Incentive System Design Based on Accrual Accounting: A Summary and Analysis

This paper provides a formal analysis on how to design accrual based incentive systems so that a manager’s and owner’s interests are properly aligned. We introduce a general framework to summarize the literature, provide various extensions to it, and point to some of its limitations. We characterize the entire class of goal-congruent and preference-similar incentive systems when the owner has perfect as well as imperfect information about the manager’s preferences. This allows us to show how compensation functions and performance measures are interrelated and to demonstrate what information must be incorporated into compensation functions and performance measures. We illustrate how robust these results are, especially with respect to gaming and transaction smoothing. Furthermore, we show how to produce consistent performance measures by capitalizing investment costs and constructing appropriate depreciation schedules. Finally, we analyze the flexibility of accrual- versus cash-based allocation rules and highlight connections to the notion of conservatism.