It isn't just reporting bad behavior/good behavior. He's supposed to be a liaison between the kids and Santa. My kids tell him what they want for Christmas, what they think Santa should bring me and my husband, and ask him to bring messages to Santa, the other elves, and the reindeer (and now to the tooth fairy, the easter bunny, the sandman, and Jack Frost, since seeing Rise of the Guardians lol). It's really cute.
The Naughty and Nice lists are also part of Santa, and kids know it. The kids love the elf--they're thrilled while he's here and sad to see him go on Christmas Eve. In their worldview, he's part if the magic of the season. That a small part of his function is to help Santa with his Naughty and Nice lists isn't any different to them (or us) than Mommy and Daddy serving the same purpose. I think some people may be over thinking the whole thing.