Accounting Earnings Processes, Inter-temporal Incentives and Their Implications for Valuation

Abstract

Accounting measures such as levels and changes in residual earnings are widely used for performance evaluation and executive compensation (Healy, JAE (1985)). Quite often, these compensation contracts are of the linear form. Residual earnings are also important for valuation (Ohlson, CAR (1995), Easton and Harris, JAR (1991)). We address the following three questions in this paper: (1) What plausible economic conditions would support the sufficiency of an accounting measure for managerial compensation? (2) What is a sufficient accounting measure for valuing firms and what is the nature of the economy that supports this sufficiency? (3) What, if any, is the connection between the two measures? We show in a mutiperiod agency setting with hidden action, where managerial effort dynamically influences the random evolution of a general class of residual earnings, that linear compensation contracts based on weighted sum of the levels and changes of residual earnings are indeed optimal. We characterize the contract explicitly and show that the weights are determined solely by the earnings persistence parameter. For this economic setting, we demonstrate that the valuation function will be identical to the compensation contract (up to a simple transformation). This implies that incentive contracts can be aligned with valuation objectives. Thus we provide the theoretical underpinnings for linear contracting based on residual earnings and their implications for valuation.