Jonathan Bonham

REVISION: Regulating, motivating and measuring ESG outcomes
Date Posted:Fri, 06 May 2022 05:00:08 -0500
Using a principal-agent model in which shareholders care about financial as well as environmental and social (ESG) outcomes, we provide a theoretical framework for regulating and measuring ESG outcomes. We show that when ESG cannot be reliably measured, regulators can improve ESG outcomes by subsidizing (taxing) the financial performance of firms with ESG-aligned (-misaligned) technologies; we show that ESG-contingent financial subsidies induce green innovation; and we show that ESG subsidies exacerbate greenwashing whereas income taxes dampen earnings management. We also present a framework for ESG reporting and show that many general financial accounting principles – which are oriented toward estimating shareholder wealth – are also applicable to measuring shareholder welfare, suggesting that GAAP provides a useful launching pad for the development of ESG reporting standards.

REVISION: Contracting on What Firm Owners Value
Date Posted:Thu, 03 Feb 2022 15:44:47 -0600
We revisit foundational questions in agency theory while assuming that the agent can fine-tune the joint distribution of all contractible and non-contractible performance measures. Under this assumption, optimal contracts behave as if the principal were making inferences about the outcome she values rather than about the agent's action. This has significant implications for what measures are included in contracts and how those measures are used. Most importantly, Holmström's (1979) informativeness principle changes. A performance measure is valuable if it improves inferences not about the agent's action, but about the outcome the principal values; and if that outcome is contractible, additional measures have no value. Our model predicts that contracts should be written only on outcomes that firm owners value, consistent with real-world contracts that tie executive pay to only a handful of accounting, market, or nonfinancial measures.

REVISION: Contracting on Aggregated Accounting Estimates
Date Posted:Thu, 03 Feb 2022 15:44:33 -0600
Using a principal-agent setting in which the agent has a rich action space, we provide a novel framework for studying accounting measurement and aggregation. We show that the optimal contracting process can be decomposed into three stages: constructing unbiased estimates of items that the principal values, aggregating those estimates using the weights in the principal's objective (as opposed to weighting by sensitivity or precision), and compensating the agent on the aggregated estimate. This decomposition provides a theoretical justification for contracting on highly-aggregated accounting metrics. Moreover, our results reconcile the conflict between the stewardship and valuation uses of information; when the agent has flexible control over firm performance, evaluating the manager and valuing the firm are one and the same. In a highly tractable specification of our model in which normal distributions arise endogenously, we show that optimal measurement rules are conservative yet ...

REVISION: An Accounting Framework for ESG Reporting
Date Posted:Sun, 30 Jan 2022 17:47:18 -0600
Using a principal-agent model in which shareholders care about financial as well as environmental and social (ESG) outcomes, we provide a theoretical framework for measuring and motivating improvements in shareholder welfare. The optimal contract is executed in three stages. First, financial and ESG outcomes are measured using available data, then they are aggregated according to the weights in the shareholder's welfare function, and finally the agent is compensated on estimated welfare. We show that many general financial accounting principles – which are oriented toward estimating shareholder wealth – are also applicable to measuring of shareholder welfare. For example, we show that optimal ESG measurement rules are conservative: they discount ESG data by the agent's ability to engage in greenwashing in order to produce unbiased estimates of ESG performance. We also study how regulators can use taxes/subsidies to affect social outcomes. We demonstrate the potential unintended ...

REVISION: Contracting on Aggregated Accounting Estimates
Date Posted:Sun, 30 Jan 2022 17:47:10 -0600
Using a principal-agent setting in which the agent has a rich action space, we provide a novel framework for studying accounting measurement and aggregation. We show that the optimal contracting process can be decomposed into three stages: constructing unbiased estimates of items that the principal values, aggregating those estimates using the weights in the principal's objective (as opposed to weighting by sensitivity or precision), and compensating the agent on the aggregated estimate. This decomposition provides a theoretical justification for contracting on highly-aggregated accounting metrics. Moreover, our results reconcile the conflict between the stewardship and valuation uses of information; when the agent has flexible control over firm performance, evaluating the manager and valuing the firm are one and the same. In a highly tractable specification of our model in which normal distributions arise endogenously, we show that optimal measurement rules are conservative yet ...

REVISION: Contracting on What Firm Owners Value
Date Posted:Sun, 30 Jan 2022 17:46:55 -0600
We revisit foundational questions in agency theory while assuming that the agent can fine-tune the joint distribution of all contractible and non-contractible performance measures. Under this assumption, optimal contracts behave as if the principal were making inferences about the outcome she values rather than about the agent's action. This has significant implications for what measures are included in contracts and how those measures are used. Most importantly, Holmström's (1979) informativeness principle changes. A performance measure is valuable if it improves inferences not about the agent's action, but about the outcome the principal values; and if that outcome is contractible, additional measures have no value. Our model predicts that contracts should be written only on outcomes that firm owners value, consistent with real-world contracts that tie executive pay to only a handful of accounting, market, or nonfinancial measures.

REVISION: An Accounting Framework for ESG Reporting
Date Posted:Thu, 27 Jan 2022 11:27:35 -0600
Using a principal-agent model in which shareholders care about financial as well as environmental and social (ESG) outcomes, we provide a theoretical framework for measuring and motivating improvements in shareholder welfare. The optimal contract is executed in three stages. First, financial and ESG outcomes are measured using available data, then they are aggregated according to the weights in the shareholder's welfare function, and finally the agent is compensated on estimated welfare. We show that many general financial accounting principles – which are oriented toward estimating shareholder wealth – are also applicable to measuring of shareholder welfare. For example, we show that optimal ESG measurement rules are conservative: they discount ESG data by the agent's ability to engage in greenwashing in order to produce unbiased estimates of ESG performance. We also study how regulators can use taxes/subsidies to affect social outcomes. We demonstrate the potential unintended ...

REVISION: Shaping Incentives through Measurement and Contracts
Date Posted:Mon, 24 Jan 2022 05:34:36 -0600
I develop an agency model in which performance measurement and compensation contracts are jointly used to shape incentives. When an agent has extensive control over firm value, there tend to be many optimal measures – each implying a unique optimal contract with a strikingly simple closed form – that efficiently motivate the same productive action. Because incentives can be embedded in the measure or the contract, any distortions in one are offset by adjusting the other, which can lead to highly nonlinear contracts. When the agent is risk neutral and has unlimited liability, there exist optimal measures that induce linear, convex, concave, bang-bang, piece-wise linear, S-shaped, or standard bonus contracts with floors, ceilings, and hurdles. When the agent has limited liability, standard bonus contracts written on understated measures tend to be jointly optimal. When the agent is risk averse, perfect measures are uniquely optimal whereas imperfect measures tend to distort firm value.

REVISION: Contracting on Aggregated Accounting Estimates
Date Posted:Mon, 24 Jan 2022 05:11:43 -0600
Using a principal-agent setting in which the agent has a rich action space, we provide a novel framework for studying accounting measurement and aggregation. We show that the optimal contracting process can be decomposed into three stages: constructing unbiased estimates of items that the principal values, aggregating those estimates using the weights in the principal's objective (as opposed to weighting by sensitivity or precision), and compensating the agent on the aggregated estimate. This decomposition provides a theoretical justification for contracting on highly-aggregated accounting metrics. Moreover, our results reconcile the conflict between the stewardship and valuation uses of information; when the agent has flexible control over firm performance, evaluating the manager and valuing the firm are one and the same. In a highly tractable specification of our model in which normal distributions arise endogenously, we show that optimal measurement rules are conservative yet ...

REVISION: Shaping Incentives through Measurement and Contracts
Date Posted:Tue, 04 Jan 2022 18:52:08 -0600
This paper presents a tractable and reusable framework for investigating the effects of measurement on optimal contracts and managerial activity. The distinctive assumption is that the agent can fine-tune the joint distribution of all value-relevant outcomes and contractible performance measures. This assumption permits tractable solutions for the optimal contract and distribution without placing exogenous restrictions on their shapes. The solution comprises a contract with four potential sources of nonlinearity – measurement, risk aversion, limited liability, and the principal’s preferences – and a distribution that is a straightforward transformation of this contract. I illustrate the framework’s versatility through a series of applications that rationalize common contractual forms such as options, accounting-based bonus plans, and accounting-based performance shares, and I show how different contractual forms motivate the agent to influence distributional properties such as means, ...

REVISION: Dynamic Moral Hazard and Optimal Accruals
Date Posted:Tue, 04 Jan 2022 07:56:06 -0600
We derive optimal contracting and accrual accounting policies in a continuous-time moral hazard framework. An agent who takes actions to generate current and future cash flows is compensated via a contract written on cash flows, which contain timing errors, and accounting earnings, which correct these timing errors at the expense of introducing measurement errors. We show that deferred incentives and accruals are substitutes in solving the incentive problems created by cash flow timing errors. Late in the agency relationship, the optimal contract is short-term and the optimal accrual policy is standardized -- it is time invariant, accrual-heavy, and driven by measurability rather than agency-specific parameters. By contrast, early in the agency relationship the optimal contract is long-term and the optimal accrual policy is non-standardized -- it changes over time, corrects fewer timing errors than the standardized policy, and varies with agency-specific parameters. Our model sheds ...

REVISION: Contracting on Aggregated Accounting Estimates
Date Posted:Mon, 27 Dec 2021 06:29:56 -0600
Using a principal-agent setting in which the agent has a rich action space, we provide a novel framework for studying accounting measurement and aggregation. We show that the optimal contracting process can be decomposed into three stages: constructing unbiased estimates of items that the principal values, aggregating those estimates using the weights in the principal's objective (as opposed to weighting by sensitivity or precision), and compensating the agent on the aggregated estimate. This decomposition provides a theoretical justification for contracting on highly-aggregated accounting metrics. Moreover, our results reconcile the conflict between the stewardship and valuation uses of information; when the agent has flexible control over firm performance, evaluating the manager and valuing the firm are one and the same. In a highly tractable specification of our model in which normal distributions arise endogenously, we show that optimal measurement rules are conservative yet ...

REVISION: Dynamic Moral Hazard and Optimal Accruals
Date Posted:Mon, 27 Dec 2021 06:07:47 -0600
We investigate the impact of accrual accounting on contracting and the characteristics of optimal accrual policies in a continuous-time moral hazard framework. An agent who controls unobservable fundamental performance is compensated via a contract written on cash flows, which contain timing errors, and accounting earnings, which correct timing errors at the expense of introducing measurement errors. Deferred incentives and accruals are substitutes in solving the incentive problems created by cash flow timing errors, and accruals dominate deferred incentives as measurement becomes more precise. If cash flows and earnings are sufficiently informative, then accruals are the primary control mechanism late in the agency relationship when the most efficient accrual policy is time-invariant and standardized - it is driven by measurability rather than agency-specific parameters. By contrast, deferred incentives are the primary control mechanism early in the agency relationship, when the ...

REVISION: Shaping Incentives through Measurement and Contracts
Date Posted:Mon, 27 Dec 2021 06:03:29 -0600
This paper presents a tractable and reusable framework for investigating the effects of measurement on optimal contracts and managerial activity. The distinctive assumption is that the agent can fine-tune the joint distribution of all value-relevant outcomes and contractible performance measures. This assumption permits tractable solutions for the optimal contract and distribution without placing exogenous restrictions on their shapes. The solution comprises a contract with four potential sources of nonlinearity – measurement, risk aversion, limited liability, and the principal’s preferences – and a distribution that is a straightforward transformation of this contract. I illustrate the framework’s versatility through a series of applications that rationalize common contractual forms such as options, accounting-based bonus plans, and accounting-based performance shares, and I show how different contractual forms motivate the agent to influence distributional properties such as means, ...

REVISION: Contracting on Aggregated Accounting Estimates
Date Posted:Thu, 18 Nov 2021 14:23:23 -0600
Using a principal-agent framework in which the agent chooses the joint distribution over all contractible and non-contractible signals, we provide a theoretical justification for contracting on aggregated accounting estimates. The optimal contracting process can be decomposed into three stages: estimating individual items that the principal values, aggregating those estimates using the weights in the principal's objective (as opposed to weighting by sensitivity or precision), and compensating the agent based on the aggregated estimate. In a highly tractable specification of our model in which normal distributions arise endogenously, we show that optimal measurement rules are conservative yet produce unbiased estimates. Furthermore, we show that a weaker link between investment and future returns warrants more conservative treatment of expected future benefits, providing a contracting rationale for the immediate expensing of R&D, the capitalization of PP&E and the accrual of ...

REVISION: Contracting on What Firm Owners Value
Date Posted:Wed, 25 Aug 2021 09:34:42 -0500
We revisit foundational questions in agency theory while assuming that the agent can fine-tune the joint distribution of all contractible and non-contractible performance measures. Under this assumption, optimal contracts behave as if the principal were making inferences about the outcome she values rather than about the agent's action. This has significant implications for what measures are included in contracts and how those measures are used. Most importantly, Holmström's (1979) informativeness principle changes. A performance measure is valuable if it improves inferences not about the agent's action, but about the outcome the principal values; and if that outcome is contractible, additional measures have no value. Our model predicts that contracts should be written only on outcomes that firm owners value, consistent with real-world contracts that tie executive pay to only a handful of accounting, market, or nonfinancial measures.

REVISION: Dynamic Moral Hazard and Optimal Accruals
Date Posted:Wed, 07 Jul 2021 05:35:25 -0500
We investigate the impact of accrual accounting on contracting and the characteristics of optimal accrual policies in a continuous-time moral hazard framework. An agent who controls unobservable fundamental performance is compensated via a contract written on cash flows, which contain timing errors, and accounting earnings, which correct timing errors at the expense of introducing measurement errors. Deferred incentives and accruals are substitutes in solving the incentive problems created by cash flow timing errors, and accruals dominate deferred incentives as measurement becomes more precise. If cash flows and earnings are sufficiently informative, then accruals are the primary control mechanism late in the agency relationship when the most efficient accrual policy is time-invariant and standardized - it is driven by measurability rather than agency-specific parameters. By contrast, deferred incentives are the primary control mechanism early in the agency relationship, when the ...

REVISION: Dynamic Moral Hazard and Optimal Accruals
Date Posted:Wed, 07 Jul 2021 05:35:24 -0500
We investigate the impact of accrual accounting on contracting and the characteristics of optimal accrual policies in a continuous-time moral hazard framework. An agent who controls unobservable fundamental performance is compensated via a contract written on cash flows, which contain timing errors, and accounting earnings, which correct timing errors at the expense of introducing measurement errors. Deferred incentives and accruals are substitutes in solving the incentive problems created by cash flow timing errors, and accruals dominate deferred incentives as measurement becomes more precise. If cash flows and earnings are sufficiently informative, then accruals are the primary control mechanism late in the agency relationship when the most efficient accrual policy is time-invariant and standardized - it is driven by measurability rather than agency-specific parameters. By contrast, deferred incentives are the primary control mechanism early in the agency relationship, when the ...

REVISION: Shaping Incentives through Measurement and Contracts
Date Posted:Tue, 03 Nov 2020 06:46:30 -0600
I develop an agency model in which performance measurement and compensation contracts are jointly used to shape incentives. When an agent has extensive control over firm value, there tend to be many optimal measures — each implying a unique optimal contract with a strikingly simple closed form — that efficiently motivate the same productive action. Because incentives can be embedded in the measure or the contract, any distortions in one are offset by adjusting the other, which can lead to highly nonlinear contracts. When the agent is risk neutral and has unlimited liability, there exist optimal measures that induce linear, convex, concave, bang-bang, piece-wise linear, S-shaped, or standard bonus contracts with floors, ceilings, and hurdles. When the agent has limited liability, standard bonus contracts written on understated measures tend to be jointly optimal. When the agent is risk averse, perfect measures are uniquely optimal whereas imperfect measures tend to distort firm value.

REVISION: Does It Pay to 'Be Like Mike'? Aspirational Peer Firms and Relative Performance Evaluation
Date Posted:Thu, 09 Aug 2018 22:55:43 -0500
We examine the manner and extent to which firms evaluate performance relative to aspirational peer firms. Guided by the predictions of an agency model, we find that CEO compensation increases in the correlation between own and aspirational peer firm performances. In addition, we define and test conditions where aggregate peer performance, which has been the primary focus of prior relative performance evaluation studies of competitive peers, is expected to have an association with CEO compensation. These conditions are supported by our empirical results. Finally, we document that our results are more pronounced when the firm-peer relationship is one-way and the peer firm is in a different industry and therefore is more aspirational.

REVISION: Does It Pay to 'Be Like Mike'? Aspirational Peer Firms and Relative Performance Evaluation
Date Posted:Sat, 16 Jun 2018 12:17:18 -0500
We examine the manner and extent to which firms evaluate performance relative to aspirational peer firms. Guided by the predictions of an agency model, we find that CEO compensation increases in the correlation between own and aspirational peer firm performances. In addition, we define and test conditions where aggregate peer performance, which has been the primary focus of prior relative performance evaluation studies of competitive peers, is expected to have an association with CEO compensation. These conditions are supported by our empirical results. Finally, we document that our results are more pronounced when the firm-peer relationship is one-way and the peer firm is in a different industry and therefore is more aspirational.

REVISION: Does It Pay to 'Be Like Mike'? Aspirational Peer Firms and Relative Performance Evaluation
Date Posted:Tue, 06 Feb 2018 01:29:06 -0600
We examine the manner and extent to which firms evaluate performance relative to aspirational peer firms. Guided by the predictions of an agency model, we find that CEO compensation increases in the correlation between own and aspirational peer firm performances. In addition, we define and test conditions where aggregate peer performance, which has been the primary focus of prior relative performance evaluation studies of competitive peers, is expected to have an association with CEO compensation. These conditions are supported by our empirical results. Finally, we document that our results are more pronounced when the firm-peer relationship is one-way and the peer firm is in a different industry and therefore is more aspirational.

REVISION: Does it Pay to 'Be Like Mike'? Aspirational Peer Firms and Relative Performance Evaluation
Date Posted:Sun, 13 Aug 2017 22:54:25 -0500
We examine the manner and extent to which firms evaluate performance relative to aspirational peer firms. Guided by the predictions of an agency model, we find that CEO compensation increases in the correlation between own and aspirational peer firm performances. In addition, we define and test conditions where aggregate peer performance, which has been the primary focus of prior relative performance evaluation studies of competitive peers, is expected to have an association with CEO compensation. These conditions are supported by our empirical results. Finally, we document that our results are more pronounced when the firm-peer relationship is one-way and the peer firm is in a different industry and therefore is more aspirational.

REVISION: Does it Pay to 'Be Like Mike'? An Empirical Test of Dynamic Relative Performance Evaluation
Date Posted:Thu, 15 Jun 2017 07:30:06 -0500
We provide empirical support for the widespread use of implicit dynamic relative performance evaluation (DRPE) in executive compensation. Consistent with the DRPE theory proposed in Hemmer (2016), we find that CEO compensation increases in the correlation between own and aspirational peer firm performances. In addition, we define and test conditions under which aggregate peer performance, which has been the primary focus of prior relative performance evaluation (RPE) studies, is expected to have a positive or a negative association with CEO compensation. These conditions are supported by our empirical results. Finally, we document that our results are more pronounced when the peer relationship is one-way and the peer firm is in a different industry and therefore, arguably, more aspirational.

REVISION: Does it Pay to 'Be Like Mike'? An Empirical Test of Dynamic Relative Performance Evaluation
Date Posted:Sat, 20 May 2017 14:21:29 -0500
We provide empirical support for the widespread use of implicit dynamic relative performance evaluation (DRPE) in executive compensation. Consistent with the DRPE theory proposed in Hemmer (2016), we find that CEO compensation increases in the correlation between own and aspirational peer firm performances. In addition, we define and test conditions under which aggregate peer performance, which has been the primary focus of prior relative performance evaluation (RPE) studies, is expected to have a positive or a negative association with CEO compensation. These conditions are supported by our empirical results. Finally, we document that our results are more pronounced when the peer relationship is one-way and the peer firm is in a different industry and therefore, arguably, more aspirational.