Endogenous Accounting Bias when Decision Making and Control Interact

This paper analyzes how accounting biases endogenously arise as firm owners’ optimal response to balance different stewardship uses of accounting information systems. Specifically, we identify conditions under which the nature of the stewardship use affects whether the accounting system exhibits conservative or liberal bias. We distinguish two types of stewardship uses of accounting information: one is to motivate the (standard) managerial efforts that affect the first moment (mean) of the firm output, and the other is to motivate the managerial efforts that facilitate the principal’s decision making by affecting the second moment of the firm output (we refer to such efforts as the decision-facilitating efforts). We find that, while conservative bias may be optimal when accounting information is used only to motivate mean-increasing efforts (Kwon, Newman, and Suh 2001; Kwon 2005), liberal bias is necessary when decision making and control interact in the sense that accounting information is also used to motivate decision-facilitating efforts. We illustrate the above idea in a simple model where an accounting system provides information relevant both for making decisions and for evaluating an agent. As a first benchmark, we demonstrate that, in the absence of evaluation considerations, an unbiased accounting (classification) system is preferred for providing useful decision-making information, thus establishing an endogenous need for an information system. As a second