Copyright 9-14-98

The Stewardship Role of Accounting

by Richard A. Young
1. Introduction
One important role of accounting is in the valuation of an asset or firm. When
markets are perfect one can value assets at their market value (mark-to-market accounting)
and the change in the book value of owner's equity, or income, measures the change in
firm value. When markets are not perfect, accounting can still be used to approximate the
change in the value of the firm. Recommended references on the valuation role of
accounting include Edwards and Bell (1961), Feltham and Ohlson (1995), Ijiri (1975),
Ohlson (1995), Paton (1922), and Paton and Littleton (1940). Under the valuation
perspective the emphasis is on how accounting measures firm value.
An important additional role of accounting that arises when markets are not perfect
is stewardship. Large firms entrust assets and decisions to managers. Managers have
informational advantages with respect to whether they made appropriate use of the assets to
which they were entrusted. This situation is one example of a market imperfection.
Accounting data may be used to mitigate the negative effects of manager's private
information and, in turn, enhance firm value. There is an array of literature in accounting
and finance that examines this issue. Recommended references on the stewardship role of
accounting include Demski (1982) and Gjesdal (1981). Other stewardship references
include Harris and Raviv (1978) and Jensen and Meckling (1976). The stewardship issue
is also of continuing practical interest. For example, in the early 1980s the magnitude of
CEO salaries came under close scrutiny, and in the 90s there has been considerable
attention given to using residual income and its variants such as EVA (Economic Value
Added) to improve firm performance. Under the stewardship perspective, the emphasis is
on how accounting affects firm value.
To give insight into how accounting and other information can influence manager
behavior and hence firm value, it is useful to think about a simple insurance setting. We
may think of automobile drivers as demanding insurance because they are risk averse, and
large insurance companies can profit because they are less risk averse. If insurance
companies approach risk neutrality, the optimal insurance contract from a risk sharing
perspective would remove all the risk from the risk averse driver. Yet automobile
insurance contracts often are characterized by deductibles, which leave some of the risk on
the driver. One explanation is that the driver is able to affect the probability of an accident.
Further, the driver may get enjoyment from speeding. Thus, once completely insured (i.e.,
Richard A. Young 2 Copyright 9-14-98
no deductibles), the driver would have incentives to be less careful than if not insured. The
driver's ability to buy insurance affects the probability that an accident occurs. This
situation is called moral hazard. Deductibles are useful because they give the insured a
stake in whether an accident occurs. For the insurance company to make a profit it is
important that they choose a premium and deductible that gives the insured the appropriate
incentives to drive carefully. That is, they trade off the benefits of lower accident
probabilities against the benefits of improved risk sharing.
1
The insurance metaphor can be usefully applied to the role of accounting
information in mitigating the stewardship problem and hence increasing firm value. Since
we are developing intuition at this stage, we shall think of information in a generic way.
But we should keep in mind that data collected by accountants has characteristics that make
it especially useful in mitigating the stewardship problem.
2. A simple stewardship setting
We proceed with a stylized example. Alice is the risk neutral owner of a retail
firm.
2
Ralph is her only sales employee. We assume that Ralph's actions can affect sales.
Expected sales will be higher if he tries every customer on the list, is careful to set up
appointments convenient for the customer, and makes sure he is on time and prepared to
discuss the specific customer's needs. The relationship between Ralph's actions, the state
of nature (s
1
or s
2
), and sales is described in the table below. Note that, even if Ralph is
diligent (a
H
), he might get unlucky and obtain low sales (e.g., he might not meet up with
receptive customers). However, if he is not diligent (a
L
), he has no chance at high sales.
3
P(s
1
) = 1/2 P(s
2
) = 1/2
s
1
s
2
a
L
= 0 $100,000 $100,000
a
H
= 1 0 $100,000 $200,000
In order to address a control or stewardship problem, there must be potential
conflict between Ralph and Alice over actions. This is accomplished by assuming Ralph
has preferences for both payments and action. In particular, we assume Ralph has a utility

1
The same sort of intuition applies to a setting where individuals have private
information regarding their own health. The premium appropriate to charge a healthy
individual would be too low for individuals of poor health. One way the insurance
company can sort those applying for insurance is to offer different deductible/premium
combinations. This problem is referred to as adverse selection.
2
Accounting information may be used to better share risk or to help with the
stewardship problem. The assumption of risk neutrality allows us to focus on the
latter and makes it easier to work out the numerical example.
3
All that is really important is that the probability of sales be affected by the action.
Richard A. Young 3 Copyright 9-14-98
function defined over wealth (w) and action (a) as follows: U(w,a)

= u(w) a. Ralph likes
money and is either risk neutral or risk averse. That is, u > 0 and u 0. Further, we
assume a
L
= 0 and a
H
= 10. Thus, for a given payment w, Ralph's utility (U) is lower
under a
H
than under a
L
.
This is a very simplistic way to capture conflict. We have simply assumed being
diligent is costly to Ralph. For example, he may have to give up Monday night football or
time with his family to take out a client. But be sure to understand the important thing is
Ralph and Alice disagree about which action they should take. It is not important that we
view choice of a
L
as being lazy. Nevertheless, for brevity we shall refer to Ralphs
action as effort.
The sequence of events is important. Alice first chooses a contract, and then offers
it to Ralph. Then Ralph chooses either to accept the contract from Alice or to take an
administrative position elsewhere. If he goes elsewhere, Ralph receives the certainty
equivalent of $40,000 with no effort. If instead he decides to join Alices firm, he then
selects action a
H
or a
L
, according to his own self-interest.
Ralph and Alice know that the contract is enforceable as long as it is based on
things that are publicly observable or easily verifiable.
4
Thus, Alice can commit to any
payment scheme that is based on observable performance measures. We will consider
cases where Ralphs action is and is not observed by Alice. Throughout, we assume both
Ralph and Alice observe the sales level. We emphasize that this is an extremely simple
example of a stewardship problem, but that makes it a good place to start.
3. Finding an optimal contract general approach
Alice's objective is to offer the best contract which induces Ralph to join her firm
and take the action she desires, recognizing that Ralph acts in his own best interests. In
order to determine which contract Alice should offer, we proceed in the following steps:
(1) find the least-cost contract that induces Ralph to join the firm and to
choose a
L
,
(2) find the least-cost contract that induces Ralph to join the firm and to
choose a
H,
(3) determine which of these two contracts maximizes Alices expected utility.

4
One reason that accounting is especially useful in contracting is that it often uses
"hard" data (see Ijiri, 1975). For example, accounting tends to rely less on
expectations of the future (which are hard to verify) and more on the effects of
historical transactions.
Richard A. Young 4 Copyright 9-14-98
4. Risk neutral incentives
In this section we show that potential incentive problems are easily resolve when
Ralph is risk neutral (u(w) = w), despite Ralphs aversion to effort and Alices potential
uncertainty about effort.
Step (1): Inducing a
L
If Alice were interested in finding the least-cost contract that induces a
L
, she must
make sure of two things: Ralph will participate in the firm, and he will prefer a
L
to a
H
. This
is formally stated in the linear programming problem below. Notice it allows for the
general case where both effort and sales are observable. The subscript denotes sales in
thousands and the argument in parenthesis is effort.
Minimize w
100
(a
L
)
Participation: w
100
(a
L
) 40,000 (P)
Incentive compatibility: w
100
(a
L
) .5 w
100
(a
H
) + .5 w
200
(a
H
) - 10 (IC)
The objective function is Alices expected cost if she writes an act- and sales-
contingent contract, assuming Ralph chooses a
L
. The (P) constraint ensures Ralph wishes
to join Alices firm if he chooses a
L
. The left-hand side of (P) reflects that if Ralph chooses
a
L
, sales will definitely be 100,000 and his personal cost of effort is zero. The right-hand
side of (P) is Ralphs expected utility if he does not join the firm which under our
assumptions is: U(40,000,0) = 40,000 0 = 40,000. The (IC) constraint ensures Ralph
prefers a
L
to a
H
. The right-hand side of (IC) reflects that if Ralph chooses a
H
, sales will be
100,000 with probability .5 and 200,000 with probability .5.
One important thing to establish is that a
L
can be optimally induced with a simple,
fixed-wage contract. A fixed-wage contract is one in which payment does not depend on
sales. Thus, we substitute w
100
(a
L
) = w
100
(a
H
) = w
200
(a
H
) = w into the objective function
and (P) and (IC) to obtain the following.
Minimize w
subject to: w 40,000 (P)
w w 10 (IC)
The solution is w = 40,000 and Alices expected cost is 40,000. Observe that (P)
is binding but (IC) is not binding.
5
The fact that (IC) is not binding tells us Alice would do
no better if she could observe Ralphs action.

5
Not binding refers to a condition where the inequality is strict.
Richard A. Young 5 Copyright 9-14-98
Step (2): Inducing a
H
If Alice were interested in finding the least-cost contract that induces a
H
, she must
make sure Ralph will participate in the firm and will prefer a
H
to a
L
. Again, this program
allows for the general case where both effort and sales are observable.
Minimize .5 w
100
(a
H
) + .5 w
200
(a
H
)
Participation: .5 w
100
(a
H
) + .5 w
200
(a
H
) 10 40,000 (P)
Incentive compatibility: .5 w
100
(a
H
) + .5 w
200
(a
H
) - 10 w
100
(a
L
) (IC)
The objective function is Alices expected payment to Ralph, reflecting that when a
H
is chosen sales may be either 100,000 or 200,000. The left-hand side of (P) is now
Ralphs expected utility if he chooses a
H
, and the right-hand side is his expected utility if he
does not join the firm. The right-hand side of (IC) is Ralphs expected utility if he chooses
a
L
.
We see that the approach we tried earlier of paying Ralph the simple fixed-waged
contract will not work, since IC would then appear as follows.
w - 10 w (IC)
This is, of course, impossible.
There are two ways to resolve this problem. One is to observe Ralphs action. But
this is in general costly to Alice. We shall see that because Ralph is assumed to be risk
neutral (for now), Alice can costlessly motivate a
H
without observing Ralphs action. To
see this, assume the payment to Ralph depends only on sales. That is, let w
100
(a
H
) =
w
100
(a
L
) = w
100
, and w
200
(a
H
) = w
200
. Now the program to find the least-cost contract is as
follows.
Minimize .5 w
100
+ .5 w
200
.5 w
100
+ .5 w
200
10 40,000 (P)
.5 w
100
+ .5 w
200
- 10 w
100
(IC)
Now the (IC) constraint can be satisfied if Alice pays a larger amount for sales of
200,000 than for sales of 100,000, i.e., if she offers a bonus for high sales. To see this,
we can rewrite (IC) as follows.
.5 (w
200
- w
100
) 10 (IC)
w
200
- w
100
20
Notice that this means the optimal contract that induces a
H
must place risk on Ralph. But so
far Ralph is assumed risk neutral, so Alice does not need to pay a risk premium.
One solution to this program is w
200
= 39,010 and w
100
= 41,010. Alices expected
cost is 40,010. Another solution is to set w
200
= 70,010 and w
100
= 10,010. In fact, Alice
could simply sell the firm to Ralph and let him absorb all the sales risk. Notice again that
(IC) is not binding, indicating there is no reason for Alice to observe Ralphs effort.
Richard A. Young 6 Copyright 9-14-98
Step (3): Select the optimal contract Risk neutral case
Now that we have found the least-cost way to motivate a
L
and a
H
, we determine
which contract maximizes Alice's expected utility, defined as expected sales minus
expected payment to Ralph. The least-cost contracts are written below. Since in this
example Contract RN-2 gives Alice an expected utility level greater than Contract RN-1,
Alice optimally offers Contract RN-2.
Contract RN-1 Contract RN-2
w = 40,000 w
100
= 39,100
w
200
= 41,100
Ralph's optimal action a
L
a
H
Alice's expected utility 60,000 109,900
Ralph's expected utility 40,000 40,000
Finally, note that whichever level of effort is being motivated, no further
improvement would be obtained by its observation. This implies that if Ralph were risk
neutral, monitoring procedures such as internal auditing would not be valuable. Since we
often observe monitoring of management behavior in practice, in order to understand it, we
must expand the model. It turns out that by expanding the model to make Ralph risk
averse, we will be able to derive a value to monitoring his effort.
5. Risk averse incentives
In this section we will assume u(w) = w, which is a concave function and so
captures risk aversion for Ralph. This assumption introduces a potential cost to Alice. If
in order to induce incentives Alice must impose risk on Ralph, Alice will bear a cost due to
the risk premium she must pay to induce Ralph to accept employment.
Step (1): Inducing a
L
The mathematical program for the case where a
L
is to be induced is as follows.
Again, the program allows for the general case where both effort and sales are observable.
Minimize w
100
(a
L
)
subject to: u(w
100
(a
L
)) u(40,000) (P)
u(w
100
(a
L
)) .5 u(w
100
(a
H
)) + .5 u(w
200
(a
H
)) - 10 (IC)
In the risk neutral analysis conducted in section 4 we demonstrated that a
L
can be
induced without placing risk on Ralph. That solution will work here, of course. And we
know this is a good idea from a risk sharing perspective, since now Ralph is risk averse
and Alice is risk neutral.
We show that a
L
can be motivated without imposing risk on Ralph by setting
w(a
L
,w
100
) = w(a
L
,w
100
) = w(a
L
,w
100
) = w, which transforms the program as follows.
Richard A. Young 7 Copyright 9-14-98
Minimize w
u(w) u(40,000) (P)
u(w) u(w) - 10 (IC)
Clearly, paying a fixed wage satisfies (IC) and is the least-cost way to satisfy (P) as
well. The solution is w = 40,000, and Alices expected cost is 40,000. Since (IC) is not
binding, if a
L
is to be motivated there is no value to monitoring effort.
Step (2): Inducing a
H
The program to find Alices least-cost contract that induces a
H
when Ralph is risk
averse is as follows.
Minimize .5 w
100
(a
H
) + .5 w
200
(a
H
)
subject to: .5 u(w
100
(a
H
)) + .5 u(w
200
(a
H
)) 10 u(40,000) (P)
.5 u(w
100
(a
H
)) + .5 u(w
200
(a
H
)) - 10 u(w
100
(a
L
)) (IC)
Case I: Act observable
Unlike the case where Ralph is risk neutral, it will be important whether effort is
observable. To see this, first consider the case where effort is observable. The goal is to
see if (IC) and (P) can be satisfied without placing risk on the risk averse manager. This
means that w
100
(a
H
) = w
200
(a
H
) = w
H
. Simplify the notation further by setting w
100
(a
L
) =
w
L
. Then the program to induce a
H
becomes as follows.
Minimize w
H
subject to: u(w
H
) 10 u(40,000) (P)
u(w
H
) - 10 u(w
L
) (IC)
Clearly a contract which sets w
H
= 40,000 and w
L
sufficiently small (say, zero) will
satisfy (IC) and place no risk on the risk averse manager. So here, with the act observable,
Alices cost is 40,000.
Case II: Act unobservable:
We now consider the case where Alice cannot directly observe whether Ralph is
diligent. Alice may find it prohibitively costly to determine Ralph's effort. For example,
she probably does not want to follow Ralph around. If that was a good idea, she would do
the selling herself. Where the effort is not observable by Alice, Ralphs pay cannot depend
on effort. So Alice must set w
100
(a
H
) = w
100
(a
L
) = w
100
and w
200
(a
H
) = w
200
(a
L
) = w
200
.
The program becomes as follows.
Minimize .5 w
100
+ .5 w
200
subject to: .5 u(w
100
) + .5 u(w
200
) 10 u(40,000) (P)
.5 u(w
100
) + .5 u(w
200
) - 10 u(w
100
) (IC)
Richard A. Young 8 Copyright 9-14-98
Rewriting (IC), we obtain the following, which is similar to the risk neutral, act
unobservable case.
.5 [ u(w
200
) - u(w
100
) ] 10
or u(w
200
) - u(w
100
) 20 (IC)
Here we see risk must be place on Ralph, as in the risk neutral case. Since placing
risk on Ralph is costly to Alice, (IC) will be binding. So now both (IC) and (P) are
binding. Finding an optimal contract in this case involves solving two equations and two
unknowns. The solution is u(w
100
) = u(40,000), so w
100
= 40,000, and u(w
200
) =
u(w
100
)+ 20. Further, with u(w) = w, we obtain w
200
= (200+20)
2
= 48,400. Alices
expected cost is .5(40,000) + .5(48,400) = 44,200
Step (3): select the optimal contract
Now that we have found the least-cost way to motivate a
L
and a
H
, we check to see
which contract maximizes Alice's expected utility. We consider the observability
assumptions separately.
If Alice could observe Ralphs effort, Contract RA-2 is the least-cost contract that
motivates a
H
. Since it provides Alice with an expected utility level greater than under
Contract RA-1, Alice optimally offers Contract RA-2.
Case I: Act observable
Contract RA-1 Contract RA-2
w = 40,000 w
H
= 44,100, w
L
= 0
Ralph's optimal action a
L
a
H
Alice's expected utility 100,000 40,000 = 60,000 150,000 44,100 = 105,900
Ralph's expected utility 200 200
If Alice were unable to observe Ralphs effort, Contract RA-3 is the least-cost
contract that motivates a
H
. Since it provides Alice with an expected utility level greater than
under Contract RA-1, Alice would optimally offer Contract RA-3.
Case II: Act unobservable
Contract RA-1 Contract RA-3
w = $ 40,000 w
100
= 40,000
w
200
= 48,400
Ralph's optimal action a
L
a
H
Alice's expected utility 100,000 40,000 = 60,000 150,000 44,200 = 105,800
Ralph's expected utility 200 200
6. Summary
There are several things to note. First, in the case where Ralph is risk neutral
incentive compatibility is not binding. Whether Ralphs action is observable or not,
Richard A. Young 9 Copyright 9-14-98
inducing a
H
has the same expected cost to Alice. This means that an IS that revealed
Ralphs action would have no value. Further, complicated performance systems, those that
use different performance measures, would not be necessary.
Second, consider the case where Ralph is risk averse. Here, Alices expected cost
of inducing a
H
is higher if she cannot observe his action. Her expected utility when
inducing a
H
decreases from 105,900 to 105,800. That is, her expected utility is lower
under Contract RA-3 (the sales-contingent contract) than if she could offer Contract RA-2
(the act-contingent contract). The reason is when the act is unobservable, in order to
motivate a
H
Alice must base Ralph's pay on the level of sales. Thus, Ralph faces risk,
even if he chooses a
H
. Since Ralph is risk averse this is costly to Alice. In our example,
when the act is observable Alice can place no risk on Ralph by offering him Contract RA-2,
which pays $44,100 for sure under a
H
. However, under Contract RA-3 Alice pays an
expected amount to Ralph of .5(40,000)+.5(48,400) = 44,200. The difference in
expected pay to Ralph (44,200 - 44,100) is exactly the amount by which Alice's expected
utility is lower in the act unobservable setting. The $100 is the risk premium that Alice
must pay to induce Ralph to choose a
H
when the act is not observable.
Third, we must check to see whether when the act is unobservable Alice still prefers
that Ralph work hard. Why must we check? Remember that Alice's expected utility under
Contract RA-3 would be lower than it was under Contract RA-2 (which was enforceable
only when the act is observable). In fact, it is possible that when the act is observable Alice
would prefer to motivate a
H
by offering Contract RA-2, but when the act is unobservable
she would prefer to motivate a
L
and hence offer Contract RA-1. This dependence of the
equilibrium action on whether it is observable may be a little counterintuitive, at least
without careful thought. This phenomenon would occur if the risk premium Alice must
provide to Ralph under Contract RA-3 exceeded Alice's incremental expected profit that
would result in the act observable case between Contract RA-2 and Contract RA-1.
Fourth, this analysis can be used to determine the maximum amount that Alice
would pay for a perfect IS that revealed Ralph's effort. Alice would pay up to 105,900 -
105,800 = $100 for perfect auditing. The argument is as follows. If auditing costs more
than $100, she would not hire the auditor and offer Ralph Contract RA-3 (the sales-
contingent contract). On the other hand, if auditing costs less than $100, she would hire
the auditor and offer Contract RA-2 (the act-contingent contract).
Richard A. Young 10 Copyright 9-14-98
Self-study exercise
Assume an incentive problem of the type above, with a relationship between
Ralph's action, the state of nature, and sales dollars as follows.
P(s
1
) = 1/2 P(s
2
) = 1/2
s
1
s
2
a
L
= 0 $Y $Y
a
H
= 10 $100,000 $X
Ralph has utility function for wealth (w) and effort of w - v, and has the option of going
to an administrative position where he receives $40,000 for sure, and which requires no
effort.
Write down the optimal contract for each of the following cases, considering both
the act-observable and act-unobservable settings. Also, write down the maximum amount
Alice would pay for perfect information about Ralph's action.
CASE A: X = 200,000 Y = 101,000
CASE B: X = 108,300 Y = 100,000
CASE C: X = 108,000 Y = 100,000
Check Figures:
Optimal Contract
Act observable Act unobservable Value of information.
A: w = 44,100 if a = a
H
w
100
= 44,100 105,900 - 105,900 = 0
0 if a = a
L
w
200
= 44,100
w
101
= 0
B: w = 44,100 if a = a
H
w = 40,000 60,050 - 60,000 = 50
0 if a = a
L
C: w = 40,000 w = 40,000 60,000 - 60,000 = 0
Richard A. Young 11 Copyright 9-14-98
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Harris, M. and A. Raviv, "Some Results on Incentive Contracts with Application to
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and Ownership Structure," Journal of Financial Economics, Vol. 3, 1976.
Ohlson, J., "Earnings, Book Values, and Dividends in Equity Valuation," Contemporary
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Paton, W., Accounting Theory, Accounting Studies Press, Ltd., 1922.
__________ and A. Littleton, An Introduction to Corporate Accounting Standards. AAA,
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