Leading Indicator Variables, Performance Measurement, and Long‐Term Versus Short‐Term Contracts

Leading Indicator Variables, Performance Measurement, and Long‐Term Versus Short‐Term Contracts ABSTRACT In this article we develop a multiperiod agency model to study the role of leading indicator variables in managerial performance measures. In addition to the familiar moral hazard problem, the principal faces the task of motivating a manager to undertake “soft” investments. These investments are not directly contractible, but the principal can instead rely on leading indicator variables that provide a noisy forecast of the investment returns to be received in future periods. Our analysis relates the role of leading indicator variables to the duration of the manager's incentive contract. With short‐term contracts, leading indicator variables are essential in mitigating a holdup problem resulting from the fact that investments are sunk at the end of the first period. With long‐term contracts, leading indicator variables will be valuable if the manager's compensation schemes are not stationary over time. The leading indicator variables then become an instrument for matching the future investment return with the current investment expenditure. We identify conditions under which the optimal long‐term contract induces larger investments and less reliance on the leading indicator variables as compared with short‐term contracts. Under certain conditions, though, the principal does better with a sequence of one‐period contracts than with a long‐term contract. http://www.deepdyve.com/assets/images/DeepDyve-Logo-lg.png Journal of Accounting Research Wiley

Leading Indicator Variables, Performance Measurement, and Long‐Term Versus Short‐Term Contracts

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Publisher
Wiley
Copyright
Copyright © 2003 Wiley Subscription Services, Inc., A Wiley Company
ISSN
0021-8456
eISSN
1475-679X
D.O.I.
10.1046/j.1475-679X.2003.00125.x
Publisher site
See Article on Publisher Site

Abstract

ABSTRACT In this article we develop a multiperiod agency model to study the role of leading indicator variables in managerial performance measures. In addition to the familiar moral hazard problem, the principal faces the task of motivating a manager to undertake “soft” investments. These investments are not directly contractible, but the principal can instead rely on leading indicator variables that provide a noisy forecast of the investment returns to be received in future periods. Our analysis relates the role of leading indicator variables to the duration of the manager's incentive contract. With short‐term contracts, leading indicator variables are essential in mitigating a holdup problem resulting from the fact that investments are sunk at the end of the first period. With long‐term contracts, leading indicator variables will be valuable if the manager's compensation schemes are not stationary over time. The leading indicator variables then become an instrument for matching the future investment return with the current investment expenditure. We identify conditions under which the optimal long‐term contract induces larger investments and less reliance on the leading indicator variables as compared with short‐term contracts. Under certain conditions, though, the principal does better with a sequence of one‐period contracts than with a long‐term contract.

Journal

Journal of Accounting ResearchWiley

Published: Dec 1, 2003

References

  • Cooperative Investments and the Value of Contracting
    Che, Che; Hausch, Hausch
  • Balancing Performance Measures
    Datar, Datar; Kulp, Kulp; Lambert, Lambert
  • Agent Employment Horizons and Contracting Demand for Forward‐Looking Performance Measures
    Dikolli, Dikolli
  • Controlling Investment Decisions: Depreciation and Capital Charges
    Dutta, Dutta; Reichelstein, Reichelstein
  • Contracting Theory and Accounting
    Lambert, Lambert
  • On the Use of Nonfinancial Performance Measures in Management Compensation
    Sliwka, Sliwka

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