A Contracting Perspective On Earnings Quality

ARTICLE IN PRESS
Journal of Accounting and Economics 39 (2005) 265294

www.elsevier.com/locate/econbase
A contracting perspective on earnings quality$

Peter O. Christensena, Gerald A. Felthamb,, Florin S- abacc
a
Department of Accounting and Finance, University of Southern Denmark, DK-5230 Odense M, Denmark
b
Sauder School of Business, University of British Columbia, 2053 Main Mall, Vancouver,
BC, Canada V6T 1Z2
c
Department of Accounting and MIS, University of Alberta, Edmonton, Canada T6G 2E1
Received 14 May 2003; received in revised form 5 May 2004; accepted 9 June 2004
Available online 3 March 2005
Abstract
This paper analyzes the impact of signal-to-noise-ratios and the autocorrelation of a

performance measure on the principals welfare in dynamic agencies with renegotiation. We
consider the impact of changes in the persistent, transitory, and reversible components of
accounting earnings on its usefulness in valuation versus contracting. Increasing the persistent
components and reducing the reversible components are generally desirable for valuation, but
not for contracting. Eliminating transitory components of earnings is generally desirable for
valuation, but not necessarily for contracting. We discuss the contracting implications of
differences in the autocorrelations of accounting earnings versus stock returns.
r 2005 Elsevier B.V. All rights reserved.
JEL classification: D80; J33; M41; M43
Keywords: Contracting; Management compensation; Accruals; Earnings quality; Performance measure

autocorrelation
$
We are grateful to participants in research seminars at the University of British Columbia, University
of Southern Denmark, University of Alberta, the 2002 EAA Congress, and the Stanford Accounting
Summer Camp 2002. We thank Mark Huson, Tom Scott, and Heather Wier for their comments on the
papers empirical implications. We also thank the referee (Stan Baiman) and the editor for their many
thorough comments. Financial support has been provided by the Social Sciences Research Council of
Denmark, the Danish Association of Certied Public Accountants, the Social Sciences and Humanities
Research Council of Canada, and the J.D. Muir fund at the University of Alberta.
Corresponding author. Tel.: +1 604 822 8397; fax: +1 604 822 9470.
E-mail address: jerry.feltham@sauder.ubc.ca (G.A. Feltham).
0165-4101/$ - see front matter r 2005 Elsevier B.V. All rights reserved.
doi:10.1016/j.jacceco.2004.06.002
ARTICLE IN PRESS
266 P.O. Christensen et al. / Journal of Accounting and Economics 39 (2005) 265294
1. Introduction
What characteristics make earnings (or other accounting information) a good

measure of rm performance? What items should be included in earnings (or other
accounting information) for rm performance measurement? Answering such
questions requires distinguishing between the valuation (forecasting) and contracting
roles of earnings (or other accounting information), since information system
rankings for valuation and contracting do not generally coincide (see Gjesdal, 1981).
In this paper, we examine the role played in contracting by the autocorrelation of
accounting earnings. This correlation is determined by the interaction of persistent,
transitory, and reversible earnings components. Our analysis explores the impact of
changes in these components on the usefulness of accounting earnings in contracting
versus valuation. This analysis is consistent with the Holthausen and Watts (2001)
framework, in which incentive contracting is one of the signicant factors impacting
nancial reporting.
A series of empirical papers examine properties of earnings and other accounting
variables, notably accruals and cash ows, that make earnings useful in valuation
(for example Dechow, 1994; Sloan, 1996; Dechow et al., 1998; Dechow and Dichev,
2002). Of particular interest in these studies are the time-series properties of
accounting information relative to their ability to forecast future value-relevant
variables. Including transitory earnings, such as gains or losses on marketable
securities, or the foreign currency translation adjustment, reduces the ability of
current earnings to forecast future earnings. Similarly, accrual estimation errors that
reverse in future periods, such as errors in estimates of uncollectible accounts
receivable, are forecasting noise that reduce the usefulness of earnings in valuation.
Both transitory earnings and accrual estimation errors generally reduce the
persistence of earnings, and persistence is desirable in forecasting. What are the
implications of these characteristics for the use of accounting earnings in managerial
incentive compensation?
Numerous theoretical papers in the economics and accounting literature have
explored the relation between performance measure characteristics and optimal
incentive contracts, and the resulting payoffs to the principal. The initial papers (e.g.,
Holmstrom, 1979, 1982; Gjesdal, 1981, 1982) were based on single-period, single-task
models, and considered the desirable characteristics of either a single performance
measure, or a pair of measures. This literature attracted the attention of accounting
researchers because accounting measures, e.g., accounting earnings, are frequently
used as performance measures in managerial incentive compensation either as an
alternative to, or in combination with other measures, such as the rms stock price.
A series of accounting papers have developed further insights based on the single-
period agency models (e.g., Banker and Datar, 1989; Lambert and Larcker, 1987;
Bushman and Indjejikian, 1993; Sloan, 1993). Single-task, single-period models are
inherently limited in their representation of performance measure characteristics.
The focus is on the precision of the performance measures with respect to the
action taken by the agent and the correlation among the measures that are or might
be used.
ARTICLE IN PRESS
P.O. Christensen et al. / Journal of Accounting and Economics 39 (2005) 265294 267
The hallmark of accounting earnings is its use of accruals to develop monthly,

quarterly, or annual measures in an environment in which the actions and events
interact over much longer periods. Furthermore, rms (principals) and managers
(agents) generally have contractual relations for periods longer than a month, a
quarter, or a year. This naturally raises questions as to how the inter-period
characteristics of performance measures such as accounting earnings and stock price
affect the optimal incentive contracts and the net payoff to the principal. This paper
contributes to our understanding of this issue.
Demski and Sappington (1999) warn empirical researchers about a variety of
issues that arise in examining the relation between management incentives and
performance measures. Of particular signicance here is their warning about the
impact of failing to consider inter-period effects. For example, single-period models
form the basis for the hypotheses explored in several empirical studies, such as
Lambert and Larcker (1987), Sloan (1993), and Core et al. (2003). These studies
emphasize performance measure precision and correlation of multiple performance
measures within the same period. However, we show that the autocorrelation of
performance measures also plays an important role.
A key insight is that the risk imposed on the agent, for which he must be
compensated, is increasing in the autocorrelation of the performance measure. As a
result, we hypothesize that incentive rates (or pay to performance sensitivities) are
increasing in performance measure precision and are decreasing in the autocorrela-
tion of the performance measure. This implies that accounting earnings are more
likely to be used in contracting when their autocorrelation is lower, for example, due
to a higher level of accrual estimation errors (and lower earnings quality as in
Dechow and Dichev (2002)). Furthermore, while stock returns may contain more
noise than accounting earnings, the relative attractiveness of performance measures
based on the stock return is enhanced by low autocorrelation.
To simplify the analysis and make the results transparent, we restrict our analysis
to a two-period LEN model1 in which there is a single task and a single performance
measure in each period. Furthermore, the action in period t only inuences the
performance measure for that period, but the noise in the measures is correlated
across periods. In the case of accounting earnings, the correlation depends on both
the correlations in the underlying cash ows, the accruals that are used, and the
errors in measuring the various elements used in calculating accounting earnings. On
the other hand, in an efcient market, the stock returns would be uncorrelated.
Introducing multiple tasks within each period into our model (e.g., extending the
Feltham and Xie (1994), single-period multi-task model to multiple periods) would
expand the characteristics of interest to include intra-period, as well as inter-period,
1
The LEN model assumes linear contracts, exponential utility, and normally distributed performance
measures and is widely used in the literature on multiple tasks and performance measures (e.g. Feltham
and Xie, 1994; Datar et al., 2001; Ziv, 2000). Several recent agency theory papers employ the LEN
framework in multi-period settings (e.g. Dutta and Reichelstein, 1999; Reichelstein, 2000; Dutta and
Zhang. 2002).
ARTICLE IN PRESS
congruency with the principals expected payoff. Perfect congruency in this case
means achieving the rst-best relative effort mix within and across periods.
Multi-period contracting raises issues with respect to the feasible level of
commitment by the principal and the agent. We assume there is less than full
commitment. In particular, we assume that while the principal commits to retain the
agent for two periods, he cannot commit not to renegotiate the initial two-period
contract at the start of the second period (i.e., offer the agent an alternative contract
which the agent can accept or reject).2 Renegotiation of long-term contracts is
difcult to preclude, since the courts are unlikely to sustain ex ante commitments if
both parties support an ex post change.3 However, we only allow renegotiation
subsequent to the rst-period action and the release of the rst-period report. This
timing is critical for the results obtained. In particular, it is important that there be
no renegotiation between an action and the following report.
The impact of contract renegotiation on the demand for information has received
signicant attention in the economics literature, e.g., Hart and Tirole (1988),
Dewatripont (1989), Fudenberg and Tirole (1990), Hermalin and Katz (1991), Ma
(1994), and Dewatripont and Maskin (1995). A key insight is that reducing the
precision of the ex post beliefs about future events at the time of renegotiation can be
valuable because it reduces the extent to which the ex post efcient renegotiated
contract deviates from the ex ante efcient contract. This is particularly relevant for
how accounting information is produced and reported. For example, Arya et al. (1998),
Demski and Frimor (1999), Christensen et al. (2002) show how earnings management
can improve contracting efciency. Likewise, Indjejikian and Nanda (1999) offer
within period aggregation of performance measures as another mechanism for reducing
the precision of ex post beliefs at the time of renegotiation in dynamic agencies.
We examine the simultaneous impact of the period-specic variance (which we
frequently refer to as noisiness) and autocorrelation on the value of performance
measures in a dynamic (two-period) pure moral hazard principal-agent model with
renegotiation.4 The design of an accounting system implicitly determines both the
noisiness and correlation of accounting earnings, and accounting earnings is often
used for both performance evaluation and rm valuation. Our analysis provides a
2
We treat the desire to contract with one agent for two periods as exogenous. For simplicity, we also
assume the agent commits to stay for two periods. However, the latter is not essential, since the principal
could structure the payments such that the agent would choose to stay (see Christensen et al., 2003).
3
If complete contracts are possible, a commitment not to renegotiate is valuable ex ante to the principal,
and a reputation mechanism may serve to enforce such a commitment. On the other hand, Hart and
Holmstrom (1987) raise the possibility that renegotiation plays a useful role in a world with incomplete
contracts and Kreps (1990) examines the possibility that corporate culture is an implicit commitment for
the resolution of unforeseen contingencies; again, with incomplete contracts, commitment to explicit long-
term contracts may not have value. In a similar vein, renegotiation effectively allows contracting on
unveriable information in Hermalin and Katz (1991).
4
The noisiness of a performance measure determines the informativeness of the measure with respect to
the agents action, whereas the correlation between performance measures determines the informativeness
of one measure relative to the noise in the other. Together they determine the ex ante incentive risk
premium paid to the agent. See Rajan and Sarath (1997) for an examination of the role played by
performance measure correlation in a single-period full-commitment setting.
ARTICLE IN PRESS
contracting perspective on earnings quality and we describe circumstances under

which accounting measurement noise can provide efcient reduction of its
autocorrelation. This result is contrasted to a valuation perspective on earnings
quality, as presented in, e.g., Dechow and Dichev (2002) or the survey by Schipper
and Vincent (2003). Gjesdal (1981) shows that information system rankings for
decision making and stewardship do not generally coincide. Our analysis provides an
example of that conict.
Specically, we show how the stochastic characteristics of the various components
of accounting earnings have differing effects on the value of accounting earnings as a
performance measure in incentive contracting. Persistent random variations (e.g., the
uncontrollable portion of earnings due to persistent market conditions) are always
undesirable, transitory random variations (e.g., gains/losses on marketable
securities) are generally undesirable, while reversible random variations (e.g.,
accrual estimation errors) are generally desirable. This is in contrast with the
valuation perspective in which persistence is generally desirable, while transitory and
reversible random variations are always undesirable.
We consider both positive and negative correlation. The analytical literature has
generally assumed positively correlated performance measures, as in Holmstroms
(1999) career incentive model (see also Gibbons and Murphy, 1992; Meyer, 1995;
Meyer and Vickers, 1997; Indjejikian and Nanda, 1999). There is empirical evidence
on the time-series properties of earnings which supports the assumption of positive
correlation of accounting-based performance measures, e.g., Ball and Watts (1972)
on the random walk hypothesis for accounting earnings, and Myers (1999) on
abnormal accounting earnings. On the other hand, there is also empirical evidence
supporting the assumption of negative correlation in some settings. Kormendi and
Lipe (1987) nd that the time-series properties of earnings vary across rms and the
persistence of earnings shocks is less than what a random walk would imply. Sloan
(1996) presents evidence on lower persistence of the accrual component of earnings
than of cash ows, and Dechow et al. (1999) show that the persistence of abnormal
earnings is reduced by the presence of transitory earnings components. These results
provide indirect evidence on accruals introducing negative correlations between
successive periods accounting performance measures, consistent with the idea that
errors in estimating accruals, once reversed, create ex ante negatively correlated
reports. Thus, observed time-series properties of earnings are the result of many
interacting factors, among which managerial ability or job t, accruals, and
measurement errors play an important role.
Our results show the importance of explicitly considering the simultaneous impact
of performance measure noisiness and autocorrelation in a dynamic agency. We
consider three types of noise: persistent, transitory (i.e., period-specic), and accrual
estimation errors (that are reversed in the next period). All three types of noise
increase the noisiness of the performance measures (and, thus, reduce their
individual informativeness about the agents actions), but they have differing effects
on the performance measure correlation. If there is full commitment, then reducing
any type of noise is benecial to the principal. With renegotiation, however, only
persistent noise reduction is benecial to the principal in all circumstances. Reducing
ARTICLE IN PRESS
transitory or accrual estimation errors below certain cutoff levels may be inefcient
in the presence of persistent noise, since accrual (transitory) noise reduces the
(absolute value of the) performance measure correlation. In fact, with identical
periods, there is an optimal amount of accrual noise which results in uncorrelated
performance measures. This highlights the fact that while improving earnings
quality by reducing accrual estimation errors may be benecial from a valuation
perspective (i.e., reduces mispricing of a rms shares), it may not be benecial if
earnings are used for incentive contracting.
For simplicity, we only consider a two-period model in which the agent performs a
single task in each period and each task only impacts the performance measure for
the corresponding period. The non-contractible payoffs to the principal may be
short- or long-term, but the payoffs from period t effort are aggregated and
measured in date t dollars. A more general model (see, for example, Christensen et
al., 2004) would consider intra-period congruency issues by including multiple tasks
in each period (e.g., current sales activity and undertaking capital investments),
recognizing that these actions may inuence both current and future performance
measures, and explicitly considering the relation between the performance measures
and the principals payoffs. We caution the reader that our insights into the impact
of noise and autocorrelation on the relative effectiveness of alternative performance
measure would likely be affected if we examined a more general model. For example,
stock returns are more likely than conservative accounting earnings to be affected by
current actions that only have long-term consequences. This may be particularly
important in empirical studies that examine the relative use of stock prices and
accounting earnings as performance measures.
Section 2 presents the basic two-period model. Section 3 characterizes the optimal
renegotiation-proof long-term contracts and the value of the information system as
functions of the noisiness of the performance measures for each period, and their
autocorrelation. Section 4 models the impact of three types of noise on the aggregate
noisiness and correlation of the two performance measures. Section 5 concludes the
paper with empirical implications of our analysis.
2. The basic model
We consider a two-period model in which a principal hires an agent to perform a

single task in each of the two periods. The agents effort in period t is denoted at,
t 1; 2; and a a1 ; a2 : The principal is risk neutral and, for simplicity, indifferent
with respect to the timing of the outcome and compensation paid, i.e., all amounts
are measured in the same dollars and, thus, there is no discounting. The principals
expected outcome (i.e., the aggregate value of the gross cash ows he receives prior
to paying compensation) from employing an agent who exerts effort a1 and a2 in
period 1 and 2 is Exja bo b1 a1 b2 a2 ; where bo 40 is the principals expected
outcome if the agent is hired but provides zero effort, and bt X0; t 1; 2; is the
expected outcome (i.e., the aggregate value of all current and future gross cash ows)
generated per unit of effort at.
ARTICLE IN PRESS
We assume the principal cannot observe the agents actions and the principals
outcome is not contractible information, e.g., he does not realize the outcome until
after the termination of the agents contract. A contractible performance measure yt
is reported at the end of each period t 1; 2; where yt at t ; t N0; s2t ; and
Cov1 ; 2 rs1 s2 ; r 2
1; 1:
The performance measures have the following key features. First, the impact of the
actions on the expected performance measures is linear and at positively inuences the
expectation of only yt (i.e., a1 does not affect the second performance measure).5
Second, as commonly assumed in the literature, the joint distribution of the noise
terms is independent of the actions. Third, the performance measures have been scaled
(without loss of generality) so that they have mean at. Fourth, and most importantly,
the noise levels in the two performance measures are potentially correlated.
The conditional expected performance levels at the time the actions are selected are
Ey1 ja1 a1 ; Vary1 ja1 s21 , (1a)
Ey2 ja1 ; a2 ; y1 a2 ly1

a1 ; Vary2 ja1 ; a2 ; y1 1
r2 s22 , (1b)
where l rs2 =s1 : That is, the posterior mean of y2 depends on the second-period
action a2 as well as on y1
a1 : However, the posterior variance of y2 is independent
of the specic values of y1, a1, and a2, but is lower than the variance of y1 if the two
performance measures are correlatedirrespective of the sign of that correlation.
The agent has exponential utility with respect to aggregate compensation minus an
aggregate personal monetary cost of effort. He may receive compensation at the end
of each period, but his exponential preferences are such that he is indifferent
regarding the timing of his compensation.6
ua c; a
exp
rc
12a21 a22 ; r40,
where c is his aggregate compensation and 12a21 a22 is his aggregate personal
monetary cost of effort. The agent has alternative employment that will yield a
5
As pointed out earlier, a more general model would consider multiple tasks within each period and
would recognize that the actions differ with respect to their impact on current and future performance
measures. With a single task per period, an action may affect both current and future performance
measures, but, in that setting, we can assume the performance measures have been transformed so that the
current action only impacts the current performance measure. For example, suppose the performance
measures are zt ; t 1; 2; and both are inuenced by a1 such that
z1 m1 a1 d1 ; z2 m12 a1 m2 a2 d2 .
Observe that y1 z1 =m1 ; and y2 z2
m12 z1 =m1 =m2 are informationally equivalent representations of
the performance measures and are such that at only affects yt : Interestingly, even if the noise terms d1 and
d2 are independent, the noise terms in y1 and y2 are negatively correlated, i.e.,
1 d1 =m1 ; 2 d2
m12 d1 =m1 =m2 .
6
As is well-known, this form of utility function, as opposed to a time-additive utility function, avoids
incentives to smooth consumption across periods. Hence, there is no need to consider either borrowing or
saving in the rst period. However, our results carry over with minor modications to settings with time-
additive utility functions, positive interest rates, and equal access to banking for the agent and the
principal (see Dutta and Reichelstein, 1999, 2003; Christensen et al., 2004).
ARTICLE IN PRESS
certainty equivalent (i.e., a reservation wage with zero effort) of co 2 0; bo ; such that
the principal strictly prefers to hire an agent even if he exerts zero effort. The agent is
committed to stay for both periods if he accepts the initial contract. To simplify the
analysis, we assume that at 2 R; and note that negative effort is costly to both the
agent and the principal.
3. Long-term contract with renegotiation
A key issue in contracting is whether the principal and agent are limited in the
commitments they can make. We believe that limitations are common and that the
inability to preclude a mutually agreeable change in a contract after a report has
been issued is particularly pervasive.7 Hence, we focus on settings in which the
principal and agent agree to a long-term contract at t 0; but the principal can
make a take-it-or-leave it offer to change the contract after the report at t 1 has
been issued.8 For example, our setting can be applied to managerial incentive
compensation, where cash compensation is set annually.9
We assume that both the initial two-period contract and the renegotiated second-
period contracts are linear.10 Renegotiation of long-term contracts is difcult to
preclude, since the courts are unlikely to sustain ex ante commitments if both parties
7
Note, it is the ability to make changes that is pervasive, not the changes per se. If contracts are
renegotiation-proof, then no changes will be observed even though they cannot be precluded.
8
The results are not materially affected by who has the bargaining power at the time of renegotiation.
We assume the principal has the residual bargaining power at both t 0 and 1.
It is well known that even in single-period agency problems, there is an incentive to renegotiate the
contract after the agent has implemented his action but before observing the performance measure, i.e.,
renegotiate to a xed wage equal to the agents certainty equivalent based on the conjectured action (see
Fudenberg and Tirole, 1990). If the agent anticipates that these incentives exist, he will choose the least
costly action. The only equilibrium in which the agent does not always choose the least costly action is one
in which he randomizes over actions. Christensen et al. (2002) consider a two-period model with self-
reported performance measures in which more costly actions can be implemented as pure strategies even
with this type of renegotiation. We exogenously restrict renegotiation to follow the release of a public
report.
9
While, in general, any contract can be renegotiated provided both parties agree, our setting is
particularly descriptive of employment relationships in which compensation is adjusted through
renegotiation (see Malcomson, 1997, for a survey). Our analysis could also be extended to a two-sided
moral hazard setting as in the literature on franchise contracts (Brickley, 2002; Lafontaine and Shaw,
1999). However, renegotiation is not descriptive of franchise contracts given that they are typically long-
term in nature and not subject to renegotiation. A discussion of the implications of contracting variable
characteristics on contract duration under both full commitment and renegotiation can be found in S- abac
(2004).
10
Although we restrict contracts to be linear, we nd that any equilibrium with renegotiation can be
implemented with a linear renegotiation-proof contract, as in Fudenberg and Tirole (1990). The short-
term incentive models employed by Gibbons and Murphy (1992), Meyer (1995), Meyer et al. (1996),
Meyer and Vickers (1997), and Indjejikian and Nanda (1999) yield equivalent results (in terms of the
induced actions and the principals expected utility). Our model is similar to the LEN model with
renegotiation in Christensen et al. (2003), where a detailed discussion of these alternative models is
provided.
ARTICLE IN PRESS
support an ex post change. We only allow renegotiation subsequent to the rst-

period action and the release of the rst-period report. This timing is critical for the
results obtained. In particular, it is important that there be no renegotiation between
an action and the following report. As Hermalin and Katz (1991) point out, even in
the Fudenberg and Tirole (1990) model with pre-report renegotiation, the principal
needs to know that an action has been taken in order for renegotiation to take place.
Rather than depending on the courts, our setting is more descriptive of a repeated
agency in which actions have short-term consequences and renegotiation is restricted
by availability of information and institutional constraints such as annual meetings
of the compensation committee. Multi-period analyses that examine the impact of
pre-report renegotiation typically assume independent performance measures (see,
e.g., Christensen et al., 2002). We examine the impact of post-report renegotiation as
in Fudenberg et al. (1990), but the autocorrelation of performance measures ensures
their sufcient conditions for no loss due to renegotiation do not apply.
3.1. Optimal linear contract with renegotiation
We assume the initial contract (at t 0) is restricted to be a linear function of the

two performance measures:
ci y1 ; y2 f i vi1 y1 vi2 y2 ,
where the superscript i denotes the initial contract. At t 1; the principal and agent
know the rst performance measure y1, the agent knows the rst action a1, and the
principal has a conjecture a^ 1 about the agents choice of a1. We treat f i and vi1 as
irrevocable at t 1 (the agent already has that part of his compensation in the
bank), but we allow the principal to offer a renegotiated linear compensation
contract cr with a revised incentive rate vr2 and a change in the xed payment Df r : If
the agent accepts the new contract, then his terminal compensation will be
cr y1 ; y2 f i vi1 y1 Df r vr2 y2 . (2)

Given the LEN assumptions (i.e., linear contracts, exponential utility, and
normally distributed performance measures), the agents certainty equivalent,
conditional on his information at the end of the rst period, equals the conditional
expected compensation minus the effort costs and the risk premium for the
compensation based on the posterior variance of the second-period performance
measure, i.e.,
CE r cr jy1 ; a1 ; a2 f i vi1 y1 Df r vr2 a2 ly1

a1

12a21 a22
12rvr2 2 2
2 1
r s2 . 3
Differentiating (3) with respect to the second-period action establishes that the
agents utility maximizing choice is ar2 vr2 : Hence, given the revised incentive rate
vr2, the agents optimal second-period action is independent of the rst-period
performance measure y1, the initial contract ci, and his rst-period action a1.
ARTICLE IN PRESS
At t 1; the principal chooses Df r and vr2 to maximize his expected payoff given
the initial contract ci, the rst-period report y1, and his conjecture of the agents rst-
period action a^ 1 ;
U p cr jy1 ; a^ 1 ; ar2 vr2 bo b1 a^ 1 b2 ar2
f i
vi1 y1

Df r
vr2 ar2 ly1
a^ 1 , 4
subject to acceptance by the agent
CEcr jy1 ; a^ 1 ; ar2 vr2 XCEci jy1 ; a^ 1 ; ai2 vi2 .
Observe that at t 1; the rst-period action has already been taken (but is only
known to the agent) and beliefs about y2 depend upon y1 and the conjectured (or
known) rst-period action a^ 1 :
It is then straightforward to show that, at the renegotiation stage, it is optimal for
the principal to offer the agent a revised second-period incentive rate based on the
posterior variance of y2, i.e.,
1
vr2 b2 ; where D12 1 r1
r2 s22 . (5a)
D12
The revision of the xed payment is the minimum change that the principal believes
will be acceptable to the agent given the observed performance measure y1 and the
conjectured action a^ 1 :
Df r y1 ; a^ 1 12far2 2
ai2 2 g 12r1
r2 s22 fvr2 2
vi2 2 g

fvr2 ar2 ly1
a^ 1
vi2 ai2 ly1
a^ 1 g. 5b
That is, the principal must compensate the agent for the change in his effort costs
and risk premium, minus the increase in his conditional expected second-period
compensation.
The principals optimal choice of vr2 and, hence, the agents choice of ar2, are
independent of f, y1, a^ 1 and a1. Furthermore, Df r y1 ; a^ 1 is a linear function of y1 and
a^ 1 :11 These features are important for the analysis that follows because they imply
that the agents realized compensation (see (2)) from any initial linear contract plus
the changes characterized by (5) can be expressed as a linear function of y1 and y2.
The intercept equals f i plus the intercept of Df r y1 ; a^ 1 ; the slope with respect to y1
equals vi1 plus the slope of Df r y1 ; a^ 1 ; and the slope with respect to y2 equals vr2. Of
course, if the initial contract species vi2 vr2 ; then Df r y1 ; a^ 1 0; i.e., there is no
change in the contract at t 1 and the initial contract is dened to be renegotiation-
proof. This leads to the following proposition.
Proposition 1. For any optimal initial linear contract that is subject to renegotiation
satisfying (5), there exists an equivalent initial linear contract that is renegotiation-
proof (i.e., the results are the same and no change takes place at t 1).
11
This is common in many of the dynamic LEN models, but it is not the case in all models. For example,
Feltham et al. (2004) consider a model in which b2 is a random variable and y1 is correlated with both y2
and b2. In that case, vr2 varies with y1 and Df r y1 ; a^ 1 is a quadratic function of y1.
ARTICLE IN PRESS
This proposition implies that we can restrict our analysis to linear renegotiation-
proof contracts.12 Given acceptance of the initial renegotiation-proof contract c
f ; v1 ; vr2 ; the agent chooses a1 to maximize his ex ante certainty equivalent:
CEcja1 ; ar2 f v1 a1 vr2 ar2
12a21 ar2
2

12rv21 s21 vr2 2 r
2 s2 2rs1 s2 v1 v2 . 6
Differentiating with respect to a1 establishes that the agents optimal action choice
is a1 v1 :
Now consider the principals choice of f and v1 in c f ; v1 ; vr2 ; given that he
anticipates that the agent will choose a1 v1 and a2 ar2 vr2 ; and that there will be
no contract change at t 1 (so that Df r 0). The principals decision problem at
t 0 can be expressed as
maximize U p cja1 ; ar2 bo b1
v1 a1 b2
vr2 ar2
f , (7a)
f ;v1 ;a1
subject to CEcja1 ; ar2 Xco , (7b)
a1 v 1 . (7c)
The optimal rst-period incentive rate and expected payoff to the principal (see
appendix for derivation) are:
1
vr1 b1
gvr2 , (8a)
D01
U pr bo
co P01 A1 P12 A2 , (8b)
where
1 1 2 1 1
P01 b ; A1
rrb1 s1 b2 s2
gvr2 b1 ,
2 D01 1 D01 D12
1 1 2 1 1 1
P12 b ; A2
rr2 s22 b22
2 D12 2 2 D01 D212
and D01 1 rs21 ; D12 1 r1
r2 s22 ; g 1=D01 rs21 l 1=D01 rrs1 s2 : The
two terms P01 and P12 represent the principals surplus in each period if two
different agents were employed in the two periods. The other two terms represent
adjustments due to the use of the rst-period performance measure in reducing the
risk imposed on the agent and are explained below: A2 represents the cost of
window-dressing effort in the rst period, while A1 represents an externality due to
the productive impact of rst-period effort and the insurance adjustment made to the
rst-period incentive rate.
12
Fudenberg and Tirole (1990) obtain this result for optimal contracts, whereas we restrict our analysis
to linear contracts. The key is that, in our model, a linear renegotiation offer is also ex ante linear. This is
not true in general (see footnotes 10 and 11).
ARTICLE IN PRESS
3.2. Effort-incentive and risk-reduction roles of the first-period performance measure
Motivation of productive effort is the primary role of the performance measures.

However, if the performance measures are correlated, then the rst-period
performance measure also plays a risk-reduction role with respect to the second-
period incentive risk. To explore these issues, we consider a series of special cases.
The incentive rates and the principals expected net payoff for each case are
summarized in Table 1.
Case (i) Basic effort-incentive model: Effort is productive in both periods (b1,
b2 40) and the performance measures are uncorrelated (r 0). In this setting, the
two performance measures play pure effort-incentive roles. The incentive rates are
less than rst-best (i.e., vt obt ) because the principal must pay the agent a risk
premium for any incentive risk that is imposed upon the agent. Increasing the
noisiness st of the performance measures decreases the incentive rates, the
corresponding actions, and the principals expected net payoff Pt :
Case (ii) Basic insurance model: First-period effort has no impact on the
principals payoff (b1 0) or on the rst-period report (y1 1 ), which is correlated
with the second-period performance measure (ra0). Since the agents rst-period
action does not affect the rst performance measure, the agent will not exert any
costly rst-period effort. Consequently, since it is correlated with the second-period
Table 1
Incentive rates and principals expected net payoff
Case (i). Basic effort-incentive model (r 0):

1 1
v1 b1 ; v2 b2 ; U p bo
co P01 P02 ,
D01 D02
1 1 2 1 2
where D01 1 rs21 ; D02 1 rs22 ; and P01 b ; P02 b .
2 D01 1 D02 2
Case (ii). Basic insurance model (ra0; b1 0; y1 1 ):

1
v1
lv2 ; v2 b2 ; U p bo
co P12 ,
D12
1 1 2
where l rs2 =s1 ; D12 1 r1
r2 s22 ; and P12 b .
2 D12 2
Case (iii). Basic window dressing model model (same as (ii) except that y1 a1 1 ):
1
v1
gv2 ; v2 b2 ; U p bo
co P12 A2 ,
D12
1 1 1 1
where g rs2 l; and A2
rr2 b22 .
D01 1 2 D01 D212
Case (iv). General model (same as (iii) except that b1 40):

1 1
v1 b1
gv2 ; v2 b2 ; U pr bo
co P01 A1 P12 A2 ,
D01 D12
1 1
where A1
rrb1 s1 b2 s2 .
D01 D12
ARTICLE IN PRESS
report, the principal can costlessly use the rst-period report to optimally reduce the
agents ex ante risk by setting v1
lv2 : This implies that v2 and Upr are
independent of s1 ; decreasing in s2 ; and increasing in r2 : Interestingly, the principals
expected payoff in this case is the same as when there is no contract until after the
rst-period report is released, in which case the only role played by y1 is to reduce the
posterior variance of the second-period report.
Case (iii) Basic window dressing model: This case is the same as (ii) except that
both performance measures are effort-informative (y1 a1 1 ). In this case, it is no
longer costless to use the rst-period report to reduce the agents ex ante risk, since
setting v1 a0 will induce costly rst-period effort, with no productive benet.
Feltham and Xie (1994) refer to this costly rst-period performance manipulation
as window dressing. The cost of the window dressing is represented by the net
payoff adjustment of A2. This adjustment, which is always negative, reects the cost
of the rst-period window dressing effort induced by v1, and the reduced insurance
(as reected by a smaller absolute value for v1
gv2 ; since gol).
Case (iv) General model: This case is the same as (iii) except that both actions are
productive (b1 40). In this setting (which is also given in (8)), the rst-period
incentive rate is the sum of the pure effort-incentive rate in case (i) and the pure
insurance rate with window dressing in case (iii). As in case (iii), A2 is a window
dressing adjustment to the principals net payoff. In addition, there is a rst-period
adjustment of A1, which reects an externality associated with the fact that the
insurance component
gv2 of v1 has an impact on the rst-period outcome.13
3.3. Comparative statics
Given that we have normalized the performance measures so that they have unit
sensitivity to the effort for the period, the reporting system can be characterized by
the standard deviations s1 ; s2 ; and the correlation r: We now examine the impact of
changes in those parameters on the principals expected net payoff, which can be
expressed as a function of the incentive rates as follows:
U pr vr1 ; vr2 bo b1 vr1 b2 vr2
12fvr2 r2 r2 2 r2 2 r r
1 v2 rv1 s1 v2 s2 2rs1 s2 v1 v2 g.
(9)
If both incentive rates are positive, then the partial derivatives of (9) with respect
to r; s1 ; and s2 are all negative, reecting increases in the ex ante risk premium that
must be paid to the agent, ceteris paribus. With renegotiation, y2 is used solely to
13
With renegotiation, the second-period incentive rate is strictly an effort incentive rate.
Renegotiation eliminates the use of the second-period performance measure to provide insurance with
respect to the rst-period incentive risk. With full commitment, on the other hand, the incentive rates for
both periods consist of an effort incentive rate and an insurance rate, based on prior beliefs. That is, the
full-commitment incentive rates, vc1 and vc2, can be characterized as follows:
b1 rrs21 c b2 rrs22 c
vc1
v ; vc2
v .
1 rs1 1 rs21 2
2 1 rs2 1 rs22 1
2
ARTICLE IN PRESS
induce second-period productive effort, so vr2 is always positive (see (5a)). However,
y1 is used to both induce rst-period productive effort and to insure second-period
risk (see (8a)). If the correlation is positive, then the insurance component of vr1 is
negative and it can dominate the effort-incentive component, resulting in vr1 o0:
Of course, we are primarily interested in the total derivative of Upr with respect to
the three system parameters, which we obtain by differentiating (8b). This provides
the following relatively simple set of results for the identical periods case (i.e., b1
b2 b and s1 s2 s), which is representative of an ongoing rm.
Proposition 2. With renegotiation-proof contracts and identical periods
(a) dU pr =dro0 for all r;

(b) dU pr =ds1 o0 if ; and only if ; r2 r
1rs2 o1;
(c) dU pr =ds2 o0 for all r:14
Observe that if r is positive, then increasing r makes y1 more informative about 2 :

This has no impact on P01 ; but increases P12 : However, the insurance rate
g
becomes more negative resulting in less rst-period effort, and both adjustments (i.e.,
A1 and A2) become more negative. The changes in the adjustments dominate, so that
increasing r; when it is positive, reduces the principals expected net payoff.
On the other hand, if r is negative, then increasing r makes y1 less informative
about 2 : This too has no impact on P01 ; but decreases P12 : Now the insurance rate
g becomes less positive again resulting in less rst-period effort. As a consequence,

A1 becomes less positive, while A2 becomes more negative. Hence, all effects are
negative and increasing r reduces the principals expected net payoff when r is
negative, as well as when it is positive.
Increasing s2 also has no impact on P01 ; but decreases P12 due to increased
posterior uncertainty, irrespective of the sign of r: More second-period risk creates a
demand for more insurance, which in turn results in more window dressing. Hence,
increasing s2 makes the adjustment A2 more negative, irrespective of the sign of r:
On the other hand, window dressing decreases (increases) the rst-period effort and
payoff if r is positive (negative). Hence, increasing s2 makes adjustment A1 more
negative (more positive) if r is positive (negative). The negative effects always
dominate, so that increasing s2 reduces the principals net payoff for all r:
The impact of increasing s1 is more subtle. On the one hand, it parallels the
preceding case in that increasing s1 reduces P01 ; but has no impact on P12 ; reecting
its direct effect on the incentive risk associated with inducing rst-period effort.
However, it also affects the cost of using the rst-period performance measure to
insure the ex ante second-period incentive risk given that the rst-period effort can
be used to window dress the rst-period performance measure. Recall that in the
basic window dressing model, increasing s1 increases the window dressing
adjustment A2. That is, if the rst-period effort is non-productive but inuences
the rst-period performance measure, then increasing the noisiness of that measure
14
The derivatives with respect to period-specic noise dU pr =dst ; are evaluated at s1 s2 s:
ARTICLE IN PRESS
(relative to the effort cost) while holding the correlation constant, reduces the level of
v1 required to provide a given level of insurance, and this in turn reduces the absolute
level of costly window-dressing effort. (The insurance rate g becomes more
positive (negative) if the correlation r is positive (negative).)
The above phenomenon also occurs within the general model, but now increasing
s1 affects the benet externality A1 as well. If rs21 41 and r is positive, then A1 is
increasing in s1 : That is, the insurance externality associated with reducing the rst-
period benet increases (becomes less negative). The net result is that in the general
model, if the informativeness of the rst performance measure is small enough
relative to r, and r is positive and large enough, increasing the noisiness of the rst-
period performance measure relative to the effort cost (while holding the correlation
constant) will increase the principals expected payoff.
To summarize, we have shown how performance measure correlation and
noisiness affect the principals expected utility. Autocorrelation plays a particularly
important role in ranking information systems. Since the value of an information
system generally decreases with the noisiness of each performance measure and with
the correlation of the performance measures, there is a potential trade-off in
performance measure design between increasing noisiness and decreasing correlation.
4. Impact of accounting measurement errors
We now explore the implications of three types of performance measure noise that
are common in accounting-based performance measures (such as operating earnings
or residual operating income at either the rm or divisional level). The rst is
persistent and representative of random economic events, such as changes in
consumer demand or market competitiveness, that have long-lasting effects.
Alternatively, it can represent random, but persistent, agent characteristics, as in
the career concerns literature (see Gibbons and Murphy, 1992; Holmstrom, 1999).
The second is transitory and representative of economic events or measurement errors
that vary independently from period to period (e.g., gains or losses on marketable
securities, or the foreign currency translation adjustment). The third is accrual
measurement error and representative of errors that have a two-period effect, with the
error in one period reversing in a subsequent period (e.g., an underestimate of the
allowance for bad debts is reversed when debts are known to be uncollectible, or
conservative biases in the estimation of future gains/losses which are later corrected).
Since the principal is risk neutral, it is immaterial for incentive purposes whether
the noise is attributable to economic events (e.g., random variations in cash ows) or
randomness in the accounting numbers. However, the randomness in the accounting
numbers is of particular interest because the measures used and the procedures
employed to implement those measures are assumed to be under the control of the
principal (i.e., he chooses the accounting system, including the internal and external
auditors). We do not endogenously model the manipulation of accounting measures
by management. Instead, we treat all manipulations as exogenous and implicit in the
characteristics of the reporting system.
ARTICLE IN PRESS
4.1. A model of the noise process
Let xt represent the outcome (e.g., cash ow) generated by the action taken in
period t, measured in date t dollars (irrespective of timing at which the outcome is
realized). We assume, as in the career concerns model with identical periods, that
xt 12ba bat m dtx ,
where m represents a persistent incremental outcome (due to the agents ability), dtx
represents transitory variations in the outcome, and bo is the principals expected
outcome from employing an agent who chooses zero effort in both periods. The
outcome is not contractible, but there is an accounting report that measures the
outcome with error.15 Let dty and yt represent transitory and accrual measurement
errors initiated in period t. The transitory errors only affect the report in period t,
whereas the accrual errors are reversed in the subsequent period. Hence, the
contractible accounting measure for date t is
y^ t 12bo bat m dt yt
yt
1 ,
where dt dtx dty is the total transitory component.
The prior beliefs about the persistent, transitory, and accrual error components
are m N0; s2m ; dtx N0; s2dx ; dty N0; s2dy ; dt N0; s2d ; and yt N0; s2yt ;
respectively, and are mutually independent. Hence, the normalized performance
measures (divide by b and subtract 12bo =b) for periods 1 and 2 are
1
yt at t ; where t m dt yt
yt
1 ; t 1; 2. (10)
b
Consequently, t N0; s21 ; and the variances and correlation of the performance
measures are
1 2
s2t sm s2d s2yt s2yt
1 ; t 1; 2, (11)
b2
s2m
s2y1
r Corry1 ; y2 qq . (12)
s2m s2d s2y0 s2y1 s2m s2d s2y1 s2y2
To summarize, the reported performance measure consists of a deterministic

component 12bo bat that is controlled by the agent, a random persistent component
m; a random transitory component dt ; and a random accrual error yt
yt
1 including
the reversal of the accrual error from the previous period. Our parametric analysis
considers changes in sm ; sd ; and sy1 ; i.e., the standard deviations of the three random
components of the performance measures.16 We refer to these as changes in
15
For simplicity, we assume that the accounting measure is equal to the outcome plus noise. Introducing
a deterministic or stochastic bias in the accounting measure due to, for example, conservative accounting
practices would not alter the results as they would apply to controlling the common noise components of
the outcome and the performance measures, together with accrual estimation errors.
16
Varying sy1 captures the impact of varying only the reversible accrual estimation errors, while varying
sy0 and sy2 amounts to varying the transitory noise components.
ARTICLE IN PRESS
persistent noise (sm ), transitory noise (sd ), and accrual noise (sy1 ), respectively. The
following proposition identies, based on (11) and (12), the impact of increasing the
three types of noise on the aggregate noisiness of the two normalized performance
measures and their correlation.
Proposition 3.
(a) Aggregate noisiness: qs=qsm 40; qst =qsd 40; qst =qsy1 40:
(b) Correlation: qr=qsm 40; qr=qsd o40 if sy1 o4sm ; qr=qsy1 o0:
Increasing any of the three noise components increases the aggregate noisiness of the
performance measures. The impact on correlation is varied: increasing the persistent
noise sm always increases the correlation; increasing accrual noise sy1 always reduces
the correlation and makes it negative if sy1 4sm ; and increasing the transitory noise
sd moves the correlation closer to zero.
4.2. The impact of accounting measurement errors on mispricing
Before exploring the impact of the three types of noise on the principals expected
utility in a contracting setting, we consider the impact of accounting measurement
errors on the mispricing of the rm at t 1 given that y1 is reported instead of x1.
The t 1 market price, given y1 and conjectured actions a^ 1 ; a^ 2 ; is
2s2m s2dx
p1 y1 Ex1 x2 jy1 ; a^ 1 ; a^ 2 bo ba^ 1 a^ 2
s2m s2d s2y0 s2y1
m d1 y1
y0 .
If there are no measurement errors, then x1 12bo by1 and the rms intrinsic t 1
market value is
2s2m s2dx
p1 x1 x1 Ex2 jx1 ; a^ 1 ; a^ 2 bo ba^ 1 a^ 2 m d1x .
s2m s2dx
We represent the mispricing as the expected squared difference between the market
price and the intrinsic market value:
2s2m s2dx 2 s2dy s2y0 s2y1
Efp1 y1
p1 x1 g2 .
s2m s2dx s2dy s2y0 s2y1 s2m s2dx
It follows that reducing the variance of either transitory or accrual measurement

errors (i.e., s2dy or s2yt ) reduces mispricing. Increasing the variance of the persistent
component (which in this case is the same as increasing earnings persistence) also
reduces mispricing if the persistent component dominates the transitory and
reversible components. This is consistent with the commonly held view that errors in
estimating some value-relevant measure of earnings reduce the benecial role of
ARTICLE IN PRESS
reported earnings (see, for example, Dechow and Dichev, 2002). As illustrated by
our example, this position is based on a forecasting perspectiveestimation errors
reduce the precision of the information resulting in less accurate forecasts.
4.3. Impact of accounting measurement errors on the principals expected utility
The most prominent general result for single-period agencies is that a more
action informative ex post information system is valuable (cf. Holmstrom, 1982;
Gjesdal, 1982; Kim, 1995). Hence, removing noisiness from a performance
measure is valuable. However, while reducing performance measure noisiness is
unambiguously benecial in a single-period agency, this does not necessarily hold in
a multi-period model, as we must also consider the impact of reducing noisiness on
performance measure autocorrelation.
We now proceed to analyze how changes in the parameters sm ; sd ; and sy1 affect
the principals expected utility in contracting with an agent for two identical periods.
The following proposition summarizes those effects.
Proposition 4. Assume identical periods: sy0 sy2 :17
(a) persistent noise: dU pr =dsm o0:

pr
(b) transitory noise: dU
p =ds d jsd 0 40 if sy0 sy1 sy2 0 and
2
sm 1; b o2 7r:18
(c) accrual noise: dU pr =dsy1 sm
sy1 X0:
The results in this proposition are obtained by evaluating total derivatives of the
form:
dU pr =dsi dU pr =dsqs=qsi dU pr =drqr=qsi ; i m; d; y1 . (13)
Proposition 3 establishes that reducing any of the three types of noise reduces the
aggregate noisiness, and Proposition 2 establishes that reducing aggregate noisiness
generally increases the principals expected utility. However, as established by
Proposition 3, the impact of the three types of noise have differing effects on
correlation, and this yields the differences between the three results in Proposition 4.
Result (a) of Proposition 4 follows from the fact that reducing sm decreases r
and s and Proposition 2 establishes that reducing r and s generally increases
17
This assumption implies y1 and y2 have the same prior variances, which simplies the results. Of
course, in a truly dynamic setting, the accounting report in which y0 is initiated will reduce the posterior
variance of y0 compared to the variance of accrual measurement errors not yet initiated. Recognizing this
effect amounts to assuming that, at the contract date t 0; the performance measure variances are
increasing over time, i.e., s22 4s21 : This does not change the qualitative nature of the results.
Alternatively; if we assume syt sy for t 0; 1, 2, and that changing the procedures for determining
accounting accruals controls sy ; then presults
(a) and (b) are unchanged, while (c) is replaced by
dU pr =dsy jsy 0 40 if sm 1; b2 o2 5r:
18
In general, the derivative with respect to sd can be both positive and negative. However, the closed-
form expressions are complex, and the result in the proposition holds by continuity for a wider range of
parameters.
ARTICLE IN PRESS
pvarying transitory noise, sd : (a) bt 1; r 1;

Fig. 1. Principals expected utility with identical periods for
sm 1; syt 0 for t 0; 1; 2 and (b) bt 1; r 1; sm 2; sy1 1; and sy0 sy2 0:
Upr.19 Result (b) in Proposition 4 demonstrates that reducing transitory noise is not
always desirable.20 Proposition 3 establishes that increased transitory noise moves
the correlation closer to zero. The benets of reduced positive correlation (if sd is
increased and sm 4sy1 ) can be sufciently strong to offset the negative effect of
increased noisiness. Under those conditions, there is an interior optimal amount of
19
The principals expected utility is decreasing with increased noisiness whenever dU pr =ds1 o0: In the
other cases, even if dU pr =ds40; which happens only for large positive correlation and large noisiness
relative to the risk aversion parameter, the loss from increased correlation exceeds any offsetting gain of
reduced noisiness.
20
With full commitment, on the other hand, it is always benecial to reduce transitory noise.
ARTICLE IN PRESS
Fig. 2. Principals expected utility with identical periods for varying accrual noise, sy1 : bt 1; r 1;
sd 0; sm 1; sy0 sy2 0:
transitory noise, so that reducing transitory noise below the optimum reduces the
principals expected utility. This case is illustrated in Fig. 1a along with the
corresponding results for full commitment.
If the correlation is negative, then both incentive rates are positive and it is always
optimal to reduce transitory noise. On the other hand, if the correlation is positive,
but not too high, then both incentive rates are again positive and the principals
benet from reduced noisiness exceeds the loss from increased correlation. This case
is illustrated in Fig. 1b.
Now consider part (c) of Proposition 4.21 As noted above, Proposition 2
establishes that it is generally valuable to reduce both noisiness and correlation.
Proposition 3 establishes that while decreasing accrual noise decreases aggregate
noise, it also increases correlation, even if the correlation is negative. The benet of
reduced correlation exceeds the negative effect of increased aggregate noisiness if the
accrual noise is increased up to the point where sy1 sm : At that point, the two
performance measures are uncorrelated and a maximum for the principals expected
utility is attained. As a result, reducing accrual noise below the persistent noise reduces
the principals expected utility. This is illustrated in Fig. 2.
It can also be shown that the principals expected utility reduces to zero for large
amounts of transitory noise (see Figs. 1a and b), and goes even below zero for large
amounts of persistent noise. This follows from the combined effect of bringing the
correlation to zero or one, and signicantly increasing the aggregate noisiness of the
performance measures. In contrast, a large amount of accrual noise reduces the
21
Interestingly, with full commitment, while the principal strictly prefers to reduce both persistent and
transitory noise, he is indifferent to changes in accrual noise. The latter occurs because, with identical
periods, the incentive rates are equal in the two periods and, therefore, the accrual measurement errors
cancel out in the agents compensation.
ARTICLE IN PRESS
principals expected utility to a lesser extent, since the increase in aggregate noisiness
is compensated by the countervailing effect of moving the correlation closer to
negative one, resulting in a lower bound for the principals expected utility that is
signicantly different from zero (see Fig. 2).22 Thus, if the costs of reducing noisiness
are taken into account, scarce noise reduction dollars are better allocated to reducing
persistent noise and transitory noise, rather than accrual noise.
5. Concluding remarks and empirical implications
5.1. Basic theoretical insights
Our paper uses a multi-period LEN model to examine how the precision and the
autocorrelation of a single performance measure affect the value of that measure in
incentive contracting, and how autocorrelation affects the optimal incentive rates
across time if there is contract renegotiation. If incentive rates are positive and held
constant, then increasing either the variance or the autocorrelation of the
performance measure increases the ex ante risk premium that must be paid to the
agent. However, the impact of these changes is quite different when we treat the
incentive rates as endogenous, particularly in settings in which there are multiple
periods and contracts can be renegotiated at the end of each period.
The noise in performance measures is correlated across periods due to a number of
factors: persistent economic conditions or managerial ability result in positive
correlation, while accrual estimation errors or uncertainty regarding the realization
of an aggregate amount across periods result in negative correlation. The net
correlation of the performance measures is determined by the combined effect of
these factors, plus transitory noise or measurement errors.
With renegotiation, the second-period incentive rate is chosen strictly on the basis
of the ex post variance of the second-period performance measureits ex ante risk
implications are ignored. Hence, from an ex ante perspective, if the correlation is
positive, the second-period incentives are too strong and the size of the distortion is
increasing in the correlation. In addition, the ex ante risk is considered by the
principal in setting the rst-period incentive rate, and that includes considering the
anticipated distortion in the ex ante risk due to the distortion in the second-period
incentive rate. As a result, from an ex ante perspective, if the correlation is positive,
the rst-period incentives are too weak. These distortions become more severe as the
autocorrelation increases. Hence, the principals expected utility is decreasing in the
autocorrelation of the performance measure.
This has implications for the choice of performance measures. Increasing
performance measure noisiness while also decreasing performance measure
22
The limiting value of the principals expected utility for the amount of accrual errors going to
innity is
b4 2b2 3rs2d 2s2m 3rsy0 sy2
lim U pr .
sy1 !1 2b2 2rs2d 2s2m rsy0 sy2 2
With the parameters in Fig. 2, the limiting value is 0.28.
ARTICLE IN PRESS
autocorrelation (e.g., by increasing transitory or reversible noise) could increase the

principals expected utility.23 On the other hand, increasing both performance
measure noisiness and performance measure autocorrelation (e.g., by increasing
persistent noise) reduces the principals expected utility.
5.2. Accounting earnings: incentives versus valuation
We apply the above analysis to accounting-based performance measures and show

that transitory and accrual estimation errors have the potential to mitigate the
adverse effects of persistent performance measure noise (even though both types of
noise have negative consequences from the forecasting perspective that underlies
valuation). As a result, in discussing earnings quality, there is a tradeoff between
valuation and contracting when considering both accrual estimation errors and
transitory earnings components (noise).
Accounting earnings is a commonly used performance measure. Some of its
characteristics are constrained by GAAP. However, GAAP allows considerable
discretion, particularly with respect to the choice of accruals (either through the
accounting policies that are used or through the specic numbers chosen).
Furthermore, the principal can choose to exclude some items (e.g., extraordinary
items) from the earnings number used for performance evaluation. Hence, both the
principal and agent can potentially inuence the autocorrelation and precision of
accounting earnings. A key implication of the distortion created by renegotiation
when there is autocorrelation is that, if accounting earnings is used as a performance
measure, then, for incentive purposes, the principal prefers accounting choices that
minimize autocorrelation, while maintaining or increasing precision.
A major segment of the nancial reporting research literature (e.g., Dechow, 1994;
Dechow et al., 1998) focuses on the use of accounting earnings as either a source of
or representation of information used in valuing the rm. In that literature, positive
correlation, often in the form of persistence in accounting earnings is viewed as a
desirable characteristic. If the correlation is positive, then increased correlation
results in more precise beliefs about next periods earnings given current earnings.
For example, there is much discussion of the quality of earnings or quality of the
accruals used in determining those earnings. Dechow and Dichev (DD) (2002), for
example, dene and measure accrual quality by the standard deviation of accrual
estimation errors and their reversals (the accrual estimation errors are the residuals
from a regression of changes in working capital on past, present, and future cash
ows).
The DD denition of earnings quality implies that more autocorrelation is
preferred to less. They present evidence that both cash ows and accruals exhibit
positive autocorrelation, but they report (Table 5, p. 50) that earnings persistence is
23
Increasing the reversible accrual estimation errors is generally valuable whenever the performance
measures are positively correlated. In contrast, increasing transitory noise is valuable only in extreme
cases, when the correlation is very close to one, and the insurance role of the rst-period performance
measure dominates its productive role, resulting in a negative rst-period incentive rate.
ARTICLE IN PRESS
negatively related to accrual estimation errors. This leads them to state that
estimation errors and their subsequent corrections are noise that reduces the
benecial role of accruals (Dechow and Dichev, 2002, p. 36). Our model is
consistent with DDs empirical evidence in that we represent accrual estimation
errors as reducing autocorrelation in earnings. However, given our focus on
incentive contracting, we demonstrate that the benecial role of accruals can be
increased by accrual estimation errors and their subsequent corrections.
The DD earnings quality criterion for choosing accruals is inconsistent with
what we might call the performance measure quality criterion. Consequently, the
choice of accruals may depend upon whether the principal is primarily concerned
with the use of accounting earnings as information for investors or as a performance
measure for dynamic incentive contracting (assuming the same information system is
used for both valuation and contracting). Of course, our analysis also suggests that
the principal is more likely to choose accounting earnings as a performance measure
if its autocorrelation is low. These two factors lead us to hypothesize that:
accrual estimation errors are larger in rms that make signicant use of
accounting earnings as a performance measure for incentive contracting
(relative to rms that use other performance measures and are publicly traded).
In addition to the choice of accruals, choosing an accounting earnings measure for
use in valuation or for measuring management performance also involves decisions
as to what to include in the earnings measure and what to exclude. A valuation
perspective argues for excluding (for valuation purposes) those elements of current
income that are uncorrelated with future comprehensive income. This is manifested
in empirical research which frequently uses income before extra-ordinary items, on
the grounds that these are transitory and do not help predict future operating income
or extra-ordinary items. It is also manifested in the argument for focusing on core
or pro forma earnings. A performance evaluation perspective can also result in the
exclusion of extra-ordinary items, but the fact they are transitory is not a sufcient
argument for their exclusion. Transitory income is still income and represents value
earned by the rm. If it is a windfall unrelated to the agents actions, then its
exclusion is likely to be benecial for incentive purposes since its removal reduces
performance measure noise per unit of effort (e.g., gains and losses on marketable
securities, or the foreign currency translation adjustment (see Biddle and Choi, 2002;
S- abac et al., 2005). On the other hand, if the mean of the transitory item is inuenced
by the agents actions, then its exclusion can increase the variance of the performance
measure per unit of effort.24
Finally, the time-series properties of accounting numbers, such as earnings, are
endogenously affected by the design of the accounting system. That design should
reect a tradeoff between the valuation and contracting roles of the accounting
24
Biddle and Choi (2002) show that net income dominates comprehensive income in explaining
executive cash compensation, consistent with the idea that most items added to net income to obtain
comprehensive income are transitory and outside the managers control (see also Holthausen and Watts,
2001).
ARTICLE IN PRESS
numbers. Consequently, the qualitative characteristics of the accounting numbers

(such as earnings quality) will be suboptimal with respect to either role, even if the
manager cannot manipulate the accounting numbers.
5.3. Accounting earnings versus stock price as performance measures
Theoretical papers such as Banker and Datar (1989), Bushman and Indjejikian
(1993), Feltham and Xie (1994), and Feltham and Wu (2000) use single-period
models to examine how precision and correlation affect the value of alternative
performance measures and the relative weights assigned to pairs of measures.
Empirical papers such as Lambert and Larcker (1987) and Sloan (1993) use insights
from some of these theoretical papers to generate hypotheses regarding the relative
use of accounting earnings and stock price as performance measures.25
Sloan (1993), for example, controls for the insurance effect of performance
measure correlation within periods (he uses the term risk sharing where we use
insurance), and nds evidence that incentive weights decrease with correlation
between earnings and stock price. We suggest that autocorrelation will be an equally
important effect for each performance measure taken separately. The two types of
correlation within and across periods) will simultaneously impact the relative
incentive weights on earnings and stock price. Following Feltham and Wu (2000),
the impact of within period correlation can be controlled for by using what they refer
to as the ltered price, in which case only the autocorrelation would matter. The
ltered price can be represented by the residual from a regression of price on
earnings and would be uncorrelated with earnings within the same period.
Theoretically, market efciency will result in uncorrelated stock returns, whereas
accounting earnings (a measure of the change in book value of equity) are likely to
be correlated (in the absence of mark-to-market accounting). This suggests that the
relative use of stock price based measures versus accounting earnings based measures
will tend to be greater than hypothesized based on period-by-period precision and
within period correlation.
More generally, building on the Lambert and Larcker (1987), Sloan (1993), and
Feltham and Wu (2000) papers, our theory leads to the following hypotheses:
Ceteris paribus, rms are more likely to base their incentive contracts on
performance measures that have lower autocorrelation.
The incentive weight on a performance measure is negatively related to its
noisiness and to its autocorrelation.
Both Lambert and Larcker (1987) and Sloan (1993) report higher sensitivity of
cash compensation to changes in earnings than to stock prices. In general, our theory
requires identication of the autocorrelation for the performance measures that are
used in a each rms bonus plans. This is critical, since for a random walk we would
have a high positive correlation between adjacent periods in earnings levels, and zero
25
While Lambert and Larcker (1987) refer to some of the dynamic agency literature, they assume that
the incentive rates only depend on the signal-to-noise ratios, as in the single-period models.
ARTICLE IN PRESS
correlation in rst differences. The theory predicts a lower incentive weight on levels
than on rst differences in this case due to the radically different autocorrelations.
However, it is a practical empirical question whether researchers can obtain
sufcient time-series data to estimate the autocorrelations.
More generally, we provide a rationale for using earnings measures in incentive
compensation not previously considered: the accrual process results in a lower
autocorrelation for earnings than for cash ows, which then makes earnings a more
efcient contracting variable. Watts and Zimmerman (1986) argue that earnings are
informative when rm (or rm segment) value is unobservable, while Watts (2003),
and Leone et al. (2004) suggest that earnings conservatism has value from a
contracting perspective.26 While conservatism introduces some reversible estimation
errors in the earnings series (Basu, 1997), the overall effect on accrual estimation
errors is ambiguous. Thus, our theoretical model presents a rationale for the
contracting demand for earnings that is complementary to accounting conservatism.
5.4. Additional issues
There are additional issues of interest that are beyond the scope of the model in
this paper. For example, there is the horizon problem which requires a distinction
between the last periods of a managers tenure and earlier periods (Gibbons and
Murphy, 1992; Murphy and Zimmerman, 1993). Based on the two-period model,
one needs to generalize cautiously, and we refer the reader to S- abac (2004) and
Christensen et al. (2004), who provide a detailed analysis of the multi-period case.
The features that are apparent from the two-period model are that, given
autocorrelation and the possibility of renegotiation, the incentives in a managers
terminal year will be stronger than is optimal from a full-commitment ex ante
perspective. Moreover, the strength of the terminal year incentives is increasing in
the autocorrelation. On the other hand, the insurance effects that impact incentive
rates in the rst period, make that incentive weight decrease in the autocorrelation.
This intuition is supported by the analysis in S- abac (2004) and leads to the following
hypothesis:
The incentive rates in the last periods of a managers tenure increase in the
absolute value of the performance measure autocorrelation. The incentive rates in
earlier periods of a managers tenure decrease in the performance measure
autocorrelation.
Interestingly, Baber et al. (1998) nd that the sensitivity of cash compensation to
earnings is increasing in earnings persistence, and that the effect is stronger for CEOs
approaching retirement. Their ndings appear consistent with the second half of our
26
Our model does not allow for considering different incentive rates for positive and negative
unexpected performance, since the contracts are restricted to be linear. Thus, we can only refer to
conservatism in the performance measure (earnings), as opposed to cash compensation conservatism, in
which compensation reacts asymmetrically to good and bad news. The analysis in Leone et al. (2004) that
considers compensation conservatism, allows for non-linear contracts and is outside our papers
framework.
ARTICLE IN PRESS
hypothesis. Similarly, Huson et al. (2003) compare the sensitivity of pay and
performance measures in the last period of a managers tenure and in previous
periods and nd a negative association between changes in compensation and
discretionary accruals in the last period of a managers tenure. This is consistent with
the fact that accruals initiated in the last period of a managers tenure have no
benecial insurance effect for future compensation.
Other interesting dynamic agency issues are managerial turnover and contract
duration. Those are briey discussed in Christensen et al. (2003), and explored in
detail by S- abac (2004). The main nding links the autocorrelation of performance
measures to the possibility of optimal contract duration, resulting in endogenous
turnover and managerial performance surrounding turnover that provides an
alternative theoretical framework to that currently used in the literature (see
Brickley, 2003, for a recent discussion, Murphy and Zimmerman, 1993, and Huson
et al., 2004, for the relation between CEO turnover and performance).
Finally, there are consumption smoothing and reporting timing issues that the
present model does not address and we refer the reader to Christensen et al. (2004).
Appendix A. Proofs
Proof of Proposition 1. If (ci, cr, a) is an equilibrium with renegotiation, we have

shown that cr is linear in the two performance measures if offered as an initial
contract. In addition, the acceptance of cr as a renegotiation offer implies that cr is
also acceptable if offered as an initial contract. The action induced in the rst period
is the same with renegotiation and with cr as an initial contract since renegotiation is
rationally anticipated and the incentive for air1 is given by vi1 y1 Df r y1 ; a^ 1 ; which is
the same incentive for the rst-period action offered by cr.27 The second-period actions
are the same since they are determined by the contract in effect in the second period,
which is cr in both cases. Finally, the compensation paid to the agent is determined by
cr in both cases and thus, the principals expected utility is the same. &
A.1. Derivation of optimal renegotiation-proof contract and expected net payoff
Constraint (7b) is binding, which implies

f i co 12rv21 s21 vr2 2 r 1 2 r2
2 s2 2rs1 s2 v1 v2
2v1 v2 . (A.1)
Substituting (A.1) and (7c) into (7a) yields the following unconstrained decision
problem for the principals choice of v1:
U p cja1 v1 ; ar2 vr2
bo b1 v1 b2 vr2
12fv21 vr2 2 2 r2 2 r
2 rv1 s1 v2 s2 2rs1 s2 v1 v2 g. A:2
27
The key is that it is sub-optimal for the agent to select an action different from a^ 1 and then reject the
renegotiation offer.
ARTICLE IN PRESS
The derivative of (A.2) with respect to v1 is

qU p =qv1 b1
fv1 rv1 s21 rs1 s2 vr2 g
which yields (8a). Substituting (5a) and (8a) into (A.2) yields (8b).
A.2. Identical periods case
Substituting b and s into (5a), (8a), and (8b) yields:

1
vr1 b
rs2 lvr2 ; D01 1 rs2 , (A.3a)
D01
1
vr2 b; D12 1 r1
r2 s2 , (A.3b)
D12

pr o o 1 2 1 1 2 1 1 1 2 2
U b
c b 1
2rrs 1
rr s .
2 D01 D12 D12 D01 D12
(A.4)
Proof of Proposition 2. The proofs are straightforward computations involving the

taking of partial derivatives of the closed-form expressions for the expected utilities.
In (a) we differentiate (A.4) with respect to r; whereas in (b) and (c) we differentiate
(8b) with respect to st and then evaluate them for b1 b2 b and s1 s2 s:
Since the details are tedious, we merely provide the nal results
(a) dU pr b2 s2 r1 s2 r2
r 2r3 r2 s4 1
r1 r3

o0; since 2
r
dr 1 rs2 1 r1
r2 s2 3
r3 40 for all r:
(b) dU pr b2 sr1 r1 r1
rs2 1
rr2 r
1s2

o0 if; and only if,
ds1 1 rs2 2 1 r1
r2 s2 2
rr2 r
1s2 o1:
(c) dU pr b2 sr1 r1 2s2 r1
r2 1 r r2 s4 1
r3 1 r

o0: &
ds2 1 rs2 2 1 r1
r2 s2 3
Proof of Proposition 3. These results are obvious from (11) and (12). &
Proof of Proposition 4. These results follow from evaluating (13) using (A.4) to
obtain dU pr =ds and dU pr =dr; and using (11) and (12) to obtain qs=qsi and qr=qm;
for i m; d; y: In part (b), the derivative is evaluated at sy0 sy1 sy2 0 and
sm 1:

dU pr rb4
4b2 r
3r2

dsd sm 1; syt sd 0 b2 r2
ARTICLE IN PRESS
and the rest follows from determining the sign of the quadratic (in b2) function
b4
4b2 r
3r2 : &
References
Arya, A., Glover, J., Sunder, S., 1998. Earnings management and the revelation principle. Review of
Accounting Studies 3, 734.
Baber, W.R., Kang, S.-H., Kumar, K.R., 1998. Accounting earnings and executive compensation: the role
of earnings persistence. Journal of Accounting and Economics 25, 169193.
Ball, R., Watts, R., 1972. Some time-series properties of accounting income. Journal of Finance 27,
663681.
Banker, R.D., Datar, S.M., 1989. Sensitivity, precision, and linear aggregation of signals for performance
evaluation. Journal of Accounting Research 27, 2139.
Basu, S., 1997. The conservatism principle and the asymmetric timeliness of earnings. Journal of
Accounting and Economics 24, 337.
Biddle, G.C., Choi, J.-H., 2002. Is comprehensive income irrelevant? Working Paper, Hong Kong
University of Science & Technology.
Brickley, J.A., 2002. Royalty rates and upfront fees in share contracts: evidence from franchising. Journal
of Law, Economics, and Organization 18, 511535.
Brickley, J.A., 2003. Empirical research on CEO turnover and rm-performance: a discussion. Journal of
Bushman, R.M., Indjejikian, R.J., 1993. Accounting income, stock price, and managerial compensation.
Journal of Accounting and Economics 16, 323.
Christensen, P.O., Demski, J.S., Frimor, H., 2002. Accounting policies in agencies with moral hazard and
renegotiation. Journal of Accounting Research 40, 10711090.
Christensen, P.O., Feltham, G.A., S- abac, F., 2003. Dynamic incentives and responsibility accounting: a
comment. Journal of Accounting and Economics 35, 423436.
Christensen, P.O., Feltham, G.A., Hofmann, C., S- abac, F., 2004. Timeliness, accuracy, and relevance in
dynamic incentive contracts, Working Paper, Sauder School of Business.
Core, J.E., Wayne Guay, Verrecchia, R.E., 2003. Price versus non-price performance measures in optimal
CEO compensation contracts. The Accounting Review 78, 957981.
Datar, S., Kulp, S.C., Lambert, R.A., 2001. Balancing performance measures. Journal of Accounting
Research 39, 7592.
Dechow, P.M., 1994. Accounting earnings and cash ows as measures of rm performance: the role of
accounting accruals. Journal of Accounting and Economics 18, 342.
Dechow, P.M., Dichev, I., 2002. The quality of accruals and earnings: the role of accrual estimation errors.
The Accounting Review 77, 3579.
Dechow, P.M., Kothari, S.P., Watts, R.L., 1998. The relation between earnings and cash ows. Journal of
Dechow, P.M., Hutton, A.P., Sloan, R.G., 1999. An empirical assessment of the residual income valuation
model. Journal of Accounting and Economics 26, 134.
Demski, J., Frimor, H., 1999. Performance measure garbling under renegotiation in multi-period agencies.
Journal of Accounting Research 37, 187214.
Demski, J.S., Sappington, D.E.M., 1999. Summarization with errors: a perspective on empirical
investigations of agency relationships. Management Accounting Research 10, 2137.
Dewatripont, M., 1989. Renegotiation and information revelation over time: the case of optimal labor
contracts. The Quarterly Journal of Economics 104, 589619.
Dewatripont, M., Maskin, E., 1995. Contractual contingencies and renegotiation. The RAND Journal of
Economics 26, 704719.
Dutta, S., Reichelstein, S., 1999. Asset valuation and performance measurement in a dynamic agency
setting. Review of Accounting Studies 4, 235258.
ARTICLE IN PRESS
Dutta, S., Reichelstein, S., 2003. Leading indicator variables, performance measurement, and long-term
versus short-term contracts. Journal of Accounting Research 41, 837866.
Dutta, S., Zhang, X.-J., 2002. Revenue recognition in a multiperiod agency setting. Journal of Accounting
Research 40, 6783.
Feltham, G.A., Xie, J., 1994. Performance measure congruity and diversity in multi-task principal/agent
relations. The Accounting Review 69, 429453.
Feltham, G.A., Wu, M.G.H., 2000. Public reports, information acquisition by investors, and management
incentives. Review of Accounting Studies 5, 155190.
Feltham, G.A., Indjejikian, R., Nanda, D.J., 2004. Dual purpose measures, Working Paper, University of
Michigan.
Fudenberg, D., Tirole, J., 1990. Moral hazard and renegotiation in agency contracts. Econometrica 58,
12791320.
Fudenberg, D., Holmstrom, B., Milgrom, P., 1990. Short-term contracts and long-term relationships.
Journal of Economic Theory 51, 131.
Gibbons, R., Murphy, K.J., 1992. Optimal incentive contracts in the presence of career concerns: theory
and evidence. Journal of Political Economy 100, 468504.
Gjesdal, F., 1981. Accounting for stewardship. Journal of Accounting Research 19, 208231.
Gjesdal, F., 1982. Information and incentives: the agency information problem. Review of Economic
Studies 49, 373390.
Hart, O.D., Holmstrom, B., 1987. The theory of contracts. In: Bewley, T. (Ed.), Advances in Econo-
mic Theory, Proceedings of the Fifth World Congress. Cambridge University Press, Cambridge,
pp. 71156.
Hart, O.D., Tirole, J., 1988. Contract renegotiation and coasian dynamics. The Review of Economic
Studies 55, 509540.
Hermalin, B.E., Katz, M.L., 1991. Moral hazard and veriability: the effects of renegotiation in agency.
Econometrica 59, 17351753.
Holmstrom, B., 1979. Moral hazard and observability. Bell Journal of Economics 10, 7491.
Holmstrom, B., 1982. Moral hazard in teams. Bell Journal of Economics 13, 324340.
Holmstrom, B., 1999. Managerial incentive problems: a dynamic perspective. Review of Economic Studies
66, 169182.
Holthausen, R.W., Watts, R.L., 2001. The relevance of the value-relevance literature for nancial
accounting standard setting. Journal of Accounting and Economics 31, 375.
Huson, M.R., Wiedman, C., Wier, H.A., 2003. Cash compensation and earnings components around
CEO turnover: does the compensation committee see over the horizon? Working Paper, University of
Alberta.
Huson, M.R., Malatesta, P., Parrino, R., 2004. Managerial succession and rm performance. Journal of
Financial Economics 74, 237275.
Indjejikian, R., Nanda, D.J., 1999. Dynamic incentives and responsibility accounting. Journal of
Kim, S.K., 1995. Efciency of an information system in an agency model. Econometrica 63, 89102.
Kormendi, R., Lipe, R., 1987. Earnings innovations, earnings persistence, and stock returns. Journal of
Business 60, 323345.
Kreps, D., 1990. Corporate culture and economic theory. In: Alt, J.E., Shepsle, K.A. (Eds.), Perspectives
on Positive Political Economy. Cambridge University Press, Cambridge, pp. 90143.
Lafontaine, F., Shaw, K.L., 1999. The dynamics of franchise contracting: evidence from panel data.
Journal of Political Economy 107, 10411080.
Lambert, R.A., Larcker, D.F., 1987. An analysis of the use of accounting and market measures of
performance in executive compensation contracts. Journal of Accounting Research 25, 85125.
Leone, A.L., Wu, J.S., Zimmerman, J.L., 2004. Conservatism in CEO cash compensation, Working Paper,
University of Rochester.
Ma, C.A., 1994. Renegotiation and optimality in agency contracts. The Review of Economic Studies 61,
109129.
ARTICLE IN PRESS
Malcomson, J.M., 1997. Contracts, hold-up, and labor markets. Journal of Economic Literature 35,
19161957.
Meyer, M.A., 1995. Cooperation and competition in organizations: a dynamic perspective. European
Economic Review 39, 709722.
Meyer, M.A., Vickers, J., 1997. Performance comparisons and dynamic incentives. Journal of Political
Economy 105, 547581.
Meyer, M.A., Olsen, T.E., Torsvik, G., 1996. Limited intertemporal commitment and job design. Journal
of Economic Behavior & Organization 31, 401417.
Murphy, K.J., Zimmerman, J.L., 1993. Financial performance surrounding CEO turnover. Journal of
Myers, J.N., 1999. Implementing residual income valuation with linear information dynamics. The
Accounting Review 74, 128.
Rajan, M.V., Sarath, B., 1997. The value of correlated signals in agencies. RAND Journal of Economics
28, 150167.
Reichelstein, S., 2000. Providing managerial incentives: cash ows versus accrual accounting. Journal of
Accounting Research 38, 243269.
S- abac, F., 2004. Dynamic moral hazard with multiple correlated periods and renegotiation: managerial
tenure and incentives, Working Paper, University of Alberta.
S- abac, F., Scott, T.W., Wier, H., 2005. An investigation of the value-relevance of alternative foreign
exchange disclosures. Contemporary Accounting Research, forthcoming.
Schipper, K., Vincent, L., 2003. Earnings quality. Accounting Horizons 17 (Suppl.), 97110.
Sloan, R.G., 1993. Accounting earnings and top executive compensation. Journal of Accounting and
Economics 16, 55100.
Sloan, R.G., 1996. Do stock prices fully reect information in accruals and cash ows about future
earnings? The Accounting Review 71, 289315.
Watts, R.L., 2003. Conservatism in accounting part I: explanations and implications. Accounting
Horizons 17, 207221.
Watts, R.L., Zimmerman, J.L., 1986. Positive Accounting Theory. Prentice-Hall, Englewood Cliffs, NJ.
Ziv, A., 2000. Information technology and optimal rm structure. Journal of Accounting Research 38,
297328.

A Contracting Perspective On Earnings Quality

Hochgeladen von

Dokumentinformationen

Originaltitel

Copyright

Verfügbare Formate

Dieses Dokument teilen

Dokument teilen oder einbetten

Freigabeoptionen

Stufen Sie dieses Dokument als nützlich ein?

Sind diese Inhalte unangemessen?

Copyright:

Verfügbare Formate

A Contracting Perspective On Earnings Quality

Hochgeladen von

Copyright:

Verfügbare Formate

ARTICLE IN PRESS

Journal of Accounting and Economics 39 (2005) 265294

A contracting perspective on earnings quality$

This paper analyzes the impact of signal-to-noise-ratios and the autocorrelation of a

JEL classification: D80; J33; M41; M43

Keywords: Contracting; Management compensation; Accruals; Earnings quality; Performance measure

What characteristics make earnings (or other accounting information) a good

The hallmark of accounting earnings is its use of accruals to develop monthly,

contracting perspective on earnings quality and we describe circumstances under

2. The basic model

We consider a two-period model in which a principal hires an agent to perform a

Ey2 ja1 ; a2 ; y1  a2 ly1

3. Long-term contract with renegotiation

support an ex post change. We only allow renegotiation subsequent to the rst-

3.1. Optimal linear contract with renegotiation

We assume the initial contract (at t 0) is restricted to be a linear function of the

cr y1 ; y2 f i vi1 y1 Df r vr2 y2 . (2)

CE r cr jy1 ; a1 ; a2 f i vi1 y1 Df r vr2 a2 ly1

subject to CEcja1 ; ar2 Xco , (7b)

3.2. Effort-incentive and risk-reduction roles of the first-period performance measure

Motivation of productive effort is the primary role of the performance measures.

Case (i). Basic effort-incentive model (r 0):

Case (ii). Basic insurance model (ra0; b1 0; y1 1 ):

Case (iv). General model (same as (iii) except that b1 40):

3.3. Comparative statics

Proposition 2. With renegotiation-proof contracts and identical periods

(a) dU pr =dro0 for all r;

Observe that if r is positive, then increasing r makes y1 more informative about 2 :

g becomes less positive again resulting in less rst-period effort. As a consequence,

4. Impact of accounting measurement errors

4.1. A model of the noise process

To summarize, the reported performance measure consists of a deterministic

4.2. The impact of accounting measurement errors on mispricing

It follows that reducing the variance of either transitory or accrual measurement

4.3. Impact of accounting measurement errors on the principals expected utility

(a) persistent noise: dU pr =dsm o0:

pvarying transitory noise, sd : (a) bt 1; r 1;

5. Concluding remarks and empirical implications

5.1. Basic theoretical insights

autocorrelation (e.g., by increasing transitory or reversible noise) could increase the

5.2. Accounting earnings: incentives versus valuation

We apply the above analysis to accounting-based performance measures and show

numbers. Consequently, the qualitative characteristics of the accounting numbers

5.3. Accounting earnings versus stock price as performance measures

5.4. Additional issues

Proof of Proposition 1. If (ci, cr, a) is an equilibrium with renegotiation, we have

A.1. Derivation of optimal renegotiation-proof contract and expected net payoff

Constraint (7b) is binding, which implies

The derivative of (A.2) with respect to v1 is

A.2. Identical periods case

Substituting b and s into (5a), (8a), and (8b) yields:

Proof of Proposition 2. The proofs are straightforward computations involving the

Das könnte Ihnen auch gefallen

Ey2 ja1 ; a2 ; y1 a2 ly1