When Do Subjective Nonfinancial Performance Measures Reduce Long-Term Investments?

Abstract

One commonly discussed advantage of nonfinancial performance measures is that they can mitigate distortions in financial performance measures and, thus, improve firms’ future financial performance. However, prior empirical findings on the relation between nonfinancial measures and future financial performance have been mixed. Ittner and Larcker (1998b) call on research to identify circumstances under which nonfinancial measures improve firms’ future performance. This paper sheds some light on this research question by identifying tradeoffs that play a role in determining when subjective nonfinancial performance measures (SNPMs) increase or decrease long-term investments. In our principal-agent model, if it is easy (difficult) to achieve a high SNPM with investment and/or the net investment return is small (large), the SNPM will reduce (increase) the expected long-term investment, making the principal worse off (better off). These results are consistent with prior empirical findings and provide a framework for thinking about the use of SNPMs.