Agency Theory, incentive contracts and performance measures

This paper begin by explaining how agency models are formulated to capture incentive problems caused by moral hazard and adverse selection problems, and discuss the reasons why agency theory models are difficult to solve. Then represent agency theory results in the form of a mathematical model for the employment contracting setting of agent (management) and the describe characteristics of performance measures specified in the contract for performance evaluation of agent. These qualities include informativeness, controllability, congruity and timeliness. Appropriate selection accounting-based measures of performance or market- based in motivating agent behavior and reduce conflicts of interest between the principal and the agent has an impact. Performance measures included in the compensation contracts and bonus plans of agent may create conditions where earnings management occurs.