An International Meeting of the American Accounting Association American Accounting Association 2006 Annual Meeting August 6–9, 2006 Washington, D.C.

Mehmet Ozbilgin
Baruch College - CUNY

Mark Penno
University of Iowa

Abstract: Contracting theory presumes an uncontestable report on which to base required payments. We demonstrate the importance of decision rights for this central feature of the theory by examining the optimal assignment of the right to choose from a menu of ex ante identical, but noisy, performance measures. We identify conditions where a principal would strictly prefer to assign these rights to his agent even though the choice is made after the report is realized. What is surprising about the result is that neither individual has a natural advantage in making the choice, and the assignment of rights alleviates problems jointly caused by the agent’s risk aversion, principal’s inability to commit to a reporting system, and a measurement system that detects shirking better than working. We also identify conditions for which the principal welcomes a larger menu of performance measures from which the principal or the agent can choose.

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