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Abstract:
A firm with two divisions, each run by a risk-averse manager, contracts with the two managers to operate their divisions and possibly engage in interdivisional trade. Each division can increase the total surplus generated through interdivisional trade by making costly relationship-specific investments. The terms of trade are determined through negotiations between the two managers. Managerial compensation contracts are linear functions of divisional profit and firm-wide profit. If managers are compensated solely on the basis of their divisional profits, they invest less than the first-best amounts. While compensation contracts based on firm-wide profits alone can induce first-best investments, they impose extra risk on risk-averse managers. Therefore, we find that optimal linear compensation contracts will contain both divisional and firm-wide components. Our analysis also identifies a feature of negotiated transfer pricing, namely interdivisional risk-sharing, and characterizes its impact on the design of optimal contracts.

Abstract:
A firm with two divisions, each run by a risk-averse manager, contracts with the two managers to operate their divisions and possibly engage in interdivisional trade. Each division can increase the total surplus generated through interdivisional trade by making costly relationship-specific investments. The terms of trade are determined through negotiations between the two managers. Managerial compensation contracts are linear functions of divisional profit and firm-wide profit. If managers are compensated solely on the basis of their divisional profits, they invest less than the first-best amounts. While compensation contracts based on firm-wide profits alone can induce first-best investments, they impose extra risk on risk-averse managers. Therefore, we find that optimal linear compensation contracts will contain both divisional and firm-wide components. Our analysis also identifies a feature of negotiated transfer pricing, namely interdivisional risk-sharing, and characterizes its impact on the design of optimal contracts.

Abstract:
This paper examines alternative accrual accounting rules from an incentive and control perspective. For a range of common production, financing and investment decisions we consider alternative asset valuation rules. The criterion for distinguishing among these rules is that the corresponding performance measure should provide managers with robust incentives to make present value maximizing decisions. Such goal congruence is shown to require intertemporal matching of revenues and expenses, though the specific form of matching needed for control purposes generally differs from GAAP. The practitioner oriented literature on economic profit plans has made various, and at times conflicting, recommendations regarding adjustments to the accounting rules used for external financial reporting. Our goal congruence approach provides a framework for comparing and evaluating these recommendations.

Managerial performance measures, accrual accounting, incentive contracts, economic theory, economics of organizations, cost

Abstract:
This paper develops a multiperiod principal-agent model in which a manager must be given incentives to undertake investments and to exert personally costly effort. Investments are soft (e.g., intangible assets) and therefore entail measurement errors for the accounting system as it seeks to separate investments from operating expenditures. This separation is of no concern to the stock market which draws on its own information about future cash flows resulting from current investments. The firm's stock price, however, reflects all value relevant information, parts of which are not incentive relevant. Optimal incentive provisions must combine forward looking market information with backward looking accounting information. Under certain conditions, optimal performance measures can be expressed as a weighted average of economic value added (residual income) and market value added.

Performance measurement, managerial compensation

Abstract:
We examine alternative performance measures for a manager who has superior information about the profitability of an investment project and contributes to periodic operating cash flows through his efforts. We find that residual income based on a suitably chosen depreciation schedule is an optimal performance measure. To address the underlying agency problem, the charge for capital in the calculation of residual income must be based on a hurdle rate that exceeds the principal's cost of capital. We also establish that proper matching of periodic operating cash flows with a share of the initial investment cost (via depreciation charges) is essential if the performance measure is to support optimal incentive provisions for a sufficiently wide class of agency problems.

Abstract:
This paper examines the choice of asset valuation rules from a managerial control perspective. A manager creates value for a firm through his effort choice each period. To support its operating activities, the firm also engages in financing transactions such as credit sales to its customers. These financing transactions merely change the pattern of cash flows across periods but have no effect on the value of the firm. An optimal compensation scheme must therefore shield the manager from the risk associated with such transactions. If the firm operates an accrual accounting system in which receivables are capitalized at their fair values, we show that residual income eliminates this risk and provides an optimal performance measure. On the other hand, compensation schemes based only on realized cash flows can be optimal only under exceptional circumstances.

The paper also considers a setting in which the principal can observe not only the aggregate cash flow, but also the amount of realized bad debt losses each period. In this setting, an optimal compensation scheme must also shield the manager from the default risk associated with credit transactions. We demonstrate that this can be achieved if receivables are valued according to the allowance method that leads to a proper matching of sales revenues and bad debt expenses each period.

Abstract:
Investment decisions frequently require coordination across multiple divisions of a firm. This paper explores a class of capital budgeting mechanisms in which the divisions issue reports regarding the anticipated profitability of proposed projects. To hold the divisions accountable for their reports, the central office ties the project acceptance decision to a system of cost allocations comprised of depreciation and capital charges. If the proposed project concerns a common asset that benefits multiple divisions, our analysis derives a sharing rule for dividing the asset among the users. Capital charges are based on a hurdle rate determined by the divisional reports. We find that this hurdle rate deviates from the firm's cost of capital in a manner that depends crucially on whether the coordination problem is one of implementing a common asset or choosing among multiple competing projects. We also find that more severe divisional agency problems will increase the hurdle rate for common assets, yet this is generally not true for competing projects.

capital budgeting, hurdle rates, decentralization, agency problems

Abstract:
The principles that govern the recognition of revenues (and expenses) are the key determinants of the properties of accrual accounting information. This paper studies the revenue recognition question from a stewardship perspective. Our results show that it is optimal to carry products at their historical costs until revenues are realized. Revenues are considered realized when the amount of associated cash flows can be measured in an objective and verifiable fashion. In contrast, we demonstrate that mark-to-market accounting, although sensible from an equity valuation perspective, generally does not provide efficient aggregation of raw information to solve the stewardship problems. In particular, mark-to-market accounting based on anticipated performance of the manager does not necessarily induce the manager to actually deliver such performance. Our analysis also identifies situations where the realization principle needs to be modified with the asset valuation rule of lower-of-cost-or-market. Such results highlight that conservatism may be a desirable feature of accounting measurements for managerial performance evaluation purposes.

Abstract:
This paper examines changes in market information after the Supreme Court endorsement of the fraud-on-the-market rule in 1988. The fraud-on-the-market doctrine materially reduces plaintiffs burden of proof reliance in shareholder litigation brought under Rule 10b-5 of the federal securities law. The Supreme Court endorsement of this doctrine is a turning point in its widespread acceptance. To investigate the effect of this change in the liability regime on firms disclosure incentives, we partition our sample of earnings surprises into quartiles based on the magnitude of the year-to-year change in earnings. For the quartile of observations with the most negative earnings changes, we find material declines, after 1988, in forecast errors in each of the last six months preceding the earnings announcement date. We also examine voluntary disclosure behavior of bad news firms, and find evidence of an increase in disclosure of bad news. Moreover, we find strong evidence which suggests that bad news firms warn investors on a more timely basis in the post-1988 period. For the good news quartile, in contrast, we do not find significant differences along any of these dimensions. The fact that these findings occur for the lowest quartile of earnings changes, but not for the highest quartile, suggests support for our interpretation that these changes represent firms response to a material change in the legal environment. If, after 1988, firms perceive higher expected legal costs associated with failure to disclose negative information, a rational response would be to increase the timeliness with which negative information is disseminated.

Abstract:
The objective of this paper is to explore the effects of analyst bias on the voluntary disclosure decisions of corporate managers. It is shown that when a manager believes that an analyst following his firm might be exhibiting undue optimism, he will grant the analyst access to his private information not only if it is favorable, but, potentially, also if it is sufficiently unfavorable. In contrast, when the manager believes that the analyst may be exhibiting undue pessimism, he will withhold access not only when the information is unfavorable, but, possibly, also when it is sufficiently favorable. These strategies differ not only from each other, but also from the optimal strategy in a setting without analyst bias. These differences make clear that any analysis of managerial disclosure strategies must take into account the possible biases of analysts and, by extension, the nature of the information currently in the possession of investors in the marketplace. The analysis also explores the effect of changes in the economy's parameters on the probability of managerial disclosure. Some of these results again differ from those obtained in a setting without analyst bias and have the potential of generating future empirical work.

Abstract:
This paper develops a multiperiod agency model to study the use 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 which 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 in comparison to short-term contracts. Under certain conditions, though, the principal does better with a sequence of one-period contracts than with a long-term contract.

Abstract:
This paper develops a multiperiod agency model to study the use 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 which 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 in comparison to short-term contracts. Under certain conditions, though, the principal does better with a sequence of one-period contracts than with a long-term contract.

Abstract:
This paper examines a multiperiod principal-agent model in which a divisional manager has superior information regarding the profitability of an investment project available to his division. The manager also contributes to the periodic operating cash flows of his division through personally costly effort. We demonstrate that it is optimal for the principal to delegate the investment decision and base the manager's compensation on the residual income performance measure. Our analysis points to a class of depreciation rules and to a particular capital charge rate which together ensure that a profitable (unprofitable) project makes a positive (negative) contribution to the residual income in every period. As a consequence, the compensation parameters for each period can be chosen freely so as to address the moral hazard problems without impacting the manager's investment incentives.

capital budgeting, residual income, depreciation, hurdle rate, agency problems

Abstract:
This paper examines a multiperiod principal-agent model in which a divisional manager has superior information regarding the profitability of an investment project available to his division. The manager also contributes to the periodic operating cash flows of his division through personally costly effort. We demonstrate that it is optimal for the principal to delegate the investment decision and base the manager's compensation on the residual income performance measure. Our analysis points to a class of depreciation rules and to a particular capital charge rate which together ensure that a profitable (unprofitable) project makes a positive (negative) contribution to the residual income in every period. As a consequence, the compensation parameters for each period can be chosen freely so as to address the moral hazard problems without impacting the manager's investment incentives.

capital budgeting, residual income, depreciation, hurdle rate, agency problems

Abstract:
This paper characterizes optimal pay-performance sensitivities of compensation contracts for managers who have private information about their skills, and those skills affect their outside employment opportunities. The model presumes that the rate at which a manager's opportunity wage increases in his expertise depends on the nature of that expertise, i.e., whether it is general or firm-specific. The analysis demonstrates that when managerial expertise is largely firm-specific (general), the optimal pay-performance sensitivity is lower (higher) than its optimal value in a benchmark setting of symmetric information. Furthermore, when managerial skills are largely firm-specific (general), the optimal pay-performance sensitivity decreases (increases) as managerial skills become a more important determinant of firm performance. Unlike the standard agency theoretic prediction of a negative trade-off between risk and pay-performance sensitivity, the paper identifies plausible circumstances under which risk and incentives are positively associated. In addition to providing an explanation for why empirical tests of risk-incentive relationships have produced mixed results, the analysis generates insights that can be useful in guiding future empirical research.

Executive Compensation, Pay-Performance Sensitivity, Risk, Incentives

Abstract:
This paper considers an agency model in which a firm's manager receives private information about an investment project. The manager has unique skills that are essential for implementing the project, and he can pursue the project inside the firm or as an outside venture on his own. The firm's owner thus faces a potential managerial retention problem, where the severity of the retention problem depends on the project's outside viability. My analysis shows that if the managerial retention problem is not too severe, the owner can delegate the investment decision to the manager and use a residual-income-based bonus contract to give the manager incentives to work hard and make appropriate investment decisions. If the retention problem is severe, however, the owner must use an option-based compensation contract to retain the manager and provide him with appropriate incentives. I also establish that as the managerial retention problem becomes more severe, the owner reduces the rate of return, or hurdle rate, required to approve the investment project. These results predict that new-economy firms, in which managerial expertise is critical and yet mobile, are more likely to (1) include stock options in their managers' compensation contracts, and (2) apply lower hurdle rates for approving capital investments.

capital investments, stock options, managerial retention, managerial incentives

Abstract:
This paper examines the choice of asset valuation rules from a managerial control perspective. A manager creates value for a firm through his effort choices. To support its operating activities, the firm also engages in financing activities such as credit sales to its customers. Since such financing activities merely change the pattern of cash flows across periods, an optimal compensation scheme must shield the manager from the risk associated with the financing activities. We show that residual income combined with fair value accounting for receivables eliminates this risk and provides an optimal performance measure. In contrast, compensation schemes based only on realized cash flows can be optimal only under exceptional circumstances. We also consider a setting in which there is sufficiently disaggregated information about periodic cash flows so as to eliminate not only the risk associated with financing activities but also the risk associated with customer defaults. The principal then wants to depart from fair value accounting.

Abstract:
In this paper I examine the effects of private and public disclosures on the informational efficiency of stock prices. In addition to making a public announcement such as an earnings announcement, a public firm can make private disclosure to an analyst. If the analyst's relative information advantage is below a threshold level, private disclosure to the analyst leads to more efficient stock price. I demonstrate that the allocation of information across market participants is an important determinant of price efficiency. While accounting regulators often argue the need for equal access to information, the paper shows that there are conditions under which a limited amount of informational inequality may lead to more efficient stock prices.

Abstract:
This paper presents a model of strategic behavior by a privately informed trader and liquidity traders near to the anticipated release of public signals such as earnings announcements. The private information of the informed trader is long-lived in the sense that the public signal does not completely eliminate the informed trader's informational advantage. In keeping with recent empirical findings, conditions are identified under which market depth may be higher or lower after earnings announcements than before. Previous studies predicting lower depth following the release of public signals assume that private information is short-lived, and rely on the arrival of new private information at that time. This distinction in the longevity of private information is important since earnings announcements are unlikely to fully reveal private information acquired beforehand.

Abstract:
This paper investigates how strategic trading around the time of earnings announcements affects market liquidity (e.g., bid-ask spreads). We model an investor with private information in advance of an earnings announcement (e.g., inside information). The investor trades both before and after the earnings announcement in a market populated by liquidity-motivated traders who have some discretion over the time of their trades. The main result of the analysis is that an earnings announcement which reduces and insider's private information may lead to a less liquid market in the post-announcement period.