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Contracting on the stock price and forward-looking performance measures

Author: Vaysman, Igor ; Dikolli, ShaneINSEAD Area: Accounting and ControlIn: European Accounting Review, vol. 15, no. 4, December 2006 Language: EnglishDescription: p. 1-20.Type of document: INSEAD ArticleNote: Please ask us for this itemAbstract: We examine the use of earnings, forward-looking performance measures, and stock prices in managerial compensation. When the firm's owner and its manager have identical time preferences, the stock price is not useful for motivating the manager, as it is a noisy aggregation of a forward-looking measure and future earnings. In contrast, when the owner and the manager have conflicting time preferences, the noisy stock price is useful for contracting. If the manager has no access to banking and cannot trade the firm's shares, the timeliness of the stock price dominates the extra risk imposed by its noise. At the same time, forward-looking performance measures (such as customer satisfaction) can induce a desirable allocation of management effort between the short-term and long-term more efficiently than the stock price can. Forward-looking performance measures and the stock price are thus not direct substitutes in rewarding farsighted effort.
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We examine the use of earnings, forward-looking performance measures, and stock prices in managerial compensation. When the firm's owner and its manager have identical time preferences, the stock price is not useful for motivating the manager, as it is a noisy aggregation of a forward-looking measure and future earnings. In contrast, when the owner and the manager have conflicting time preferences, the noisy stock price is useful for contracting. If the manager has no access to banking and cannot trade the firm's shares, the timeliness of the stock price dominates the extra risk imposed by its noise. At the same time, forward-looking performance measures (such as customer satisfaction) can induce a desirable allocation of management effort between the short-term and long-term more efficiently than the stock price can. Forward-looking performance measures and the stock price are thus not direct substitutes in rewarding farsighted effort.

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