Internal and External Information System Choices and Mutual Interdependencies

This paper considers a one shot principal-agent problem. The owner of a firm hires a manager. As firm value is non-contractible, 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 window dressing to increase income only.
At the beginning of the game, the owner decides whether to implement an internal information system (IIS) and either installs a more or less restrictive set of accounting standards.
If he implements an IIS, it provides the manager with private information about the business environment the firm faces. If he picks a restrictive financial accounting system, as opposed to a discretionary one, window dressing activities become less effective. In the absence of an IIS, the agency problem is a moral hazard problem. Implementing an IIS creates an adverse selection problem on top.
We find that it can either be optimal to implement a restrictive accounting system with or without an IIS, or to combine a discretionary system with an IIS. Whenever the business environment the firm faces is more likely to be bad than good, restrictive accounting is preferred. If it is more likely to be good than bad either combining restrictive financial accounting with no IIS or combining discretionary financial accounting with an IIS is optimal. Implementing an IIS becomes favorable if the firm’s environment is sufficiently heterogeneous. However, more heterogeneity per se increases agency costs and reduces the principal’s payoff.