Endogenous Accounting Bias when Decision Making and Control Interact

We analyze the design of an accounting information system and identify how the nature of incentive problems can alter the direction and magnitude of endogenous bias. First, we show that, while using accounting information for decision-making purposes may favor an unbiased accounting system, the use of the same accounting information for a stewardship role to address the incentive problems entails endogenous bias in accounting reports. Specifically, consistent with earlier research, we find that conservative bias may be optimal when the only incentive problem is to motivate the agent to take a mean-increasing effort. Second, we show that some bias is needed (although the direction of the bias is inconsequential) when the only incentive problem is to motivate a decision-facilitating effort by the agent that reduces uncertainty and assists the principal's decision making. However, liberal bias (i.e., aggressive recognition of good news) is necessary when accounting information is used to induce both mean-increasing and decision-facilitating efforts. Liberal bias arises here because the principal seeks a system to reward the agent for reducing uncertainty and thus needs to reward average outcomes. The classification of average outcomes as good news means aggressive accounting may be in the best interest of a firm seeking to mitigate multiple incentive concerns.