A few stylized observations on accounting discretion

Purpose – The purpose of this paper is to explore the role of accounting discretion in a principal-agent setting, wherein accounting information is used in performance evaluation. The agent may choose one from among several allowable accounting methods. However, limited audit resources allow only for verification of only the method the agent chooses, and this is the only one used to determine the agent's compensation. Design/methodology/approach – This paper uses the model developed by Penno (1990) and construct relatively simple examples that illustrate the effects of accounting discretion on performance evaluation. These examples may make the implications of Penno (1990) clearer to educators and practitioners. Findings – Accounting discretion can be useful in performance evaluation even if the accounting method chosen is not disclosed. Lower limits on compensation reduce the usefulness of accounting discretion. If the principal declares a preferred accounting treatment, it enhances the usefulness of accounting discretion; in fact, it guarantees that accounting discretion is weakly preferred to no discretion. Practical implications - Accounting discretion is often viewed pejoratively. Those responsible for designing performance evaluation schemes should be aware of the potential benefits of accounting discretion, and those charged with promulgating accounting rules should consider the possibility that rules can be too inflexible. Originality/value – This paper provides accessible illustrations of the effects of accounting discretion on performance evaluation and offer discussion to place the conclusions drawn from the model into a standard setting context.