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Managing Dynamic Relationships


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Iamdeeplyindebtedtomyadvisor,ProfessorJoelS.Demski,forhisguidanceandsupportalongmyjourneyoflearninginthePh.D.program.Hisfaithandpassionforscholarshiphavebeenthegreatestinspirationinthepursuitofmyacademiccareer.Hetaughtmemuchmorethanknowledgeandskills.Hetaughtmeaboutlife.IwishtothankProfessorKarlHackenbrackandProfessorJonathanHamiltonfortheirhelpthroughoutmystudyattheUniversityofFlorida.Iamgratefulfortheircommentsformydraftsandpatienceinreadingandreningmywork.IthankProfessorHaijinLinforherconstantencouragementandsuggestions.IhavealsobenetedfromdiscussionswithProfessorJohnFellingham,ProfessorDavidSappingtonandProfessorNathanStuart.Iwishtoexpressmydeepappreciationtomyfellowdoctoralstudents,especiallyMonikaCausholli,LiangFu,CarlosJimenez,RichardLuandAdamosVlittis,whohaveprovidedmewithwonderfulmemoriesattheUniversityofFlorida.Finally,Iamtrulythankfulformyhusband,YuanfangLin,forhispatience,understandingandencouragementineverystepofmydissertationwriting. iii

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page ACKNOWLEDGMENTS ............................. iii LISTOFTABLES ................................. vi LISTOFFIGURES ................................ vii ABSTRACT .................................... viii CHAPTER 1INTRODUCTION .............................. 1 2LITERATUREREVIEW .......................... 5 2.1DelegatingDecisionRights ....................... 5 3THEONE-PERIODMODEL ........................ 19 3.1TheRoleofCommunication ...................... 19 3.1.1TheModel ............................ 19 3.1.2ContractingwithFullCommitment .............. 22 3.2TheRoleofAuditing .......................... 26 3.3Summary ................................ 27 4THEDYNAMICMODEL .......................... 28 4.1Fullrevelation .............................. 34 4.1.1ContinuationContractwithFullRevelation .......... 35 4.1.2Ex-AnteContractsthatareConsistentwithFullRevelation 36 4.2PartialRevelation ............................ 39 4.2.1Benchmark:NoAuditCasePPna 39 4.2.1.1Continuationcontractswithpartialrevelation ... 39 4.2.1.2Ex-antecontractsthatareconsistentwithpartialrevelation ....................... 42 4.2.2TheOriginalProblemPP 45 4.3TheOptimalInformationFlow .................... 46 4.4Summary ................................ 47 5UNVERIFIABLEINFORMATION ..................... 49 5.1TheInvestmentProblem ........................ 50 iv

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...................... 52 5.3Summary ................................ 55 6CONCLUSION ................................ 57 APPENDIX:THEPROOF ............................ 61 REFERENCES ................................... 77 BIOGRAPHICALSKETCH ............................ 82 v

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Table page 3{1Audittechnology ............................... 26 4{1Comparingthecontrolcost ......................... 46 vi

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Figure page 2{1Thegeneraltimeline ............................. 7 3{1Thetimelineinafullcommitmentsetting ................. 22 4{1Timelinewhenrenegotiationispresent ................... 30 4{2Theindierencecurve ............................ 41 5{1Timelinewhenunveriableinformationisobserved ............ 53 vii

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Thisdissertationinvestigatestheroleofinformationinlong-termmanagerialinvestmentdecisions.Theregulatoryenvironmentofnancialreportingandauditingdictateshowinformationiscommunicatedandthushasasignicanteectonmanagerialbehavior.Standardsetterswhobelievethatthegoalofnancialreportingandauditingisonlytomaintainaccuracysimplifytheanalysisandoverlookthefactthatmanagersarerationaleconomicagents.Enlargingtheusefulinformationset,wetheninvestigatetheroleofunveriableinformationinmanagerialinvestmentdecisions.Contractrenegotiationisservedasamechanismtomakeuseofnewlydiscoveredinformation,evenifitisunveriable.Itisecienttotaketimelyinformationintoconsiderationinalong-termcontractingrelationship. viii

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Financialreportsarecommunicationsbetweenmanagersandinvestors.Wheninvestorsdelegatedecisionrightstomanagers,thereisademandforinformationaboutmanagers'action.Atthesametime,howinformationisreportedaectsmanagers'incentivestofullltheirresponsibilities,whichinturnaectstheunderlyingresourceallocation.Forexample,giventhewidespreadconcernforaccuracyofnancialreportsinthepost-Sarbanes-Oxleyenvironment,managersrespondbyabandoningaccountingtreatmentbutresortingtorealbusinessdecisionstomanagerearnings,asdocumentedinarecentsurveypaper(Graham,HarveyandRajgopal[2005]).Managersmaydelayaprotableprojectbecauseitrequiresanimmediateinjectionoffund,whichcanlowerthecurrentearnings.Apparently,therulesonnancialreportingandauditingchangethepreparers'behavior.SincemostbusinessactivitiesintheUnitedStatesarecarriedoutininvestor-ownedbusinessenterprises,howtheinformationismeasuredfornancialreportinghasasignicantimpactonthewelfareofeconomy.Measurementitselfchangesthebehaviorofthesubjectthatisbeingmeasured. SomeissuedandproposedFASBstatementshavebeencriticizedfortheirdysfunctionaleectsonresourceallocation.Forexample,criticsofStatementNo.8(replacedbySFASNo.52)contendthattheinclusionofgainsandlossesfromtranslationofforeigncurrencymayforcecompaniestoengageinuneconomicalhedgingtransactions.Amongalltheconcerns,themostsignicantcausemaybemanagers'incentivestructureispreoccupiedwithshort-termnancialresults.Thecompany'sinterimnancialinformationisreviewedbyauditors(SeePCAOBAuditingStandardNo.1).Someevenarguedthatthetimeforcontinuousaudit 1

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hascome,whichallowsusingnancialinformationwithauditedreportinrealtime(SeeSearcyandWoodroof[2003]).Wheninvestmentoutcometakesalongtimetorealize,however,periodicnancialreportingandauditingchangemanagers'incentivesinmakingproperinvestmentdecisions.Manyofthenancialreportingrulesorauditproceduresseemtoignorethedynamiceectofmanagers'decisions.Forexample,auditorsareinstructedtomakesureallamountsarecorrectlyincluded(thecompletenessobjective)andtransactionsarerecordedintheperiodwhentheyactuallytookplace(thecutoobjective)(Arens,Elder,andBeasley2005).Whiletransactionsreectmanagers'long-termperspectiveindecisionmaking,therelatedreportingissuesshouldalsobecarefullyaddressed.Otherwise,themisalignedmanagerialincentiveswilldrivethermtooperateataninecientlevel. Thisdissertationhighlightstheeconomicsubstanceinevaluatingrulesofnancialreportingandauditing.Dierentaccountingsettingscannotbeunderstoodwithoutconsideringtheeectonmanagerialactions.Moreover,theuniqueroleplayedbyaccrualsforcesustounderstandaccountingfromamulti-periodperspective.Theeectfromdynamicplanningaddsmoreconcernstostandard-setting,becausethestandard-settersarenotregulatingnaturebutarerationaleconomicagents. Thisconcernraisesquestionsaboutthezealouspursuitinaccuracyofnancialreports,especiallytheconceptof\neutrality".Neutralityisdenedas\absenceinreportedinformationofbiasintendedtoattainapredeterminedresultortoinduceaparticularmodeofbehavior."(FASBConceptsNo.2)Inasettingwithsymmetricandperfectinformation,suchabiascanbeeasilyremovedandeachparty'sbehaviorcanbecostlesslymonitored.Inothertimes,reportingstandardsaecttheparties'incentivestocommunicatetheunobservableinformation,whichinturnsaectstheparties'incentivestoperformtheirduties.Reporting

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standardsareboundto\induceaparticularmodeofbehavior".Anaiveviewofstandard-settingwillcausetheeconomytoperformataninecientlevel. Theplanofthestudyisinthefollowingorder.InChapter2,Iselectivelyreviewthehistoricalandcontemporaryliterature.Threelinesofliteratureareexplored:rst,delegatinginvestmentdecisionstomanagers;second,dynamicconsiderationsforstandard-setting;third,theauditfunction. InChapter3,Iintroduceasingle-periodmodelthatstudiestheroleofcommunicationandauditing.Eventhoughthemodelisabstractedfromanydynamiceect,ithelpsansweringthefollowingquestions:First,whyinvestmentdecisionisdelegatedandwhatproblemscouldthiscausetoinvestors?Second,whatkindofinformationcaninvestorsobtainfromnancialreportsandiscommunicatingtheinformationhelpfultosolvetheproblems?Third,forpubliccompanies,arelatedissuewithnancialreportingisthatthereportedinformationisaudited,whatisthevalueofauditing? InChapter4,adynamicmodelisstudied.Whentherearelonglagsbetweenthemanager'seortandtheproject'snaloutcome,reportedinformationcanbeusedforotherpurpose.Forexample,themanager'scontractissubjecttorenegotiation.Renegotiationoccursaslongastherearemutualgainsfromrevisingthecontract.Thedisclosedinformationwillbeusedinthefuturewhenpartiesstarttodiscussthemanager'scompensationpackage.Anticipatingthat,themanagerchangeshisinitialmotivations. InChapter5,arelatedproblemishowtoimplementoptimalinvestmentpolicy.Previouslywefocusonusingrevelationmechanisms(communication)tomotivatethemanager.Nowwefocusesonusingobservedinformationtodesignrightincentivestructures,eventheinformationisnotveriable.Inthischapter,wedonotconstrainourunderstandingofmanagerialinvestmentbehaviorbyreading

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nancialreports(wearedealingwithunveriableinformation).Weinvestigatethelargelibraryofaccountinginformation. InChapter6,Isummarizethemainresultsofthedissertationandprovidedirectionsforfutureresearch.

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Itappearsthatthetraditionalagencytheorywouldsucetoexplaintheproblem,becauseitsharesasimilarfeaturewhenaconictofinterestexistsinagency:theagenthasincentivetoshirk,becauseexertinghighereortingatheringinformationincurshigherdisutility,andhiseortisnotobservabletotheprincipal.Butthenewproblemismoredelicatebecausetherearetwoseparatedecisionsneedtobemade:thedecisionforinformationacquisitionandforproduction.Whethertodelegateonlytheinformationacquisitiondecisionorbothtotheagentgeneratesastreamofrelatedresearchquestions,particularlywhenthecollectednewinformationisonlyobservabletotheagent.Forexample,theprincipalmightwanttodelegatetheproductiondecisiontotheagentaswell,ifitiscostlytocommunicatetheagent'sprivateinformationtotheprincipal.Itseemstobemoreecienttohandoverthedecisionrighttothebetter-informed.Butbeingprivatelyinformed,theriskaverseagentmightseekaproductionlevelinhisowninterestotherthantheriskneutralprincipal's.Thenthereissomespillovereectbetweenmotivatinginformationacquisitionandmotivatingproductiondecision.Thespilloverbetweenthetwoactivitiescouldbecomesoseverethattheprincipal 5

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wouldnditoptimaltoexplicitlyallowsomeunderinvestmentoroverinvestmentinproduction,inordertomotivatetheagentmoreecientlytoacquireinformation.Theseconcernsaretermedinducedmoralhazard,whichhighlightsthetensionbetweenthetwocontrolproblems.Thatiswhysometimesitisnotworthwhileatalltomotivateanyinformationacquisitionactivities,eveniftheinformationisuseful.Iwillexplorevariousrelatedsettingsintheliterature.Whilesomelettheagentchoosehiseortingatheringinformationasmentionedabove,otherstreattheinformationsystemasexogenouslyendowedtotheagent.Buttheyareallconcernedwithhowthevaluableinformationshouldbeutilizedindecisionmaking. Beforeweproceed,let'sintroducesomecommonnotationsandassumptionsintheliterature: C()=theagent'scostfunctionsfromexertingeortineithergatheringinformationorproduction.C0()>0;C00()>0.(Theagent'sutilityfunctioncanbeadditivelyormultiplicativelyseparableinwageandeort)

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ContractingAgent'seortAgentInvestingeortOutputI(x;m())ingatheringobservesinproductionisobservedinformation,signal()e()x Thegeneraltimeline ConroyandHughes[1987]areamongtherstwhoaddresstheproblemofhowtomotivatetheagenttoacquireinformation.Theyincludeseveralimportantassumptionsbesidesotherclassicalassumptionsintheirmoralhazardmodel:(1)theacquiredinformationbytheagentispubliclyobservable;(2)theprincipalretainstherighttotaketheproductiveeort,uponobservingtheagent'scollectedinformation;and(3)highereortingatheringinformationispreferredbecauseitshiftstheexpectedoutcomexfromproductiontotherightinthesenseofrst-orderstochasticdominance.Therstassumptionputstheextracontrolproblemduetoasymmetricinformationtosilence.Sotheonlyfocusisthemoralhazardconcerninexertingeorttoacquireinformation.Giventhattheacquiredinformationisveriable,itismoreecienttolettheprincipaldecidetheproductionlevel.Thesecondassumptioneasesthemoralhazardconcernwithrespecttoproductiveeort.Thethirdassumptionimpliesthatthefocuseortcanberankedinthesamewayasinconventionalagencytheory.Thethreeassumptionsmaketheirresultssimilartotheconventionalagencytheory.Theconventionalagencytheory'sfocusonmotivatingtheproductiveeortehasbeenshiftedtomotivatingtheinformationgatheringeortonly.Theirmodelisdistinctfromotherworksinthisareainthattheagentcannotobserve.Hiseort

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canonlylethimobserveasampleoutcomey,whichisnotasucientstatisticoftheunderlyingstate.Themainresultis,ifandonlyiftheproductionoutcomexisconditionally(ony)informativeabouttheagent'seort, Penno[1984]directlyaddressedtheeectofthepre-decisionasymmetricinformationinsidetherm,whentheagentisdelegatedtoconductaproductivedecision.Thenthedeeperquestioniswhethertheagentshouldbegrantedsuchanaccesstoprivateinformationpriortoaction.Hismodelassumestheagent'sprivateinformationisexogenouslyendowed.Althoughtheprincipalcandesigntheinformationsystemonlyaccessibletotheagent,theagentisnotendogenouslymotivatedtoacquirethisinformation.Thatis,referringtoourtimeline,thestepatt=1isomitted.Theagent'sinformationishiseort'smarginaleect,indicatingtherandomworkingenvironment.Forexample,theinformationcouldbethepotentialmarketdemand:ifthedemandisrathersluggish,investingmuchinmarketingactivitiesisuseless;thereliabilityofmachinery,whichiscrucialindecidingtheeciencyofanyproductiveeort.Specically,theeectoftheinformationisperfectsubstitutefortheagent'seortf(xj;e)=f(xje):iftheagentobservesasignalindicatingthathighoutputwillprobablyoccur,itisnotnecessaryforhimtoworkhardinordertoachievethegoal.Forthatexactreason,theprincipalmightnotbewillingtolettheagenthavesomesuperiorinformationthanherself.Ontheotherhand,theinformationcanalsohelptheagentreduce

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eortwhenthereisalmostzeromarginaleectforhiseort,whileincreaseeortwhenitsmarginaleectishigh.Thepaperdemonstratesthatiftheprincipalcancostlesslyprovidepartitionontheinformationsettotheagent,astrictParetoimprovementwilloccur. Themainresultis,assumingtheoptimaleorteinducedbytheoptimalcontractundersymmetricinformation(noprivateinformationisaccessibletotheagent),andtheprincipalcancostlesslydesignthepartitionontheagent'sprivateinformationset,thenthereisapartitionon:[0; ],suchthatastrictParetoimprovementwilloccur.Theintuitionisasfollows.Considerthispartition:f[0;];(; )g.Foranarbitrarilysmall,theagentsavesonhiseortfrometo0ifheknew[0;]realizes;buthiseortuponobserving(; )increases,whichincreasestheprincipal'sexpectedutility.Theneteectistoincreaseexpectedproduction.Thus,providingpartitiontotheagentimprovesthetotalwelfare,evenitisonlyobservabletotheagent. Amajorassumptionhereisthattheprincipalisabletodesigntheinformationsystem,whichisalittleatoddswiththeissuethattheinformationisonlyobservabletotheagent,nottheprincipal.Inanotherwords,theprincipalcancontrolhowmuchtheagentknows,butshecannotobservewhattheagentknows.Itseemsthattheagentusuallyhasmuchmorebroadchannelsthantheprincipalinordertoknowthedetailsofproductionenvironment.Thecontrolproblemthattheprincipalfacesoriginatesfromtheagent'ssuperiorknowledge.Iftheprincipalcancontroltheagent'sknowledge,theproblemisalleviated.Therefore,whethersomeinformationasymmetryshouldbecreatedintentionallyinorganizationsdeservesmoreattention. Lambert[1986]studiedamoresensiblesettingwheretheagentneedstoexerteorttoacquireusefulinformation.Basedonobservedinformation,theagentismotivatedtomakeaproperinvestmentdecision.Iftheagentinvests,

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theprojectreturns(randomly)eitherahighcashow
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andtoexertaneorttoimplementtheproject.Whethertheagentinvestsiscontractible;theothertwodecisionsarenotobservable.Theagent'seortingatheringinformationtoevaluatetheproject,,iseither0or1,withcostcifheworks.Hisimplementationeortise2(0;1],withcoste.xT=X(eT)isthetargetchosenbytheprincipal,i.e.,eTisdeterminedendogenously.Iftheprojectisundertaken,theoutcomeisafunctionofboththeprojectqualityandtheagent'simplementationeortx=X(e),2f0;1g.Theagent'seort=1allowshimtoobservetwodistinctsignalsgorb,whichisinformativeabouttheprojectquality.Itisassumedthattheprincipalinducestheagenttoinvestwhengrealizes,andrejecttheprojectwhenbrealizes.Theinformationgorbisnotobservable. Thecontractdependsontheoutcomeandinvestmentdecision.Sincethereareonlytwosignals,andaseparatingequilibriumisassumed.Theagent'sprivateinformationisfullyrevealedbyhisobservableinvestmentdecision.Forthesamereason,thereisnoproblemofunderinvestmentoroverinvestment(incontrastwithLambert[1986]).Sotheonlyspillovereectinthismodelisbetweenmotivatinginformationacquisitionandprojectimplementatione. Thepapershowsthatiftheconcernofmotivatinginformationacquisitiondominatestheconcernofmotivatingprojectimplementation,theriskimposedontheagentforthepurposeofmotivatinginformationacquisitionissucienttomotivatehimtoexerthigheortinprojectimplementation.Thenanyinformativemeasureoftheimplementationeortisredundant.Thestudyoersanotherviewwhyrmsoftendisregardsomeinformativeperformancemeasuresinevaluatingtheirmanagers. Anotherinterestingresultisthatmotivatinginformationacquisitionisnevergratuitousevenwhenspilloverbetweenmultipletasksispresentinsidetherm.Imposingrisktomotivatetheagenttoworkdiligentlyinprojectimplementationwillnotautomaticallyoertheagentenoughincentivetoacquireinformation

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beforehand.Itisalwaysmoreecientfortheprincipaltoexplicitlymonitortheagent'seortininformationacquisition.Innextchapter,Ishowanauditofnancialreportsprovidessuchmonitoringtomotivatetheagenttobecomeinformed. 2.2Dynamicconsiderationsforstandard-setting Standardsettersbelievetheprimaryroleofnancialreportingistofacilitatedecisionmaking.\Financialreportingshouldprovideinformationthatisusefultopresentandpotentialinvestorsandcreditorsandotherusersinmakingrationalinvestment,credit,andsimilardecisions."(FASB,ConceptsStatementNo.1)Therefore,accuratenancialreportsmaybemoreuseful.Althoughitistrueforasingledecision-maker|aninformationsystemispreferredtoitsBlackwellgarbling,itisgenerallynotthecasewhentherearemultipleplayersandthegamelastsmorethanoneperiod.

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seemtocareenoughabouttheeconomicfoundationforstandard-settingsuchasthedynamiceectdrivenbyrationalexpectation.Accountingpoliciesseemtobeshort-termoriented.Attentionshavebeenfocusedonproducingaccurateandreliablenancialreportsatanysnapshotoftime,whichisatoddswiththegoing-concernassumption. Amongotherearlyworkondynamicconsiderationforaccountingpolicies,Christensen,DemskiandFrimor[2002]studiedaccountingpolicieswherecontractsaresubjecttorenegotiation.Renegotiationaectsdynamicusesofinformation.Thedisclosedinformationwillbeusedinthefuturewhenpartiesstarttodiscusstheagent'scompensationpackage.Anticipatingthat,theagentchangeshisinitialmotivations.Inatwo-periodmoralhazardsetting,aperfectaccountingsystemcausestheagent'sincentivestocollapseasinFudenbergandTirole[1990].Theintuitionisasfollows.Oncetheagenthasexertedeort,itisecienttoprovidetheagentwithcompleteinsurance.Foreseeingthathiseventualpaymentwouldbeindependentoftheoutcome,theagentwouldthenprefertochoosethelowestfeasiblelevelofeort.However,otherregimesthatallowtheagenttomoveoutputfromthersttothesecondperiodprovidehimincentivestoworkintherstperiodbecausetheagent'seortcreatesreservesthatwillberewardedinthesecondperiod.Thepaperexaminestheeectofdierentaccountingpoliciesontheagent'srst-periodeort:perfectaccounting,aggregateaccountingandconservativeaccounting.Theresultemphasizesthatpolicy-makersarenotonlyconcernedaboutmakingagoodchoicebutalsoconstrainedbythefactthatplayersarestrategicinmakingtheirchoicesaswell. GiglerandHemmer[2004]comparedtworeportingregimesontheinformationabouttheagent'spastaction,whencontractrenegotiationisconsidered.Twoperformancemeasuresareconsidered:early-revealedinformation(y)andlate-revealedinformation(x).Thelateinformationispubliclyobservable.But

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theearlyinformationcaneitherbemadepublicbyatransparentregime,orbekeptprivateunderanopaqueregime.Sotheprincipalhastorelyontheagent'sself-reportonyunderanopaqueregime.Iffullcommitmentisachievableincontracting,transparencyiscertainlypreferred,becauseitisusuallyextracostlytoinducetheagenttoreporttruthfully.Butrenegotiationmakestheproblemmoresubtle.Renegotiationtendstomakethecontractrelymoreontheinformationrevealedbeforerenegotiation,becausetheinformationrevealedafterrenegotiationbecomeslesscredible.Iftheagent'shigheortismotivated,theinsuranceopportunityfromusingthelater-revealedinformationislost.Thecontractdoesnotreferencethelateinformation.Attherenegotiationstage,theagent'seortissunkandtheprincipal'sonlygoalistoreducecompensationcostbyloweringriskpremium.Shewillthenoerafull-insurancecontractgiventheinformationobservedbeforerenegotiation.Thatis,theagent'sincentivecanbeprovidedonlythroughashort-termcontract:ontheearly-revealedinformationyonly.Thisopensadoortoanopaqueregime,wheretheagent'sinformationiskeptprivatebeforerenegotiationandisonlyrevealedattherenegotiationstage.Thus,thelater-revealedinformationcanbeused.Itisusedtoinducetheagenttoreporthisprivateinformationtruthfullyattherenegotiationstage.Sincenomorerenegotiationisallowedafterward,theRevelationPrincipalapplies.

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oerstheprincipalextraincentivetoreferencethelateinformation.Thusbothinformationcanbeusedinthecontract,loweringcompensationcost. Twostudiesonrenegotiationareincludedheretodemonstratethedynamicconcerns.Renegotiationallowstheprincipaltomoveagainbasedonherobservationatsomeinterimstage.Anticipatingtheprincipal'smove,theagentreviseshiscurrentchoices.Dynamicconcernsarealsopresentinotherscenarios.Forexample,BaimanandRajan[1995]studyasettingwithincompletecontracts. 2.3Auditing Auditingisanattestationservice.Todoanaudit,theremustbesomeinformationtobeattested.Somecommunicationproblemsmustbepresentfortheauditortoverify.Financialreportsarecommunications.Itimpliesweneedtoconsideratleastthreepartiesinordertostudyauditingquestions:investors,themanagerandtheauditor.Theincentiveinteractionsamongthethreepartiesgiverisetothedemandofauditing.Ontheonehand,itisimportanttorecognizetheareaofauditingiscloselyrelatedtotheareaofnancialaccountingandcertainlycannotbeisolatedwithmanagerialincentives.Ontheotherhand,wendthatinliteratureitisdiculttoendogenizethethreeparties'behavioralltogether. Antle[1982,1984]usesamulti-agentmodeltostudytheroleofcommunicationandauditing.Investorshireamanagertoperformdutiesthataecttheoutcomeoftherm.Investorshireanotheragent|theauditor|toengageinsomeinvestigativeactionaboutthemanager.Thecontractibleinformation(e.g.,earnings)isobservabletothemanageronly.Therefore,withoutanauditor,themanagerwouldnothaveincentivestoperformhisdutiessincehecanreportwhateverisinhisbestinterest.Theauditorexertseorttoverifythemanager'sself-reportb,observessomeinformationAandissuesareportbA.Themanagerandtheauditorchoosetheiractionssimultaneously.Theprincipal's(investor's)goalistodesignthecontractsusingbothagents'reportstomotivateeachother.

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Iftheauditorworksandtruthfullyrevealsherobservation,herreportshouldbeconsistentwiththemanager's.Likewise,thepaymenttothemanagershouldbesethigheriftheauditor'sreportconrmshisreportandtheoppositeholdsifthetworeportsconict.Thethree-playerframeworkisusefultovisualizetherelationbetweeninvestors,themanagerandtheauditorandisalsowidelyusedinpractice.Nevertheless,themodelisnottractableenoughtoincorporatethatside-paymentscanbetransferredfromthemanagertotheauditor.Auditor'sindependenceispresumedinthattheauditorisabletodenyself-interestedbehaviorcompletely.Antle[1982]noted,\ModelingtheauditorasaplayeropensaPandora'sboxofmethodologicalproblems."Again,themodelisagoodbenchmarktoembarkonauditingissues,butmorequestionsneedtobeanswered.Forexample,lawrequiresnocontingentfeesbepaidtoauditors;withthemanager'sreportabsent,whatmechanismcanprovidetheauditorwithincentivestowork? Baiman,EvansandNoel[1987]alsosetupathree-playergamebutthesequenceofeventsisdierent.Theauditoratteststothemanager'sreportafteritisissued,sotheauditor'sreportisconditionalonthemanager'sreport.Oneoftheresultsisthatthereexistsnoequilibriuminwhichthemanagerreportsfully.Thisisbecauseiftheauditorknowsthemanager'sreportiscorrect,shewouldnotexpendeorttoauditit.Themanager'smisreportingbehavioristoleratedonlytoprovidetheauditorwithincentivestowork.Fortractability,themanagerismodeledtotakenoproductiveactionandhisonlyjobistoreporthisobservation.Thepurposeofthemodelistoshowtheroleofauditorasa\utility-maximizingagent",butthemodelseemstobetoofocusedontheauditorwhileoverlysimpliesthemanager'sbehavior. Manyotherworkscircumventthemodelingimpedimentbyfocusingontheinteractionbetweentwopartiesonly,leavingthe\unimportant"issuesexogenous.FellinghamandNewman[1985]studiedanauditor-managergame,wherethe

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managerchoosestheeorttoreducetheprobabilityofamaterialerrorandtheauditorchooseswhethertoextendauditprocedures.Thetwoplayersmovesimultaneously.Thefocusofthepaperistoshowtheauditorshouldconsidertheauditriskmodelstrategically.Themanager'sbehaviorisinuencedbyhisconjectureoftheauditor'sactionandviceversa.Relyingonsingle-persondecisiontheory,theauditorendedupwithincorrectevaluationofauditrisk.Themodelishighlystylizedbutitisamongthersttopointoutthatasuccessfulauditreliesonathoroughunderstandingofmanagerialincentives.Inaddition,thepapershowsthattheauditormayfrequentlyusearandomizedstrategy.Thatis,themanagercannotpredictwhattheauditorwilldoandhecanonlyguesstheauditor'sstrategyprobabilistically.Anecdotalevidenceshowsthatmanyauditfailuresareduetopre-determinedanalyticalprocedures,becauseitiseasyforthemanagertoplanaccordingly.Strategicconsiderationsareindispensabletostudyauditingissues. Leavingnancialreportingproblemsunmodeled,AntleandNalebu[1991]focusedonthenegotiationprocessbetweentheauditorandmanager.Financialstatementsshouldbereadasajointoutputfromtheauditor-managernegotiation.Theusersonlyseethenalnegotiatedoutcome.Whetherconservatismreignsinthenaloutcomeisunclearevenwhentheauditorstartswithaconservativegesture.Themanagerhassuperiorinformationandheonlyprotestsunderstatements.Thepapershows,withacost-sharingcontractdesignedtomaximizejointauditor-managersurplus,theexpectedexpostbiasisalwaysupward. Cuccia,HackenbrackandNelson[1995]studiedtheabilityofprofessionalstandardstomitigateaggressivereporting.Althoughtheexperimentwassetinataxsetting,theissueseemstobemoregeneraltoallreportingbehavior.Thepapershowsthatpractitionerswillinterpretmoreliberallyavagueprofessionalstandardinordertojustifyaggressivereportingwhileinterprettheevidencemoreliberally

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whenfacingamorestringentstandard.Theresultsareintuitivetocapturethepractitioners'intentionstoexploitdiscretionembeddedinprofessionalstandards.Butwhythepractitionersalwayschoosetoreportaggressivelyisnotclear.Thepractitioners'incentives(forexample,resultedfromcompensationpackage)arenotexplicitlystudied. 2.4Summary Inthischapter,Iselectivelyreviewedtheliteratureinthreeareas:Delegatingdecisionrights,Dynamicconcernsforstandard-settingandAuditing.Westartwiththeroleofnancialreporting,approachingfromamanagementstewardshipperspective.(FASB,ConceptsStatementNo.1)Wheninvestorsrelyonamanager'sexpertiseanddelegatesomedecisionstothemanger,thereisademandforinformation.Communicationisvaluableespeciallywhenthemanagerendogenouslyacquirestheinformationanduseittomakeaproductiondecision.Apparently,nancialreportingandauditingstandardsthatgovernthecommunicationprocessaectmanagerialdecision-makingandhaveprofoundconsequencesonunderlyingresourceallocation.Ponderingonmanagerialdecision-making,weraisesomeconcernsforperiodicnancialreportingandauditing.Dowepursueanaccuratenancialreportingsystemoradynamiccommunicationprocess? Thevalueofauditingisdirectlyrelatedtothevalueofnancialreporting.Theliteraturerevealsthedicultytoincorporateinterestedparties(investors,themanagerandtheauditor)endogenously.Italsopresentsustheopportunitytopractisetheartofmodeling.Weemphasizeontherst-ordereects:theremustbesomereportingproblemsthatauditingcanhelpalleviate(theendogenously-createddemandforauditing)andtheremustbesomestrategicconsiderationsinauditing.Thenanothertoughchoicehastobemade.Dowefocusonthemanager'sstrategicconsiderationsortheauditor's?

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19

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(randomly)eitherahighcashow
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reservationutilityleveliser0=1.Let(U)betheinversefunction,thatis,theprincipalwillpaytheamountofI=(U)=1 Theoptimalinvestmentpolicydeservessomeexplanations.Irestricttheanalysistothecaseswheretheprincipalprefersthatthemanagerselecttheriskyprojectonlyif1or2isobserved.Thatis,iftheprincipalcaneitherobservethemanager'seortorthemanager'scollectedinformation(therst-bestscenario),thisinvestmentpolicywillreturnthelargestexpectedcashow. Condition1.2 >x>3 Tocapturetheideathattheinformation-discoveringactivitiesarepervasiveinpractice,Ifurtherassumethatacquiringinformationisalwayspreferred,thatis,higheortHisalwaysmotivated. >>x>>3

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indicatedtheprojectisnotprotable,ordidhesimplymakethedecisionwithoutsearchingforinformation?Theprincipaldoesnotknow,either,whetherthemanagerfollowedthedesiredinvestmentpolicy,becausetheprincipalcannotobservetheinformationthemanageractedupon. Thetimelineinafullcommitmentsetting Themanager'seortisnotpubliclyobservable,noristhecollectedinformation.Themanagerobservesthesignalandhastheauthoritytomaketheinvestmentdecision.

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underadirectrevelationmechanismonly(Myerson[1979],HarrisandTownsend[1981]).Themanager'scompensationiscontingentontherealizedcashow(ex)andhisreportonthereceivedsignal(b).Therearevepaymentlevels| Themanagerismotivatedtoexerthigheort,sohisexpectedutilityisEU=erc[P11 U2;U Subjectto: (1)EUm U1+(1m)U U2+(1m)U

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Inequality(1)istheIRconstraint;inequalities(2)-(4)aretheICconstraintsforeortselection.Ifthemanagerdecidestoshirk,hecandisguisehisbehaviorbyclaiminghereceivessignal1,2or3,buthecannotreallyobservethesignalsohehastorelyonmtoevaluatehisexpectedutility.Inequalities(5)-(10)aretheICconstraintsforeachmanagertypetoreporthisinformationtruthfullyafterhavingexertedtheeorttoacquirethatinformation.Noticethattheproblemofmotivatingthemanagertoinvestproperlyhasbeenreplacedwiththeproblemofmotivatingthemanagertoreporttruthfully.Thisisbecausetheinvestmentdecisionisobservableandthuscanbeenforcedbasedonthereportedinformation. Thecontractshouldnotonlymotivatethemanagertoinvestproperly,butalsomotivatehimtoacquireinformation.Lemma1showshowthemanager'sincentivesinthetwotasksinteract.TheintuitionissimilartoLambert[1986].Whentheprojectisexpectedtoberelativelymoreprotable,thatis,m>2,(themeanisabovethemedian.)themanagerwouldalwaysinvestifhedidnotacquireanyinformation.Thisisbecausetheadvocatedinvestmentpolicy12j3encouragesinvestingatanysignalrealizationbetterthan3butnowtheexpectationmisalreadyabovethecutoinvestmentlevel.Thus,themanager'so-equilibriumbehavior(i.e.,whenheshirks)istoclaimhereceivedsignal1or2,sothatheisjustiedtoinvest.Thismeansconstraints(2)and(3)arebinding.

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Therefore,theprincipalhastodesigna\lessattractive"contracttoalleviatethemanager'stemptationtoinvest.Sheequatesthecontractfortheinvestingtypetothenon-investingtype,thatis,type2receivesthesamepaymentastype3, Themanager'sincentivesaredierentwhenthepriorisopposite,thatis,m2(themeanisbelowthemedian.)Inthiscase,ifthemanagerdecidestoshirk,heisnotclearaboutwhethertoinvestorrejecttheprojectbecausemisbetween2and3.Constraints(3)and(4)arebinding.Ifthemanagerinvestswithoutcollectinganyinformation,thereisahighprobabilityhemightbewrongbecausetheprojectisnotveryattractive:m2.Ifthemanagerrejectstheprojectwithoutcollectinganyinformation,hischanceofbeingcorrectisalsoslimbecausehemaymisstheinvestmentopportunityintwopossibleevents1and2.Therefore,withlessconcerntomotivatethemanagertoacquireinformation,theprincipalcanimposeriskonbothtype1andtype2. Finally,weneedtoconrmthereisnobetterinvestmentpolicyinthesecond-bestsetting.Theprincipalcanchoosetoinduceinvestingintheprojectonlywhenthemanagerreceivesthebestnewsandforgotheprojectotherwise,thatis,policy1j23.Thecontracttoimplement1j23consistsoffourpaymentsf

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Table3{1. Audittechnology Approve Disapprove Themanager'sreportistrue 1 2)and2(0;1 2)sotheauditor'sreportisinformativeaboutthetruestatusofthemanager'sinformation.

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Currently,itismandatorytoaudittheannualnancialstatementsforpubliccompanies.Withoutincurringextracosts,theprincipalcannotbeworseobyreferencingthecontracttotheauditor'sreport.Itissimplybecausetheprincipalmaintainsfullcommitmentpower,andshealwayshastheoptiontoignoretheauditor'sreportwhenoeringthecontractatthestartofthegame.Moreover,inthetwo-tasksetting,anaudithasstrictvalue.Ontheonehand,itveriesthemanager'sself-reportsothecontractbasedthereonforcesthemanagertoreporttruthfully.Basedonthe(truthful)information,thedesiredinvestmentpolicycanbeenforced.Ontheotherhand,thecontractthatreferencestheauditor'sreportprovidesthemanagergreaterincentivetobecomeinformed:ifthemanagerdidnotworkhardtosearchforinformation,hepossessednoinformation,sohehadtolieallthetime;buttheauditordetectslyingwithapositiveprobability.Aneectiveauditmakesthetwotasksbecomemorecomplementaryandthustheexpectedcompensationcostisreduced.

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Animportantissueishowtoauditthemanager'sacquiredinformation.Itmaynotalwaysbeecienttomotivatethemanagertoreportaccuratelywhatheknowsbecauseoftheincentiveissuesthatariseindynamicemploymentrelationships.Whentherearelonglagsbetweenthemanager'seortandtheproject'snaloutcome,themanager'scontractisfrequentlysubjecttorenegotiation.Iftheauditormotivatesthemanagertorevealhisinformationaccurately,inequilibrium,theinvestorswouldbeabletoinferperfectlythatthemanagerhasexertedeorttoacquireinformation.Atthefollowingrenegotiationencounter,thecontractwillberevisedtoprovidemoreinsurancetotheriskaversemanager,thatis,thepaymentswillnotvarywiththeoutcomeoftheproject.Foreseeingthatthenalcontractwillnotdependontheproject'soutcome,exante,themanagerwouldhavelessincentivetobecomeinformed.Sincerenegotiationoccursaslongastherearemutualgainsfromrecontracting,thistradefrictionitselfcanlimittheusefulnessofaccuratenancialreports.Unlesstheauditor'sreportishighlyinformativeaboutthemanager'sprivateinformation,itisnotbenecialfortheinvestorstoknowthemanager'sinformationfully.Arm'slengthrelationshipsmaybepreferredinthedynamicinvestmentgame. Asmentionedpreviously,fullcommitmentmaynotbearealisticscenario.Theremaybeseveralyearsbeforetheproject'soutcomeisrealized.Throughouttheinterveningyears,partiescanalwayschoosetotearuptheinitialcontractandopenanewcontract,aslongasbothpartiesagreetotherevision.Renegotiationthusentersourlong-termproject-investingstorynaturally. 28

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Renegotiationimpliesinterimoptimization.Fromanexanteperspective,theinterimoptimizationproblemmayaddconstraints,becausebothparties'expostincentivesneedtobeconsideredattherenegotiationstage.Theamountofinformationtoberevealedbeforerenegotiationaectstheinterimoptimizationproblem.Recallingthefullcommitmentcase(Chapter3),fullinformationrevelationismotivatedbecausetheprincipaloersacontractrstandcommitsherselftotherulesabouthowtheinformationisused.Withtheextraoptimizationproblem,wenowreexaminewhetherinformationshouldalsobefullyrevealed. Thetimelineisrevisedtoincludetherenegotiationencounter: Attheinitialcontractingstage,theprincipaloersacontract,C1,tothemanager,whocaneitheracceptorrejectthecontract.Ifthemanagerrejectsthecontract,thegameendsandbothgettheirreservationutility. Afterthemanageracceptsthecontract,hechooseseorttocollectinformation.Basedonthesubsequentsignal,themanagermakestheinvestmentdecisionv. Theinterimreportingstagecomesbeforerenegotiationtakesplace,whenthemanagercommunicateshisinformationtothepublic(bI)

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Atthenalreportingstage,ifthemanagerhasnotcommunicatedfullyhisprivateinformationattheinterimreportingstage,hecanelecttoreportitnow(bF).Theprojectoutcomeisrealizedandthemanageriscompensatedbasedonwhichevercontractisinplace. C1to()mentauditorC2orx.gatherdecisionveriesPaymentinfor-basedreport,mademationonissuesA Timelinewhenrenegotiationispresent Attherenegotiationstage,theprincipalmakesatake-it-or-leave-itoertothemanager. Onemayalsoconsideranothertimelinewheretheinvestmentdecisionismadeafterrenegotiation,thusaftertheinterimreportingstage.Thealternativetimelinedoesnotchangetheresultsqualitively,however.Fullinformationrevelationbeforerenegotiationwillrenderafullinsurancecontinuationcontractwhethertheinvestmentdecisionismadebeforeorafterrenegotiation,becausetheinvestmentdecisionisobservableandnofurtherincentiveconcernsareleftattherenegotiationstage.(DetailswillbeclearerafterIintroducetherenegotiation-proofcontract.)Moreover,thecurrenttimelineseemstobemoreplausible,sincetheinvestmentdecisionisdelegatedtothemanagerbutcommunicationoftenoccursatyear-end.4

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attentiontothecontractsthatarerenegotiationproof.Acontractisrenegotiationproofif,attherenegotiationstage,itminimizestheexpectedcompensationcostwhileleavingnomanagertypeworseorelativetotheinitialcontract.Thatis,thecontractisoptimalfromtheprincipal'sperspective,conditionalonherconjectureregardingthechoicesthemanagerhasmade.Thus,theprincipalwillnotchoosetoalteritattherenegotiationstage. Theprincipalchoosesacontinuationcontractbasedonwhatsheknows:observingthemanager'sinterimreportbIandtheauditor'sreportA,sheupdatesherbeliefaboutthemanager'sprivateinformationthroughPr(jbI;A).Ofcourse,theposteriorprobabilitydistributionPr(jbI;A)alsodependsontheprincipal'sconjectureregardingthemanager'seortandthedisclosurelevelenforcedbytheauditor. Sincetheinvestmentdecision(v=0or1)issunkandthedecisioncanbeperfectlyinferred,type1or2cannotbemixedwithtype3.

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Fortype1or2,whoinvested:2Xi=1Pr(ijbIj;Ak)[i( amongallthecontractsf( Fortype3,whodidnotinvest:(u3k) amongallthecontractsf(u3k)gthatsatisfyforany(bI3;Ak): Attherenegotiationstage,theprincipalchoosesamongtheincentive-compatiblecontractsthatwillbeacceptedbyeachmanagertype.Theinterimincentivecompatibilityconstraints(IIC)restrictthesetofcontractstothosethatinducetruthfulreportingfromthemanager,thatis,alltheprivateinformationwillberevealedatthenalreportingstage.TheRevelationPrincipleisinvokedherebecausethetimelinepresumesnomorerenegotiation.NoticetherearenoIICconstraintsforthemanagerwhoreceivedsignal3,becausenoasymmetricinformationproblemremains.(IICconstraintsareimposedfortype1or2,becauseenteringtherenegotiationstagetheprincipalmaynotbecertainaboutthesetwotypes.)Theinterimindividualrationalityconstraints(IIR)restrictthe

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possiblecontinuationcontractstotheclassinwhicheachtypeisoereda(weak)improvementinexpectedutilityrelativetotheexistingcontractC.IIRconstraintsaredenedrecursively.Ifnoneofthecontractslowerstheexpectedcompensationcostrelativetotheexistingcontract,C,theprincipalhasnoincentivetooeranyrenegotiation;hence,thecontractCisrenegotiationproof. Therefore,withoutlossofgenerality,weonlyconsiderrenegotiation-proofcontracts.Exploitingthisrepresentationdevice,therestoftheanalysisshowstheoptimaldisclosurelevelenforcedbyanauditor. Atthenalreportingstage,anyunreportedinformationwillberevealed,sothefocusishowmuchinformationshouldbedisclosedattheinterimreportingstage.Sincetheinvestmentdecisionissunk,thereareonlytworeportingrules:1.Themanagerismotivatedtoreportcompletelywhatheknows,ff1gf2gf3gg.Theauditorexamineswhetherthemanager'sreportistruthful.Thispartitionisdenotedasfullrevelation.2.Thetype3managerismotivatedtoreporttruthfullyasbI3,buttypes1and2aremotivatedtoreportthesameasbI1.Thustheprincipalwillknowthemanagerreceivedsignal3whenhereportsbI3,butwillnotknowthemanager'sinformationforsurewhenhereportsbI1.Inthiscase,theauditoronlyverieswhetherthemanager'sinvestmentdecisionisjustiedbasedonhisacquiredinformation.Thatis,theauditoronlyworriesaboutthemisstatementsthataecttheprincipal'sperceptionabouttherm'sinvestmentopportunities,andaminormisstatementbetween1and2istolerable.Denotethispartition,ff1;2gf3gg,aspartialrevelation.

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Intuitively,anauditenforcingfullinformationrevelationattheinterimstagecanbeharmful.Infact,themanagerneverdisclosesallofhisinformationbeforerenegotiationifthereisnoauditortoattesttohisreport. Themanagerknowsthatifherevealsallofhisinformation,thestoryendsthere:hehasacquiredinformationandinvestedaccordingtotheinstructedpolicy.Thereisnoincentiveproblemleftfortheprincipaltosolveattherenegotiationstage.Theprincipalwilloerafullinsurancecontract.Butknowingthenalcontractisafullinsurancecontract,themanagerwouldprefertheloweortinstead.

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Fortunately,wehaveanauditor.Asweshallseenext,themanager'sincentivetoacquireinformationiscompletelyprovidedbycontractingontheauditor'sreport. Givenanauditorandusingtherenegotiation-proofrepresentation,wecharacterizetheoptimalfullrevelationcontract.Sincethemanagerreportsallhisinformationbeforerenegotiation,noinformationisleftforlaterreporting,andthecontractonlyreliesontheinterimreport(bI),theauditor'sreport(A)andtheprojectoutcome(ex). subjectto: and: (u3k) subjectto Attherenegotiationstage,sixpossibleeventsmaybeobserved:(bI1;AT),(bI1;AF),(bI2;AT),(bI2;AF),(bI3;AT)and(bI3;AF).NotetheonlyconstraintineachinformationeventisoneIIRconstraint,andtherearenoIICconstraints.TheprincipalbelievesthemanagerhasmadetheproperstrategychoicesBT=(H;

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(11)EU[m U1T+(1m)U U1F+(1m)U (12)EU[m U2T+(1m)U U2F+(1m)U (13)EUU3T+(1)U3F (15)

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(17)U3T+(1)U3F (19)[3 (20) whereEU=ercf2Xj=1Pj(1)[j

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opportunitytoinsuretheriskaversemanager.Renegotiationreducestheeciencyofcontractingwiththeagent. Renegotiationaddsextraconstraints;however,andconsequentlytheexpectedcompensationcostwillbehigher.Pursuingfullrevelationbeforerenegotiationalsomakestheprincipalshort-sighted:thecontractputsalltheweightontheauditor'sreportandignoresthepotentialinformationcontentoftheinvestmentoutcome.Themanager'sincentivesareprovidedcompletelyfromtheauditor'sreport.Butcantheauditorliveuptosuchanexpectation?Thenextpropositionshowsitdependscriticallyontheaudittechnology. Proposition4impliesthattheaudittechnologydetermineswhetheritisbenecialtorevealtheinformationfully.Iftheauditerrorsarecloseto0,itisequivalenttoallowingtheprincipaltoobservethemanager'sinformationdirectly.Thecontrolproblembecomestrivial,therst-bestscenario.Butiftheauditerrors

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arelarge,theauditor'sreportisnotinformativeenoughtomotivatehigheort.Thedecisionabouttheprojecthastobemadewithoutinformation.Ifthisisthecase,theprincipalcanswitchtotheotherreportingruletomotivatethemanager. ifbI1isobserved:2Xi=1Pi subjectto

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ifbI3isobserved: (u3) subjectto NoticetheprincipaloerscontractCPnatoinduceatruthfulreportfromtype1andtype2:IIC-i;bI1.Thisistheonlyincentiveproblemfortheprincipalattherenegotiationstage.Asweshallsee,thisincentiveproblemisessential.Withoutit,afullinsurancecontractwillresultandthemanagerwouldnotexerthigheort(seeLemma3).Butnowtheprincipalhastoimposeriskinordertoinducetruthfulreporting.Therisk,fromlettingpaymentsvarywiththenaloutcome,canbesucienttomotivatethemanagertoexerthigheort. U2=U

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U2=U CPnaisthenrenegotiationproofifandonlyif 0( Theintuitioncanbegraspedfromthefollowinggure. Figure4{2. Theindierencecurve Theslopeoftheindierencecurveforthetype1manageris1

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type(2)butimposesomeriskonthehightype(1)inordertodeterthelowtypefrommimickingthehightype.Naturally,ifthelowtype'spaymentcouldbesethigher|fromI2toeI2|hewillhavelessincentivetomimicthehightype.Thustheriskimposedonthehightypecanbereducedfrom( subjectto (25)EUm U1+(1m)U U2+(1m)U

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0( (35) WhereEU=ercf2Pi=1Pi[i Inequality(25)istheAIRconstraint.Inequalities(26)-(28)aretheAICconstraintsforeortselection.Inequalities(29)-(32)aretheAICconstraintsforinvestmentpolicy12j3.Theseexanteconstraintsmakesurethattheprincipal'sexpostbeliefsattherenegotiationstageareconsistentwiththeagent'sstrategies.Noticethattheextraconstraintsresultingfromrenegotiationare(33)-(35). whenm>2,

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whenm2, 0( Takingintoaccounttheeectofrenegotiation,themanager'sexanteincentivesareasfollows.Sincenoriskisimposedontype2,type2andtype3mustreceivethesamepaymentU2=U3inordertoinducepolicy12j3.Fromtheeectofrenegotiation,U2=2 IfthecontractspeciedinProposition5doesnotsatisfytherenegotiation-proofcondition,theprincipalwillincreasetype2'spaymentandreducetheriskimposedontype1(RefertoFigure1).Thereducedriskontype1willnotbesucienttomotivatethemanagertoexerthigheort.If1iscloseenoughto1,however,therenegotiation-proofconditioncanbesatised.With1

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closeto1, 0( 0( Theprincipalcannotbehurtbytheauditor'sreport,althoughitisissuedbeforerenegotiation.Thisisbecausetheauditor'sreportisonlyagarblingofthemanager'sreportedinformation,andtheprincipalcannotobtainmoreinformationfromobservingtheauditor'sreport.Releasingtheauditor'sreportdoesnotcreateanincentivefortheprincipaltofurtherrenegotiatethecontract.Butitsreleasehelpstheprincipalmonitorthemanager'sinvestmentdecisionsandprovidesshort-termcommitmentbeforerenegotiationtakesplace,sotheauditor'sreportisvaluabletomotivatethemanagertoacquireinformation.(Recallthevalueofauditinginthefullcommitmentsetting.Theauditor'sreportisinformativeabout

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themanager'seort.Ifthemanagerdidnotacquireanyinformation,hehastolieandtheauditorcandetectlyingwithapositiveprobability.) UsingthesameparametervaluesofthenumericalexampleasinSection6.1.2,thetablebelowcomparesthetotalexpectedcompensationbetweenthetworeportingrules. Table4{1. Comparingthecontrolcost (;) (.2,.2) (.3,.1) (.4,.2) (.4,.4) 200.89 201.08 203.04 212.09 206.38 206.93 209.75 215.86 (.45,.45) (.45,.47) (.47,.47) (.49,.49) 250.08 278.21 341.28 1647.66 220.94 221.86 222.68 223.69

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Thetableshowsthatfullrevelationdominatespartialrevelationwhenandaresmall,butthecompensationcostincreasesdramaticallywhenandarecloseto0:5.Thecompensationcostfrominducingfullrevelationissensitivetotheaudittechnology.Whenauditaccuracyishigh,itiswisetousetheauditor'sreportfully,i.e.,theauditorisinstructedtocheckalldetailsofthemanager'sinformation.Butiftheauditaccuracyistoolow,thecompensationcostbecomesextremelylarge;ultimatelytheauditor'sreportbecomesuselesstoprovidethemanagerincentivetochoosehigheort. TheprooffollowsdirectlyfromPropositions4and5andLemma5. Parallelingtheauditor'sdecision,thisresultalsospeakssubtlytothevalueofearningsmanagement.Auditorsarelesslikelytorequireadjustmentofearnings

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managementattemptswhensomeinformationissubjecttomorediscretion.(SeeNelson,Elliott,andTarpley[2002].)Perhapsthisisbecauseallowingsomeinformationtobekeptprivatecanavoiddisruptingthemanager'slong-termobjective.Withholdinginformationarisesduetothejointeectoflong-terminvestmentplansandauditerrors.

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Inthischapter,weconsideralargersetofavailableinformationforinvestmentdecisions.Usefulinformationisnotlimitedtonancialreports.Informationthatcomestohelpcanvaryfromaformalmanagerialaccountingsystemtoawalkaroundthefactory.Oneproblemis,someoftheinformationisunveriable.Forinstance,inthedevelopmentofaproject,boththeprincipalandthemanagercommonlyobserveinformationbeforemakingthenextmove.Butevaluationoftheprojectbasedontheobservedinformationmaybesubjective.Itisnoteasytopresentsuchinformationtoathirdpartywithoutcausingambiguity,sothistypeofinformationcannotbeusedincontractingwiththemanager. Undersomecarefully-designedmechanisms,thistypeofinformationcanstillbeusefulfordecisionsevenifitisnotdirectlycontractible.DemskiandSappington[1991]provideaninterestinganalysisinwhichboththeprincipalandagentexertproductiveeort.Theprincipalobservestheagent'seort(theunveriableinformation)andhastheoptiontorequiretheagenttopurchasethebusinessatapre-negotiatedprice.Forexample,aretailerusuallycandiscernthequalityofaproductmanufacturedbyacorporationbeforesupplieseorttomarkettheproduct,andthecorporationhassucientfundtobuyouttheretailer.Theproblemcanbesolvedcostlesslybylettingthemanufacturerbuyoutthebusinesswhenevertheproductqualityisnotsatisfactory.BaimanandRajan[1995]studyasettingwhereonlytheprincipalcanobservetheunveriableinformationsosheissubjecttomoralhazardconcernswhenshepaystheagentbasedontheunveriableinformation.Onecleverwaytousetheunveriableinformationwithmultiple 49

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agentsistoallowtheprincipaltoallocatediscretionarybonusamongtheagentsbutthetotalbonuspoolisbasedonsomecontractibleinformation. Sincetheacquiredinformationisnotcontractible,theprincipaloerscontractf ;Ug.Thepaymentdependsonex2f ;U[P11+P22]( Subjectto: (36)EUm U+(1m)U

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whereEU=ercf[P11+P22] Iftherst-bestpolicyisimplemented,themanagerhasmoreincentivestoavoidsearchinginformationbecausetheexpectedprotabilitymisalreadyabovetheinducedinvestmentlevel2.Theproject,\onaverage",isprotable.Themanager'sincentivestosearchforinformationaredierentwhenimplementingthepolicy1j23.Themanagercannottellwhethertheprojectisworthinvestingbasedonlyontheexpectedprotabilitym.\Onaverage",theprojectmayormaynotbeworthinvesting.Therefore,therisk-aversemanagerwouldsearchformoreinformationtosettletheuncertainty.Itbecomeslesscostlytomotivatethemanagertoacquireinformation.Iftheinvestmentgainisnottoolargetosacricewhen2isobserved, Inordertomotivatethemanagertoacquireinformation,itisgenerallybenecialtoimposemaximaluncertaintysotherisk-aversemanagerismorewillingtoreducetheriskbyacquiringinformation.Inducingthemanagertomakeanecientinvestmentdecision,however,hastorelyontheacquiredinformation.Theamountofriskhastomatchupwiththemanager'stype,i.e.,hisinformation.Theriskytype(themanagertypewhoobservesrelativelybadsignal2)shouldbeprovidedmoreinsurancerelativetothesafetype(1).Therefore,itisdicultto

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reconciletheconictindesigningthecontract.Thatis,thecontractmaynotbeabletoprovideincentivestoacquireinformationandinvestecientlyatthesametime. Inthissection,weresorttoexpostcontractrenegotiationtoimplementoptimalinvestmentpolicy,withoutinvokinganyreportoftheunveriableinformation.Theprincipaloerstorenegotiatethemanager'sexistingcontractaftertheacquiredinformationisobservedbutbeforethemanagermakesanyinvestmentdecision.Nowthenewcontinuationcontractcantakeintoaccountthe

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realizedinformationimplicitly.Therisklevelbasedontheinformationcanbesetproperlysothatthemanager'sinvestmentincentivescanbestraightenedout.Thefollowingtimelinereectsthechangeintheorderofevents. C1toobservedorx.gatherPaymentinfor-mademation Timelinewhenunveriableinformationisobserved Attherenegotiationstage,theprincipaloersanewcontinuationcontracttominimizetheexpectedcompensationcostgiventheobservedinformation.Ofcourse,theinitialcontractprovidesthemanagerwiththedefaultutilitylevel.TheresultissimilartothefullrevelationcaseinChapter4.SinceIassumethereisnoextracosttoimplementanyinvestmentpolicy,theprincipal'soptimalchoiceistooerafullinsurancecontractbasedontheobservedinformation.Supposetheinitialcontractf

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Theeectofrenegotiationistoreduceriskpremium.Inthiscase,whenthereisnomoreincentiveproblemfortheprincipaltohandle,theriskpremiumisreducedtozero.Withaxedpayment,themanageriscompletelyshieldedfromanyriskresultingfromhisinvestmentdecision.Hewillimplementtherst-bestinvestmentpolicy. Inordertomotivatethemanagertoacquireinformation,thefollowingconstraintsarebindingfortheinitialcontractf USB+(1m)U USB+(1m)U Thebenetofrenegotiationis,itisolatesthespillovereectbetweenacquiringinformationandmakinganinvestmentdecision.Afterthemanager'seortissunk,

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thecontractisrevisedtoreectthecurrentsituation.Thecurrentsituationistoinducethemanagertomakeaproperinvestmentdecision,sotheexpostecientcontractwillprovidethemanagerwiththerightincentives.Theincentivesarereshuedtoaccommodatethecurrentneed. ThisresultcanbeseenasanapplicationofHermalinandKatz[1991]inamulti-tasksetting.Renegotiationoccursandtakesadvantageoftheunveriableinformation.Incontrast,thecompensationcostcannotbereducedtotherst-bestlevelasinaconventionalmoralhazardmodel.Thesameastheirmodel,theprincipalcanobservethemanager'seortdirectly:ifthemanagerworks,1,2or3canbeobserved,butifheshirks,noinformationisobserved.Buttheinitialcontractsetsdierentdefaultutilitylevelsbasedontheobservedinformation.Hence,therenegotiationprocesscannotlowerthemanager'sdefaultutilitydirectlytotherst-bestlevel.Endogenouslycreatedinformationchangesthemanager'spreferenceenteringtherenegotiationstage. WehavestudiedcontractrenegotiationinChapter4and5,buttheeectsaredistinct.Chapter4studiesasettingwhererenegotiationispurelyatradefriction.Whenthemanagerholdsprivateinformation,howtheinformationisreportedaectsthefollowingrenegotiationprocesswhichaectsthemanager'sincentiveinproductiveactions:acquiringinformationandmakingaproperinvestmentdecision.Chapter5dealswithunveriablebutobservableinformation.Therearenoreportingproblems.Renegotiationservesasamechanismtousetheunveriableinformationindirectly,thuscanbebenecial.

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incentivesarenotadjustedproperlyalongtheproject'sduration.Newlydiscoveredinformationcallsforare-evaluationoftheproject'sprotability.Howtomakeuseofthediscoveredinformationisthefocusofthischapter,evenifthediscoveredinformationisunveriableandthuscannotbeuseddirectlyincontractingwiththemanager.Insteadofrelyingonsomerevelationmechanisms,theprincipalcanrenegotiatetheexistingcontractbasedonthenewlydiscoveredinformation.Theexpostecientcontractprovidesthemanagerwithup-to-dateincentivestomakeaproperinvestmentdecision. Onecaveatofourmodelisthattheinvestmentcostissimpliedtobezero.Therefore,afullinsurancecontractisresultedtotakecareoftheinvestmentincentives.Iftheprojectneedsanunobservablefundinjectionafterthecontractisrenegotiated,thenariskycontractwillbeoered.Maybeitisnotbenecialtoisolatethetwotasksbyinsertingcontractrenegotiationinbetween.Sometimes,thespillovereectmaybebenecial.Forexample,theriskimposedtomotivatethemanagertoacquireinformationmaycoincidewiththerisktomotivatethemanagertomakeaproperinvestmentdecision,soitistrivialtoconsiderimplementingtheinvestmentdecision.Sometimes,inducinganecientinvestmentpolicymayalsoautomaticallymotivatethemanagertoacquireinformation.Thenatureofmultitaskingdeterminestheusefulnessofcontractrenegotiation.

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Acquiringinformationforariskaversemanagerisneveratrivialtask.Onemightthinktheimposedriskfrommotivatinganothertaskwouldnaturallyforcethemanagertocollectmoreinformation.Butthecontractdesignissubtle.Iftheimposedriskonthemanageristoosmall,hewillnotacquireinformation,butjustinvestintheproject;iftheimposedriskistoohigh,themanagerwillnotdotheworkeither,butjustforgotheproject. Anauditofthemanager'sacquiredinformationisbenecialbecauseitalignsthemanager'sincentivesinacquiringusefulinformationandinmakingaproperinvestmentdecision.Butiftheboardofdirectorscannotcommitnottousethedisclosedinformationtorenegotiatetheinitialcontract,anextensiveauditmayexacerbatethecontrolproblem.Therefore,iftheaudittechnologyisnothighlyeectiveinidentifyingmisstatements,theauditormayonlywanttoverifywhetherthemanager'sreportisconsistentwithhisinvestmentdecision,butallowthemanagertokeepthenerdetailsprivate.Thisarrangementisbenecialbecauseitalsoreinsintheself-interestedbehaviorcomingfromtheowner'sside.Togetherwiththemanager'sbehavior,itdepictsaninterestingbalanceinequilibrium. 57

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Financialreportscontaininformationthatisusefulforfuturedecision-making.Theconsequencesofpastdecisionsarealsorecordedinnancialreports.Theauditorveriesthereportedinformationthusservesasamonitoringdeviceofmanagers'decisions.Itisimportantfortheauditortounderstandthemanager'sdynamicdecisionsmaking.Themanager'sdecisioninnancialreportingiscorrelatedwithhisdecisioninproductiveactions,whichinturnaectstheunderlyingresourceallocation.Expostusesofreportedinformationinuencethemanager'sexanteincentivestoacquireinformationandmakeaproperinvestmentdecision.Itisalsoimportanttorecognizetheeconomicconsequencesofstandardsetting.Therulesonnancialreportingandauditingchangethepreparers'behavior.Standard-settersarenotregulatingnaturebutrationaleconomicagents. Theresultsechothelineofliteraturethatprovidesexplanationsforearningsmanagementbasedontheeectofrenegotiation(aviolationoftheRevelationPrinciple'sassumptions).

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\interior"|motivatingaccuratenancialreportsmayormaynotbeecient.Auditors'judgmentsarethecenterpiece. Somearguethatweimposetoomuchresponsibilityontheauditor.Theauditor'sjobisto\checkwhetherareportednumberiscorrect".Theauditordoesnotaskwhyandhowthenumberisgenerated.Astheauditorassessesauditriskandmaterialitybeforeperformingsubstantivetestsoftransactions,however,sheisconcernedaboutmanagement.SAB99advisestheauditortoinvestigatethemanager'sincentivescarefullyasopposedtosettingsomemechanicmaterialitythreshold.AccountingrmshireexpertstoauditR&Dcontractsbecausetheyhavesuperiorknowledgetoevaluatethemanager'sperformance.Auditingisnotasimpletaskinthatitrequirestheauditorformulatejudgments.Thedeepertheauditorunderstandsmanagerialdecisions,theeasiertheauditorreachesacorrectconclusion. Someworryabouttheauditor'sincentivesifsheisprovidedmorediscretion.Thatisavalidconcern.Thereisanotherroundofincentiveproblems.OneproblemishowthePCAOBevaluatestheauditor'sworkwhentheiropinionisatoddswiththeauditor'sjudgments.Auditor'sexposuretolegalliabilityforcesstandardsetterstoconsidersimple,rules-basedstandardsthatpermitslessdiscretion.Theauditfees,marketcompetition,etc.,allinuencetheauditor'sbehavior.Amodelwithmultipleplayerswouldbemoreappropriatetoaddressthesequestions.Butourmodelprovidesasalientstructureoftheauditfunction.Moreimportantly,wepointoutthegapintheunderstandingofnancialreportingandauditing.Ifnancialreportingisasophisticatedcommunicationprocess,auditingshouldhelptoservethisgoal.Werstprovideabenchmarkwhereanidealauditorshouldperform,thenwesearchforfeasiblemechanismstoinducetotheauditortoperformaswehope.Afterall,thequestionsboildowntothetradeobetweenrevealinginformationenforcedbyanauditorandtheresulting

PAGE 68

concernsforeciency.Themainmessagefrommystudyiswellreectedhere:theoptimalauditor'schoicedependsonthecontextthatcreatestheincentivenexusandthereisnopanaceaforallthereportingissues.Auditorsareexpectedtorelyonjudgmentstodeliverhigh-qualitywork. Besidesrevelationmechanisms,thereareothermechanismsmakethediscoveredinformationuseful.Contractrenegotiationtakesintoconsiderationnewlydiscoveredinformation.Thusthemanager'sinvestmentincentivesarebetteralignedwiththecurrentsituation.Inthisway,thespillovereectbetweeninformationacquisitionandinvestmentdecisionscanbeisolated.Eciencyisstrictlyimproved.However,theresulthingesontheassumptionthatthereisnoadditionalcosttoinvestintheproject.Anextensionwoulddropthisassumptionandexaminemoreaboutthespillovereectbetweenthetwotasks.Wemightndthatinterimcontractrenegotiationcandisruptthesynergybetweenthetwotasks.

PAGE 69

A.whenm>2. Inalessrestrictedproblem,whereonlyconstraints(1)(2)(3)(8)(10)arepresent,alltheconstraintsarebinding.ThenIshowthelessrestrictedprogramisfeasibletotheoriginalproblem. Let;1;2;3;4representtheLagrangianmultipliersforeachconstraint.TheFOCsprovide 0( P11]+2erc P1(11)]+2erc P22)+31 P2(12)]+31 [U0()]2U00()>0.SotheRHSincreasesinU. Suppose3=4=0.WithU3> U2;U U2;U P22>1m P2(12).2 61

PAGE 70

Only3>0;4>0isvalid.Constraints(8)and(10)arebinding:2 Suppose1=2=0,thenwehave Itiseasytocheckthattherestofconstraintsaresatisedwiththeestablishedbindingconstraints.Hence,constraints(1)(2)(3)(8)(10)arebindingfortheoriginalprogram.TheFOCsandm P11<1m P1(11)imply B.whenm2. Similarly,wecanndthebindingconstraintsare(1)(3)(4)(7).Reassign;1;2;3torepresenttheLagrangianmultipliersforthesefourconstraints.TheFOCsfromtherelaxedproblemare: 0( P22)+2erc+31 P2(12))+2erc+31 Itisalsoeasytocheckthattherestoftheconstraintsaresatisedwiththeestablishedbindingconstraints.TheFOCsand2 P221m P2(12)implies

PAGE 71

UiF;U Subjectto: (A1)EU[m U1T+(1m)U U1F+(1m)U (A2)EU[m U2T+(1m)U U2F+(1m)U (A3)EUU3T+(1)U3F (A5)U3T+(1)U3F (A7)U3T+(1)U3F (A9)[3 (A10)

PAGE 72

WhereEU=ercf2Xi=1Pi[(1)(i A.whenm>2 0(U3T)=erc+1erc+2erc3 P3(1)+41 P3+41 .Therefore,constraintU3T=U3Fimposesextracoststotheproblem. Theproofform2issimilar. Sinceaddingmoreauditswillnotincreasethecompensationcostwhen1and2arereported,auditingisstrictlyvaluabletotheprincipal.QED.

PAGE 73

typeofthemanageratleastthesameexpectedutilityasCbutleadstoalowercompensationcostfortheprincipal.Yetsuchacontractcannotexist,becauseCisthenalcontractandhenceoptimalattherenegotiationstage.ThusCisrenegotiationproofgiventhemanager'sstrategyprole.Themanager'sstrategiesremainthesame,becausehiscompensationdependsonlyonthenalcontract.Ifinequilibrium,themanagerchoosesBwhenbCistheinitialcontractandCisthenalcontract,thenhemakesthesamechoiceswhenCisoeredinitially.QED. subjectto and subjectto

PAGE 74

WithasingleIIRconstraintineachinformationevent,theprincipal'sbeststrategyistooeraxedpayment: 1

PAGE 75

Thus,shouldbelargeenoughtosatisfythetwoinequalities.When;!0,theRHSofthetwoinequalitiesiscloseto1socanbereducedcloseto0.!0meansthecompensationcostbecomescas;!0,i.e.,therst-bestsolutionbecomesfeasibleinthelimit. When;!0:5.FirstmultiplyP1,P2,P3totheinequalities(12)-(14),respectively.Thenaddthethreeinequalitiestogether.Thisrearrangementreturns Substitutingthenegativeexponentialutilityandrewritingtheinequality,wehave Theinequalitymustholdfortheprogramtobefeasible.erc>1and1>implyercPi(1)>Pi.ThustheLHSislessthan0.TheinequalityrequirestheRHSmustbelessthan0,too.ThisimpliesatleastonePj(1)ercPjfromtheRHSmustbegreaterthan0,i.e.,1>erc.Butwhen;!0:5,thisinequalitywillbeviolated.QED.

PAGE 76

samepayments u=u TheFOCswithrespectto 0( P11+P22(P1+P2)and0(u P1(11)+P2(12)(P1+P2).

PAGE 77

Weknow>0,becausetheprincipalcanalwaysreducetheexpectedcompensationcostbyoering( 2Supposeneitherconstraintisbinding.Costminimizationimpliesaxed-amountpaymenttotype1and2,respectively.Inordertoinduceatruthfulreport,thepaymentsshouldbeequal:u1=u2.Butafullinsurancecontractisnotoptimal. 3SupposeIIC-1isbinding,butIIC-2isnonbinding.Thenthecostminimizationsubjecttotherestofconstraintsyields u2,and2>3,theinequalitycannothold. 4IfIIC-2isbinding,butIIC-1isnonbinding.Thenthecostminimizationsubjecttotherestofconstraintsyields FromLemma3,weknowtheoptimalrenegotiation-proofcontractinsuresthelowtype(2),butimposessomeriskonthehightype(1).Butthisconditionmaynotbesucientforthecontracttoberenegotiationproof.Theprincipalmightbeabletooerthehightypemoreinsurancebyincreasingthelowtype'sexpected

PAGE 78

utility.Shekeepsdoingthisuntilthegainfrommoreinsuranceforthehightypeisbalancedobythelossfromhigherpaymenttothelowtype. Noticeitisnotbenecialtoincreasethehightype'sexpectedutility.Keepingthelowtype'sutilityunchangedandmaintainingtheincentiveconstraintIIC-2,theprincipalhastoimposemoreriskonthehightypeinordertopreventthelowtypefrommimicking(SeeFigure1).Theprincipalhastopaythehightypemorefortheincreasedexpectedutilitylevelandtheincreasedriskpremium.Thereisnogainfortheprincipal.Thus,theprincipal'sonlystrategyistoincreasethelowtype'sutilitywhilekeepingthehightype'sexpectedutilityconstant. LetV2=U2+,whereisasmallpositivenumber.Keepingthecontractincentivecompatibleandthehightype'sexpectedutilityconstant,wehave

PAGE 79

Rearrangingit,wehavetheinequalityP1 0( subjectto (25)EUm U1+(1m)U 0( (35) WhereEU=ercfP1[1 Since1>2>3,withconstraint(34),constraint(29)and(31)arenonbinding.Wehavetwosituations: Ifm>2,m U1+(1m)U

PAGE 80

analysis,Ionlyconsiderwhenthecontractisrenegotiationproof,i.e.,whenconstraint(35)issatised.) TheFOCsare 0( P11]22 P1(11)]212 InowshowtheAIRconstraint(25)isalsobinding.TheproofissimilartoFudenbergandTirole[1990].Currently,wehavetwobindingconstraints,(26)and(34).Obviously,oeringrentdoesnotrelaxtheequalities.Theonlypossiblebenetofoeringrentistorelaxtherenegotiation-proofconstraint:P1 0( 0( V1+1 U1erR+1 U1+1 Therefore,wecansolvethreeequations(25),(26)and(34)forthreeunknowns.ThiscompletestheprooffortherstpartofProposition5. Ifm2,m U1+(1m)U

PAGE 81

(1)IfbI1andAIkareobserved:2Xi=1Pi subjectto (2)IfbI3andAIkareobserved: (u3k) subjectto FromLemmas3and4,contractCPtakesthefollowingform:

PAGE 82

andCPisrenegotiationproofifandonlyifthefollowinginequalityissatised: 0( TheoverallproblemPPis: Subjectto: U1T1+(1m)U U1F1+(1m)U U1T2+(1m)U U1F2+(1m)U 0( Where

PAGE 83

0( P11+P22]+22 P1(11)+P2(12)]+212 U;U 0and2>0.TheIRconstraintisalwaysbinding,thus>0. Whenm>2,ttiseasytocheckthattherestofconstraintsaresatisedwiththeestablishedbindingconstraints. Similarly,ifimplementingtheinvestmentpolicy1j23,wecanndthebindingconstraintsare USB+(1m)U

PAGE 84

Itturnsoutthecontractthatimplementstherst-bestpolicy12j3isfeasibletoinducethepolicy1j23,since2 U+(1m)U >UandthenercfP11 FromProposition7,weknowthebindingconstraintsforthesecond-bestcontractf USB+(1m)U USB+(1m)U USB+(1m)U

PAGE 85

1.Antle,R.\TheAuditorasanEconomicAgent."JournalofAccountingResearch(1982):503-527. 2.Antle,R.\AuditorIndependence."JournalofAccountingResearch(1984):1-20. 3.Antle,R.,andB.Nalebu.\ConservatismandAuditor-ClientNegotiation."JournalofAccountingResearch(Supplement1991):31-54. 4.Arens,A.,R.ElderandM.Beasley.AuditingandAssuranceServices|AnIntegratedApproach.PrenticeHall,2005. 5.Arya,A.,J.GloverandS.Sunder.\EarningsManagementandtheRevelationPrinciple."ReviewofAccountingStudies(1998):7-34. 6.Baiman,S.\DiscussionofConservatismandAuditor-ClientNegotiation."JournalofAccountingResearch(Supplement1991):55-59. 7.Baiman,S.,J.EvansIIIandJ.Noel.\OptimalContractswithaUtility-MaximizingAuditor."JournalofAccountingResearch(1987):217-244. 8.Baiman,S.,andM.Rajan.\Centralization,Delegation,andSharedResponsibilityintheAssignmentofCapitalInvestmentDecisionRights."JournalofAccountingResearch(Supplement1995):135-164. 9.Baiman,S.andM.Rajan.\TheInformationalAdvantagesofDiscretionaryBonusSchemes."TheAccountingReview(1995):557-579. 10.Christensen,J.\CommunicationinAgencies."BellJournalofEconomics(1981):661-74. 11.Christensen,J.,andJ.Demski.\ReportingDiscretionandAuditing."Workingpaper,UniversityofFlorida,2003. 12.Christensen,J.,andJ.Demski.\AsymmetricMonitoring:GoodversusBadNewsVerication."SchmalenbachBusinessReview(July,2004). 13.Christensen,J.,andJ.Demski.\TheNon-NeutralityofReportingStandards."Workingpaper,UniversityofFlorida,2006. 77

PAGE 86

14.Christensen,P.,J.DemskiandH.Frimor.\AccountingPoliciesinAgencieswithMoralHazardandRenegotiation."JournalofAccountingResearch(2002):1071-90. 15.Christensen,P.,G.FelthamandF.Sabac.\DynamicIncentivesandResponsibilityAccounting:AComment."JournalofAccountingandEconomics(2003):423-436. 16.Christensen,P.,G.FelthamandF.Sabac.\AContractingPerspectiveonEarningsQuality."JournalofAccountingandEconomics.Forthcoming. 17.Conroy,R.,andJ.Hughes.\DelegatingInformationGatheringDecisions."TheAccountingReview(1987):50-66. 18.Cremer,J.,andR.McLean.\FullExtractionoftheSurplusinBayesianandDominantStrategyAuction."Econometrica,56,1247-1258. 19.Cuccia,A.,K.HackenbrackandM.Nelson.\TheAbilityofProfessionalStandardstoMitigateAggressiveReporting."TheAccountingReview(1995):227-248. 20.Demski,J.,andH.Frimor.\PerformanceMeasureGarblingUnderRenegotiationinMulti-PeriodAgencies."JournalofAccountingResearch(Supplement1999):187-214. 21.Demski,J.,andD.Sappington.\DelegatedExpertise."JournalofAccountingResearch(1987):68-89. 22.Dye,R.\AuditingStandards,LegalLiability,andAuditorWealth."JournalofPoliticalEconomy(1993):887-914. 23.FASB,ConceptsStatementNo.1:ObjectivesofFinancialReportingbyBusinessEnterprises(FASB,1978). 24.FASB,ConceptsStatementNo.2:QualitativeCharacteristicsofAccountingInformation(FASB,1980). 25.Fellingham,J.,andP.Newman.\StrategicConsiderationsInAuditing."AccountingReview(1985):634-650. 26.Frimor,H.\RenegotiationandAsymmetricInformationinMultiperiodAgencies."Ph.D.dissertation(1996),OdenseUniversity. 27.Fudenberg,D.,andJ.Tirole.\MoralHazardandRenegotiationinAgencyContracts."Econometrica(1990):1279-1320.

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28.Gibbins,M.,S.SalterioandA.Webb.\EvidenceAboutAuditor-ClientManagementNegotiationConcerningClient'sFinancialReporting."JournalofAccountingResearch(2001):535-563. 29.Gigler,F.,\DiscussionofCentralization,Delegation,andSharedResponsibilityintheAssignmentofCapitalInvestmentDecisionRights."JournalofAccountingResearch(Supplement1995):165-175. 30.Gigler,F.,andT.Hemmer.\OntheValueofTransparencyinAgencieswithRenegotiation."JournalofAccountingResearch(2004):871-893. 31.Gigler,F.,andT.Hemmer.\OntheEconomicValueofLimitingCommitmentinAgencieswithRenegotiation."Workingpaper,UniversityofMinnesota,2005. 32.Gjesdal,F.\AccountingforStewardship."JournalofAccountingResearch(1981):208-231. 33.Godfrey,J.,andJ.Hamilton.\TheImpactofR&DIntensityonDemandforSpecialistAuditorServices."ContemporaryAccountingResearch(2005):55-93. 34.Graham,J.,C.HarveyandS.Rajgopal.\TheEconomicImplicationsofCorporateFinancialReporting."JournalofAccountingandEconomics(2005):3-73. 35.Harris,M.,andR.Townsend.\ResourceAllocationunderAsymmetricInformation."Econometrica(1981):33-64. 36.Hart,O.,andB.Holmstrom.\TheTheoryofContracts",inAdvancesinEconomicTheory,FifthWorldCongress,T.Bewleyed.,CambridgeUniversityPress.71-156. 37.Hermalin,B.,andM.Katz.\MoralHazardandVeriability:TheEectsofRenegotiationinAgency."Econometrica(1991):1735-54. 38.Hirshleifer,J.\ThePrivateandSocialValueofInformationandtheRewardtoIncentiveActivity."TheAmericanEconomicReview(1971):561-574. 39.Holmstrom,B.\MoralHazardandObservability."BellJournalofEconomics(1979):74-91. 40.Holmstrom,B.,andJ.RicartICosta.\ManagerialIncentivesandCapitalManagement."QuarterlyJournalofEconomics(1986):835-860. 41.Indjejikian,R.,andD.Nanda.\DynamicIncentivesandResponsibilityAccounting."JournalofAccountingandEconomics(1999):177-201.

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42.Kydland,F.,andE.Prescott.\RulesRatherthanDiscretion:TheInconsistencyofOptimalPlans."JournalofPoliticalEconomy(1977):473-491. 43.Lambert,R.\ExecutiveEortandSelectionofRiskyProjects."RandJournalofEconomics(1986):77-88. 44.Lambert,R.\ContractingTheoryandAccounting."JournalofAccountingandEconomics(2001):3-87. 45.Laux,V.\TheIgnoredPerformanceMeasure."Workingpaper,GoetheUniversity,2004. 46.Levitt,S.,andC.Snyder.\Isnonewsbadnews?Informationtransmissionandtheroleof`earlywarning'intheprincipal-agentmodel."RandJournalofEconomics(1997):641-661. 47.Malcomson,J.\PrincipalandExpertAgent."Workingpaper,UniversityofOxford,2004. 48.Maskin,E.,andJ.Tirole.\ThePrincipal-agentRelationshipwithanInformedPrincipal,II:CommonValues."Econometrica(1992):1-42. 49.Melumad,N.,andS.Reichelstein.\Centralizationvs.DecentralizationandtheValueofCommunication."JournalofAccountingResearch(Supplement1987):1-18. 50.Myerson,R.\IncentiveCompatibilityandtheBargainingProblem."Economet-rica(1979):61-73. 51.Nelson,M.,J.Elliott,andR.Tarpley.\EvidenceFromAuditorsAboutManagers'andAuditors'EarningsManagementDecisions."TheAccount-ingReview(Supplement2002):175-202. 52.PCAOBAuditingStandards. 53.Penno,M.\AsymmetryofPre-DecisionInformationandManagerialAccounting."JournalofAccountingResearch(1984):177-91. 54.Schipper,K.\Principles-BasedAccountingStandards."AccountingHorizons(2003):61-72. 55.Searcy,D.,andJ.Woodroof.\ContinuousAuditing:LeveragingTechnology."TheCPAJournal(2003).

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56.SECStaAccountingBulletin:No.99-Materiality. 57.Sinclair-Desgagne,B.\HowtoRestoreHigher-PoweredIncentivesinMultitaskAgencies."JournalofLaw,Economics,&Organization(1999):418-433. 58.Stiglitz,J.\Monopoly,Non-linearPricingandImperfectInformation:TheInsuranceMarket."ReviewofEconomicStudies(1977):407-430. 59.Yim,A.\RenegotiationandRelativePerformanceEvaluation:WhyanInformativeSignalMayBeUseless."ReviewofAccountingStudies(2001):77-108.

PAGE 90

JieTian,nicknamedJoyce,wasbornonMay21,1976,inBeijing,China.Herparents,ShilinTianandXulinCao,werebothengineers.AftergraduatingfromtheExperimentalMiddleSchoolofBeijing,sheenteredRenminUniversityofChinatostudyinternationaleconomics.Sheearnedherbachelor'sdegreeineconomicsinAugust,1998.Soonafterthegraduationceremony,shecametotheUnitedStatestostudystatisticsatUniversityofNevada,Reno.ShereceivedherMasterofSciencedegreeinAugust,2000.ShejoinedthePh.D.programofFisherSchoolofAccountingattheUniversityofFloridaandsheisexpectedtoreceiveaPhDdegreein2006. 82


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MANAGING DYNAMIC RELATIONSHIPS


By

JIE TIAN

















A DISSERTATION PRESENTED TO THE GRADUATE SCHOOL
OF THE UNIVERSITY OF FLORIDA IN PARTIAL FULFILLMENT
OF THE REQUIREMENTS FOR THE DEGREE OF
DOCTOR OF PHILOSOPHY

UNIVERSITY OF FLORIDA


2006


































Copyright 2006

by

Jie Tian















ACKNOWLEDGMENTS

I am deeply indebted to my advisor, Professor Joel S. Demski, for his guidance

and support along my journey of learning in the Ph.D. program. His faith and

passion for scholarship have been the greatest inspiration in the pursuit of my

academic career. He taught me much more than knowledge and skills. He taught

me about life.

I wish to thank Professor Karl Hackenbrack and Professor Jonathan Hamilton

for their help throughout my study at the University of Florida. I am grateful

for their comments for my drafts and patience in reading and refining my work. I

thank Professor Haijin Lin for her constant encouragement and s.----- -1i. ii- I have

also benefited from discussions with Professor John Fellingham, Professor David

Sappington and Professor Nathan Stuart.

I wish to express my deep appreciation to my fellow doctoral students,

especially Monika Causholli, Liang Fu, Carlos Jimenez, Richard Lu and Adamos

Vlittis, who have provided me with wonderful memories at the University of

Florida.

Finally, I am truly thankful for my husband, Yuanfang Lin, for his patience,

understanding and encouragement in every step of my dissertation writing.















TABLE OF CONTENTS


ACKNOWLEDGMENTS .......

LIST OF TABLES ...........

LIST OF FIGURES ..........

ABSTRACT ..............

CHAPTER

1 INTRODUCTION ........

2 LITERATURE REVIEW ....

2.1 Delegating Decision Rights

3 THE ONE-PERIOD MODEL .

3.1 The Role of Communication
3.1.1 The Model ......
3.1.2 Contracting with Full
3.2 The Role of Auditing ....
3.3 Summary ..........

4 THE DYNAMIC MODEL ....


page

iii

vi

vii

viii


Commitment


4.1 Full revelation . . . . . . . .
4.1.1 Continuation Contract with Full Revelation .........
4.1.2 Ex-Ante Contracts that are Consistent with Full Revelation
4.2 Partial Revelation . . . . . . .
4.2.1 Benchmark: No Audit Case P ...............
4.2.1.1 Continuation contracts with partial revelation .
4.2.1.2 Ex-ante contracts that are consistent with partial
revelation . . . . . .
4.2.2 The Original Problem PP . . .........
4.3 The Optimal Information Flow .. ...............
4.4 Sum m ary . . . . . . . .

5 UNVERIFIABLE INFORMATION .. ................

5.1 The Investment Problem .. ...................









5.2 The Effect of Renegotiation .................. ..... 52
5.3 Summary .................. ............. .. 55

6 CONCLUSION .................. ............. .. 57

APPENDIX: THE PROOF .................. ......... .. 61

REFERENCES .......... .. ............. ...... .. 77

BIOGRAPHICAL SKETCH .............. . .. 82















LIST OF TABLES
Table page

3-1 Audit technology ............... ........... .. 26

4-1 Comparing the control cost ............. ... ..... 46















LIST OF FIGURES
Figure page

2-1 The general timeline ............... .... 7

3-1 The timeline in a full commitment setting ............ .. 22

4-1 Timeline when renegotiation is present .............. .. .. 30

4-2 The indifference curve ............... ........ .. 41

5-1 Timeline when unverifiable information is observed . . 53















Abstract of Dissertation Presented to the Graduate School
of the University of Florida in Partial Fulfillment of the
Requirements for the Degree of Doctor of Philosophy

MANAGING DYNAMIC RELATIONSHIPS

By

Jie Tian

August 2006

C'!h In': Joel S. Demski
Major Department: Fisher School of Accounting

This dissertation investigates the role of information in long-term managerial

investment decisions. The regulatory environment of financial reporting and

auditing dictates how information is communicated and thus has a significant

effect on managerial behavior. Standard setters who believe that the goal of

financial reporting and auditing is only to maintain accuracy simplify the analysis

and overlook the fact that managers are rational economic agents. Enlarging the

useful information set, we then investigate the role of unverifiable information in

managerial investment decisions. Contract renegotiation is served as a mechanism

to make use of newly discovered information, even if it is unverifiable. It is

efficient to take timely information into consideration in a long-term contracting

relationship.















CHAPTER 1
INTRODUCTION

Financial reports are communications between managers and investors. When

investors delegate decision rights to managers, there is a demand for information

about managers' action. At the same time, how information is reported affects

managers' incentives to fulfill their responsibilities, which in turn affects the

underlying resource allocation. For example, given the widespread concern for

accuracy of financial reports in the post-Sarbanes-Oxley environment, managers

respond by abandoning accounting treatment but resorting to real business

decisions to manager earnings, as documented in a recent survey paper (Graham,

Harvey and R i-, -pal [2005]). Managers may delay a profitable project because

it requires an immediate injection of fund, which can lower the current earnings.

Apparently, the rules on financial reporting and auditing change the preparers'

behavior. Since most business activities in the United States are carried out in

investor-owned business enterprises, how the information is measured for financial

reporting has a significant impact on the welfare of economy. Measurement itself

changes the behavior of the subject that is being measured.

Some issued and proposed FASB statements have been criticized for their

dysfunctional effects on resource allocation. For example, critics of Statement No.

8 (replaced by SFAS No.52) contend that the inclusion of gains and losses from

translation of foreign currency may force companies to engage in uneconomical

hedging transactions. Among all the concerns, the most significant cause may

be managers' incentive structure is preoccupied with short-term financial results.

The company's interim financial information is reviewed by auditors (See PCAOB

Auditing Standard No.l). Some even argued that the time for continuous audit









has come, which allows using financial information with audited report in real time

(See Searcy and Woodroof [2003]). When investment outcome takes a long time

to realize, however, periodic financial reporting and auditing change managers'

incentives in making proper investment decisions. A1 iw: of the financial reporting

rules or audit procedures seem to ignore the dynamic effect of managers' decisions.

For example, auditors are instructed to make sure all amounts are correctly

included (the completeness objective) and transactions are recorded in the period

when they actually took place (the cutoff objective) (Arens, Elder, and Beasley

2005). While transactions reflect managers' long-term perspective in decision

in, 1:;i- the related reporting issues should also be carefully addressed. Otherwise,

the misaligned managerial incentives will drive the firm to operate at an inefficient

level.

This dissertation highlights the economic substance in evaluating rules

of financial reporting and auditing. Different accounting settings cannot be

understood without considering the effect on managerial actions. Moreover,

the unique role p1l iv. d by accruals forces us to understand accounting from a

multi-period perspective. The effect from dynamic planning adds more concerns

to standard-setting, because the standard-setters are not regulating nature but are

rational economic agents.

This concern raises questions about the zealous pursuit in accuracy of financial

reports, especially the concept of "neutrality". Neutrality is defined as "absence

in reported information of bias intended to attain a predetermined result or to

induce a particular mode of behavior." (FASB Concepts No. 2) In a setting with

symmetric and perfect information, such a bias can be easily removed and each

party's behavior can be costlessly monitored. In other times, reporting standards

affect the parties' incentives to communicate the unobservable information,

which in turns affects the parties' incentives to perform their duties. Reporting









standards are bound to "induce a particular mode of b, !i i.,'. i A naive view of

standard-setting will cause the economy to perform at an inefficient level.

The plan of the study is in the following order. In C'!i lpter 2, I selectively

review the historical and contemporary literature. Three lines of literature are

explored: first, delegating investment decisions to managers; second, dynamic

considerations for standard-setting; third, the audit function.

In C'!i lpter 3, I introduce a single-period model that studies the role of

communication and auditing. Even though the model is abstracted from any

dynamic effect, it helps answering the following questions: First, why investment

decision is delegated and what problems could this cause to investors? Second,

what kind of information can investors obtain from financial reports and is

communicating the information helpful to solve the problems? Third, for public

companies, a related issue with financial reporting is that the reported information

is audited, what is the value of auditing?

In ('! Ilpter 4, a dynamic model is studied. When there are long lags between

the manager's effort and the project's final outcome, reported information can

be used for other purpose. For example, the manager's contract is subject to

renegotiation. Renegotiation occurs as long as there are mutual gains from revising

the contract. The disclosed information will be used in the future when parties

start to discuss the manager's compensation package. Anticipating that, the

manager changes his initial motivations.

In ('! Ilpter 5, a related problem is how to implement optimal investment

policy. Previously we focus on using revelation mechanisms (communication) to

motivate the manager. Now we focuses on using observed information to design

right incentive structures, even the information is not verifiable. In this chapter, we

do not constrain our understanding of managerial investment behavior by reading






4


financial reports (we are dealing with unverifiable information). We investigate the

large library of accounting information.

In C'!i lpter 6, I summarize the main results of the dissertation and provide

directions for future research.















CHAPTER 2
LITERATURE REVIEW

2.1 Delegating Decision Rights

Investors hire a manager to make various decisions. It is probably because

the manager's expertise offers him a unique access to some information set. Upon

observing and analyzing the acquired information, investors are updated about the

state of nature, thus being able to adjust the production plan. Since the collected

information is valuable to reduce the risk of future production, these information

discovering activities, though costly, should be encouraged.

It appears that the traditional agency theory would suffice to explain the

problem, because it shares a similar feature when a conflict of interest exists in

agency: the agent has incentive to shirk, because exerting higher effort in gathering

information incurs higher disutility, and his effort is not observable to the principal.

But the new problem is more delicate because there are two separate decisions

need to be made: the decision for information acquisition and for production.

Whether to delegate only the information acquisition decision or both to the agent

generates a stream of related research questions, particularly when the collected

new information is only observable to the agent. For example, the principal might

want to delegate the production decision to the agent as well, if it is costly to

communicate the agent's private information to the principal. It seems to be

more efficient to hand over the decision right to the better-informed. But being

privately informed, the risk averse agent might seek a production level in his own

interest other than the risk neutral principal's. Then there is some spillover effect

between motivating information acquisition and motivating production decision.

The spillover between the two activities could become so severe that the principal









would find it optimal to explicitly allow some underinvestment or overinvestment in

production, in order to motivate the agent more efficiently to acquire information.

These concerns are termed induced moral hazard, which highlights the tension

between the two control problems. That is why sometimes it is not worthwhile at

all to motivate any information acquisition activities, even if the information is

useful. I will explore various related settings in the literature. While some let the

agent choose his effort in gathering information as mentioned above, others treat

the information system as exogenously endowed to the agent. But they are all

concerned with how the valuable information should be utilized in decision making.

Before we proceed, let's introduce some common notations and assumptions in

the literature:

x = production outcome, with x E X, where X represents an interval of the

real line or some discrete levels.

T] = the agent's effort in gathering information, i.e., choosing among different

information system.

7r(T) = the signal which the agent privately observes, based on the information

system he selects. 7 e II, where II is a bounded interval on the real line or some

discrete levels.

m(7) = the agent's report given 7. m(7) E M, where M is the acceptable

reports set.

e(7) = the agent's production effort given r.

I(.) = the agent's compensation where I(.) is piecewise continuous.

U(I) = the agent's utility function with U'(I) > 0, U"(I) < 0.

C(-) = the agent's cost functions from exerting effort in either gathering

information or production. C'(.) > 0, C"(.) > 0. (The agent's utility function can

be additively or multiplicatively separable in wage and effort)

x I = the principal's utility function.









f(x lT, e) = the posterior probability density of outcomes.

f(T) = the prior probability density of the signals.

H = the reservation utility of the agent.


t=0 t = t=2 t=3 t=4


Contracting Agent's effort Agent Investing effort Output
I(x, m(7)) in gathering observes in production is observed
information, Tr signal 7r(q) e(7) x

Figure 2 1. The general timeline


Conroy and Hughes [1987] are among the first who address the problem of

how to motivate the agent to acquire information. They include several important

assumptions besides other classical assumptions in their moral hazard model: (1)

the acquired information by the agent is publicly observable; (2) the principal

retains the right to take the productive effort, upon observing the agent's collected

information; and (3) higher effort in gathering information rI is preferred because

it shifts the expected outcome x from production to the right in the sense of

first-order stochastic dominance. The first assumption puts the extra control

problem due to ..i- iii i I ic information to silence. So the only focus is the

moral hazard concern in exerting effort to acquire information. Given that the

acquired information is verifiable, it is more efficient to let the principal decide

the production level. The second assumption eases the moral hazard concern

with respect to productive effort. The third assumption implies that the focus

effort Tr can be ranked in the same way as in conventional agency theory. The

three assumptions make their results similar to the conventional agency theory.

The conventional agency theory's focus on motivating the productive effort e has

been shifted to motivating the information gathering effort TI only. Their model is

distinct from other works in this area in that the agent cannot observe 7. His effort









can only let him observe a sample outcome y, which is not a sufficient statistic of

the underlying state 7. The main result is, if and only if the production outcome

x is conditionally (on y) informative about the agent's effort l,] the principal

is better off by contracting on both the sample outcome y and the production

outcome x than on the sample outcome y alone. Since their analysis applies to

some outsourcing contracts between the firm and an outsider, for example, market

researchers, political pollsters, census takers, and so on, it is a useful extension of

agency theory.

Penno [1984] directly addressed the effect of the pre-decision .i-1i:i:. 1i ic

information inside the firm, when the agent is delegated to conduct a productive

decision. Then the deeper question is whether the agent should be granted such

an access to private information prior to action. His model assumes the agent's

private information is exogenously endowed. Although the principal can design

the information system only accessible to the agent, the agent is not endogenously

motivated to acquire this information. That is, referring to our timeline, the

step at t = 1 is omitted. The agent's information is his effort's marginal effect,

indicating the random working environment. For example, the information could

be the potential market demand: if the demand is rather sluggish, investing much

in marketing activities is useless; the reliability of machinery, which is crucial

in deciding the efficiency of any productive effort. Specifically, the effect of the

information is perfect substitute for the agent's effort f(x 1, e) = f(x le): if the

agent observes a signal indicating that high output will probably occur, it is not

necessary for him to work hard in order to achieve the goal. For that exact reason,

the principal might not be willing to let the agent have some superior information

than herself. On the other hand, the information can also help the agent reduce


1 That is, f(x y, Tr) depends on Tr.









effort when there is almost zero marginal effect for his effort, while increase effort

when its marginal effect is high. The paper demonstrates that if the principal can

costlessly provide partition on the information set to the agent, a strict Pareto

improvement will occur.

The main result is, assuming the optimal effort e* induced by the optimal

contract under symmetric information (no private information is accessible to

the agent), and the principal can costlessly design the partition on the agent's

private information set, then there is a partition on II : [0, 7], such that a strict

Pareto improvement will occur. The intuition is as follows. Consider this partition:

{[0, e] (c, T)}. For an arbitrarily small e, the agent saves on his effort from e* to

0 if he knew [0, e] realizes; but his effort upon observing (e, T) increases, which

increases the principal's expected utility. The net effect is to increase expected

production. Thus, providing partition to the agent improves the total welfare, even

it is only observable to the agent.

A 1 i, i" assumption here is that the principal is able to design the information

system, which is a little at odds with the issue that the information is only

observable to the agent, not the principal. In another words, the principal can

control how much the agent knows, but she cannot observe what the agent knows.

It seems that the agent usually has much more broad channels than the principal in

order to know the details of production environment. The control problem that the

principal faces originates from the agent's superior knowledge. If the principal can

control the agent's knowledge, the problem is alleviated. Therefore, whether some

information .,-i-::i.:, I ry should be created intentionally in organizations deserves

more attention.

Lambert [1986] studied a more sensible setting where the agent needs to

exert effort to acquire useful information. Based on observed information, the

agent is motivated to make a proper investment decision. If the agent invests,









the project returns (randomly) either a high cash flow 7 or a low cash flow x.

Rejecting the project will keep the status quo, that is, a constant cash flow x will

result, and x < x < T. The cash flow E {x, x,} is observed by both parties.

Three cash flows are used to model the trade-off between motivating the manager

to make a proper investment decision and compensating the manager for the

risk he bears. A distinct feature of this model from conventional agency theory

is that the agent's effort cannot be ranked in the sense of first-order stochastic

dominance. If the contract imposes too little risk on the agent, the agent would

not search for information but choose the risky project; if the contract imposes

too much risk, the agent would not work either but p1 iv safe. The contract

design is more delicate. The analysis shows that without communication, both

underinvestment and overinvestment may occur. But with communication, the

problem of underinvestment can be tamed. This result sheds some light on the role

of financial reporting from the stewardship perspective. If financial reporting is to

communicate information to investors, it helps adjusting risk level on managers so

they would work more diligently.

Lambert [1986] can be seen as an example of Demski and Sappington [1987].

Demski and Sappington [1987] formulated a general model to study the spillover

effect between motivating the agent to acquire information and to make a proper

decision: planning and implementation. They show that even if implementation

creates no disutility to the agent, the implementation activity can be distorted

in order to provide the agent with incentives to become informed. While

communication can alleviate the induced moral hazard, sometimes communication

offers no gain. The result depends on the specific information structures.

Laux [2004] continued to investigate the spillover effects among multiple

tasks. Specifically, three tasks are motivated: the agent is motivated to gather

information; to make an investment decision based on the observed signal;









and to exert an effort to implement the project. Whether the agent invests is

contractible; the other two decisions are not observable. The agent's effort in

gathering information to evaluate the project, Tr, is either 0 or 1, with cost c if he

works. His implementation effort is e E (0, oo], with cost e. XT = X(eT) is the

target chosen by the principal, i.e., eT is determined endogenously. If the project is

undertaken, the outcome is a function of both the project quality and the agent's

implementation effort x = OX(e), 0 E {0, 1}. The agent's effort T] = 1 allows him to

observe two distinct signals 7, or 7b, which is informative about the project quality

0. It is assumed that the principal induces the agent to invest when 7, realizes, and

reject the project when 7b realizes. The information 7r, or rb is not observable.

The contract depends on the outcome and investment decision. Since there

are only two signals, and a separating equilibrium is assumed. The agent's private

information is fully revealed by his observable investment decision. For the same

reason, there is no problem of underinvestment or overinvestment (in contrast with

Lambert [1'1- ,]). So the only spillover effect in this model is between motivating

information acquisition T] and project implementation e.

The paper shows that if the concern of motivating information acquisition

dominates the concern of motivating project implementation, the risk imposed

on the agent for the purpose of motivating information acquisition is sufficient to

motivate him to exert high effort in project implementation. Then any informative

measure of the implementation effort is redundant. The study offers another view

why firms often disregard some informative performance measures in evaluating

their managers.

Another interesting result is that motivating information acquisition is never

gratuitous even when spillover between multiple tasks is present inside the firm.

Imposing risk to motivate the agent to work diligently in project implementation

will not automatically offer the agent enough incentive to acquire information









beforehand. It is ah--,v- more efficient for the principal to explicitly monitor

the agent's effort in information acquisition. In next chapter, I show an audit

of financial reports provides such monitoring to motivate the agent to become

informed.

2.2 Dynamic considerations for standard-setting

Standard setters believe the primary role of financial reporting is to facilitate

decision making. "Financial reporting should provide information that is useful to

present and potential investors and creditors and other users in making rational

investment, credit, and similar decisions." (FASB, Concepts Statement No. 1)

Therefore, accurate financial reports may be more useful. Although it is true for a

single decision-maker-an information system is preferred to its Blackwell garbling,

it is generally not the case when there are multiple p l i rs and the game lasts more

than one period.2

Kydland and Prescott [1977] investigated various occasions where a policy-maker

has to make a decision. A1 ii.: have argued that, at each point in time, the decision

should be made optimal given the current and past situation. But the current

actions of economic agents also depend in part on their expectations of future

policy changes. A well-known example is patent policy. Given that resources

have already been spent on inventive activities, the efficient policy is not to offer

patent protection in order to reduce monopoly rents. But we know this decision

will ruin the incentives to engage in any inventive activities. This expectation

affects agents' current actions, which in turn affect the policy-maker's future choice.

Convergence does not ah--,v- occur. Accounting poliiv--makers, however, do not



2 In a trading game, for example, if all investors get the same information and
make a decision on it, investors may well prefer that information not be provided.
See Hirschleifer [1971],









seem to care enough about the economic foundation for standard-setting such

as the dynamic effect driven by rational expectation. Accounting policies seem

to be short-term oriented. Attentions have been focused on producing accurate

and reliable financial reports at any snapshot of time, which is at odds with the

going-concern assumption.

Among other early work on dynamic consideration for accounting policies,

C'!i -I. I i, Demski and Frimor [2002] studied accounting policies where contracts

are subject to renegotiation. Renegotiation affects dynamic uses of information.

The disclosed information will be used in the future when parties start to discuss

the agent's compensation package. Anticipating that, the agent changes his initial

motivations. In a two-period moral hazard setting, a perfect accounting system

causes the agent's incentives to collapse as in Fudenberg and Tirole [1990]. The

intuition is as follows. Once the agent has exerted effort, it is efficient to provide

the agent with complete insurance. Foreseeing that his eventual p .ivment would

be independent of the outcome, the agent would then prefer to choose the lowest

feasible level of effort. However, other regimes that allow the agent to move

output from the first to the second period provide him incentives to work in the

first period because the agent's effort creates reserves that will be rewarded in

the second period. The paper examines the effect of different accounting policies

on the agent's first-period effort: perfect accounting, ..-'--regate accounting and

conservative accounting. The result emphasizes that policy-makers are not only

concerned about making a good choice but also constrained by the fact that p1 ii- rs

are strategic in making their choices as well.

Gigler and Hemmer [2004] compared two reporting regimes on the information

about the agent's past action, when contract renegotiation is considered. Two

performance measures are considered: early-revealed information (y) and

late-revealed information (x). The late information is publicly observable. But









the early information can either be made public by a transparent regime, or

be kept private under an opaque regime. So the principal has to rely on the

agent's self-report on y under an opaque regime. If full commitment is achievable

in coi i, iiir. transparency is certainly preferred, because it is usually extra

costly to induce the agent to report truthfully. But renegotiation makes the

problem more subtle. Renegotiation tends to make the contract rely more on

the information revealed before renegotiation, because the information revealed

after renegotiation becomes less credible. If the agent's high effort is motivated,

the insurance opportunity from using the later-revealed information is lost. The

contract does not reference the late information. At the renegotiation stage, the

agent's effort is sunk and the principal's only goal is to reduce compensation cost

by lowering risk premium. She will then offer a full-insurance contract given the

information observed before renegotiation. That is, the agent's incentive can be

provided only through a short-term contract: on the early-revealed information

y only. This opens a door to an opaque regime, where the agent's information is

kept private before renegotiation and is only revealed at the renegotiation stage.

Thus, the later-revealed information can be used. It is used to induce the agent to

report his private information truthfully at the renegotiation stage. Since no more

renegotiation is allowed afterward, the Revelation Principal applies.3 Motivating

truthful report on the early information y will in turn provide the agent incentive

to exert high effort. Therefore, although the early information is kept private, it



3 There is a minor problem with the constraints listed in the opaque regime.The
ex ante truthtelling constraints (TT,'i) should not be imposed, because full
commitment is not maintained as required by revelation principal. The ex post
truthtelling constraints (ITTH and ITT,) are valid because full commitment is
achieved at the renegotiation stage. This might change some points stated in the
paper. But since the ex post truthtelling constraints will automatically imply the
ex ante truthtelling constraints, the equilibrium is not changed.









offers the principal extra incentive to reference the late information. Thus both

information can be used in the contract, lowering compensation cost.

Two studies on renegotiation are included here to demonstrate the dynamic

concerns. Renegotiation allows the principal to move again based on her observation

at some interim stage. Anticipating the principal's move, the agent revises his

current choices. Dynamic concerns are also present in other scenarios. For example,

Baiman and R li in [1995] study a setting with incomplete contracts.

2.3 Auditing

Auditing is an attestation service. To do an audit, there must be some

information to be attested. Some communication problems must be present for

the auditor to verify. Financial reports are communications. It implies we need to

consider at least three parties in order to study auditing questions: investors, the

manager and the auditor. The incentive interactions among the three parties give

rise to the demand of auditing. On the one hand, it is important to recognize the

area of auditing is closely related to the area of financial accounting and certainly

cannot be isolated with managerial incentives. On the other hand, we find that in

literature it is difficult to endogenize the three parties' behavior all together.

Antle [1982, 1984] uses a multi-agent model to study the role of communication

and auditing. Investors hire a manager to perform duties that affect the outcome

of the firm. Investors hire another agent-the auditor-to engage in some

investigative action about the manager. The contractible information 7r (e.g.,

earnings) is observable to the manager only. Therefore, without an auditor, the

manager would not have incentives to perform his duties since he can report

whatever is in his best interest. The auditor exerts effort to verify the manager's

self-report wr, observes some information A and issues a report A. The manager

and the auditor choose their actions simultaneously. The principal's (investor's)

goal is to design the contracts using both agents' reports to motivate each other.









If the auditor works and truthfully reveals her observation, her report should be

consistent with the manager's. Likewise, the p clientt to the manager should be

set higher if the auditor's report confirms his report and the opposite holds if the

two reports conflict. The three-pl! i'- r framework is useful to visualize the relation

between investors, the manager and the auditor and is also widely used in practice.

Nevertheless, the model is not tractable enough to incorporate that side-pl ivments

can be transferred from the manager to the auditor. Auditor's independence is

presumed in that the auditor is able to deny self-interested behavior completely.

Antle [1982] noted, "Modeling the auditor as a pl! i,- r opens a Pandora's box of

methodological problems." Again, the model is a good benchmark to embark on

auditing issues, but more questions need to be answered. For example, law requires

no contingent fees be paid to auditors; with the manager's report absent, what

mechanism can provide the auditor with incentives to work?

Baiman, Evans and Noel [1987] also set up a three-pl li-, r game but the

sequence of events is different. The auditor attests to the manager's report after

it is issued, so the auditor's report is conditional on the manager's report. One

of the results is that there exists no equilibrium in which the manager reports

fully. This is because if the auditor knows the manager's report is correct, she

would not expend effort to audit it. The manager's misreporting behavior is

tolerated only to provide the auditor with incentives to work. For tractability,

the manager is modeled to take no productive action and his only job is to report

his observation. The purpose of the model is to show the role of auditor as a

"utility-maximizing i,'' ni but the model seems to be too focused on the auditor

while overly simplifies the manager's behavior.

Many other works circumvent the modeling impediment by focusing on the

interaction between two parties only, leaving the "unimportant" issues exogenous.

Fellingham and Newman [1985] studied an auditor-manager game, where the









manager chooses the effort to reduce the probability of a material error and

the auditor chooses whether to extend audit procedures. The two p!l li- rs move

simultaneously. The focus of the paper is to show the auditor should consider

the audit risk model strategically. The manager's behavior is influenced by his

conjecture of the auditor's action and vice versa. Relying on single-person decision

theory, the auditor ended up with incorrect evaluation of audit risk. The model

is highly -1 i i. .1 but it is among the first to point out that a successful audit

relies on a thorough understanding of managerial incentives. In addition, the

paper shows that the auditor may frequently use a randomized strategy. That is,

the manager cannot predict what the auditor will do and he can only guess the

auditor's strategy probabilistically. Anecdotal evidence shows that many audit

failures are due to pre-determined analytical procedures, because it is easy for the

manager to plan accordingly. Strategic considerations are indispensable to study

auditing issues.

Leaving financial reporting problems unmodeled, Antle and N I. 1buff [1991]

focused on the negotiation process between the auditor and manager. Financial

statements should be read as a joint output from the auditor-manager negotiation.

The users only see the final negotiated outcome. Whether conservatism reigns

in the final outcome is unclear even when the auditor starts with a conservative

gesture. The manager has superior information and he only protests understatements.

The paper shows, with a cost-sharing contract designed to maximize joint

auditor-manager surplus, the expected ex post bias is alv-i-, upward.

Cuccia, Hackenbrack and Nelson [1995] studied the ability of professional

standards to mitigate .,.-i'ressive reporting. Although the experiment was set in a

tax setting, the issue seems to be more general to all reporting behavior. The paper

shows that practitioners will interpret more liberally a vague professional standard

in order to justify ,.-- ressive reporting while interpret the evidence more liberally









when facing a more stringent standard. The results are intuitive to capture the

practitioners' intentions to exploit discretion embedded in professional standards.

But why the practitioners albv-- choose to report .,-.--ressively is not clear. The

practitioners' incentives (for example, resulted from compensation package) are not

explicitly studied.

2.4 Summary

In this chapter, I selectively reviewed the literature in three areas: Delegating

decision rights, Dynamic concerns for standard-setting and Auditing. We start

with the role of financial reporting, approaching from a management stewardship

perspective. (FASB, Concepts Statement No.l) When investors rely on a manager's

expertise and delegate some decisions to the manger, there is a demand for

information. Communication is valuable especially when the manager endogenously

acquires the information and use it to make a production decision. Apparently,

financial reporting and auditing standards that govern the communication process

affect managerial decision-making and have profound consequences on underlying

resource allocation. Pondering on managerial decision- 11 i1:;i:- we raise some

concerns for periodic financial reporting and auditing. Do we pursue an accurate

financial reporting system or a dynamic communication process?

The value of auditing is directly related to the value of financial reporting.

The literature reveals the difficulty to incorporate interested parties (investors,

the manager and the auditor) endogenously. It also presents us the opportunity to

practise the art of modeling. We emphasize on the first-order effects: there must be

some reporting problems that auditing can help alleviate (the endogenously-created

demand for auditing) and there must be some strategic considerations in auditing.

Then another tough choice has to be made. Do we focus on the manager's strategic

considerations or the auditor's?















CHAPTER 3
THE ONE-PERIOD MODEL

3.1 The Role of Communication

The manager commonly expends effort to investigate profitability before

investing in a risky project. Periodic financial reporting allows the manager to

communicate the acquired information to the investors so that the investment

decision can be monitored.1 But the self-reported information may not reflect the

true value based on the manager's observation. For example, R&D expenditures

may carry some information about the firm's future investment opportunities.

Although R&D expenditures are all expensed as incurred, classification of R&D

expenditures can be problematic. The manager may want to include ordinary

operating expenditures in R&D. R&D expenditures can also be classified as the

follow-through in an early stage of commercial production so the amount can be

capitalized. Due to lack of active markets, classification of R&D expenditure is

difficult. Therefore, the auditor's report, as a reliable (but imperfect) source about

the manager's private information, can be valuable in monitoring the manager's

behavior.

3.1.1 The Model

The risk-neutral principal (investors) owns an option to invest in a risky

project. She hires a risk-averse manager to make a decision on whether to invest

in the project: v E {0, 1}. If the manager invests, v = 1, the project returns



1 Penno [1984], Lambert [1986], Demski and Sappington [1987] and Melumad
and Reichelstein [1987] have shown that in many cases, communication is strictly
valuable when the manager has superior pre-decision information.









(randomly) either a high cash flow 7 or a low cash flow x. Rejecting the project

(v = 0) will keep the status quo, i.e., a constant cash flow x will result, and

x < x < T. The cash flow x E {x,x,7} is observed by both parties.2 The

manager can understand more about the risky project by searching for additional

information. Let the information be the posterior probability of the high outcome

occurring: Pr(T| ) = 7. The manager observes three such signal realizations:

1 > 7T > 72 > 73 > 0. The prior probabilities of these signals' occurring are P1,

P2 and P3, respectively.3 Therefore, if the manager does not work, he can only
3
predict the project's profitability via the expectation of the signals: m -- Piri.
i=1
The manager's effort can be either high or low: r] {c]H, IL}. The personal cost

of low effort is normalized to 0, but the manager incurs cost c > 0 if he exerts

high effort, ]H. (That is, working hard allows the manager to observe a better

information system UrH.) The manager is assumed to incur no extra cost to invest

in the project. Hence, the only moral hazard concern is to motivate the manager to

acquire information. As we shall see, the manager's investment decision affects his

decision to acquire information when the two tasks are jointly motivated.

Since risk aversion is a first-order effect and the change in risk aversion is

not, I assume constant absolute risk aversion for the manager's utility function:

U(I, c) = exp(-r(I c)). I is the manager's compensation and c is the monetary

cost of exerting high effort. Without loss of generality, the manager's next best

employment opportunity is assumed to carry a certainty equivalent of 0, that is, his



2 As in Lambert [1986], three cash flows are necessary to model the trade-off
between motivating the manager to make a proper investment decision and
compensating the manager for the risk he bears.

3 As we shall see, at least three signals are required to characterize the interim
communication problem when renegotiation is present.









reservation utility level is -e-o = -1. Let '(U) be the inverse function, that is,

the principal will 'p iv the amount of I = T(U) = -- n(-U) to the manager.

The optimal investment policy deserves some explanations. I restrict the

analysis to the cases where the principal prefers that the manager select the risky

project only if 71 or 72 is observed. That is, if the principal can either observe the

manager's effort or the manager's collected information (the first-best scenario),

this investment policy will return the largest expected cash flow.4 This assumption

is stated as

Condition 1. 722x + (1 7r2) > x > 7r3x + (1 7r3)

The principal only wants to avoid the worst scenario 7s. Let 712 17r3 denote

this investment policy. Obviously, this is the first-best investment policy. The

rest of this analysis examines how the contract is designed in order to implement

the first-best policy and whether the first-best policy is still optimal in various

second-best settings.

To capture the idea that the information-discovering activities are pervasive in

practice, I further assume that acquiring information is ahv--, preferred, that is,

high effort UrH is ah--bv- motivated.5

Notice the principal can infer perfectly the investment choice from the final

outcome (, x or x), because the choice renders (ii- iiI outcomes. This does not,

however, make our problem disappear. The principal does not know why the

project was selected or rejected. Was it because the signal the manager received



4 Two manager types are induced to invest because there should be some pooling
before renegotiation takes place. The details will be clear when renegotiation-proof
contracts are introduced.

5 This assumption can be satisfied when the project is very risky, i.e., 7ir + (1 -
7ri) >> x >> 7rT3 + (1 7T3), and the cost to acquire information (c) is not too
large.









indicated the project is not profitable, or did he simply make the decision without

searching for information? The principal does not know, either, whether the

manager followed the desired investment policy, because the principal cannot

observe the information the manager acted upon.

3.1.2 Contracting with Full Commitment

The direct output of the manager's effort is information. Auditors, whose

stock in trade is their ability to process information, seem to be helpful here. This

section shows why the principal is better off imposing an audit. As a benchmark,

the principal is assumed to maintain the full commitment power in this section.

(Full commitment means the principal can credibly promise not to alter the terms

of a contract, even if it is common knowledge that mutual gains are available from

revising the contract.)




Principal Manager Manager Manager makes Manager Outcome
offers CBM chooses observes investment reports i, realized
effort Tr to signal decision auditor x, x or x,
gather 7(q) based on 7 verifies Payment made
information report,
issues A

Figure 3-1. The timeline in a full commitment setting


The manager's effort is not publicly observable, nor is the collected information.

The manager observes the signal and has the authority to make the investment

decision.6 The Revelation Principle allows us to look for the optimal solution



6 This regime is equivalent to the one in which the principal retains the
authority to make the investment decision, because the manager communicates
his information and the investment decision is observed. A similar situation can be
found in Melumad and Reichelstein [1987].









under a direct revelation mechanism only (\ yerson [1979], Harris and Townsend

[1981]). The manager's compensation is contingent on the realized cash flow (e)

and his report on the received signal (if). There are five p ivment levels-Il, I; 72,

I2; I3 when the investment policy 7rFr2 173 is implemented. Correspondingly, the
induced utility levels are U1,Ui; U2,U2; U3. Since the manager's investment

decision is observable, all the other off-equilibrium outcomes can be easily

penalized. (For example, if the manager reported 73, but invested in the project,

the principal would observe I or x, and the manager is then punished so severely

that he would never make that choice.) At the end of this section, I will show that

the implemented investment policy is indeed optimal.

The manager is motivated to exert high effort, so his expected utility is

EU = e[Pil17U1 + Pi(1 7Tl), + P272U72 + P2(1 72)2 + P3U3]. But if he

shirks, his expected utility is based on the expectation of the project's profitability:
3
m >Pi7ri. The principal's constrained cost-minimization problem (PBM) is:
i=

2
Min YNP*t[i(Ui) + (1 rTT)(UL)] + P3 (U3)
U1,UI,U2,U,3i= 1

Subject to:



EU > -1 (1)

EU > nUi + (1 m)U (2)

EU > mU2 + (1 rn)2 (3)

EU > U3 (4)

7rU1 + (1 7Tl)i > 7rU72 + (1- 27l)U (5)

7lU1 + (1 T)U1 > U3 (6)









72U2 + (1 72)L2 > 72U1 + (1 72)L (7)

72 + (1 72)2 > U3 (8)

U3 > 7T3U1 + (1 7T3)1i (9)

Us > TTU2 + (1 73)2 (10)

Inequality (1) is the IR constraint; inequalities (2)-(4) are the IC constraints

for effort selection. If the manager decides to shirk, he can disguise his behavior

by claiming he receives signal 71, 72 or 7r3, but he cannot really observe the signal

so he has to rely on m to evaluate his expected utility. Inequalities (5)-(10) are

the IC constraints for each manager type to report his information truthfully after

having exerted the effort to acquire that information. Notice that the problem of

motivating the manager to invest properly has been replaced with the problem

of motivating the manager to report truthfully. This is because the investment

decision is observable and thus can be enforced based on the reported information.

Lemma 1. Assume no audit is performed. If m > 72, the optimal contract

imposes risk on type 7T only, that is, U1 > U, and U72 = V; if m < 72, the optimal

contract may impose risk on types 7r and r2, that is, U1 > UU and U2 > UV2

The contract should not only motivate the manager to invest properly, but

also motivate him to acquire information. Lemma 1 shows how the manager's

incentives in the two tasks interact. The intuition is similar to Lambert [1986].

When the project is expected to be relatively more profitable, that is, m > 72,

(the mean is above the median.) the manager would ahv--l- invest if he did

not acquire any information. This is because the advocated investment policy

7r172 lT3 encourages investing at any signal realization better than r3 but now the

expectation m is already above the cutoff investment level. Thus, the manager's

off-equilibrium behavior (i.e., when he shirks) is to claim he received signal Tr or

72, so that he is justified to invest. This means constraints (2) and (3) are binding.









Therefore, the principal has to design a "less atti I li,1 contract to alleviate the

manager's temptation to invest. She equates the contract for the investing type

to the non-investing type, that is, type 2T receives the same p client as type 7r3,

U2 = V Us. Type 72 is then indifferent between investing and not investing.

Equivalently, he is indifferent between reporting 72 and 7r3. The investment policy

affects the manager's incentive to acquire information. The manager's incentive to

invest is set weaker in order to provide him with a stronger incentive to search for

information.

The manager's incentives are different when the prior is opposite, that is,

m < 72 (the mean is below the median.) In this case, if the manager decides to

shirk, he is not clear about whether to invest or reject the project because m is

between 72 and 73. Constraints (3) and (4) are binding. If the manager invests

without collecting any information, there is a high probability he might be wrong

because the project is not very attractive: m < 7r2. If the manager rejects the

project without collecting any information, his chance of being correct is also slim

because he may miss the investment opportunity in two possible events 7r and 7r2.

Therefore, with less concern to motivate the manager to acquire information, the

principal can impose risk on both type 7i and type 7r2.

Finally, we need to confirm there is no better investment policy in the

second-best setting. The principal can choose to induce investing in the project

only when the manager receives the best news and forgo the project otherwise, that

is, policy 71127ra73. The contract to implement TrT1r27T3 consists of four 1p .vments

{Ui, U1; U; U3 }, which can implement policy T17T2 ir3 because type 72 is offered a

fixed p .iment and thus is indifferent between investing and not investing. Investing

when signal 72 is realized not only increases the expected cash flow as indicated

by Condition 1, but also expands the set of variables for contracting (U2 and









U2, instead of a single p ivment U2). Thus it is never wise to deviate from policy

71TiTT2 73.

3.2 The Role of Auditing

We now introduce the audit function by assuming the auditor is well motivated

by professional standards, and follows the audit rules diligently. The model focuses

on the procedure of auditing and its function to discipline the manager's possibly

opportunistic (off-equilibrium) behavior. The auditor samples and tests the

transactions and so is prone to errors. The audit technology is summarized using

the following conditional probabilities:

Table 3-1. Audit technology

Approve Disapprove
The manager's report is true 1 a a
The manager's report is false 3 1 3


The auditor's report is AT if she approves the manager's treatment and issues

AF if she does not. a can be interpreted as a Type I error and 3 as a Type II

error.8 I assume a E (0, ) and 3 E (0, {) so the auditor's report is informative

about the true status of the manager's information.9

Proposition 1. Auditing is strictly valuable in a full commitment setting.



7 Remember I have assumed it is ah--,v- preferred to acquire information. Other
investment policies 1TT273 or iTT127T31, i.e., abh--v~- rejecting the project or ah--v-
investing in the project, do not require the manager to collect any information to
implement the policy.


8 For simplicity, I assume the audit technology does not vary with the manager's
reporting strategies. For example, the sampling error is 3 whether the type 7r3
manager reports 7r or 72. This simplification only reduces the notation and does
not qualitatively change the results.

9 It is common in the literature to model audit technology as a garbling of the
manager's information. For example, Dye [1993] and Antle [1984].









Currently, it is mandatory to audit the annual financial statements for public

companies. Without incurring extra costs, the principal cannot be worse off by

referencing the contract to the auditor's report. It is simply because the principal

maintains full commitment power, and she alv--i- has the option to ignore the

auditor's report when offering the contract at the start of the game. Moreover,

in the two-task setting, an audit has strict value. On the one hand, it verifies the

manager's self-report so the contract based thereon forces the manager to report

truthfully. Based on the (truthful) information, the desired investment policy can

be enforced. On the other hand, the contract that references the auditor's report

provides the manager greater incentive to become informed: if the manager did not

work hard to search for information, he possessed no information, so he had to lie

all the time; but the auditor detects lying with a positive probability. An effective

audit makes the two tasks become more complementary and thus the expected

compensation cost is reduced.

3.3 Summary

This chapter extends the line of literature where the agent is motivated

to generate information before making a decision.10 In such situations, the

contract has to provide incentives for the agent not only to make a proper decision

based on the observed information but also to acquire that information. One of

the interesting findings is that the principal at times has to distort the agent's

decision-making incentives in order to provide sufficient incentives for the agent to

acquire information. I show that an audit of the acquired information helps align

the agent's incentives in both tasks and therefore is strictly valuable.




10 Other examples include finding out about the probability of winning before
tendering the bid and researching the potential investments before choosing
portfolios for clients. See Lambert [1986], Demski and Sappington [1987], Laux
[2004] and Malcomson [2004].















CHAPTER 4
THE DYNAMIC MODEL

An important issue is how to audit the manager's acquired information. It

may not alv-- i- be efficient to motivate the manager to report accurately what

he knows because of the incentive issues that arise in dynamic employment

relationships. When there are long lags between the manager's effort and

the project's final outcome, the manager's contract is frequently subject to

renegotiation. If the auditor motivates the manager to reveal his information

accurately, in equilibrium, the investors would be able to infer perfectly that the

manager has exerted effort to acquire information. At the following renegotiation

encounter, the contract will be revised to provide more insurance to the risk

averse manager, that is, the p .ivments will not vary with the outcome of the

project. Foreseeing that the final contract will not depend on the project's

outcome, ex ante, the manager would have less incentive to become informed.

Since renegotiation occurs as long as there are mutual gains from reconl i ,l .iii

this trade friction itself can limit the usefulness of accurate financial reports. Unless

the auditor's report is highly informative about the manager's private information,

it is not beneficial for the investors to know the manager's information fully. Arm's

length relationships may be preferred in the dynamic investment game.

As mentioned previously, full commitment may not be a realistic scenario.

There may be several years before the project's outcome is realized. Throughout

the intervening years, parties can ahv--, choose to tear up the initial contract and

open a new contract, as long as both parties agree to the revision. Renegotiation

thus enters our long-term project-investing story naturally.









Renegotiation implies interim optimization. From an ex ante perspective,

the interim optimization problem may add constraints, because both parties' ex

post incentives need to be considered at the renegotiation stage. The amount of

information to be revealed before renegotiation affects the interim optimization

problem. Recalling the full commitment case (C'! Ilpter 3), full information

revelation is motivated because the principal offers a contract first and commits

herself to the rules about how the information is used. With the extra optimization

problem, we now reexamine whether information should also be fully revealed.

The timeline is revised to include the renegotiation encounter:

At the initial contracting stage, the principal offers a contract, C1, to the

manager, who can either accept or reject the contract. If the manager rejects the

contract, the game ends and both get their reservation utility.

After the manager accepts the contract, he chooses effort Tr to collect

information. Based on the subsequent signal, the manager makes the investment

decision v.

The interim reporting stage comes before renegotiation takes place, when the

manager communicates his information to the public (Vi)1 and the auditor verifies

the manager's report (A).2

At the renegotiation stage, the principal offers a new continuation contract,

C2, to the manager. If C2 is rejected, C1 is the final contract and determines the

manager's compensation. If C2 is accepted, it becomes the final contract.



1 It is common for the board of directors to observe some information before
convening to evaluate the manager's performance.

2 To capture the feature of periodic auditing, the auditor issues the report at the
interim reporting stage.






30


At the final reporting stage, if the manager has not communicated fully his

private information at the interim reporting stage, he can elect to report it now

(F T). The project outcome is realized and the manager is compensated based on

whichever contract is in place.3




Principal Manager Manager Manager Manager Contract Manager Outcome
offers chooses observes makes reports re- reports realized,
contract effort fr signal invest- i, negotiated iF X, x
C1 to 7T(r) ment auditor C2 or x.
gather decision verifies Payment
infor- based report, made
nation on 7T issues
A

Figure 4-1. Timeline when renegotiation is present


At the renegotiation stage, the principal makes a take-it-or-leave-it offer to

the manager.4 The manager can take the newly offered continuation contract C2

or reject it so the initial contract C1 remains in effect. I will show we can restrict



3 I allow two reporting stages to ensure there is no restriction on the timeline.
Renegotiation can take place before or after information release.
One may also consider another timeline where the investment decision is made
after renegotiation, thus after the interim reporting stage. The alternative timeline
does not change the results qualitively, however. Full information revelation
before renegotiation will render a full insurance continuation contract whether the
investment decision is made before or after renegotiation, because the investment
decision is observable and no further incentive concerns are left at the renegotiation
stage. (Details will be clearer after I introduce the renegotiation-proof contract.)
Moreover, the current timeline seems to be more plausible, since the investment
decision is delegated to the manager but communication often occurs at year-end.

4 It is comparatively simple to let the principal (instead of the agent) propose
a contract at the renegotiation stage. Since the manager possesses private
information, the contract proposal itself can reveal information. More analyses
can be found in Maskin and Tirole [1992].









attention to the contracts that are renegotiation proof. A contract is renegotiation

proof if, at the renegotiation stage, it minimizes the expected compensation cost

while leaving no manager type worse off relative to the initial contract. That is, the

contract is optimal from the principal's perspective, conditional on her conjecture

regarding the choices the manager has made. Thus, the principal will not choose to

alter it at the renegotiation stage.

The principal chooses a continuation contract based on what she knows:

observing the manager's interim report V' and the auditor's report A, she updates

her belief about the manager's private information through Pr(T ri A). Of course,

the posterior probability distribution Pr(7rl A) also depends on the principal's

conjecture regarding the manager's effort Tr and the disclosure level enforced by the

auditor.

Since the investment decision (v = 0 or 1) is sunk and the decision can be

perfectly inferred, type 7v or 7r2 cannot be mixed with type r3.5 The continuation

contract takes the following form {(UjkikiU i), (U3k)}Jje{,2},ke{T,F},ie{1,2}. Type 71

or 72a manager's utility levels are specified in the first parenthesis. The p clientt

depends on the interim reports (-f, Ak), the final report (rii) and the realized cash

flow (7, x). Type 73 manager's utility level is specified in the second parenthesis.

Since type 73 is not induced to invest and the investment decision is observable,

type 7r3 can be identified with certainty after the interim reporting stage. The

p livment only depends on the manager's report (V\) and the auditor's report (Ak).

Definition. A contract C = {(Ujki, jkiJ, (U3k)}jE{1,2},kE{T,F},ie{1,2} is

renegotiation proof, for distribution Pr(T ri A), if it minimizes the expected

compensation cost given Pr(7rl A):


5 I will show the policy 7T12 i 3 is still optimal.in Sections 5 and 6.









For type 7v or 7r2, who invested:
2
Pr(7i t-, ,Ak)[7it-I ) + (1 i)(k)l
i 1

among all the contracts {(7., jkij)}je{1,2},ke{T,F},ie{1,2} that satisfy for any

(wf, Ak):




7iUjki + (1 7i)Ljki > 7r 7 + (1 7r) Vi' e {1, 2} (IIC-7w, 7rij, Ak)



tr ijki + (1 ri)ujki > TU7iji + (1 i)LLjki (IIR-t-i, trj, Ak)

For type i73, who did not invest:




among all the contracts {( )} that satisfy for any (i(, Ak):



> U3k (IIR-73, Ak)

At the renegotiation stage, the principal chooses among the incentive-compatible

contracts that will be accepted by each manager type. The interim incentive

compatibility constraints (IIC) restrict the set of contracts to those that induce

truthful reporting from the manager, that is, all the private information will

be revealed at the final reporting stage. The Revelation Principle is invoked

here because the timeline presumes no more renegotiation. Notice there are no

IIC constraints for the manager who received signal 73, because no .i-ii. Ii ic

information problem remains. (IIC constraints are imposed for type i71 or 7t2,

because entering the renegotiation stage the principal may not be certain about

these two types.) The interim individual rationality constraints (IIR) restrict the









possible continuation contracts to the class in which each type is offered a (weak)

improvement in expected utility relative to the existing contract C. IIR constraints

are defined recursively. If none of the contracts lowers the expected compensation

cost relative to the existing contract, C, the principal has no incentive to offer any

renegotiation; hence, the contract C is renegotiation proof.

Proposition 2. Suppose an equilibrium exists in which (1) the initial contract

is C, (2) the final contract is C* and (3) the manager's strategy profile is B = (UIH,

71i2 1i3, i, F). There then exists an equilibrium in which C* is the initial as well

as the final contract, and the manager's strategy profile is unaltered.

Therefore, without loss of generality, we only consider renegotiation-proof

contracts. Exploiting this representation device, the rest of the analysis shows the

optimal disclosure level enforced by an auditor.

At the final reporting stage, any unreported information will be revealed, so

the focus is how much information should be disclosed at the interim reporting

stage. Since the investment decision is sunk, there are only two reporting rules: 1.

The manager is motivated to report completely what he knows, {{7i}{7r2}{73}}.

The auditor examines whether the manager's report is truthful. This partition

is denoted as full revelation. 2. The type 73 manager is motivated to report

truthfully as i4, but types ri and w2 are motivated to report the same as w{. Thus

the principal will know the manager received signal 7-3 when he reports i, but will

not know the manager's information for sure when he reports w{. In this case, the

auditor only verifies whether the manager's investment decision is justified based on

his acquired information. That is, the auditor only worries about the misstatements

that affect the principal's perception about the firm's investment opportunities,

and a minor misstatement between -1 and 2a is tolerable. Denote this partition,

{ {i "72}{1i3}, as partial revelation.









4.1 Full revelation

If the manager's information is disclosed before the renegotiation stage, the

principal will use the disclosed information to renegotiate the original contract.

Foreseeing that, the manager has less incentive to give away his advantage.

Consequently, if the principal continues to push for more information, the manager

may have less incentive to acquire information.

Intuitively, an audit enforcing full information revelation at the interim stage

can be harmful. In fact, the manager never discloses all of his information before

renegotiation if there is no auditor to attest to his report.

Lemma 2. Without an auditor, information acquisition followed by full

information revelation at the interim reporting stage cannot be sustained in

equilibrium.

The manager knows that if he reveals all of his information, the story ends

there: he has acquired information and invested according to the instructed policy.

There is no incentive problem left for the principal to solve at the renegotiation

stage. The principal will offer a full insurance contract. But knowing the final

contract is a full insurance contract, the manager would prefer the low effort

instead." Notice this result is reminiscent of Fudenberg and Tirole [1990]. The

difference is that in my scenario the reporting problem is intertwined with the

effort problem. The pursuit of truthful reporting completely removes the manager's

incentive to exert effort to acquire information. The reporting requirement pollutes

the real production.



6 The only feasible equilibrium other than implementing the low effort TIL is in
mixed strategies. This paper assumes high effort is ahv--, preferred. I will show
later, with the auditor's report or adequate information rationing, high effort (in
pure strategies) is indeed implementable.









Fortunately, we have an auditor. As we shall see next, the manager's incentive

to acquire information is completely provided by contracting on the auditor's

report.

Given an auditor and using the renegotiation-proof representation, we

characterize the optimal full revelation contract. Since the manager reports all

his information before renegotiation, no information is left for later reporting, and

the contract only relies on the interim report (w'), the auditor's report (A) and the

project outcome (e).

4.1.1 Continuation Contract with Full Revelation

At the renegotiation stage, the principal offers CT {(Ujk, Ljk), (U3k)}jE{i,2},ke{T,F}

that minimizes:


7T 7.,) + (1- 7r)TLik)


subject to:


7,/ ., + (1 iJ) jk > 7jUjk + (1 m)uLk


(IIR-7j, Ak)


and:


\ (, ,)


subject to


> U3k (IIR-3,Ak)

At the renegotiation stage, six possible events may be observed: ( (, AT),

(w{,AF), (72,Ar), (72,AF), (V, Ar) and (i ,,AF). Note the only constraint in
each information event is one IIR constraint, and there are no IIC constraints. The

principal believes the manager has made the proper strategy choices BT = (lH,









7172 13, j rj), so no incentive problem remains at the renegotiation stage. In
the next subsection, I will show that the principal's beliefs about the manager's

choices are indeed correct.

Proposition 3. When the auditor's report is used to enforce full revelation,

-p ,'ments to the manager do not vary with the final outcome of the project.

4.1.2 Ex-Ante Contracts that are Consistent with Full Revelation

At the initial contracting stage, the principal offers a contract CT

{(Ujk, Ujk), (U3k)}j{1,2},ke{T,F} that is renegotiation proof given the principal's
beliefs and the contract induces the manager to choose strategies consistent with

the principal's beliefs BT = (/H, 17172 1T3, v = Tj). The principal's overall problem
7T, therefore, is:


2
Min P I{(1 a) [ 4(UT) + (1 (t )w >(U )]
Ujk,ULj,U3k j-1

+ a[j4,(Uj,) + (1 7T,)(U1)]} + P3{( a) 3T(U3T) + a(U3F)}

Subject to:



EU> -1 (11)

EU > 3[mUnI + (1 nm),T] + (1 )[mU1F + (1 m)1F] (12)

EU > 3[mU2T + (1 Tm)21 + (1 )[mU2 + (1 nm)2F (13)

EU > U3T + (1 )U3F (14)

(1 a)[7T1U71 + (1 TT1)1] + aTT1FI + (1 1TT)u1]

> s3iUT2r + (1 7i)1 + (1 0)[717U2 + (1 7iL)1F (15)









> U3T + ( )U3F (16)

(1 a)[72U2T + (1 72)T2r] + a[72 2 + (1 72)L2Fl

> 0[Kr1T + (1 1F2)u] + (1 )[i1F + (1 12)Lf] (17)

> U3T + ( )U3F (18)

(1 a)U3T + aU3F

> 0[771T + (1 3)LmT] + (1 3)[31F + (1 73)LF] (19)

> 0[u3 2T + (1 73)L2] + (1 3)[3U2F + (1 3)L2F] (20)

U1T = UIT (21)

U2T 2T (22)

7U1F -= L (23)

U2F 2F (24)

where

2
EU e- { P(1 a)[7UFjT r+ (1 TF)Uj]
j=1

+ PJa[7jUjp + (1 Tj)J]F + P3[(1 a)U3T + aU }

The ex-ante individual rationality constraint (AIR) is (11). Inequalities

(12)-(20) are the ex-ante incentive compatibility constraints (AIC). Among them,

(12)-(14) are included to motivate the manager to collect information and (15)-(20)
are included to motivate him to report truthfully. Inequalities (21)-(24) are the

constraints resulting from renegotiation. Notice that problem PT differs from the

full commitment case by adding four extra constraints (21)-(24), i.e., the project

outcome is not used. The presence of renegotiation makes the contract fail to

reference another informative contracting variable. Hence, the principal loses the









opportunity to insure the risk averse manager. Renegotiation reduces the efficiency

of contracting with the agent.7

The auditor's report is issued before renegotiation; thus, the contract that

references the report can provide some short-term commitment. When the

auditor's report is observed (AT or AF), the manager's utility level based on the

auditor's report is in the bank. The principal cannot lower the manager's utility

level at the following renegotiation stage. Recalling the full commitment setting,

the auditor's report is useful to motivate information acquisition and truthtelling.

In the same way, the auditor's report can be used to induce high effort, even in the

presence of renegotiation.

Renegotiation adds extra constraints; however, and consequently the expected

compensation cost will be higher. Pursuing full revelation before renegotiation also

makes the principal short-sighted: the contract puts all the weight on the auditor's

report and ignores the potential information content of the investment outcome.

The manager's incentives are provided completely from the auditor's report. But

can the auditor live up to such an expectation? The next proposition shows it

depends critically on the audit technology.

Proposition 4. When a,3 -- 0, the compensation cost is close to the

first-best case; but when a, 3 -- 0.5, motivating high effort becomes infeasible.

Proposition 4 implies that the audit technology determines whether it is

beneficial to reveal the information fully. If the audit errors are close to 0, it is

equivalent to allowing the principal to observe the manager's information directly.

The control problem becomes trivial, the first-best scenario. But if the audit errors



7 Notice that investment policy 71Tr217 is motivated here. Other policies are
not optimal. Since the overall contract does not reference the project outcome, the
contract is the same no matter what investment policy is motivated.









are large, the auditor's report is not informative enough to motivate high effort.

The decision about the project has to be made without information. If this is the

case, the principal can switch to the other reporting rule to motivate the manager.

4.2 Partial Revelation

Alternatively, the manager can be induced to reveal his information partially

at the interim reporting stage {{i7, 72}{73}}- and the remaining information

is solicited after renegotiation. Accordingly, the auditor here only verifies whether

the received signal falls into the investment region {71, 772} or the non-investment

region {13}. The essence of partial revelation can be best illustrated through a

benchmark case where no audit is available. I will then show that the original

problem 7P is simply an improved version of the benchmark case. Denote the

benchmark case as PL.

4.2.1 Benchmark: No Audit Case PL

4.2.1.1 Continuation contracts with partial revelation

At the renegotiation stage, the principal updates her beliefs about the

manager's type based on his report iij. Given the manager's reporting strategy

both type 71 and type 72 report 1{, but type 7r3 reports -the principal has

Pr(7 {l) -= P Vi E {1, 2} and Pr(73 1r) = 1. The principal offers

C = { (Ui,Ui), (U3)}iE{1,2} that minimizes
if f{i is observed:
2

i= 1

subject to


7TTi + (1 7) j > 7TTi, + (1 )L,; Vi' e {1, 2} (IIC-7it, 1)


iTUi + (1 7i)L > 73Ui + (1 7i) iU


(IIR-7i, ,1)









if wr is observed:


vlf(n.)

subject to



U3 > U3 (IIR-7T3)

Notice the principal offers contract CL to induce a truthful report from type

r1 and type w2i: IIC-ri, {. This is the only incentive problem for the principal

at the renegotiation stage. As we shall see, this incentive problem is essential.

Without it, a full insurance contract will result and the manager would not exert

high effort (see Lemma 3). But now the principal has to impose risk in order to

induce truthful reporting. The risk, from letting p ',lments vary with the final

outcome, can be sufficient to motivate the manager to exert high effort.

Lemma 3. If C, is a renegotiation-proof contract and induces investment

policy 12TTliTT3, the following must hold:



U1 > U1,

U2 -2 U2,

7"2U2 + (1 7"2)L2 72U1 + (1 7"2)1.


The continuation contract insures the low type (72) but imposes risk on the

high type (r1i). This is the main result from Stiglitz's [1977] insurance-policy-offering

problem. The key to this adverse selection problem is that a full insurance contract

is not optimal. A pooling contract that involves complete insurance limits the

principal's ability to extract rents from different agent types. Thus the contract

(for the high type) alv--,v- involves risk and varies with the final project outcome.





41


Lemma 4. Let C = {(U(I Ui), (U3)}ji{1,2} be a feasible continuation contract
satisfying


1 > U1

U2 =2

r72U2 + (1


- 2,

- 72)L2 2 771 + ( 1 72) .


CL is then renegotiation proof if and only if


P1 < 7Tl- 7T2 _"(U2)
P2 i- (1 -r (1) /(L1)
The intuition can be grasped from the following figure.




It l









II
450 (,L1)


Figure 4-2. The indifference curve

The slope of the indifference curve for the type 71 manager is U and
2 U'( for the type 72 manager. Thus type 7Fi's indifference curve is alv--

steeper than type 72's, as type 7r2 with a higher probability of encountering the low
outcome values insurance more. It is optimal for the principal to insure the low









type (72) but impose some risk on the high type (71) in order to deter the low type

from mimicking the high type. Naturally, if the low type's p clientt could be set

higher-from I2 to -2 he will have less incentive to mimic the high type. Thus the

risk imposed on the high type can be reduced from (II,/,) to (II, 1). By doing so,

the principal's compensation cost may be lowered because the risk premium paid to

the high type is reduced, although the p clientt to the low type is increased. But

this alteration leaves some room for the principal to improve the current contract.

She keeps altering the p clients until the gain from reducing the risk imposed on

the high type is balanced off by the loss from increasing the p liment to the low

type. That is, the principal reduces T'(U1) ''(iU) while increasing T'(U2) until

the inequality in Lemma 4 holds. If the inequality is satisfied, it means no gain

remains to be reaped via renegotiation, and the principal has reached the optimum.

That is, the contract is renegotiation proof.

4.2.1.2 Ex-ante contracts that are consistent with partial revelation

Foreseeing these effects of renegotiation, the principal solves the ex-ante

problem PL.

2
Min YPt[ (U) + (1 7)w(U)] + P3'(U3)
UiLi,U3 i 1
subject to



EU > -1 (25)

EU > mU1 + (1 m)U1 (26)

EU > mU2 + (1 m)UL (27)

EU > U3 (28)









7iiU + (1 i)L, > U3 (29)

2a72 + (1 72)L2 > U3 (30)

U3 > 1 T3 + (1 73)U1 (31)

U3 > T37U2 + (1 73)U2 (32)

2 2 (33)

7T2 U2 + (1 7T2)2 w- 1 + (1 12) (34)
P1 11 w12 "(U2)
< (35)
P2 7 1(l- 71) TWO (L)
2
Where EU ej{ZP[U, + (1 )U] + P3U3}.
i= 1
Inequality (25) is the AIR constraint. Inequalities (26)-(28) are the AIC

constraints for effort selection. Inequalities (29)-(32) are the AIC constraints for

investment policy 712Tr 3. These ex ante constraints make sure that the principal's

ex post beliefs at the renegotiation stage are consistent with the agent's strategies.

Notice that the extra constraints resulting from renegotiation are (33)-(35).8

Proposition 5. When motivating partial revelation without an audit, the

optimal renegotiation-proof contract CP takes the following form:

when m > 72,



8 The policy 7rr2 173 is still optimal in the partial revelation case. Implementing
policy 71 1T27r3 is not optimal. The investing type will be offered with a full
insurance contract. The same contract has to be offered to the non-investing types.
With a full insurance contract, high effort cannot be motivated ex ante.












SPI(1 i) + (P2 + P3)( ) 1- ( r)en-r
P3(72 73)
-P17 (P2 + P3)72 + m7e-
P1 P( -2 T3)
U3 -- r- +e-^
U2 112 U3 2 (i7 --2)e -r-
P(2 2 2 3)

when mn < 2a,



S PI(1 1 i) + (P2 + P3)(1 7) (1 2)e6-r
PU( i =2)

S-P7 1 -(P2 + P3)72 + 2-rc
P1I 72)
U2 1L2 U3 _1,

if the renegotiation-proof condition m < (-2 is satisfied.

Taking into account the effect of renegotiation, the manager's ex ante

incentives are as follows. Since no risk is imposed on type 72, type 72 and type

7i3 must receive the same p client U2 U3 in order to induce policy 71r2 73. From

the effect of renegotiation, U2 = 7r2U1 + (1 r2)U1, the manager will implement

policy 71ri2 T3. If the prior belief indicates the project is promising (m > 72);

however, the manager might want to misreport as 7i in order to avoid searching

for information. That is, constraint (26) is binding. Similarly, if the project is not

that promising, (m _< 72), he might reject the project (by claiming 73) before ever

searching for information. That is, constraint (28) is binding.

If the contract specified in Proposition 5 does not satisfy the renegotiation-proof

condition, the principal will increase type 7r2's p .,ment and reduce the risk

imposed on type 7rl (Refer to Figure 1). The reduced risk on type 7rl will not

be sufficient to motivate the manager to exert high effort. If 7r is close enough

to 1, however, the renegotiation-proof condition can be satisfied. With r7









close to 1, Ui, Ul, U2 are all finite terms. Hence the ratio I,-(U2) in the

renegotiation-proof condition is also finite, but the ratio 11-r2 can go unbounded.

Thus, contract CP will be able to motivate the high effort. To illustrate the

feasibility of this contract, consider the following numerical example. Let vi = .9,

7r2 .5, 73 .1, P1 .4, P2 .4, P3 = .2, c = 200 and r = .0001. The optimal

contract is 7I 1097.67, 1 = -1341.46, 2 3 = -196.08, and the contract does

satisfy the renegotiation-proof condition: P = 1, and 71-w2 J(U2) 18.6.
P2( ) 4"(Ui)-4"(U1)
The total expected compensation is 223.86. (In the remainder of the analysis,

I consider the contract C, only when the renegotiation-proof condition can be

satisfied.)

4.2.2 The Original Problem PP

Now return to the original problem where an audit is available. The audit

function at the interim reporting stage is to discern whether the manager's

information is consistent with the reporting rule {{T7r, 72}{T3}}. The auditor

does not distinguish whether the manager received good news (72) or great news

(Tr). Thus the audit function is in effect designed to monitor the manager's

investment decisions.

Lemma 5. An audit is weakly efficient in the partial revelation case.

The principal cannot be hurt by the auditor's report, although it is issued

before renegotiation. This is because the auditor's report is only a garbling of the

manager's reported information, and the principal cannot obtain more information

from observing the auditor's report. Releasing the auditor's report does not create

an incentive for the principal to further renegotiate the contract. But its release

helps the principal monitor the manager's investment decisions and provides

short-term commitment before renegotiation takes place, so the auditor's report

is valuable to motivate the manager to acquire information. (Recall the value of

auditing in the full commitment setting. The auditor's report is informative about









the manager's effort. If the manager did not acquire any information, he has to lie

and the auditor can detect lying with a positive probability.)

4.3 The Optimal Information Flow

Compared with the full revelation case, partial revelation limits the principal's

incentive to renegotiate the contract. Restraining information flow, as a substitute

for commitment, can make it easier for the principal to manage the long-term

relationship with the manager. Recall that the manager's incentive to reveal his

information fully at the interim reporting stage depends solely on the auditor's

report. The audit technology determines whether to pursue full revelation.

Specifically, if the audit accuracy is high, i.e., a,/3 -- 0, when to reveal the

manager's information is trivial. However, if the audit accuracy is low, i.e.,

a,/3 -- 0.5, when to reveal the manager's information is crucial. Inducing partial

revelation can successfully motivate the manager to exert high effort, even if no

auditor is present. In this way, the adverse consequence of low audit accuracy can

be avoided.

Proposition 6. If a,3 -i 0, full revelation can be preferred; if a,3 -i 0.5,

partial revelation is preferred.

Using the same parameter values of the numerical example as in Section

6.1.2, the table below compares the total expected compensation between the two

reporting rules.

Table 4-1. Comparing the control cost

( ) (.01, .01) (.2, .2) (.3, .1) (.4, .2) (.4, .4)
full revelation 200.02 200.89 201.08 203.04 212.09
partial revelation 204.46 206.38 206.93 209.75 215.86
((o,3) (.4, .45) (.45, .45) (.45, .47) (.47, .47) (.49, .49)
full revelation 221.43 250.08 278.21 341.28 1647.66
partial revelation 218.28 220.94 221.86 222.68 223.69









The table shows that full revelation dominates partial revelation when a and 3

are small, but the compensation cost increases dramatically when a and 3 are close

to 0.5. The compensation cost from inducing full revelation is sensitive to the audit

technology. When audit accuracy is high, it is wise to use the auditor's report fully,

i.e., the auditor is instructed to check all details of the manager's information. But

if the audit accuracy is too low, the compensation cost becomes extremely large;

ultimately the auditor's report becomes useless to provide the manager incentive to

choose high effort.

The proof follows directly from Propositions 4 and 5 and Lemma 5.

4.4 Summary

Partial revelation can be useful. The acquired information is forward looking

and communicating it requires estimation. Daily involvement with the firm's

operations and the expertise to search for information put the manager in a better

position to interpret the acquired information than the auditor. The auditor will

commonly have difficulty reaching agreements with the manager on the reporting

issues. Realizing that the audit accuracy can be low in handling this type of

information, the auditor should be motivated to allow the manager to withhold

some information. The audit is still useful because it verifies whether the manager's

investment decision is justified by his acquired information. But leaving some

information unverified can benefit the long-term contracting relationship in that

it allows investors to learn gradually about the manager throughout the project

and matches better with the manager's long-term perspective. Of course, some

accounts are easier to verify than others. If the auditor is confident with her audit

technology, it is reasonable to enforce full revelation. Again, the auditor's judgment

is required.

Paralleling the auditor's decision, this result also speaks subtly to the value of

earnings management. Auditors are less likely to require adjustment of earnings






48


management attempts when some information is subject to more discretion.

(See Nelson, Elliott, and Tarpley [2002].) Perhaps this is because allowing some

information to be kept private can avoid disrupting the manager's long-term

objective. Withholding information arises due to the joint effect of long-term

investment plans and audit errors.















CHAPTER 5
UNVERIFIABLE INFORMATION

In this chapter, we consider a larger set of available information for investment

decisions. Useful information is not limited to financial reports. Information that

comes to help can vary from a formal managerial accounting system to a walk

around the factory. One problem is, some of the information is unverifiable. For

instance, in the development of a project, both the principal and the manager

commonly observe information before making the next move. But evaluation of

the project based on the observed information may be subjective. It is not easy to

present such information to a third party without causing ambiguity, so this type of

information cannot be used in contracting with the manager.

Under some carefully-designed mechanisms, this type of information can

still be useful for decisions even if it is not directly contractible. Demski and

Sappington [1991] provide an interesting analysis in which both the principal

and agent exert productive effort. The principal observes the agent's effort (the

unverifiable information) and has the option to require the agent to purchase the

business at a pre-negotiated price. For example, a retailer usually can discern the

quality of a product manufactured by a corporation before supplies effort to market

the product, and the corporation has sufficient fund to buy out the retailer. The

problem can be solved costlessly by letting the manufacturer buy out the business

whenever the product quality is not satisfactory. Baiman and R li in [1995] study a

setting where only the principal can observe the unverifiable information so she is

subject to moral hazard concerns when she p .]i- the agent based on the unverifiable

information. One clever way to use the unverifiable information with multiple









agents is to allow the principal to allocate discretionary bonus among the agents

but the total bonus pool is based on some contractible information.

5.1 The Investment Problem

Returning to our investment problem, we know some times underinvestment

or overinvestment may occur. One of the reasons may be the decision-facilitating

information is unverifiable. The received signals 71, 72T or 73 are difficult to

articulate so the contract cannot take each contingency into consideration. With

the contract going incomplete, some efficiency is lost when the investment decision

is delegated to the manager. (For simplicity, I assume both the principal and

manager can observe the information, even it is unverifiable. A more general

situation would be, the principal and manager observe different information since

they may have their own information sources and may interpret the information

differently even when they are reading the report from the same consultant.)

Since the acquired information is not contractible, the principal offers contract

{U,U, U}. The p ,iment depends on x {7,x, x} only. To minimize the expected

compensation cost, the following program (P2FB) is set up to implement the

first-best investment policy 1r2 173s.




Min [Pii + P27 2]T(U7) + [P1(1 T1) + P2l 2t)] ) + P'V3)
u,u_,u

Subject to:




EU > -1 (36)

EU> mU + (1 m)U (37)










EU > U (38)

727U+(1 7r2)> U (39)

U > 3U+ ( 3)U (40)

where EU ec"{[P171 + P27T2]+ [P1(1 ) + P2( 2)U+ P3U}.

Proposition 7. When m > 72, implementing 1172713 is strictly less costly

than implementing the first-best policy 121a 73.

If the first-best policy is implemented, the manager has more incentives to

avoid searching information because the expected profitability m is already above

the induced investment level r2. The project, "on av I', is profitable. The

manager's incentives to search for information are different when implementing the

policy 11 7273. The manager cannot tell whether the project is worth investing

based only on the expected profitability m. "On av( I ;, the project may or

may not be worth investing. Therefore, the risk-averse manager would search for

more information to settle the uncertainty. It becomes less costly to motivate

the manager to acquire information. If the investment gain is not too large to

sacrifice when 2a is observed,1 the principal can be better off implementing the

"second-b. policy 7rr27r3.

In order to motivate the manager to acquire information, it is generally

beneficial to impose maximal uncertainty so the risk-averse manager is more willing

to reduce the risk by acquiring information. Inducing the manager to make an

efficient investment decision, however, has to rely on the acquired information.

The amount of risk has to match up with the manager's type, i.e., his information.

The risky type (the manager type who observes relatively bad signal 72) should be

provided more insurance relative to the safe type (7r). Therefore, it is difficult to


1 That is, P2 [2r2 + (1 72)x -x] is not too large.









reconcile the conflict in designing the contract. That is, the contract may not be

able to provide incentives to acquire information and invest efficiently at the same

time.2

5.2 The Effect of Renegotiation

In order to avoid the "underinv--I ii,, problem, one approach is to set up

some revelation mechanism, where the principal and agent report their observation

to the judge simultaneously. The judge will then penalize the two if their reports

conflict. There exists a Nash equilibrium in which the parties can credibly reveal

their private information and based on the report, the optimal investment policy

can be implemented.3

Nevertheless, presenting evidence to a court seems to be different from sending

messages inside a firm. Accounting reports only admits some type of information

and is restricted in certain formats. In addition, it is difficult to proceed under the

revelation mechanism when parties have different private information.

In this section, we resort to ex post contract renegotiation to implement

optimal investment policy, without invoking any report of the unverifiable

information. The principal offers to renegotiate the manager's existing contract

after the acquired information is observed but before the manager makes any

investment decision. Now the new continuation contract can take into account the



2 Proposition 7 characterizes the problem of underinvestment. Similarly, an
overinvestment problem may happen when m < 7r2. In that case, implementing
7iTTi2 T3 may be less costly when 71r27r3 is the first-best policy. The reason is the
same: create maximal uncertainty to induce information acquiring activities. But
implementing overinvestment policy has to compensate the risk-averse manager for
the additional risk. A random cash flow results if investing when 72 is observed. So
the benefit of inducing overinvestment is relatively smaller.

3 Cremer and McLean [1988] study an auction setting where the seller wants to
induce buyers to reveal their imperfectly correlated valuation.









realized information implicitly. The risk level based on the information can be set

properly so that the manager's investment incentives can be straightened out. The

following timeline reflects the change in the order of events.




Principal Manager Unverifiable Contract Investment Outcome
offers chooses information renegotiated decision realized,
contract effort r 7() C2 made x, x
C1 to observed or x.
gather Payment
infor- made
nation

Figure 5-1. Timeline when unverifiable information is observed


At the renegotiation stage, the principal offers a new continuation contract

to minimize the expected compensation cost given the observed information. Of

course, the initial contract provides the manager with the default utility level. The

result is similar to the full revelation case in Chapter 4. Since I assume there is

no extra cost to implement any investment policy, the principal's optimal choice is

to offer a full insurance contract based on the observed information. Suppose the

initial contract {Uss, Uss, USB} induces the second-best investment policy 7 r27r3.

At the renegotiation stage, the principal offers a new contract {UI, U2}, where

the new offer is U1 when the principal observes 71, and is U2 when the principal

observes 72 or 73. Manager types 72 and r3 are offered the same contract because

the initial contract induces both types not to invest thus providing the same utility

level. If the principal does not observe any new information at the renegotiation

stage, she offers U2 to the manager. Then we have











71u7SB + (1 70i)USB U1 (41)

USB = U2 (42)

Proposition 8. The renegotiated contract {UI, U2} implements the first-best

investment policy and induces the manager to acquire information at a lower cost

compared with the second-best contract {Us0B, USB USB} where no renegotiation

takes place.

The effect of renegotiation is to reduce risk premium. In this case, when

there is no more incentive problem for the principal to handle, the risk premium is

reduced to zero. With a fixed p -,ment, the manager is completely shielded from

any risk resulting from his investment decision. He will implement the first-best

investment policy.

In order to motivate the manager to acquire information, the following

constraints are binding for the initial contract {S UiSB, USB}:
{P cSB + Pi(1 7l) B (2 + )SB} > 1
{P SBpi7 + P( ) (2 + P)USB} > -USB + (1 r)SB
e" {Pil-S + Pi(1 w)U + (p2 + P3)US} > USB

Since the renegotiated contract offers the manager the same utility level,

the manager's ex ante incentives to acquire information are not altered. (These

constraints are satisfied when we substitute the renegotiated contract {UI, U2}

with (41), (42) and mUns + (1 mn)USB U2. The last equation is implied by

the binding constraints.) Based on the newly observed information, however, the

principal is able to reduce the risk premium by insuring the manager types who are

invited to invest. Therefore, the expected compensation cost is strictly lower.

The benefit of renegotiation is, it isolates the spillover effect between acquiring

information and making an investment decision. After the manager's effort is sunk,









the contract is revised to reflect the current situation. The current situation is to

induce the manager to make a proper investment decision, so the ex post efficient

contract will provide the manager with the right incentives. The incentives are

reshuffled to accommodate the current need.

This result can be seen as an application of Hermalin and Katz [1991] in a

multi-task setting. Renegotiation occurs and takes advantage of the unverifiable

information. In contrast, the compensation cost cannot be reduced to the first-best

level as in a conventional moral hazard model. The same as their model, the

principal can observe the manager's effort directly: if the manager works, 71, 72

or 7i3 can be observed, but if he shirks, no information is observed. But the initial

contract sets different default utility levels based on the observed information.

Hence, the renegotiation process cannot lower the manager's default utility directly

to the first-best level. Endogenously created information changes the manager's

preference entering the renegotiation stage.

We have studied contract renegotiation in ('!i lpter 4 and 5, but the effects are

distinct. ('!i lpter 4 studies a setting where renegotiation is purely a trade friction.

When the manager holds private information, how the information is reported

affects the following renegotiation process which affects the manager's incentive

in productive actions: acquiring information and making a proper investment

decision. ('!C Ipter 5 deals with unverifiable but observable information. There are

no reporting problems. Renegotiation serves as a mechanism to use the unverifiable

information indirectly, thus can be beneficial.

5.3 Summary

There are long-standing concerns about efficient investments. Underinvestment

in research and development will slow down the long-term growth of the economy.

Failure to pull the plug when the project runs on a losing course can cost

the ("onI ii hugely. These problems occur partially because the manager's









incentives are not adjusted properly along the project's duration. Newly discovered

information calls for a re-evaluation of the project's profitability. How to make use

of the discovered information is the focus of this chapter, even if the discovered

information is unverifiable and thus cannot be used directly in contracting with

the manager. Instead of relying on some revelation mechanisms, the principal can

renegotiate the existing contract based on the newly discovered information. The

ex post efficient contract provides the manager with up-to-date incentives to make

a proper investment decision.

One caveat of our model is that the investment cost is simplified to be zero.

Therefore, a full insurance contract is resulted to take care of the investment

incentives. If the project needs an unobservable fund injection after the contract

is renegotiated, then a risky contract will be offered. Maybe it is not beneficial to

isolate the two tasks by inserting contract renegotiation in between. Sometimes, the

spillover effect may be beneficial. For example, the risk imposed to motivate

the manager to acquire information may coincide with the risk to motivate

the manager to make a proper investment decision, so it is trivial to consider

implementing the investment decision. Sometimes, inducing an efficient investment

policy may also automatically motivate the manager to acquire information. The

nature of multitasking determines the usefulness of contract renegotiation.















CHAPTER 6
CONCLUSION

Acquiring information for a risk averse manager is never a trivial task. One

might think the imposed risk from motivating another task would naturally force

the manager to collect more information. But the contract design is subtle. If the

imposed risk on the manager is too small, he will not acquire information, but just

invest in the project; if the imposed risk is too high, the manager will not do the

work either, but just forgo the project.1 This paper shows that .mdlll i- when

conducted properly, can help create efficient incentives for the manager to acquire

information.

An audit of the manager's acquired information is beneficial because it aligns

the manager's incentives in acquiring useful information and in making a proper

investment decision. But if the board of directors cannot commit not to use the

disclosed information to renegotiate the initial contract, an extensive audit may

exacerbate the control problem. Therefore, if the audit technology is not highly

effective in identifying misstatements, the auditor may only want to verify whether

the manager's report is consistent with his investment decision, but allow the

manager to keep the finer details private. This arrangement is beneficial because

it also reins in the self-interested behavior coming from the owner's side. Together

with the manager's behavior, it depicts an interesting balance in equilibrium.



1 Laux [2004] pointed out that motivating the manager to implement another
task cannot automatically provide the manager the right incentive to collect
information. It is ahv-- i necessary to motivate information acquisition explicitly.









Financial reports contain information that is useful for future decision-making.

The consequences of past decisions are also recorded in financial reports. The

auditor verifies the reported information thus serves as a monitoring device of

managers' decisions. It is important for the auditor to understand the manager's

dynamic decisions making. The manager's decision in financial reporting is

correlated with his decision in productive actions, which in turn affects the

underlying resource allocation. Ex post uses of reported information influence the

manager's ex ante incentives to acquire information and make a proper investment

decision. It is also important to recognize the economic consequences of standard

setting. The rules on financial reporting and auditing change the preparers'

behavior. Standard-setters are not regulating nature but rational economic agents.

The results echo the line of literature that provides explanations for earnings

management based on the effect of renegotiation (a violation of the Revelation

Principle's assumptions).2 My analysis focuses on how renegotiation affects the

manager's investment behavior when the audited information is endogenously

acquired. Audit technology determines how much information is to be disclosed.

In contrast, a perfect audit in my model results in a first-best scenario and the

manager's information should be disclosed. The intuition is that the manager's

shirking means no useful information is produced and thus will be detected in

the audit. The adverse effect of renegotiation is amplified only when the audit

technology is relatively ineffective so using the auditor's report alone is not

informative enough to provide incentives for the agent to work. My analysis

emphasizes the subi 1. i, of the audit function and therefore the solution is



2 See Demski and Frimor [1999], C'!1 i-1. i -, i, Demski and Frimor [2002],
C'!i -i. 1I-, i, Feltham and Sabac [2004] and Gigler and Hemmer [2004].









"interior" motivating accurate financial reports may or may not be efficient.

Auditors' judgments are the centerpiece.

Some argue that we impose too much responsibility on the auditor. The

auditor's job is to "check whether a reported number is correct". The auditor does

not ask why and how the number is generated. As the auditor assesses audit risk

and materiality before performing substantive tests of transactions, however, she

is concerned about management. SAB 99 advises the auditor to investigate the

manager's incentives carefully as opposed to setting some mechanic materiality

threshold. Accounting firms hire experts to audit R&D contracts because they

have superior knowledge to evaluate the manager's performance. Auditing is not

a simple task in that it requires the auditor formulate judgments. The deeper the

auditor understands managerial decisions, the easier the auditor reaches a correct

conclusion.

Some worry about the auditor's incentives if she is provided more discretion.

That is a valid concern. There is another round of incentive problems. One

problem is how the PCAOB evaluates the auditor's work when their opinion

is at odds with the auditor's judgments. Auditor's exposure to legal liability

forces standard setters to consider simple, rules-based standards that permits less

discretion. The audit fees, market competition, etc., all influence the auditor's

behavior. A model with multiple pl.i ,- rs would be more appropriate to address

these questions. But our model provides a salient structure of the audit function.

More importantly, we point out the gap in the understanding of financial reporting

and auditing. If financial reporting is a sophisticated communication process,

auditing should help to serve this goal. We first provide a benchmark where an

ideal auditor should perform, then we search for feasible mechanisms to induce

to the auditor to perform as we hope. After all, the questions boil down to the

trade off between revealing information enforced by an auditor and the resulting









concerns for efficiency. The main message from my study is well reflected here: the

optimal auditor's choice depends on the context that creates the incentive nexus

and there is no panacea for all the reporting issues. Auditors are expected to rely

on judgments to deliver high-quality work.

Besides revelation mechanisms, there are other mechanisms make the

discovered information useful. Contract renegotiation takes into consideration

newly discovered information. Thus the manager's investment incentives are

better aligned with the current situation. In this way, the spillover effect between

information acquisition and investment decisions can be isolated. Efficiency is

strictly improved. However, the result hinges on the assumption that there is no

additional cost to invest in the project. An extension would drop this assumption

and examine more about the spillover effect between the two tasks. We might find

that interim contract renegotiation can disrupt the synergy between the two tasks.














APPENDIX
THE PROOF

Proof of Lemma 1.

First we identify the binding constraints for each of the two situations: m > 7r2

or m < 72.

A. when m > 2-.

In a less restricted problem, where only constraints (1) (2) (3) (8) (10) are

present, all the constraints are binding. Then I show the less restricted program is

feasible to the original problem.

Let A, p11, 2 3, 14 represent the Lagrangian multipliers for each constraint.

The FOCs provide

Z'(U1) = Ae" + 1l [ere 1 + 12rc

4i'(gL) Ae- + pl [ c 1- r + /rc
'(U2) = erc + rc + 2(rc 2) +4 [4p7
r 1- 1 m 1 -3
4"'(g2) AeC + Ple + 2(ec P2(1- 2)] + 3 4p2(1-T2)

I'(U3) Aer + 1eerc + /2rc [33 + P41
Remember T(.) is the inverse function of U(.). Since U'(.) > 0 and U"(.) < 0,

'(-) -= y > 0 and "'(.-) [u- 2U"(.) > 0. So the RHS increases in U.
Suppose P3 = 4 = 0. With U3 > U2, 2, it implies type 7r2 manager
alv--,i- reports 7F3. Suppose p3 = 0, /4 > 0, again we have U3 > U2,U2. Suppose

p3 > 0, p4 = 0, two possibilities: ap2 > 0 and b2 = 0. a implies U2 < L2,
because r > 2 71272 + (1 72)2 < 7132 + (1 73)2, since 72 > 13.

Either constraint (8) or (10) must be violated. b implies U2,U > U3. The type 73

manager will ah--,v- report 7r2.









Only 13 > 0, p4 > 0 is valid. Constraints (8) and (10) are binding: w2U2 + (1 -

7r2)U2 T3U2 + (1 7T3)U2 U3. Since 72 i 73, the only solution is U2 2= U3.

Suppose p = P2 = 0, then we have U2 / U2, contradict to the result above.

Suppose i = 0, /2 > 0, then we have U1 = U1. With U2 U2 U3, truthful

reporting requires all the p ivments are equal. Then the manager will not work.

Suppose p > 0, P2 = 0, then we have U2 / U2, which contradicts to the derived

result U2 -= U.

It is easy to check that the rest of constraints are satisfied with the established

binding constraints. Hence, constraints (1) (2) (3) (8) (10) are binding for the

original program. The FOCs and K < Pl1m imply UI > U1.

B. when m < r2a.

Similarly, we can find the binding constraints are (1) (3) (4) (7). Reassign

A, /M1, [2, 3 to represent the Lagrangian multipliers for these four constraints. The

FOCs from the relaxed problem are:

'I(U1) Aer + I l rc + [26erc 3 7
(i) Ae rc 2rc -7r

I'(U2a) Aerc + rc 7 2) + rc P + L3
I'(L2 ) Arc + p l(erc 7-) + e rc + /3 1
-P2(I- 2) P2
W'I(U3) Xerc + 1e rc + 2(erc- )

It is also easy to check that the rest of the constraints are satisfied with the

established binding constraints. The FOCs and 2- < 1- 2 imply U1 > Ui;
P171 P1(1-7W)
P2 < P1-n implies U2 > UL. QED.
P-iT P2(1-2) ---
Proof of Proposition 1

Auditing expands the set of contracting variables. The problem with no audit

is a restricted version of the problem where an audit is available, so the no-audit

problem can be written as follows:










2
Min P{(1 a) )[Ti (77iT) + (1 7i) (UiT)]+
UiT,UiT,UiF,UiF,U3T,U3F

aL[7Tw(U7F) + (1 7Ti)4(rF)l]} + P3[(1 a)I(U3T) + a4((U3F)1

Subject to:



EU > -1 (Al)

EU > 3[mnU1r + (1 m)U,1 + (1 3)TnUIF + (1 m),]FI (A2)

EU > 3[mU2T + (1 Tm)U21 + (1 3)[mnU2F + (1 m)L2F] (A3)

EU > fU3T + (1 )U3F (A4)

(1 a) [71UIT + (1 1T1)lIT + aw[7lUF + (1 7T1)LF]

> P/[71U2T + 1 ] 1 + (1 /0)[7T1U2F + (1 T1)2F] (A5)

> U3T + (1 -3)U3F (A6)

(1 a)[7272T2 + (1 72)L2T] + a[72U2F + (1 72)2F]

> P0[72U1T + (1 712)LT] + (1 3)[722U1F + (1 712)lF] (A7)

> _U3T + (1 -/O)U3F (A8)

(1 a)U3T + aU3F

> 0[7"3U1T + (1 73)UTI + (1 3) [73U1F + (1 73)LF] (A9)

> /3 [73U2T + (1 73)r2T] + (1 /)[T3U2F + (1 7F3)L] (A10)

UiT = U7F (All)

LiT = UiF (A12)

U3T U3F (A13)









Where

2
EU e= e{ Pi[(1 a)(FiT + (1 ri)LT)+
i 1

aQ(wUiF + (1 mi)iF)] + P3[(l a)U3T + aU3F}

It is clear that auditing cannot increase the expected compensation cost by

relaxing constraints (All)-(A13). To show that auditing can strictly reduce the

expected compensation cost, consider an audit that is conducted only when r3 is

reported. That is, given UiT = U iand UT = ULiF, I show that the constraint

U3T U3F is binding.

A. when m > 72

I have shown that in the proof of Lemma 1, constraints (Al) (A2) (A3)

(A8) (A10) are binding. Let A i,p1 P2, P3, P4 represent the Lagrangian multipliers

for these constraints so they are all positive. Let p5 represent the Lagrangian

multiplier for the extra constraint (A13). The FOCs for U3T and U3F are

'I"(U3T) Aerc + ierc + p12r 13P (l + 4 + P5 )
3(1-a) 3 P3(1-a)
(U3F) rc 1lrc 2rc 3 R 5
I"(U3F) AeC + [eT +pe12 /13 -K 1 [15 p

Since A, p1,p2, 33, 4 > 0, in order for U3T U3F to hold, p5 must be negative

because 1 < K- Therefore, constraint U3T = U imposes extra costs to the

problem.

The proof for m < 72 is similar.

Since adding more audits will not increase the compensation cost when 71 and

72 are reported, auditing is strictly valuable to the principal. QED.

Proof of Proposition 2.

Suppose the principal offers Ci = C* at the initial contracting stage and that

the manager accepts and chooses strategy profile B = (T]H, 7172 73, I3 jiF). If C*

is not renegotiation proof, there must be another contract, C, which offers every









type of the manager at least the same expected utility as C* but leads to a lower

compensation cost for the principal. Yet such a contract cannot exist, because

C* is the final contract and hence optimal at the renegotiation stage. Thus C* is

renegotiation proof given the manager's strategy profile. The manager's strategies

remain the same, because his compensation depends only on the final contract. If

in equilibrium, the manager chooses B when C is the initial contract and C* is the

final contract, then he makes the same choices when C* is offered initially. QED.

Proof of Lemma 2

Suppose without an auditor, the manager reports truthfully 71, 2a or

7r3 before entering the renegotiation stage. Since the low effort produces no

information, the principal realizes the manager has already exerted effort to acquire

information. Given the principal's belief that the manager has worked, made a

proper investment decision 7Tr172 r3, and reported his private information truthfully,

a contract C = {(U71, ), (U2,)2), U3} is renegotiation proof if



Uj, Lgj arg min 7j T ((Uj) + (1 7j) (Uj)

subject to



FUTT, + (1 7F,) > >- U7 + (1 F,)U,; Vi C {1, 2}, (IIR-7w)

and



U3 E argmin l (u3)
u3
subject to


U3 > U3.


(IIR-7T3)









With a single IIR constraint in each information event, the principal's best

strategy is to offer a fixed p .,iment: Uj = U = Uj. Then the p clientss should be

equal for all the three events in order to induce the manager to report truthfully.

We have U = U2 U3, i.e., a full insurance contract. But a full insurance contract

cannot induce the manager to work, which contradicts the principal's belief that

the manager has worked. QED.

Proof of Proposition 3.

The result can be derived directly from the interim optimization program.

For 1 type v7 or 72, at each information event (wf, Ak), the principal solves a

cost-minimization problem with only one IIR constraint. The principal's optimal

strategy is to offer a fixed p .ivment conditional on each information event, i.e.,

U1T = UT U2T L2T; U1F LF; U2F U2F. For 2 type 73, there is

no room to gain via renegotiation. Since there is only one fixed p ,iment for

each information event ((,, Ak), U3T and U3F are renegotiation proof. Given

each information event, the principal offers a full insurance contract: CT

{(UIT, U1F), (U2T, U2F), (U3T, U3F)}. QED.
Proof of Proposition 4.

Considering the following contract: {IjT = c + C, IjF = 0}, where c > 0. For

this contract to be feasible for the program, the inequalities (11)-(14) should be

satisfied:

',,[(1 a)(-e-r(c+c)) + a(-e)] > -1

erc[(1 a)(-e-r(c+c)) + a(-e0)] > pe-r(c+c) (1 3)eo

Notice that other constraints are satisfied using this contract, since 1 a > 3.

Rewriting the two inequalities, we have
_6-rc > _a _r 1
_-r > a rc 3 C -rc 1-3
-- -a- 1-a-3 1-a-3









Thus, c should be large enough to satisfy the two inequalities. When c, 0,

the RHS of the two inequalities is close to -1 so e can be reduced close to 0. e 0

means the compensation cost becomes c as a,3 -i 0, i.e., the first-best solution

becomes feasible in the limit.

When a,j -i 0.5. First multiply P1, P2, P3 to the inequalities (12)-(14),

respectively. Then add the three inequalities together. This rearrangement returns




er{P[(1 a)UT + aU1F] + P2[(1 o)U2T + aU2F + [(1 a)U3T + aU3F]}

> P [/UlT + (1 I)Ul] + P2[3U2T + (1 )U2F] + PU3T + (1 U3F]

Substituting the negative exponential utility and rewriting the inequality, we

have



e-rI1T [ePi (1- a) P1/] e-r2T [ercP2(1 a) P2 1 e-r3T [eCP3(1 a) P3

> _e-rhIF [P(1 ) erc ] -rI2F 2(1- )- ec2] -e-rI3F [P3( 1-3) ecp3a]


The inequality must hold for the program to be feasible. er > 1 and 1 a > P

imply ercPi(1 a) > Pi3. Thus the LHS is less than 0. The inequality requires the

RHS must be less than 0, too. This implies at least one Pj(1 3) ercPja from

the RHS must be greater than 0, i.e., 1 3 > erca. But when a, 3 -i 0.5, this

inequality will be violated. QED.

Proof of Lemma 3

The proof is similar to Fudenberg and Tirole [1990], Lemma 2.1. There

are four situations concerning the two IIC constraints. Three of them will be

eliminated. 1Suppose both constraints are binding. IIC-7T, 1{' is binding implies
71 12
-f (~l -2) (2 1), and IIC-72, f{ is binding implies 1-g2 (1- u2) (u2 12u).
Since 711 / 712, it must be l = "u2 and u2 = u. That is, the two types receive the









same p clients 7, u, a pooling contract. There are three possibilities: a u > u,

b 7 < u, or c = u. a Suppose 7 > u is offered to both types. Consider the

following contract for type 72: a single p client to the manager who claims 72 and

U2 = 72u + (1 7a2), while keeping the contract unchanged for type 71. Then all

the constraints are still satisfied, but the compensation cost for type 72 is reduced,

because 4(U2) < 72T(7U) + (1 72)1(.). Since the compensation cost for type

7T is unchanged, the above alteration reduces the total compensation cost. b is

similar to a, except a change for type 71: a single p clientt ul = 7u + (1 7rl),

while keeping the contract unchanged for type 7r2. The expected compensation

cost is lowered. c Suppose 7 = u is offered to both types. That is, a full insurance

contract is offered and each manager type receives the same utility U = U = U.

The problem becomes



1
{U} c argmin- {[Pi7r + P2121 T(u) + [Pi(1 Ti) + P2(1 12)11u)}
u,u PI + P2

Subject to:




7T2u + (1 wT2)U > U



The first inequality is the IIR constraint for type 7r2. Since vi > 72, iT1 + (1 -

7))u > Tr2u + (1 72)u, the IIR constraint for type 71 is satisfied. Denote A and p
as the Lagrangian multipliers for the two constraints. I will show p : 0 and thus

the extra constraint u= u is costly.

The FOCs with respect to u and u are

'() 1+P (PI + P2) and (') (1- (pl + p2).
Pl7Fl+P27F2 -- PI (1- 71) +P2 (1- 72)"









We know A > 0, because the principal can alvi.-, reduce the expected

compensation cost by offering (u u E), where E is a small positive number,

and the IIR constraint will still hold. Suppose p = 0. In order to satisfy u = u,
72 must be equal to P5( 1-w72 But simple algebra returns the former
P1 7s +P2x 2 Pl(1--1)+P2(1-72)
ratio is larger than the latter because of the assumption 71 > 72. Hence, p / 0, the

constraint u = u adds more costs to the principal. Offering a full insurance contract

is not optimal.

2Suppose neither constraint is binding. Cost minimization implies a

fixed-amount p client to type 7v and 72, respectively. In order to induce a truthful

report, the p clients should be equal: u1 = u2. But a full insurance contract is not

optimal.

3Suppose IIC-71 is binding, but IIC-72S is nonbinding. Then the cost

minimization subject to the rest of constraints yields 7u = = u1. Rewriting

the two IIC constraints, we have 72a2a + (1 72)u2 > u1 2= 712 + (1 7rl)2.

This implies ~2 < u2. For the contract to be incentive compatible to induce the

investment strategy 7r172 173, the following inequalities must hold: 7r2u2+(1-7r2) 2 >

u3 > 7T3U2 + (1 73)U2. But with u2 > 72, and 72 > 73, the inequality cannot hold.

4If IIC-72 is binding, but IIC-71 is nonbinding. Then the cost minimization

subject to the rest of constraints yields T72 = 2 = 2. Rewriting the two IIC

constraints, we have 177ru + (1 7i)tt > u2 = u271 + (1 72)u1. This implies

TT > u1. QED.

Proof of Lemma 4

It is similar to Fudenberg and Tirole [1990], Lemma 2.2.

From Lemma 3, we know the optimal renegotiation-proof contract insures the

low type (72), but imposes some risk on the high type (71). But this condition may

not be sufficient for the contract to be renegotiation proof. The principal might be

able to offer the high type more insurance by increasing the low type's expected









utility. She keeps doing this until the gain from more insurance for the high type is

balanced off by the loss from higher p liment to the low type.

Notice it is not beneficial to increase the high type's expected utility. Keeping

the low type's utility unchanged and maintaining the incentive constraint IIC-72,

the principal has to impose more risk on the high type in order to prevent the low

type from mimicking (See Figure 1). The principal has to p ,li the high type more

for the increased expected utility level and the increased risk premium. There is

no gain for the principal. Thus, the principal's only strategy is to increase the low

type's utility while keeping the high type's expected utility constant.

Let V2 U2 + c, where c is a small positive number. Keeping the contract

incentive compatible and the high type's expected utility constant, we have




2V1+ (1 72)VI V2 U2 +

TIV1 + (1- 7ri)I 17U1 + (1- Ti)Li


Then we can solve the new contract for the high type as a function of the

existing contract and e:




V1 =U 1 7rl
7-1 7i2
V, = + --
7T1 7T2

Notice the risk on the high type is indeed reduced. Substitute the new contract

(V1, V-, V2) into the objective function at the renegotiation stage and take the

derivative with respect to c. For the contract to be renegotiation proof, this

derivative must be nonnegative, i.e.,











P 1 (1 7)7 P2
1[-71 '(U1) + 1'(l)] + -'(U2) > 0
PI + P2 1 72 7i 2 1 P+ 2

Rearranging it, we have the inequality < l-72 I'(U2) QED.
P2 -- 7-(1--7-) qJ'(U1I)--4J(U1)
Proof of Proposition 5

Substituting U2 2= U2 into the AIC constraints (30) and (32), we have
U2 U3. Then the overall problem ,Pa reduces to


Min Pi[7rlI(U1) + (1 7r1)T()]) + (P2 + P3) (U3)
Ul,U1,U3
subject to



EU > -1 (25)

EU > mU1 + (1 m),U (26)

EU > U3 (28)

7rl1 + (1 7rl) > U3 (29)

U3 > i3Ul + (1 i73)U1 (31)

U3 72U1+ (1 7T2)1 (34)
P!, 7TI 7T2 /(U2)
(35)
P2 1- 7i(-1) 0/(U71) 1 /1)(l)

Where EU = er{Pl [7FU + (1 7l)L] + (P2 + P3)U3}.
Since 7r > 7r2 > 7r3, with constraint (34), constraint (29) and (31) are
nonbinding. We have two situations:

If m > 72, mU1 + (1 m)U1 > U3, constraint (28) is nonbinding. I show
the only effort selection constraint (26) must be binding. Let A, 1, p2 represent

the Lagrangian multipliers for the constraint (25) (26) and (34). (For the current









analysis, I only consider when the contract is renegotiation proof, i.e., when

constraint (35) is satisfied.)

The FOCs are

'I(Ui) A-Xe + pi [ec j --F1\- /p1

i c L c P1-7) P11(1-t1)
iP'J) Ae + pi[e a p,(i)1 P2pj(iW)
'I'(U3) -Aec" + p1C+ rc 2 p2+p3

Suppose pi = 0. There are three cases. a 2 = 0 b 2 > 0 c P2 < 0. a p/ = 0

and P2 = 0 imply a full insurance contract. b and c imply either U1, LU < U3 or

UI, VU > U3. Thus constraint (26) must be binding.

I now show the AIR constraint (25) is also binding. The proof is similar

to Fudenberg and Tirole [1990]. Currently, we have two binding constraints,

(26) and (34). Obviously, offering rent does not relax the qualities. The only

possible benefit of offering rent is to relax the renegotiation-proof constraint:
P1 < 71r-2 ''(U2) A rent can only influence the inequality through the
P2 7F11(-1-'--1) q '(U1)-T/'(Lz)
ratio ,() If the rent increases the ratio, then the principal might want

to offer the manager some rent. Let -e-rR be the rent with R > 0. A contract

offering rent is V1 = -e-'(I1+R) = e-'R]1, V, = -e-'(I1+R) = e-rRU, and

V3 e-r(I3+R) = e-rU, where U1,U U3 belong to the contract without rent.

I have assumed the negative exponential utility, V'(U) = Substitute the
i i i-
function into the ratio, V2 1 = Thus offering rent
-rV ++ + I
V1 1 rU1 rU 1 U
does not relax the renegotiation-proof condition. The AIR constraint (25) must be

binding.

Therefore, we can solve three equations (25), (26) and (34) for three unknowns.

This completes the proof for the first part of Proposition 5.

If m < 72, mU1 + (1 m)LV < U3, constraint (26) is nonbinding. Similarly,

we have three equations (25), (28) and (34) for three unknowns. This completes the

proof for the second part. QED.









Proof of Lemma 5.

The problem with an audit can be solved in a similar way to the benchmark

case, except that the dimension of contracting variables is enlarged. At the

renegotiation stage, the principal offers CP {(Ulki,Liki), (U3k)}ke{T,F},ie{1,2} to

minimize:

(1) If 1f and A' are observed:
2 p
1-- [7Pi (Fi ) + (1 qi(i1J>1
i= 1


subject to


i (1k i + (i 7i' IkiF + (1 7i)tlki,; Vi' {1, 2}


riU1ki + (1 7i)u1ki > 7riUlki + (1

(2) If i and A' are observed:


subject to


S,, > U3k


From Lemmas 3 and 4, contract CP takes the following form:


Ulk1 > .ilkl

Ul7k2 r lk2

7"2U1k2 + (1


Ulk2

712)Ulk2 1 2U1kl + (1 712)lk1l,


7i)llki


(IIC-7, i, A')



(IIR-7Ti, A )


(IIR-7T3, A )






74


and CP is renegotiation proof if and only if the following inequality is satisfied:
P < 7I --72 '(Ul2) Vk c {T, F}.
P2- 7i(1-7I) (Ulkl)- '()Ulkl)
The overall problem PP is:


2
i(i 1 )[7r (7T)+(1-7i)W(L i)]+Pia[i^(Ul^)+(1- i)W(lF)]
i-l


+ P3[(1 a) (U3T) + aT(U3F)1


Subject to:



EU > -1


EU > 3[mTnUT + (1

EU > 3[mnUT2 + (1


m)UTI] + (1

m)L2}1 + (1


3)[TmUI1 + (1

3)[mTnUF2 + (


EU > 3U3T + (1 )U3F

(1 a)[7U (1 ] + + (1 l)r17T1 + Qa[TTl7F1 + (t1 ]- LiFII


> 3U3T + (1


/3)U3F


(1 a)[U2U1T2 + (1 12)LlT2 + aW2TTF2 + (1 12)lF2I


> 3U3T + (1


/3)U3F


(1 a)U3T+ aU3F

> P3[U31T + (1 -

> 3[73TIT2 + (1 -


73)LiTi] + (1

73)LIT2] + (1


3)[73U1F1 + (1

0) K3U1F2 + (1


Ulk2 1- lk2

712U1k2 + (1 7r2)lk2 = 2U1kl + (1 -
Pi l 7T2 1 "(rlk2)
P2 71(t 71) (1k1)1- Lk1)


Where


Min
Ul1ki,llki,U3k


m)ULF ,l

mn)LIUF2


F3) 1F1]

73)lLF2I


7-2)L kl











2
EU er { P(1i a) [7UtMT + (1 7T,)L,]l + Pia[7wUIFi + (1 i)tlF]i
i=

+ P3[(1 a)U3T + aU3Fp}

Thus the benchmark case Pp differs from the original problem 7P by adding

four constraints: UIT1 = UIFI, IT = UIF1, UIT2 U1F2, and U3T U3F. The

expected compensation cost of problem PP is weakly lower than that of problem

PL. QED.
Proof of Proposition 7.

Let A, P1, P2 represent the Lagrangian multipliers for each constraint (36) (37)

and (39). I show A, l, p2 > 0. The FOCs for this problem are

I"'(U) = Aee + i[e P P\ll P-P- + 72p p22
P17 Vrl +P27r2 P1i+P2 r2

{i/TT\) rc i rc I _2_-_1
'I(U) -AeTe e pg(1w_)j+p2(l_2)l 2p1(i( 9)+p2(1-_2)

'I(U) -AeC + Ie 1 2

Suppose p1 = P2 0. A constant p ,iment is then offered. The manager would

not work. Suppose 1 = 0, L2 > 0, we have U < U, U. The manager will ah--iv-

invest. Suppose /i > 0, 2 = 0, U,U < U3. The manager never invests. Therefore,

11 > 0 and P2 > 0. The IR constraint is alir-- binding, thus A > 0.

When m > 72, tt is easy to check that the rest of constraints are satisfied with

the established binding constraints.

Similarly, if implementing the investment policy T1 17273, we can find the

binding constraints are
erc{P SB Pi(l )U + (s + P3)US} > -1

erc {Pii + Pi(1 T)USB+2 3)USB} > mU + (1 )SB

rc {Pii--SB + Pi(1 i)SB + (p2 + P3)USB} > USB
crcPTU Pit -TO









It turns out the contract that implements the first-best policy 1r2 1 r3 is
feasible to induce the policy 7r11i2 3, since 727U+ (1- 2)U U, mU+(1-m)U > U
and then er'c{P7l1U + Pi(1 7i)U + (P2 + P3)U} > U. The expected compensation
cost to implement the first-best policy is [P1711 + Pr272](U) + [P1(1 711) + P2(

72)](UL) + P3J(U3), which is higher than P1TrlI(U) + PI(1 7l)(U) + (P2 +
P3)4(U3), because 72(U7) + (1- 7r2)(U) > '(U) from Jensen's Inequality. Since
the contract that implements the first-best policy is only feasible but may not be
optimal to implement policy Tr7l27 3, the expected compensation cost to implement
policy 7Ti 27r3 is strictly lower than the one that implements the first-best policy.
QED.
Proof of Proposition 8.
The manager is offered a fixed p ivment no matter what signal he receives.
Therefore, he is indifferent between investing and not investing. Implementing the
first-best investment policy is trivial.
From Proposition 7, we know the binding constraints for the second-best
contract {U17 UsB, UsB} are

e T-SB PS( B) + (P2 + P3)USB > _-
ec{PiTiU + Pi(1 t)U + (P P3)USB} U + (1 SB
{P -SB + Pi(l l)SB + (p2 + P3)USB}> _USB
-SB -SB
These constraints imply mUB + (1 m)UB USB. Substitute 7 US +

(1 Ti)USB with U1, USB with U2, and smUsB + (1 m) U with U2, we find the
constraints still hold. Therefore, the manager's incentives to acquire information
are unchanged. But with r17SB + (1 T)USB = U, we have TiT7IZ(U) +

(1 7il)0(UsB) > '(U1). Therefore, the expected compensation cost with
renegotiation, Pi'(U1) + (P2 + P3)'(U2), is lower than the expected compensation
cost without renegotiation, P7lt(4UsB) + Pi(1 Tl)(USB) + (P2 + P3)IJ(USB).
QED.















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BIOGRAPHICAL SKETCH

Jie Tian, nicknamed Jc.-v, was born on May 21, 1976, in Beijing, Cliii i Her

parents, Shilin Tian and Xulin Cao, were both engineers. After graduating from

the Experimental Middle School of Beijing, she entered Renmin University of China

to study international economics. She earned her bachelor's degree in economics

in August, 1998. Soon after the graduation ceremony, she came to the United

States to study statistics at University of Nevada, Reno. She received her Master

of Science degree in August, 2000. She joined the Ph.D. program of Fisher School

of Accounting at the University of Florida and she is expected to receive a PhD

degree in 2006.