check malingering and other ex post manifestations of moral hazard. [This advantage requires] ... that performance be accurately assessed.

Essays in accounting theory in honour of Joel S. Demski

Joel S. Demski: A Leader in Accounting Scholarship.- Joel S. Demski: A Leader in Accounting Scholarship.- General Theory.- Fair Value, Accounting Aggregation and Multiple Sources of Information.- Equilibrium Voluntary Disclosures when Firms Possess Random Multi-Dimensional Private Information.- Synergy, Quantum Probabilities, and Cost of Control.- Moral Hazard with Hidden Information.- On The Subtleties of the Principal-Agent Model.- Applied Theory.- Incentive Problems and Investment Timing Options.- Aligning Incentives by Capping Bonuses.- The Controllability Principle in Responsibility Accounting: Another Look.- Public Disclosure of Trades by Corporate Insiders in Financial Markets and Tacit Coordination.- Connections to Practice.- The Structure of Performance-Vested Stock Option Grants.- The Lcamr Missile.- Commentary and Perspectives.- A Note on the Information Perspective and the Conceptual Framework.- Economizing Principle in Accounting Research.

Endogenous Precision of Performance Measures and Limited Managerial Attention

Abstract In this paper, we model two drivers that underlie the economic trade-off that shareholders face in designing incentives for optimal effort allocation by managers. The first driver is the presence of a performance-reporting task, by which we mean managers may exert effort to improve the precision of their performance measures. The second is limited managerial attention, where performing one task may have an adverse effect on the cost efficiency of performing another. We show that the subtle interactions of the two drivers may alter the characteristics of incentive provision. First, the interaction may lead to a positive relation between the strength of the incentive and the variance of the performance measures. Second, the interaction may cause an informative performance signal to not be used in equilibrium incentive contracts. In particular, it is possible that the principal will not use a signal whose precision can be improved by the manager in order to discourage the manager from diverting attention to the performance-reporting task. Finally, we apply the model to a project-selection setting and show that, in order to induce the agent to choose higher risk, higher return projects, the principal may need to raise the bonus rate when the choice of project is unobservable.

Usefulness Lost: Aggregating Information with Differing Levels of Verifiability

In this paper, we study information asymmetries about verifiability between a principal and an agent. Our main result is that an information asymmetry about verifiability not only reduces the usefulness of a given performance measure for stewardship purposes, it can completely destroy that performance measures usefulness.

An Invitation to Theory

In this essay, I wish to invite young scholars to learn, use, and contribute to accounting theory. In this invitation, I argue theory has lineage, is important and can be fun. Its lineage comes from the post-WWII scientific revolution in management education and research. Theory is important because it is the successful interaction between theory and empirical work that ultimately advances an academic discipline. Theory can be fun because when done well, learning, using and contributing to theory can be an enjoyable activity for all scholars, either as consumers or as producers of theory.