Internal and external information system choices and mutual interdependencies

In this paper, we consider a one shot principal agent problem. The owner of the firm (principal) hires a manager (agent). As firm value is non‐contractible by assumption, an incentive contract is written on accounting income. The manager performs some productive task that increases firm value as well as income but can also engage in earnings management to increase income only. The owner needs to make several simultaneous choices. First, he needs to decide whether to implement an internal information system (IIS). Second, he has to choose from a set of (external) financial reporting systems that differ with regard to accounting discretion. Third, he needs to specify contracting details. If an internal information system is implemented it provides the manager with private information about the business environment, which, in turn, affects effort costs. In contrast, the financial reporting system choice affects the effectivity of earnings management activities undertaken by the manager. In the absence of an internal information system, the agency problem considered is a moral hazard problem that arises from private effort choices of the manager. Implementing an internal information system creates an adverse selection problem on top of the moral hazard problem. We find that for both problems agency costs increase if the business environment becomes more volatile. Holding either the IIS choice or the accounting system choice constant, we observe the following: Without an IIS, it is optimal to choose the least discretionary accounting system available. With an IIS it can either be advisable to choose the most or least discretionary accounting system depending on the probability distribution of business environments to be present. For any given accounting system, the principal implements an IIS if the volatility of the business environment is sufficiently high and v.v. The less discretionary the accounting system, however, the more volatile the business environment needs to be for an IIS to become favorable. It follows that both, accounting system and IIS choice, are mutually interdependent. E.g. it might be optimal for the principal to choose the most discretionary accounting system along with implementing an IIS. In contrast, it might be optimal not to implement an IIS along with the least discretionary accounting system depending on parameter values.