Multiple Control Systems, Accrual Accounting, and Earnings Management

The coordination of a financial reporting system and a contracting system in a principal-agent model with managerial reporting incentives and moral hazard are examined. The manager privately observes both economic earnings and the available reporting discretion. A tradeoff between the firm's financial reporting system and the contracting system determines whether the owner will find it optimal to induce the manager to report the firm's economic earnings or to manage the reported earnings by exercising reporting discretion. It is found that the principal uses the contracting system primarily to deal with moral hazard over managerial effort, and the financial reporting system to discipline the manager's reporting behavior.