The Role of Transitory Earnings for Managerial Effort Allocation to Intangibles

30 Pages Posted: 20 Aug 2013

See all articles by Yoshie Saito

Yoshie Saito

Old Dominion University - College of Business & Public Administration

Date Written: August 18, 2013

Abstract

There is a concern about the ability of earnings to adequately reflect managerial efforts to intangible-based activities. Agency theory suggests that when core earnings relay little information about managerial effort to certain activities, effort allocation will be insufficient. Risk averse managers consider costs of investing in R&D projects and determine their effort levels. I modify the analytical model of Bushman and Indjejikian (1993b) to examine the effect of the transparency of firms’ operations and the information content of earnings on managerial effort allocation. The information content of earnings is how market participants perceive the future based on core and transitory earnings. They assume that compensation contracts are based on two types of information, earnings and stock price, and there are two types of activities. My analysis differs from theirs because I decompose earnings into two components, (1) the core or persistent and (2) the transitory component that captures infrequent revisions to earnings. I show that when bonuses are tied to core earnings, under the current conservative accounting system, a large portion of total compensation in this form yields sub-optimal managerial effort exerted on intangible-based activities. I determine two conditions where transitory earnings can play an important incentive role; they can send signals about the future and security prices reflect information about them. This means that even though the accounting system creates weak value relevant core earnings concerning intangibles, if transitory earnings can provide some additional information, they can play a vital incentive role. For example, unsuccessful prior intangible investments or obsolete inventory would be reported as transitory earnings (e.g., disposal of a poorly performing line of operation, asset write-downs, inventory write-offs), which can send signals to markets about managerial effort to tackle problems. These can be useful to convey information about managerial efforts exerted on intangibles. I show that under these conditions, market-based compensation helps to mitigate inefficient effort allocation to intangible-based activities. However, the reflection of transitory earnings in market-based compensation can also encourage earnings management. Managers may allocate their effort to a nonproductive activity such as shifting operating expenses to non-operation expenses to avoid a sharp decline in security price or/and meet analyst forecasts. Such activities do not increase economic value. Thus, the ability of transitory earnings to produce proper managerial effort allocation has to be weighed against the possibility of encouraging earnings manipulation.

Keywords: intangible-based activities, non-recurring earnings, CEO incentives, compensation

JEL Classification: G32, M41

Suggested Citation

Saito, Yoshie, The Role of Transitory Earnings for Managerial Effort Allocation to Intangibles (August 18, 2013). Available at SSRN: https://ssrn.com/abstract=2312217 or http://dx.doi.org/10.2139/ssrn.2312217

Yoshie Saito (Contact Author)

Old Dominion University - College of Business & Public Administration ( email )

Norfolk, VA 23529-0222
United States

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