Baiman(1990) Agency Res in Man Acc

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Accounting rganizutionsand.Tociety.Vol. i.No.4. p. 341-371. 990. 0361-3682190 3.00 .00Printed in Great Britain Pergamon Press plc

AGENCY RESEARCH IN MANAGERIAL ACCOUNTING: A SECOND LOOK*

STANLEY BAIMANCarnegie M e l l o n U n i v er si t y

bstract

This paper surveys the recent agency literature, emphasizing its managerial accounting implications. Thepaper first describes and compares three branches of the agency literature. Attention is paid to theassumptions, focus, contributions and criticisms of each branch. Empirical tests of implications of theagency model are reviewed. Recent theoretical agency papers with managerial accounting implications arethen discussed. The last section of the paper discusses possible directions in future research which mayincrease the insights which the agency paradigm can bring to managerial accounting research.

The aim of this paper is to survey the recentagency literature, emphasizing its implicationsfor managerial accounting research. The pur-pose of this survey is different from that of anearlier one written by the author (Baiman,1982). The objective of that earlier survey wasto provide a first introduction to one particularbranch of the agency literature, the principal-agent model, and to explore its potential impli-cations for managerial accounting. Otherbranches of the agency literature wereexcluded, not because they were thought to beless important, but to make the paper less con-fusing. While the present paper also concen-trates on the principal-agent model, one of itsobjectives is to emphasize the connection be-tween the different branches of the literatureand to demonstrate how insights from the otherbranches of the literature can enrich the ques-tions addressed in the principal-agent literature.A second purpose of the paper is to discuss the

extent to which the promise of future manage-rial accounting implications mentioned in theearlier survey has been achieved.

The paper is arranged as follows. The secondsection briefly describes and compares threebranches of the literature. They are: the princi-pal-agent literature, the transaction cost econ-omics literature, and the Rochester literaturebased on the work of Jensen & Meckling( 1976).2 The third section discusses somerecent empirical tests of implications of the

agency model. Because most agency research inmanagerial accounting has been based on thebrincipal-agent branch of the literature, the restof the paper surveys recent theoretical papers inthat branch. The fourth section discusses recentpapers in that branch which have responded tosome of the criticisms of the principal-agent lit-erature mentioned in the second section and, inparticular, to those insights and criticisms of-fered by the transaction cost economics branch.

This paper was originally prepared for the 1988 Management Accounting Research Conference sponsored by the School ofAccountancy, University of New South Wales. I would like to thank Harry Evans, Nandu Nagarajan, Mark Wolfson and twoanonymous referees for very helpful comments. For other recent surveys of the agency and related literatures, see Holmstrom & Tirole ( 1987) and Hart & Holmstrom( 1987). The present survey is not meant to be comprehensive. For example, I have tried to keep the overlap with Baiman( 1982) to a minimum. Further, I have chosen to review only a representative sample of the recent literature. In addition, thispaper does not review the literature which has proposed and tested alternative behavioral models of the determinants ofmanagerial behavior. For an excellent review of this literature. see Kren & Liao ( 1988).Although it might be considered an agency model, the stewardship literature in accounting will not be discussed. The majorreason is that those recently interested in this area have tended to base their analysis on one of the three agency modelsmentioned. For example, Gjesdaf ( 1981) uses a principal-agent model to analyse the stewardship problem.

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The fifth section discusses some recent princi-pal-agent papers which explicitly model man-agerial accounting issues. The last sectionsuggests ways in which principal-agent researchmight enhance its impact on the managerial ac-

counting literature.An agency relationship exists when one or

more individuals (called principals) hire others(called agents) in order to delegate respon-sibilities to them. The rights and responsibilitiesof the principals and agents are specified in theirmutually agreed-upon employment relation-ship. Within the term employment relationship Iinclude the chosen: compensation arrangement,information systems, allocation of duties, and al-location of ownership rights.

In all agency models, individuals are assumedto be motivated solely by self-interest. An agencyproblem arises if the cooperative (or first-best)behavior, which maximizes the groups welfare,is not consistent with each individuals self-in-terest. This occurs if the employment relation-ships are such that, given that everyone else isacting cooperatively, one or more individualscould make themselves better off by deviatingfrom their cooperative behavior. Of course, ifone or more individuals are expected to deviatefrom their cooperative behavior, others may findit in their best interest to deviate. The end resultis that when cooperative behavior is not consis-tent with self-interested behavior (i.e. it is notself-enforcing), the group suffers a loss of efft-ciency and all individuals are potentially madeworse off.

All three branches of the literature providesimilar frameworks for analysing the interactionof self-interested individuals within an econ-omic context; understanding the determinantsand causes of the loss of efficiency created by thedivergence between cooperative and self-in-

terested behavior (i.e. the loss horn agencyproblems); and analysing and understanding theimplications of different control processes (e.g.budgeting systems. employment contracts,monitoring systems etc.) for mitigating the effr-

ciency loss from agency problems. The threebranches of the agency literature, however, clif-fer primarily in two ways. First, they emphasizedifferent sources of the divergence betweencooperative and self-interested behavior. Sec-ond, they emphasize different aspects of a com-mon research agenda. This common researchagenda includes: (a) careful modeling of the un-derlying economic context giving rise to theagency problems; (b) derivation of optimalemployment relationships and understanding

how the employment relationships mitigate theunderlying agency problems; (c) comparing theresults to observed practice as a check on the in-itial modeling and analysis. The similarities anddifferences in the three different agencybranches will be discussed next.

COMPARISON OF MODELS

The pri ncipal agent modelThe first agency branch to be discussed is the

principal-agent model. It typically takes the or-

ganization of the firm, including the allocation oftasks and ownership rights, as given and concen-trates on the choice of the ex ante employmentcontract and information systems.

Assumptions. In the principal-agent model,individuals are assumed to be rational and tohave unlimited computational ability. Further,they can anticipate and assess the probability ofall possible future contingencies. Any contin-gencies which are jointly observable can becostlessly used as arguments in contracts (i.e.are ex post verifiable).4 The contracts are as-

5 See Baiman (1982) for a more complete discussion of the assumptions underlying the principal-agent model.

4 An event is jointly observable if it is observable to the contracting parties. An event is verifiable if it is observable not onlyto the contracting parties but also to a third party (such as a court) who is responsible for enforcing the contract. Thus allverifiable events are jointly observable but not all jointly observable events are verifiable. The distinction betweenobservability and verifiability is important because only veritiable events can be contracted on. Until recently principal-agentmodels did not distinguish between observability and verifiability but, instead, assumed that any jointly observable event wasverifiable and could be contracted on. Some implications of this distinction will be developed later when issues of reputationare discussed.


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AGENCY THEORY IN MA4ACERML ACCOUNTING 343

sumed to be costlessly and accurately enforcedby the courts. As a result, the contracts studiedare comprehensive and complete in the sensethat for each verifiable event, they specify theactions to be taken by the contracting parties.

Further, it is usually assumed that the courts willenforce a previously agreed upon contract evenif, at some subsequent time, all the contractingparties would prefer to renegotiate the contract.Hence, there is no need for contracts to be self-enforcing.

In the principal-agent model, each indi-viduals actions are endogenously derived, basedon his well-specified preferences and beliefs.Further, each individual expects every other in-dividual to act solely on the basis of his own pre-

ferences and beliefs.Common to all principal-agent models is aninformation asymmetry assumption. The agent isassumed to have private information to whichthe principal cannot costlessly gain access. Thisprivate information may be with respect to theagents action choice and/or state information.Finally, it is usually assumed that the agent iswork-averse and risk-averse.

W h a t p r ev en t s t h e c oo p er a t i v e so l u t i o n r o mb ei n g a c h i ev ed It is information asymmetry to-gether with the agents work-aversion and risk-aversion which typically prohibits the coopera-tive solution from being achieved by self-in-terested behavior. That is, information asym-metry and agent work-aversion and risk-aversionprevent the simultaneous achievement of thecooperative allocation of risk and the coopera-tive level of production. For example, efficientrisk-sharing would require that a risk-neutralprincipal bear all of the risk associated with pro-

duction by paying the risk-averse agent a fixedwage. However, a fared wage gives the work-av-erse agent no incentive to work. Efficient pro-duction would have the principal sell the firm tothe agent for a fixed fee. But that would inefft-

ciently impose all of the production risk on therisk-averse agent. Therefore, a trade-off betweenefftcient risk sharing and efficient productionmust be made. In particular, the principal finds itoptimal to impose more than the cooperativelevel of risk on the agent in order to improve thelatters motivation to produce.

Focus . In the agency research agenda discus-sed in the introduction, the principal-agentbranch has emphasized the first two steps morethan the third. The literature has focused on theformal analysis of an explicit, internally consis-tent model of the underlying economic environ-ment in order to understand how the design ofthe employment relationship tiects the efft-ciency loss from agency problems. This then al-lows the researcher to derive the optimalemployment relationship for the specified envi-ronment.

Managerial accounting research based on theprincipal-agent model has specialized this focusto study the role played by, and hence thedemand for, managerial accounting proceduresand processes within the firm. Examples of suchprocedures and processes studied include:monitoring systems, budgeting systems, var-iance investigation systems, cost allocation sys-tems, and transfer pricing systems. This researchhas studied the effect of these and other manage-rial accounting processes on the interaction ofindividuals within the firm. Particular interesthas been paid to conditions under which these

An alternative assumption is that the agent is risk-neutral, has private state information and that the labor market is such thatthe agent must be guaranteed his minimum expected utility for each possible realization of his private information. Forexample, the agent may have private information about the productiviry of the principals capital. If the labor market is suchthat the agent can leave the firm tier he has learned the capitals productivity but the principal wants to employ the agentfor each productivity realization, then the agents employment contract must assure the agent his minimum expected utilityfor each capital productivity realization. This labor market condition is referred to as limited liability.

When the agent is risk-neutral, has private state information and the labor market assures him limited liability. the agent isin a position to misrepresent his private information, and thereby earn rents on that private information, Again, thecooperative solution cannot be achieved by self-interested behavior. In this case the principal may find it in his best interestto distort production away from the cooperative level in order to reduce the rents which the agent can earn on his privateinformation.


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j-ii STANLEY BAIMAN

systems are valuable in mitigating the firms un-derlying agency problems and how the informa-tion which they produce should be incorpo-rated into the employment contracts in order toaccomplish this reduction in agency problems.

Contribution, A major contribution of theprincipal-agent model to managerial account-ing research has been in its providing a coherentand useful framework within which we can viewmanagerial accounting procedures and posemanagerial accounting questions. For example,based on the principal-agent model, one wouldexpect to find a managerial accounting proce-dure only in contexts in which individualswould benefit from its use-by mitigating moti-

vational problems within firms made up of self-interested individuals.While this is a simple idea, it was often over-

looked in previous managerial accounting re-search. Such research often lacked both anyexplicitly stated role for managerial accountingprocedures (i.e. as the most eficient way ofmitigating motivational problems) and the pre-requisite for its use (i.e. the existence of a non-trivial motivational problem to overcome). Forexample, previous research into the role oftransfer pricing and cost allocation studied theseprocedures within models in which there wereno underlying motivational problems and inwhich the cooperative solution could beachieved without the managerial accountingprocedures of interest.* Hence while the trans-fer pricing and cost allocation rules derived fromthese earlier studies are simple and straight-for-ward, their relevance is open to question. Forwhat can one learn about specific managerial ac-

counting procedures from models in whichthere is no entiogenous demand for such proce-dures, i.e. in which their use does not make theplayers better off (and in some cases actuallymakes them worse off) relative to using some

other procedure?The principal-agent models emphasis on in-

ternal consistency, rational players and optimalsolutions forces the researcher to study the useof managerial accounting procedures within thecontext of models in which there is an underly-ing inefflciency for which the use of those proce-dures may be an optimal solution. It is this newappreciation for the role of managerial account-ing procedures and a more subtle understandingof the demand for and effect of managerial ac-

counting policies and procedures which theprincipal-agent model has brought.O

Criticisms. A number of criticisms can bemade of the principal-agent model. I will listthem here and later discuss recent papers whichaddress some of these and other criticisms.

The first set of criticisms deal with the realismof some of the assumptions underlying the prin-cipal-agent model. First, the computational re-quirements of the principal-agent formulation,the assumption that courts can costlessly and ac-curately enforce all contracts and the assump-tion that the courts will enforce contracts evenwhen all of the parties subsequently wish to re-contract are all unrealistic.

The second set of criticisms deal with thesimplicity of the models analysed. Because of theprincipal-agent models emphasis on internalconsistency and optimal solutions (and the com-putational requirements that they impose on the

Principal-agent analysis has also begun to appear in managerial accounting texts. See, for example, Kaplan ( 1982) andMagee (1986).a See, for example, Hirshleifer (1956), Kaplan & Thompson (1971) and Hamlen et aL (1977). As an example, Hirshleiferstudied transfer pricing in a model in which the owner had perfect information. As a result, there was no need for the ownerto influence divisional behavior by designing a transfer price system. Instead, the owner could achieve the cooperativesolution simply by ordering the divisions to transfer the appropriate quantities and designing a forcing contract whichassured their compliance.9 For analyses of transfer pricing and cost allocation using a principal-agent perspective, see, for example, Bairnan & Noel(1985). Demski (1981), Harris et UC 1982) and Rajan (1989). The papers discussed in the fourth and especially the fifth section illustrate the insight into the managerial accountingprocess provided by recent principal-agent research.


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AGENCY THEORY IN ,CUNAGERlAL ACCOUNTING 345

researcher) principal-agent research has beenrestricted to highly stylized, simplified models.For example, most principal-agent models takea restricted view of the environment in whichthe firm operates. The analysis of the interaction

between the optimal contract and the labor andproduct markets is often ignored in modelingthe agency problem. Related to this, the princi-pal-agent model typically ignores the effect ofthe capital markets by assuming a single ownerrather than a group of owners and debt-holders.In addition, an inherent characteristic of firms isthat they are organized as hierarchies. How-ever, there has been little modeling of hierar-chies in the principal-agent literature. Finally,the principal-agent model has often been

criticized as too narrow because it, apparently,leaves no room for trust and fairness, which arealso claimed to affect behavior.

A third set of criticisms deals with the resultsof the principal-agent model. While we oftenobserve the use of simple and robust contractformsI (i.e. contracts forms which are not sensi-tive to the underlying parameters of the prob-lem), as a result of the principal-agent modelsemphasis on internal consistency, rationalityand the optimality of contracts, we typically end

up deriving complicated contracts whose formsare very sensitive to the model assumptions. Asa consequence, some claim that the results ofprincipal-agent research gives us little insightinto the form and shape of observed contracts(see, for example, Baker et al. 1988)).

The criticisms with respect to model simplic-ity and solution complexity deserve some com-

ment at this point. There are two responseswhich can be made to them. First, they are majorcriticisms if one views the role of the principal-agent research as providing managerial account-ing algorithms which can be immediately

applied in practice. These criticisms are lesscompelling if we view the principal-agentmodel as a framework for analysing issues andhighlighting problems which arise and must beconsidered in applying managerial accountingprocedures to real-world situations.5 Second,the observed contracts against which we com-pare the optimal principal-agent contracts areusually only the explicit or formula-based partsof actual employment relationships. At all levelsof the firm there is often a great deal of discretion

involved in determining the actual compensa-tion received, expecially when one considersjob promotion, job assignment, and the alloca-tion of bonuses and perquisites. The differencesin complexity and sensitivity between princi-pal-agent contracts and observed contracts maybe much less when one factors in the discretion-ary aspects of actual contracts.

This appeal to the discretionary aspects of ob-served employment relationships raises anothercriticism of principal-agent research. As noted,

the decision as to who to promote and how to al-locate bonuses and perquisites are, in practice,often left to the discretion of supervisors ratherthan completely specified in an employmentcontract. But principal-agent research hasprimarily focused on the design of explicit con-tracts, devoting little study to the possible role ofdiscretion in rewarding agents.

A firm is a hierarchy if it is composed of two or more agents where the principal communicates and contracts with a strict

subset of agents, who in turn communicate and contract with a strict subset of agents, etc.

I2 For a notable exception see Melumad et aL ( 1989).

Ir For example, linear or piece rate contracts are observed in many situations. Constant wage contracts are even more widely

observed. Because the model views all potential contracting variables in terms of their statistical (i.e. informational) properties and

optimal contracts use all the information available, optimal contracts are sensitive to the underlying distributional properties

of the contract variables. Optimal contracts are also sensitive to the assumed preferences of the contracting parties.

This point was emphasized by Rick Antle in his Plenary Address to the 1988 American Accounting Association Annual

Meeting.

I6 Contract complexity and discretion are addressed later.

In order to study discretion, one needs to distinguish between verifiable information on which one can base contracts and

observable but unverifiable information on which one can only base discretionary behavior. See the later discussion ofreputation (footnote 37) in which this point is further developed.


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346 STANLEY BAliMAN

A final criticism is of the empirical content ofthe literature rather than of the model formula-tion. There has been relatively little direct em-pirical testing of principal-agent model results.

The tr ansaction cost economics modelBefore we begin this section, it should be

noted that the transaction cost economics ap-proach has not, as yet, had a significant effect onthe direction of managerial accounting research.Articles have advocated its use for understand-ing the evolution of managerial accounting pro-cedures (Johnson, 1983) and as a conceptualoverview of the managerial accounting process(Spicer Ballew, 1983; SwieringaWaterhouse, 1982). However, apparently no

one has taken up this latter suggestion. There-fore, the transaction cost economics model is re-viewed here, not because it has already beenapplied to managerial accounting issues, butbecause it has the potential to enrich our under-standing of the role of the managerial accountingprocess. I9

Assumptions. Like the principal-agent model,transaction cost economies assumes that all indi-viduals act in their own self-interest (this is refer-red to as opportunistic behavior). However, un-

like the principal-agent model, transaction costeconomics assumes that individuals do not haveunlimited computational ability. Rather, whileall individuals act to maximize their expectedutility, their success in doing so is restricted byboth their limited capacity to acquire and pro-cess information (as a result of bounded rational-ity) and the out of pocket cost of decision-mak-ing and contracting. Further, unlike the princi-pal-agent branch, transaction cost economicsassumes that the courts are imperfect enforcersof contracts,

As a result of bounded rationality, one cannotforesee all possible future contingencies andhence cannot incorporate these unforeseen con-tingencies into the ex ante employment con-tract. Further, as a result of contracting costs andthe imperfect nature of their enforcement by the

courts, one may choose to not incorporate intocontracts some foreseeable contingencies, evenones that are expost verifiable. Therefore, unlikethe principal-agent model, contracts are as-sumed to be incomplete. That is, it is assumed

that there exist events in the future for which thecontract does not stipulate the appropriateactions for the contracting parties. Because ofopportunism, when an uncontracted for contin-gency does arise, each party will try to exploit it(i.e. act opportunistically) to the extent thatmarket conditions allow. Therefore, when an un-contracted-for event arises, cooperative and self-interested behavior may diverge.

Notice that the use of incomplete contractsresult in a potential loss of efficiency relative to

the use of complete contracts. The reason is thatcontracting parties are never worse off, and areoften strictly better off, by contractually pre-committing to how they will act if specifiedevents occur in the future. At worst, one can al-ways precommit to act in the same way as onewould act without such an earlier contractualprecommitment, i.e. precommit to act oppor-tunistically. By definition, complete contractsallow the parties to precommit to behavior for alarger set of outcomes. For, if there exists events

which cannot be foreseen or are not specified ina contract, one cannot credibly precommit tohow one will act when those events arise.

What prevent s the cooperative solu tion fr ombeing achieved. Thus it is bounded rationality,costly contracting and imperfect enforcement ofcontracts, and their implication of incompletecontracts, which potentially prevent thecooperative solution from being attained by self-interested behavior. Notice that unlike the prin-

cipal-agent model, the cooperative solutionmay not be achievable even in the absence ofwork-aversion, risk-aversion or limited liabilityon the part of the agent.

Focus. The focus of the transaction cost econ-omics literature differs in a number ofways from

For a more complete description of this literature see Williamson ( 1975). Williamson (1986a) and Williamson (1986b).I) Examples of such potential enrichment are presented in the fourth and fifth sections.


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that of the principal-agent literature. First, theidea motivating transaction cost research is thattransactions are organized so as to minimizetransactions costs, where that term includes outof pocket costs (such as computational costs and

the cost of writing and enforcing contracts) andthe opportunity costs of inefficient contracts.Second, principal-agent research tends to focuson the contractual relationships between indi-viduals within a firm, while transaction costeconomics research tends to focus on the con-tractual relationships between firms. Third,with respect to the research agenda mentionedin the introduction, relative to principal-agentresearch, transaction cost economics places lessemphasis on the formal modeling of the underly-

ing economic environment and on deriving opti-mal solutions. It places more emphasis on theempirical testing of hypothesized explanationsfor observed organizational relationships.2Fourth, because of the diminished role for courtenforcement of contracts, transaction cost econ-omics focuses more on the design of self-enforc-ing employment relations rather than on thoseenforced by the courts. Finally, because transac-tion cost economics allows for incomplete con-tracts (and hence for signals which are jointly

observed by the contracting parties but not in-corporated into those contracts), it naturallygives rise to the study of contracts which allowfor discretionary compensation.

The procedures which the firm puts in placeto limit the opportunistic behavior that resultsfrom incomplete contracts are called gover-nance procedures.23 In essence, governance

procedures set the rules of the r e n e g o t i a t i o ng a m e which must be played when a contingencywhich is not covered by the ex a n t e contractarises. Factors such as market competition alsoact to discipline the opportunistic behavior

which arises when uncontracted for eventsoccur. Transaction cost economics is especiallyinterested in situations in which the role of com-petition as a disciplining device is reduced. Onesuch situation occurs in the presence of assetspecificity. This condition arises when the valueof an asset within an ongoing relationship ex-ceeds the value of the asset outside of the rela-tionship; that is, there are quasi-rents to begained by continuing the asset-specific relation-ship. Examples of asset specificities include:

human capital or learning by doing; site or loca-tional specificity such as that arising between ad-jacent coal mine and coal burning utility; and theuse of special purpose physical capital in orderto minimize the out of pocket cost of produc-tion.

Once the parties to a transaction have in-vested in relationship-specific assets, the partiesare no longer completely protected by the mar-ket from the opportunistic behavior of the otherparty, because the market no longer provides

perfect substitutes for the other party. Hence,asset specificity worsens the problem associatedwith incomplete contracts because in these situ-ations the extent of opportunistic behaviorwhich will be tolerated before ending the rela-tionship and devoting the asset to its next bestuse is much greater. Thus the potential for in-vesting in relationship-specific assets creates an

Decisions as to how to organize a transaction would include whether an intermediate product is produced internally or

externally, as well as whether to sell ones products through ones own stores, franchisee owned stores or independently

owned stores.* However, this difference is not as significant as it first appears. For example, although the principal and agent in principal-

agent models are usually i n f e rpe t ed a s having an employer-employee relationship, the model does not require this. In man

situations the analysis would be the same if one interpreted their relationship to be that of an owner and an independent

contractor. The problem is that none of the agency branches provides a useful definition of a firm or a useful way of locating

the border between a tirm and the market.

Recently, principal-agent researchers have started to address traditional topics within transaction cost economics but with

more emphasis on modeling the underlying environment and on deriving optimal solutions. As a result, the distinction

between principal-agent and some recent transaction cost economics research has become somewhat blurred. Some of

these papers w ill be discussed in the fourth and fifth sections.

Examples would include a firms cost accounting system as well as budgeting, transfer pricing and cost allocation rules.


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348 STAiiLfZY BALMAN

increased demand for governance procedureswhich will mitigate the effect of opportunisticbehavior when uncontracted for events occur. Amajor focus of transaction cost economics is thestudy of how the design or organizational

relationships, including governance procedures,affects the investment in relationship-specificassets, given incomplete contracting.

Contribution With incomplete contracts, thedivision of surplus when uncontracted forevents arise depends upon the players relativebargaining positions. Ones relative bargainingposition may depend upon any previous invest-ment in relationship-specific assets and the wayin which the transaction is organized, including

the agreed upon governance procedures. There-fore, a prior investment can influence both thetotal amount of surplus to be bargained over andthe players relative bargaining position when anuncontracted for contingency arises. To theextent that the latter concern influences the pre-vious investment decision, there is an invest-ment distortion. Because the way in which thetransaction is organized may also affect theplayers relative bargaining positions, it may alsoindirectly affect ones ex ante investment deci-

sion.The main insight provided by the transactioncost economics literature, therefore, is that gov-ernance matters. That is, incomplete contractsgive rise to ex post opportunistic behaviorwhich distorts ex ante investments in relation-ship-specific assets. Changes in the ownership ofthe asset and in governance procedures affectoutcomes because they change the expost bar-gaining positions of the contracting parties,which in turn affect the ex ante investment.Notice that the insight that governance mattersdepends crucially on there being uncontractedfor contingencies and hence expost bargaining.This only arises when incomplete contracts areused. In the principal-agent model the manner

in which a transaction is organized does not mat-ter because contracts are assumed to be com-plete and hence there is no expost bargaining.

As was noted earlier, transaction cost econ-omics has not yet been applied to specific man-

agerial accounting issues. Transaction cost econ-omics has, however, made a significant contribu-tion to the industrial organization literature. Ithas provided an alternative explanation for thediverse ways in which firms organize their rela-tionships. In particular, prior to transaction costeconomics, the major explanation offered fornon-standard relationships between firms wasthat they were attempts to build up or exploitmonopoly power. Transaction cost economicsanalysis has shown that some of these relation-

ships can be explained as attempts to minimizetransaction costs.

Criticisms. A number of criticisms of thetransaction cost economics model have beenmade. Most of the criticisms deal with the impre-cise specification of the model and the contextbeing analysed. First, the source and size of outof pocket contracting costs, while often used tomotivate the incompleteness of contracts, areimprecise. Further, it is never made explicitwhy the form of contract incompleteness as-

sumed is the optimal response to those contract-ing costs. Second, the notion of bounded ration-ality, although often motivating the use of in-complete contracts, is not well-defined. Thisgives rise to several questions. At what point dothese bounds prevent individuals from doingbetter? How do they cope with their bounds?And again, why does bounded rationality giverise to the form of the contract incompletenessassumed? Further, if it is bounded rationalitywhich is giving rise to contract incompleteness,how does one ex ante evaluate and choose be-tween different governance procedures whentheir reason for being is that one cannot assessthe probability or even foresee the contin-gencies for which the governance procedures

For example, if a supplier invests in a general purpose machine rather than a special purpose machine he will reduce theamount of surplus bargained over between himself and the buyer, but he may improve his relative bargaining position withthe buyer. However, for an excellent example of work where the sources of transaction costs are well-specified and indirectlymeasured, see Scholes et aL ( 1989).


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will be used? Note that this criticism does notarise when the reason for incompleteness con-tracts is the out of pocket cost of including con-tingencies in contracts.

Another model specification problem is that

the equilibrium concept that gives rise to theparticular organizational design adopted by thefirm is often unstated and the context in whichthe issue is being addressed is often not fullyspecified. As a result, the theoretical analysisdone in transaction cost economics tends to beless formal and rigorous than in principal-agentresearch.26 Finally, although transaction costeconomics problems are usually posed within amultiperiod setting, the literature has not fullyexplored the role ofreputation as a substitute for

governance procedures.Th e Rochest e r m ode l

T h e ast branch of the agency literature to bediscussed is that based on the work of JensenMeckling 1976), including the positive theoryof accounting (Watts Zimmerman, 1986).This literature shares many of the assumptionsand the method of analysis of the transactioncost economics model.

A ssu m p t i o n s. T h e Rochester model is similar

to the transaction cost economics model in thatboth emphasize transaction costs and oppor-tunistic behavior. However, in the Rochestermodel the external labor and capital markets,which are assumed to be efficient and to accu-rately anticipate the incentives of management,play a much more central role than in the otherbranches. Thus the Rochester model addressesone of the criticisms made of the principal-agent model. This literature also assumes thatobserved employment and financial contractsare optimal, given transaction costs. The positivetheory model is based not only on this agencymodel of the firm, but also on an economictheory of government regulation which viewsthe political process as a competition amongself-interested individuals for wealth transfers.

What pr v nt s t h e c oo p er a t i v e so l u t i o n r o m

26 owever. see footnote 22.

being achieved. Like transaction Cost CCOIl-omits, the presence of transaction costs impliesthe use of incomplete contracts, which togetherwith opportunistic behavior potentially pre-vents the cooperative solution from being at-

tained by self-interested behavior.

Focus. Both the Rochester and the principal-agent branches of the literature share the object-ive of understanding how agency problems ariseand how they can be mitigated by contractual,and more generally, organizational design. Thefocus and emphasis of the two branches differhowever. In contrast to principal-agent re-search but like transaction cost research, theRochester branch works with less formal and

less explicit models and analyses and em-phasizes the empirical testing of results. In par-ticular, it studies the incentives faced by the con-tracting parties given observed contracts andwhat factors might have given rise to the ob-served contracts. It does so by studying the ef-fect that (changes in) employment and financingcontracts have on the behavior of management(e.g. their financing and investment decisions)and on the stock price of the firm. The positivetheory specializes the focus to managementschoice of its financial accounting reporting pro-cedures. Notice that the Rochester branch de-emphasizes the formal derivation of optimalcontracts because, as noted above, it ussumesthat observed contracts are optimal given trans-action costs.

C o n t r i b u t i o n . All of the agency modelsassume that management acts in its own best in-terests and hence responds to the economic in-centives embodied in its employment contract.One contribution of the Rochester model and

the positive theory was in their early applica-tions of the agency framework to issues of man-agement control and the choice of financial ac-counting policy. In particular, the positivetheory expanded the role for financial account-ing information in an efficient market to includea contracting role, and thereby enriched the


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35 STANLEY BAILMAN

explanation for the choice of different financialaccounting procedures. A second, and continu-ing, contribution of the Rochester literature is inempirically testing this agency model of the firmand in identifying empirical regularities regard-

ing managements behavior and the form ofexecutive compensation contracts.

C r i t i c i sm s . 2 7 A s with transaction cost econ-omics, the concepts of equilibrium and efft-ciency as well as the size and source of transac-tion costs, while very important to the analysis,are not well-specified. Further, in the Rochesterliterature, careful modelling of the underlyingcontext and deriving optimal contracts are de-emphasized because observed contracts are as-

szimeri to be efftcient, given (usually unstatedand unmeasured) transaction costs. But as aresult, it then becomes difficult to explain whatthe motivation for the choice of those observedmanagerial contracts is (incentive, signalling, sc-reening, tax, etc.) or why contracts differ acrossdifferent firms and across time within firms.For example, while Healy ( 1985) is an excellentstudy which documents the association be-tween income manipulation and the form ofcompensation plans, it offers no convincing exp-

lanation as to why shareholders find it in theirbest interest to induce this behavior. Withoutsuch an explanation it becomes problematic asto whether we are interpreting the observedphenomena correctly.

When attempts to explain observedphenomena are made, the lack of modeling oftenresults in an appeal to unmodelled transactioncosts and political costs. But this reduces thepersuasiveness of the arguments. This is espe-cially true in the positive theorys reliance onpolitical costs to explain managements choiceof financial accounting procedures. Forexample, Watts Zimmerman (1986, p. 247)state, To avoid congressional and regulatoryagency attention with its consequent costs (andreduction in management compensation), themanager prefers the deferral method since it

lSee Christenson ( 1983) for other criticisms of this literature.See Raviv (1985) for a discussion of this point.

usually reduces the level and variance of re-ported earnings. But the deferral method can beconverted to the flow-through method at almostno cognitive cost. So what is the transaction costwhich prohibits this conversion and induces this

choice of accounting technique?

EMPIRICAL TESTS OF THE AGENCYPARADIGM

All of the agency models discussed so far sharea common view of the interaction between own-ers, managers and employment contracts: ( 1)managers act to maximize their expected utilityand hence their behavior can be influenced bythe design of their employment contracts; and(2) owners and managers collectively bear the

cost of any agency problems, hence they have anincentive to design contracts which efficientlymitigate any underlying agency problems. Thefirst point implies that we should see managerialbehavior respond to (changes in) the design ofcompensation plans in predictable ways. Thesecond point implies that in the presence of un-derlying agency problems we should see theadoption of plans which attempt to mitigatethose problems.

Most accounting related empirical agency re-

search are studies of financial accounting issuesrather than managerial accounting issues and arebawd on the positive theory of accountingmodel. Further, these studies have been the sub-ject of several prior surveys (see HolthausenLeftwich 1983; Kelly, 1983; Lambert Larcker,1985; Watts Zimmerman, 1986). Therefore, inthis section I will limit my discussion to paperswhich provide tests of the above two implica-tions of the agency model.

E v i d en c e o n t h e b eh a v i o r o f m a n a g em e n t

Most of the literature has been concernedwith testing the proposition that managerial de-cisions are affected by managerial compensationplans. Empirical tests generally support the as-sertion that capital investment decisions (Larc-ker, 1983) merger and acquisition decisions


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AGENCY THEORY IN ,MAVAGERLAL ACCOUNTING 351

(Lewellen et al. 1985; Tehranian et a l . 1987;Walking Long, 1984) and financial accountingprocedure choices (Healy, 1985) are associatedwith managerial compensation plans.

However, these tests are indirect and do not

establish causality. For example, Larcker ( 1983)demonstrates an association between the adop-tion of long-term performance plans andchanges in corporate capital investments. It ispossible that the adoption of the long-term plansincreased the planning horizon of managementwhich then led them to increase their long-terminvestments. However, as Larkcer notes, it is alsopossible that management had already decidedto increase capital investment and the adoptionof the long-term plans was a way of signalling this

to the market and of allowing management tobeneEt from this decision. This raises the issue ofwhether observed compensation plans areadopted to overcome agency problems or forother reasons, such as taxes and signalling.

E v i d en c e o n t h e d e si g n o f c on t r a c t s t o o v er -come agency problems

Murphy ( 1986) and Lewellen et a l . 1987) at-tempt to deal with this identification problem.Murphy analyses how compensation planswould

differ depending upon whether the prob-lem to overcome is one of incentives versus oneof learning the agents type. From the differentmodels, he derives different implications for thevariance of executive pay and for the relation-ship between pay and performance over timeand compares them with actual pay-experienceprofiles for executives. While the hypotheses arenot mutually exclusive, the data seem more sup-portive of the learning model than the shirkingmodel.

Lewellen et aE . (1987) examines whetherexecutive pay packages can be explained as at-tempts to reduce agency costs resulting frommanagement having a shorter decision horizonthan owners. If this were the case, then onewould expect to see the components of execu-tive pay (such as cash versus stock based com-pensation) systematically differ across firms de-pending upon how severe the horizon problemis in those firms. Lewellen et aI . 1987) hypo-

thesizes that the severity of the horizon problemis associated with certain observable Erm-specific variables and tests the association ofthese variables with the components of seniorexecutive pay. The components of the executive

pay packages are found to vary in the predictedmanner, thus supporting the argument thatthese compensation plans are designed to over-come agency problems.

Wolfson (1985) studies contracts in the oiland gas limited partnership market in whichthere is both substantial moral hazard with re-spect to the general partners decision to com-plete the drilling of a well and potentially im-portant tax implications to contract design.Wolfson identifies four different types of con-

tracts between general and limited partnerswhich make different trade-offs between the taxand incentive effects. He then derives hypoth-eses about the types of contracts one would Endin different kinds of drilling, where the moralhazard problems would be of different severity.The data support the hypotheses. Wolfson alsoderives a hypothesis about the pricing of reputa-tion for oil and gas general partners. The datasupport the hypothesis that a general partnerspast performance (reputation) is impounded in

the offering price of his new partnerships. Insummary, Wolfsons results are consistent withboth reputation and explicit incentives beingused to control moral hazard problems in oil andgas limited partnerships. Further, Wolfson(1985) is notable for directly incorporatingboth the tax and incentive aspects of contracts.

Other studies have tested formally derivedresults from the principal-agent model in whichthe underlying agency problem arises because ofmoral hazard on the part of the agent. Resultsfrom principal-agent models indicate that whenthe outputs of agents are subject to correlatedshocks, relative performance evaluation con-tracts are optimal (see Baiman Demski, 1980;Holmstrom, 1982b). Antle Smith (1986) em-pirically tests this result and Ends weak support.Banker Datar ( 1989) demonstrates that for alarge clans of production functions, the relativeamount of weight which the performanceevaluation measure should place on different


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352 STANLEY BAIMAN

signals, is related to the sensitivity of those sig-nals to the agents action and the precision ofthose signals given the agents action. LambertLarcker (1987) tests this result using securitymarket returns and accounting returns as the sig-

nals of performance. The results are weak butconsistent.

The Wolfson (1985), Murphy (1986) andLewellen et al . 1987) studies discussed abovetry to provide a more direct test of the assertionthat observed compensation contracts are cho-sen to mitigate specific agency problems. In par-ticular, the latter two papers attempt to differen-tiate between different demands for executivecompensation and to empirically test for them.However two recent papers call into question

whether the data which can be observed by anoutside researcher is sufficient to discriminatebetween several of the competing demands forexecutive compensation contracts. If one takesthe Murphy (1986) model but assumes that theagent already knows his own type, then Hagertyand Siegel (1988) show that, in a single periodworld, a contract written to overcome a moralhazard problem (in which the agents private in-formation is about his action) is observationallyindistinguishable from that written to overcome

an adverse selection problem (in which theagents private information is about the staterealization). In a similar vein, Amershi Butter-worth (1988) shows that the optimal contractbetween a principal and agent which is designedto overcome moral hazard in an environmentwith homogeneous beliefs is empirically indis-tinguishable from the optimal pure risk sharingcontract between a principal and an agent whohave heterogeneous beliefs but no problem ofmoral hazard.

The Hagerty Siegel (1988) and AmershiButterworth (1988) results obviously call intoquestion the ability of empirical research to testthe results of agency analysis and to distinguishbetween the different demands for observed

executive compensation contracts. These pap-ers indicate that observing the form of the con-tract alone, without any additional information,may not enable the ObSeNer to infer the econ-omic environment which gave rise to the con-

tract. That is, in these situations, the researcherwould have to already know what the reason forthe contract was before he or she could empiri-cally test whether the observed contract effi-ciently fullYled its purpose.

One way to knowwhether observed contractsare chosen to efficiently address specific agencyproblems is to actually create the environmentin which the contract is being chosen. This is theapproach used in experimental economics. Berget al . (1985a) sets up an experimental laborat-

ory market made up of subjects acting as princi-pals and agents. Each agent is asked to choosesome unobserved action from which he derivesdisutility. Each principal is asked to choose anemployment contract for an agent, from a previ-ously specified set of feasible contracts. Berg etal. (1985a) finds that the principals and theagents both act consistent with principal-agentresults. Thus, this experiment provides directevidence that agents act opportunistically butrespond to their compensation plans, and that

principals are aware of this and choose employ-ment contracts which efficiently mitigate thisagency problem.

Most management accounting textbooks em-phasize the use of Responsibility Accounting andthe Controllability Principle as the basis for de-signing managerial accounting reporting andperformance evaluation systems. However,Holmstrom (1979, 1982b) demonstrates thecentral importance of the Informativeness Con-dition as the basis for determining which signalsshould form the basis of principal-agent con-tracts.30 In general, the Controllability Principleand the Informativeness Condition are not thesame and can lead to different information sys-tem choices. Therefore, one test of the princi-

B Heterogeneous beliefs exist when two individuals beliefs differ even though they have the same information.

.+IThe informativeness condition states that one costless public post-decision information system is strictly Pareto superior

to a second, r e g a r d l e ss f t h e p r ef er en c e s a n d b el i ef s o f t h e p r i n c i p a l a n d a g e n t s , f and only if the signals of the first systemconvey more information about the actions chosen by the agents than do the signals of the second system. The idea of more

information as used here is that implied by the concept of statistical sufftciency as defined in statistics and decision theory.


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AGENCY THEORY IN MXVAGERIAL ACCOUNTING 353

pal-agent model would be to see which of thesetwo rules has more descriptive validity. Berg( 1988) conducts a laboratory experiment to testwhich principle is the better predictor for thesignals on which subjects choose to base their

contracts. The results indicate that while at firstthe subjects choice behavior is consistent withthe Controllability Principle and not with the In-formativeness Condition, over time their choicebehavior tends to converge to that predicted bythe Informativeness Condition. Thus, after an in-itial period, the subjects behave in a way whichis consistent with principal-agent results.3

In conclusion, empirical research based ondata from naturally occurring situations hasbeen successful in detecting a number of empir-

ical regularities which are consistent with theagency framework, but less so in testing specificprincipal-agent results. However, the resultshave to be interpreted in light of the limitationsof empirical research in this area which have al-ready been discussed. In addition, there areother inherent problems with research in thisarea, First, at best, an outside observer can typi-cally observe only the explicit parts of contracts.However, there is undoubtedly a great deal ofdiscretion involved with the actual implementa-

tion of most contracts, The use of discretion incompensation reduces what an observer caninfer by looking only at written contracts.Further, the empirical studies cited are notbased on examining managerial contracts butrather are based on estimates of compensationpaid. But looking at just the payments ignoresthe provisions for the events that did not occurand hence ignores potentially important fea-tures of the contracts.32 Another problem is thatcontracts in agency models are based on aspecific set of signals, and it may be difficult tocorrectly specify and measure these crucial vari-ables given that the researcher is limited to ex-

ternally available data. Instead, the researcher isforced to assume that included in the availabledata set are surrogates for the signals used in theagency model and in the implementation of theactual contracts.33

Thus empirical research based on data fromnaturally occurring situations has a number offormidable obstacles to overcome in testing im-plications of the agency modeL3 The experi-mental markets approach can address many ofthese issues because of the tighter experimentalcontrol which it can exercise. However, there isobviously a reduction in the richness of the con-text which can be analysed in an experimentallaboratory market. Finally, empirical and experi-mental research cannot explain why we observe

the observed empirical regularities; only thetheoretical literature can do that. I thereforeturn next to a discussion of recent theoreticalresults.

RECENT DEVELOPMENTS IN THEPRINCIPAL-AGENT PABADIGIM

The papers to be discussed in the rest of thesurvey can be classified into two groups. Thefirst group extends the principal-agent model toaddress some of the criticisms discussed earlier

and to incorporate some of the features of thetransaction cost economics model. While thesepapers do not directly deal with managerial ac-counting issues, they are nonetheless usefullydiscussed here for two reasons. First, some ofthese papers suggest potentially interesting usesand implications of management accountingprocedures which are not brought out by previ-ous principal-agent models. Second, others pro-vide additional understanding of the principal-agent model by addressing some of the criti-

cisms of the model which were mentioned earl-ier. Whether the ideas in these papers lead to abetter understanding of the managerial account-

Evidence from laboratory experiments by Berg et al ( 1988) also support principal-agent results with respect to the valueof communication when the agent is privately informed.x An alternative approach adopted by Walsh & Stewart (1988a. 1988b) is an archival approach in which one firms writtencompensation contracts over time are analysed.The Antle &Smith ( 1986) and Lambert & larcker ( 1987) studies are subject to this problem.Jensen ( 1983) discusses some other difficulties with conducting formal tests of hypotheses dealingwith organizational andcontractual forms.


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354 STANLEY BAIMAii

ing process must await future research whichapplies them to managerial accounting issues. Bymentioning them here, I hope to encourage suchfuture research. These papers are discussed inthis section. The second group of recent princi-

pal-agent papers, which more directly addressmanagement accounting issues, is discussed inthe Rfth section.

Cour t enforcement and contract i ncomplete-ness

Two major differences between the princi-pal-agent and transaction cost economicsparadigms are the extent to which contracts areassumed to be complete and courts are assumedto be efficient in enforcing contracts. One of the

encouraging recent developments has been theresponse of principal-agent theorists to some ofthe objections and insights of transaction costeconomics related to these differences. The nextthree subsections survey some of these princi-pal-agent papers.35

Contract enfor cement 6y cour ts. Recall thatthe principal-agent model assumes that courtscan costlessly and accurately enforce all con-tracts. What happens to the form of the optimal

principal-agent contract and the optimal agentaction choice when we continue to allow forcomplete contracts but assume that the courtsdo not prevent the contracting parties from re-negotiating their contract at a later date?Further, what is the cost incurred when re-negotiation is allowed?

Fudenberg & Tirole (1988) examines theseissues in the typical principal-agent problem inwhich the agent derives disutility from his actionchoice. However, unlike in the usual agencymodel, the principal and agent are allowed to re-negotiate the contract once, after the actionchoice but before the outcome occurs. Becausethe contracts are still complete, any contractwhich the principal and agent could agree to at

the time of renegotiation could be agreed tobefore renegotiation. Therefore, there is no lossof generality in restricting attention to renegoti-ation-proof contracts. Fudenberg & Tirole(1988) first shows that the only agent action

strategies which can be induced in this environ-ment are ( 1) the one in which the agent choosesthe minimum effort and (2) randomized strate-gies. It further establishes that for a large class ofproblems the cost of implementing any givensupportable agent-effort strategy is the samewith and without court enforcement of the con-tract. In these cases, dropping court enforce-ment of contracts does not change the way that(or the cost at which) given agent strategies areinduced. It only changes which strategies can be

induced.

Contract incompleteness and renegotiation .

Principal-agent research has also recentlybegun to analyse the effect of contract incom-pleteness on the design of contractual relation-ships. These models assume that the incomplete-ness arises, not because of bounded rationality,but because some states of the world or output,while jointly observable, are not verifiable tooutsiders and hence cannot be contracted on

(for example Green & wont, 1988a, 1988b;Hart & Moore, 1987; Riordan, 1987).With incomplete contracts, the demand for

renegotiation arises for different reasons than itdid in the Fudenberg & Tirole ( 1988) model. Re-negotiation occurs in Fudenberg & Tirole(1988) because, even with complete contracts,after the agent has chosen his action but beforeany new information occurs (such as the out-come realization), risk sharing can be improvedby changing the contract.36 Renegotiation oc-curs with incomplete contracts when, sub-sequent to the original contract agreement, anevent occurs which was not specified in the original contract and for which no action or rewardhas been agreed upon. Renegotiation is valuable

While I label these as examples of principal-agent research, others may label them as examples of transaction costeconomics research. I;his merely illus trates the point that parts of the two literatures are starting to overlap.(r For example, the agent can be relieved of the risk imposed in him for motivational purposes. because he has already chosenhis action.


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AGENCY THEORY IN MANAGERIAL ACCOUNTING 355

at that point if it improves how the individualswould otherwise respond to the uncontracted

for event.Hart Moore (1987) and Green 8r Laffont

(19SSa) address the basic issue of interest in

transaction cost economics, the effect of incom-plete contracts on the ex ante investment in re-lationship-specific assets, but in a more formalway than has been done in the transaction costeconomics literature. With incomplete con-tracts, it is no longer true, as in FudenburgTirole ( 1988) that without loss of generality wecan restrict ourselves to renegotiation-proofcontracts. It may be optimal to allow for re-negotiation to occur when uncontracted forcontingencies arise. Hart Moore (1987) and

Green Laffont ( 1988a) demonstrate condi-tions under which the design of the e-x ante con-tract can affect this expost renegotiation gameand can mitigate the e_x ante investment ineffi-ciency arising from the incompleteness of thecontract.

The incorporation of incomplete contractingwithin a principal-agent model raises an in-teresting managerial accounting issue. It seemsreasonable that the earlier choice of managerialaccounting procedures could affect the re-

negotiation game that takes place when uncon-tracted for contingencies arise. For example,ones leverage in renegotiation may depend onwhat information is common knowledge ormore generally on the distribution of informa-tion among the negotiating parties. This distribu-tion of information can obviously be affected bythe earlier choice of managerial accounting pro-cedures (i.e. the design of the variance analysisprocedures, monitoring system and budgetingsystem). Therefore, admitting the possibility of

incomplete contracts and allowing for renegoti-ation as a way of dealing with contract incom-pleteness introduces a new strategic element in

the choice ofmanagerial accounting proceduresthat has been ignored in principal-agent modelsto-date.

Such strategic considerations about the dis-tribution of information may provide a partial

explanation for why, in multi-division firms inwhich the divisions performances are stochasti-tally related, we often observe a division man-agers performance evaluated on the basis of hisown divisions profit, and possibly corporateprofits, rather than, as predicted by the princi-pal-agent model (Baiman Demski, 1980;Holmstrom, 1982b), on the full vector of divi-sional profits. In these cases, it may be that cor-porate headquarters anticipates the possibilityof having to renegotiate agreements with divi-

sional managers (about budgets, resource allo-cation, compensation, transfer prices, etc.) anddecides that its bargaining position would be im-proved by denying each division manager directaccess to information about the performance ofthe other divisions. This would allow corporateheadquarters to selectively reveal this informa-tion during any renegotiation. The cost of doingso, however, is that a division managers per-formance evaluation and compensation cannotbe based on information, such as the perform-

ance of the other divisions, to which he does nothave access. The improvement in corporateheadquarters strategic bargaining position ac-complished by reducing each division managersdirect knowledge about the performance of theother divisions, may more than compensate forthe reduction in motivational and risk-sharingbenefits from basing divisional performanceevaluation on own-divisional profit rather thanon the vector of divisional profits.

Contract incompleteness and reputation.Because most principal-agent research has as-sumed complete contracting, reputation3 with

37 Reputation has been used in two dilferent ways in the literature. Both uses are based on observations by others of anindividuals actions or the results of his actions. The first way in which reputation is used is with respect to others beliefs asto whether an individual possesses an inherent characteristic or fYPe over which he has no control, but which affects hispayoff function or utility for payoffs, For example, an individual may have a reputation for being a tough competitor (one whoenjoys winning independent of its monetary effects), a condition over which he has no control. For reputation in this senseto be of interest, an individual must have private information about his type, and his past behavior must be useful to othersin making inferences about his type. Much of this work is based on Kreps & Wilson ( 1982). In this section, reputation is used


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356 STANLEY BAIMAN

its potential for disciplining behavior in a multi-period setting, has been largely ignored.38 As aresult, principal-agent research has often beencriticized for not paying attention to the effect ofones action choice on ones reputation for trust

and fairness. Allowing for jointly observable butunverifiable information and incorporating in-complete contracts in a multiperiod setting al-lows concerns for trust and fairness and moregenerally reputation to endogenously arise. It isinteresting that, as noted earlier, transaction costeconomics, which is based on incomplete con-tracting, has also not extensively exploited thepotential disciplining role of reputation as a sub-stitute for or complement to formal governancestructures.

Transactions between reputable individualscan be more efftciently accomplished than be-tween those without such reputations by reduc-ing the cost of collecting information as well asthe cost of writing contracts and by increasingthe set of supportable actions. Note, howeverthat building up and maintaining a reputation isefficient only if it allows one to engage in futuretransactions which earn an above average rate ofreturn.39 For otherwise, the cost associated with

losing ones reputation would not be sufficientto dissuade a reputable party from acting oppor-tunistically. In the case of a firm in which a super-visor has discretion over how to reward an agentwhen uncontracted for contingencies arise, the

supervisor will act fairly if doing so increaseshis future opportunities to earn excess returns.In an interesting and far-ranging paper, Kreps(1984) summarizes this literature and advancesthe view that firms are essentially reputationbearers and that corporate culture is a vehiclefor establishing and maintaining that reputation.

Introducing incomplete contracts and reputa-tional considerations has a number of potentiallyinteresting managerial accounting implications.AU principal-agent based managerial account-ing research has taken a complete contractingperspective. As a result, this research has viewedmanagerial accounting procedures as producinginputs solely for use in explicit incentive con-tracts rather than for use in a reputation generat-ing process. Thus this research has ignored anobserved use for managerial accounting infor-mation and the implications which this use mayhave for the design of managerial accountingprocedures. The design of explicit incentive

in a second way. Here reputation has to do with others beliefs, based upon an individuals history of actions, as to whetherhe will choose to act in a certain way in the future. How others believe he will act in the future influences how they will actin the future which influences his payoff from acting in that way vs some other way. To illustrate, assume that two people areplaying an infinitely repeated Prisoners Dilemma game with known payoffs. Assume that they would both be better off byacting cooperatively. Further, assume that individual B announces that he will play cooperatively as long as individual Amaintains a reputation for playing cooperatively. This reputation is built up and maintained by always being observed to haveplayed cooperatively. B also announces that he will take the noncooperative action forever once A acquires a reputation foracting noncooperatively. A would acquire such a reputation by once being observed to have acted noncooperatively. ThusAs past behavior es tablished his repunzation, and B bases his action choices on As reputation. Notice that reputation is basedon Asjointly observed action. If a contract between the two individuals could be written on their verifiable action choices,then there would be no need for reputation; Bs punishment strategy could be built directly into the contract. Therefore, forreputations to be valuable in this second sense, the parties must not be able to write contracts on the information on whichthe reputation is being built (for example, As behavior may be jointly observable but not verifiable). Reputational uses ofinformation and contractual uses of information di&Ter n terms of the extent to which players can precommit to those uses.

If an enforceable contract could be written based on the As past actions (i.e. the contract was complete with respect toobservations of As actions), then B would be obligated to act noncooperatively forever if he once observed A actingnoncooperatively. If observations of As past behavior could not be written into a contract but could be used as a basis forBs action choice (i.e. the contract was incomplete with respect to observations of As actions), then B would implement thepunishment strategy once he has observed A act noncooperatively only ifU was then in B s best interest to do so. In this lattercase, Bs use of As history of action choices is discretionary.+JI ee Fama ( 1980) and Holmstrom & Ricart-Costa ( 1986) for exceptions. However, they use reputation in the first sensediscussed in the previous footnote (i.e. the markets belief as to ones type) rather than in the second sense. which is how itis used in this section.IVRecall Wolfsons ( 1985) evidence that a general partners reputation is impounded in the offering price o his new oil andgas partnerships.


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AGENCY THEORY [N MANAGERLAL ACCOUNTING 357

contracts and managerial accounting proce-dures in a world of incomplete contracts inwhich discretion arises and reputational consid-erations come into play may be quite differentfrom those which we have derived so far, based

on a world of complete contracts.The above analysis raises additional questions.

When would agency costs be mitigated by givingthe supervisor (or principal) the right to exer-cise discretion in the performance evaluationand compensation of the agent? What are the in-dustry, competitive, informational and produc-tion function characteristics which influencethe decision as to how much discretion to allowthe supervisor? Are the characteristics of themanagerial accounting system different for firms

which allow different amounts of discretion tosupervisors? What are the different characteris-tics of the information on which explicit con-tracts are based and on which discretion isbased? All of these are interesting issues forwhich both theoretical and empirical researchare required.

So notice that this recent theoretical workdealing with incomplete contracts, renegotia-tion and reputation, while not addressing man-agerial accounting issues, does have potential

implications for managerial accounting re-search. In particular, it suggests demands formanagerial accounting procedures and implica-tions that have previously been overlooked inthe literature.

T h e o m p Z ex i t y o f co n r a c t sOne of the major criticisms of the principal-

agent model is that the contracts derived areseemingly more complicated and more sensitiveto the underlying technical parameters than

those observed in practice. This, of course,raises the issue of the descriptive validity of themodel. A number of recent principal-agent papers have attempted to address this complexityissue.

L i n ea r c on t r a c t s. Linear incentive schemesare both simple and observed. Holmstrom Mil-grom (1987) shows that, by e n r i c h i n g the

strategies available to the agent, but without im-posing any cost of complexity or cost of contractdesign, one can construct models in which com-pensation schemes which are linear in timeaggregated accounts are optimal. Paradoxically,

a very complex model is needed to produce theoptimality of this simple linear scheme.

Menus of linear contracts have also beenshown to be optimal in some models in whichthe agent has private state information at thetime that the employment contract is negotiated(Laffont Tirole, 1986; Melumad Reichels-tein, 1989). However, Rogerson (1987) showsthat the class of problems for which linear con-tracts are optimal is probably not large. Further,what the above papers find is the optimality of a

menu of linear contracts where there are an infi-nite number of entries in the menu (one forevery state realization). That is, while each entryof the contract is simple, the number of entriesmake the menu of contracts quite complicated.

M u l t i p e r i o d c o n t r a c t s . Work by Lambert(1983) and Rogerson (1985) show that in re-peated agency contexts, long term contractshave memory and hence may be quite differentfrom (and much more complicated than) a sequ-

ence of already complicated one period con-tracts. However, Fudenberg et a l . 1987) showsthat the gains from long term.contracting in theLambert and Rogerson models are primarily dueto the restrictions on the agents ability to bor-row and save. The multi-period nature of thesecontracts is used to substitute for the self-insur-ance that would be available to agents if theywere allowed access to the capital markets.

In particular, Fudenberg et a l . 1987) showsthat if (a) principal and agent preferences over

future contracts are common knowledge (forexample there is no private state information);(b) the utility possibility frontier generated bythe set of incentive efftcient contracts is down-ward sloping; and (c) the employee is able toborrow and save at the same rate as the principal,then long term contracts will be no better than asequence of one-period contracts. Thus, in

I However recall the response to this criticism in the second section.


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multiperiod settings satisfying these situations,the complexity of optimal contracts is no greaterthan the complexity of single period contracts.

he use of cardinal us ordinal measur es of

performance. The above papers look at condi-tions under which optimal contracts take a sim-ple form, without exogenously restricting thecontract to be of that simple form. Obviously,one reason for simple contract forms is thatthere is a cognitive and information processingcost to contract complexity. One approach toderiving simpler contract forms which are pre-sumably more consistent with observed con-tracts, is to incorporate a contract design costwithin the agency model. Unfortunately, the

form of that cost is not well-understood. Anotherapproach to simplifying principal-agent con-tracts is to exogeneously restrict the form of thecontract or how information is used within thecontract. An example of the latter is the use of or-dinal (relative ranking) measures of perform-ance rather than cardinal (absolute) measures.Such schemes, called tournaments, are used, forexample, in rewarding salespeople based ontheir relative, rather than absolute performance.

Tournaments have been the subject of much

work (see Mookherjee ( 1988) for a summary ofthis literature). One of the problems with tour-naments is that the agents have a strong and ob-vious incentive to collude against the principalbut no incentive to help each other, even if theirabsolute performance could thus be improved.However, an advantage of tournaments is thatthey provide the principal with less of an oppor-tunity to not honor the contracts when verifica-tion is difficult. This is because the total amountof compensation paid out in a tournament, un-like in other compensation schemes, does notvary in the performance of the individuals.Hence checking that the principal has compliedwith the contract should be easier in tourna-ments than in other types of incentive schemes.

One commonly observed example of tourna-ments is promotion-based incentives where anindividuals compensation depends solely upon

358 STAMEX BAlMAN

his position in the hierarchy. The only direct in-fluence which measured performance has oncompensation is through its effect on job promo-tion. In fact, Baker et al. 1988) claims thatpromotion-based incentives are more prevalent

than performance-based incentives at lowerlevels of the firm. An unresolved issue is why in-centive compensation systems which seeminglyuse only a subset of the available data, like tour-naments and promotion-based incentives, are soprevalent.*

he strategic aspects of contr act choiceMost principal-agent research has ignored

the indirect effect which the choice of theagents compensation plan can have on the other

participants operating in the product, capitaland the labor markets. This is because theyassume that the firm is playing a game againstnature, or is operating in a market where it is sosmall that its actions have no effect on theactions of its competitors. However, Fershtman

Judd ( 1984, 1986) Fershtman et al. (1987)and Sklivas (1987) study the agent contractingproblem in a situation in which a small numberof agent-managed firms compete in the sameoutput market. They derive two interesting and

related implications of agent-managed firmscompeting in the same product markets ratherthan playing games against nature. First, they de-monstrate that the optimal agent contracts de-rived under these two different assumptions aredifferent. Second, as a result of the differences inthese contracts, they show that the agent (orfirm) behavior which is induced in these twosituations is significantly different. These resultsarise because once you allow for competitionamong firms, the choice of agent incentive con-tracts takes on strategic implications which areignored in principal-agent models in which thefirm plays a game against nature. The strategicimplications of agent contracts can be illustratedfor the following scenario.

First, assume a market in which two separatelyowned firms operate. Next, assume that eachowner delegates his firms operations to a diffe-

I See the section labelled Partial equilibrium labor markets for one possible explanation.


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AGENCY THEORY IN MANAGERLAL ACCOUNTING 359

rent agent; each owner precommits to hisagents compensation contract; and each agentknows the other agents compensation contract.Now each agents compensation depends uponhis performance, which depends upon his com-pensation contract, his action choice and theaction taken by the other agent, which is affectedby the latters compensation contract. There-fore, each owners choice of compensation con-tract affects not only his agents actions but alsothe actions of the otberf imz s agent. This is thestrategic aspect of contract design. That is, eachowner designs his agents contract to not onlymanipulate his agents incentives but also tomanipulate the other fi rm s agent s incentives.The latter consideration in designing compensa-

tion contracts is, of course, absent in models inwhich the firm is playing a game against nature.Therefore, one would expect that the employ-ment contracts in the two situations are quitedifferent.

In summary, factoring in the strategic effectsof contract design forces the principal to adoptcontracts and induce agent behavior which maybe quite different from those in which thisstrategic effect is ignored. One might expectmanagerial accounting systems (which are de-

signed, in part, to support the employment con-tracts) to also be sensitive to the extent of com-petition in the product markets. It would be in-teresting to derive such a theoretical relation-ship and then test it cross-sectionally for a sam-ple of industries. The insight provided by Fer-shtman Judd (1984, 1986), Fershtman et al .

1987), and Sklivas ( 1987) must also cause us toreassess some past empirical tests of principal-agent results. For example, the tests conductedby Antle Smith ( 1986) and Lambert Larcker

( 1987), which were discussed earlier, were withrespect to results derived from models which as-sumed that the firm competed against nature.But the tests were conducted on data fromagent-managed companies which competedagainst other agent-managed companies.

Partial equili brium labor marketAs mentioned above, most of the principal-

agent literature ignores the strategic effects that

contract choice can have on the product, capitaland labor markets. In the same way, most of theliterature has ignored the effect that the labormarket can have on the design of the employ-ment contract and on the underlying agencyproblem itself.

Fama ( 1980) asserts that the agency problemsof management are mitigated by the effect ofreputation on ones market wage. He goes so faras to state that a concern for reputation alonewill take care of any deviant incentives; there isno need for explicit incentives. Holmstrom(1982a) formalizes Famas model and finds thatwhile reputational considerations may mitigateagency problems, they are, in general, not strongenough to eliminate them. Holmstroms results

are consistent with the empirical results ofWolfson (1985) which were cited earlier.

In fact, Holmstrom Ricart-Costa (1986)shows that the operation of the labor marketmay actually serve as the sozu-ce of agency prob-lems rather than as a way of mitigating them.Assume that an agent is risk-averse but work-neutral and must pick an investment projectwhich will generate outcomes over a period oftime. Further, assume that the agent has an abil-ity type which is unknown both to himselfand to

the labor market. If the agent could precommitto lifetime employment with the firm (or equiva-lently, if the labor market could be ignored),then the cooperative solution could be achievedby paying the work-neutral agent a constantwage. However, without such precommitment,the labor market will use the outcomes of the in-vestment chosen by the agent as signals aboutthe agents type and will revise his market wageaccordingly. As a result, the agent will choose aninvestment that maximizes his human capital re-

turns while the principal wants the agent tomaximize the financial value of the firm. It is theoperation of the labor market which has createdthe agency problem.

Introducing the labor markets into the princi-pal-agent model also has implications for the de-sign of managerial accounting procedures. It isoften observed that agents are evaluated on thebasis of information which is coarser than thatpotentially available to the firm. The use of


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promotion-based incentives discussed earlier isone example of this. Another example is one inwhich individuals are evaluated and compen-sated depending upon whether they are rated tobe in the, say, top third, middle third or bottom

third of their peer group. If managers have a finerpartitioning than this, why would the firm notuse this finer partitioning to evaluate its work-ers? One reason is suggested by the Holmstrom

Ricart-Costa ( 1986) model. By basing anagents evaluation on finer information, the firmcan improve the agents motivation. However,by basing the agents evaluation on finer infor-mation, the firm is allowing the market to usethat performance evaluation to better revise theagents opportunity wage. To the extent to

which this increases the agents opportunitywage, the firm must increase the amount paid forthe agents services now and in the future.42Thus the firm may design its performanceevaluation information system (includingbudgets, variance analysis procedures, cost allo-cation methods in order to trade-off its incen-tive effects with its future wage effects. Thisreasoning is also consistent with the use ofpromotion-based vs performance-based incen-tives. Thus, as before, expanding the principal-

agent model to include the effects of markets canraise additional implications for the choice ofmanagerial accounting performance evaluationsystems and offer possible explanations for theuse of observed managerial accounting perform-ance evaluation systems.

principal-agent research has dealt with thevalue of monitoring. A number of recent papershave extended this area and have given us addi-tional insight into the optimal design of monitor-ing systems. For example, most of the value-of-

monitoring literature has assumed a faredmonitoring technology whose quality is exogen-ously given. However, recently Kumar (1989b)and Suh Kim (1989) allow the quality of themonitoring system to be a decision variable.

RECENT THEORETICAL PAPERS WITHMANAGERIAL ACCOUNTING IMPLICATIONS

In this section I discuss some of the recentprincipal-agent papers which model more di-rectly managerial accounting issues.

he v a l u e of m o n i t o r i n gMuch of the managerial accounting related

Kumar ( 1988b) studies an agency model ofthe firm in which the principal invests in a pro-duction process under the control of a manager.The manager is privately informed as to thefirms capital productivity. The agent can reportto the principal on the productivity realization

and can divert some of the principals invest-ment from production to personal (non-pecuniary) consumption. The principal can im-perfectly monitor the amount of investmentwhich has been diverted. The principal must de-cide on both how much to invest in the firmsproduction process and how much to invest inthe monitoring system. Kumar (1989b) findsthat the principal will invest more in monitoringand base the agents compensation more heavilyon the monitoring signal when the agent com-municates a low productivity state. When theagent reports a high productivity state, the prin-cipal will invest less in monitoring and base theagents compensation more on the observedoutput. The reason is that with low productivity,and compensation based solely on output, theagent sacrifices less pecuniary compensation bydiverting the resources to nonpecuniary con-sumption. To avoid this diversion of resourcesthe principal must give the agent a larger share ofthe output. Hence motivation through incentiveschemes based on output alone is costly in lowproductivity states. This creates a demand formonitoring. For high productivity states, a smal-ler share of output as compensation can increasethe agents preference for the productive invest-ment. Hence the value of monitoring is less for

In a related model, Harris & Holmstrom ( 1982) findsconditions under which the optimal compensation contract increaseswhen the agents outside opportunity wage goes up, but does not go down when the agents opportunity wage goes down.In this case, the cost of providing the labor market with information about the agents performance becomes even greater.


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AGENCJTHEORY IN MAiihCERIAL ACCOUNTING 3

Documents

Baiman(1990) Agency Res in Man Acc