Richard A. Lambert

Contracting theory and accounting

This paper reviews agency theory and its application to accounting issues. I discuss the formulation of models of incentive problems caused by moral hazard and adverse selection problems. I review theoretical research on the role of performance measures in compensation contracts, and I compare how information is aggregated for compensation purposes versus valuation purposes. I also review the literature on communication, including models where the revelation principle does not apply so that nontruthful reporting and earnings management can take place. The paper also discusses capital allocation within firms, including transfer pricing and cost allocation problems. CONTRACTING THEORY AND ACCOUNTING

Executive Stock Option Plans and Corporate Dividend Policy

This paper examines the association between the initial adoption of stock options for senior-level executives and subsequent changes in corporate dividend policy. The primary research hypothesis is that the addition of a stock option to a managers compensation package provides an incentive for the executive to reduce corporate dividends. This hypothesis follows from the observation that executive stock options are generally not “dividend protected.” The results suggest that dividends are reduced relative to expected dividends. We interpret these results as suggesting that the personal incentives of executives can affect certain aspects of the observed corporate dividend policy.

The information content of security prices: A second look

Abstract Beaver, Lambert and Morse (1980) employ a regression of percentage change in prices on percentage change in earnings in which data are grouped by the dependent variable. Reverse regression offers a more intuitive and direct way to assess the information content of security prices, the objective of Beaver et al. While grouping is asymptotically equivalent, reverse regression is a more efficient way of examining the incremental explanatory power of lagged values of percentage change in price with respect to accounting earnings.

Stock Options, Restricted Stock, and Incentives

Prior work has suggested that options represent an inefficient form of compensation because the value placed on an option by a risk-averse employee is much less than the cost of the option from the perspective of the firm. However, much of this work ignores or fails to properly incorporate the incentive effect of option-based contracts into their analysis. We use agency theory to model the optimal mix of options and stock in the compensation contract. In contrast to prior work, we show that restricted stock is generally not the optimal contract form. We present comparative static results to show how the mix between options and stock and the optimal exercise price of the options varies as a function of the exogenous parameters.

Agency Theory and Management Accounting

Abstract This chapter reviews agency theory and its application to management accounting issues. I begin by explaining how agency models are formulated to capture incentive problems caused by moral hazard and adverse selection problems, and discuss the reasons why agency theory models are difficult to solve. I then review agency theory results regarding the properties that make performance measures valuable in a contracting setting and the optimal shape of contracts. I also review the literature on communication, including models where the revelation principle does not apply, so that nontruthful reporting and earnings management can take place. I then discuss multiperiod agency models, which are critical for comparing different accrual-accounting-based measures of performance in motivating investment behavior. The chapter ends by discussing common misconceptions regarding agency theory models and discussing areas for future research.

The prospective payment system, hospital efficiency, and compensation contracts for senior-level hospital administrators

Abstract This paper examines the effect of the change from a retrospective to a prospective regulatory procedure, for reimbursing Medicare costs, on the use of bonus-based compensation contracts for senior-level hospital administrators. For a large sample of hospitals from a national survey, our results suggest that hospitals which were relatively inefficient in the time period prior to the institution of the prospective payment system tended to use contracts with larger bonuses as a percentage of base salary in the time period after this regulatory change. That is, hospitals with a relative financial condition most adversely affected by the regulatory change seem to have used bonus contracts in an attempt to motivate the administrators to improve operating efficiency and performance. We also found that hospitals were less likely to use bonus-based compensation contracts if the hospitals activities were closely monitored (by the board of directors or by the state). This result is consistent with the agency theory notion that monitoring activities and bonuses can both be used as motivational devices.

Executive compensation effects of large corporate acquisitions

This paper examines whether the changes in managerial compensation and wealth associated with an acquisition are independent of the acquisitions effect on the stock price of the acquiring firm. We find that real (inflation-adjusted) increases in compensation and wealth are observed only if an executive selects an acquisition which increases shareholder wealth. Moreover, the differential impact of the acquisition on the compensation and wealth of the top executives (especially the Chief Executive Officer) as a function of the sign of the acquisitions effect on shareholder wealth is statistically significant.

Variance Investigation in Agency Settings

Early variance investigation papers (see Kaplan [1975] for a review) were concerned with controlling mechanical production processes. More recently, the question of when to conduct an investigation has been examined from the perspective of agency theory. In an agency setting, the productive outcome is affected by both exogenous factors and the actions of an agent. An incentive problem occurs when the principal cannot observe the agents action directly. This incentive problem can be reduced if the principal can acquire additional information about the agents action. Of course, the benefits of acquiring additional information via an investigation must be weighed against the costs of conducting the investigation. For this reason, it is of interest to determine what factors affect the benefits of conducting an investigation. Baiman and Demski [1980a; 1980b] show that the productive outcome that occurs affects the benefits of investigation, and that the decision to conduct an investigation will therefore depend on the production outcome. In deriving their results, Baiman and Demski assume that the distribution of the information signal that is generated about the agents action is independent of the productive outcome. In this paper, I allow the productive outcome to affect the distribution of the information signal that the investigation generates. This allows for consideration of investigations which provide information about the environment or the

Discussion of performance measure garbling under renegotiation in multi-period agencies

Earnings management is viewed to be an activity that is widely practiced by managers. Unfortunately, the agency literature to date has not made much progress in helping us understand how, why, and when earnings management takes place. The Demski and Frimor paper contributes to this important area of accounting research in two ways. First, the paper adds to the recent work on communication that has attempted to derive conditions under which the revelation principle does not hold. As the paper discusses, the revelation principle has been a major obstacle to theoretical research into earnings management. The revelation principle states that, under certain conditions, any equilibrium which involves nontruthful reporting can be duplicated or beaten in terms of expected utilities by an equilibrium in which truthful reporting is induced. However, the revelation principle was originally developed as a modeling tool; it was not intended to be a realistic description of reporting equilibriums. Specifically, the revelation principle greatly reduces the number of alternative reporting strategies researchers must consider as possible equilibriums in their models. That is, researchers can safely confine their attention to equilibriums which motivate truthful reporting. This does not imply that there are no equilibriums which involve nontruthful reporting, only that they can be duplicated in terms of expected utilities with ones that involve truthful reporting.

Bank Relations and Borrower Corporate Governance and Incentive Structures

This paper examines the use of governance and incentive mechanisms beyond loan contract provisions that borrowers use to reduce contracting costs with lenders. We show that as the strength of the relationship between a borrower and a lender intensifies over time, borrowing firms are more likely to elect bank employees to their boards of directors, apply corporate governance structures that insulate managers from turnover, decrease managers’ risk-taking incentives, and increase information asymmetries with non-bank capital providers. Interestingly, many of the adopted governance and incentive mechanisms are commonly thought to decrease shareholder wealth outside intense bank-firm relations. Our results highlight the importance of context in assessing the costs and benefits of governance and incentive structures.