Voluntary ambiguity in incentive contracts

François Larmande
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François Larmande: EM - EMLyon Business School

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Abstract: Because accounting standards allow for some discretion in their application, accounting numbers often result from the choice of one possible interpretation among several. This paper investigates the optimal choice of a principal when this information is used for stewardship: whether committing ex-ante to using one specific interpretation, the more informative one, or keeping the ambiguity and opportunistically choosing ex-post the performance measure the least favorable to the agent. The choice between ambiguity and commitment involves a trade-off between the potential windfall for the agent (higher with commitment) and the risk of undeserved punishment (higher with ambiguity). The optimal policy depends on the risk aversion of the agent and of the extent of the ambiguity: high risk aversion and a large number of interpretations being in favor of ex-ante commitment.

Date: 2013-11-01
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Published in OR Spectrum, 2013, 35 (4), pp.957-974 P

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Persistent link: https://EconPapers.repec.org/RePEc:hal:journl:hal-02313118

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