Leading indicator variables and managerial incentives in a dynamic agency setting

Qintao Fan () and Wei Li ()
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Qintao Fan: University of Oregon
Wei Li: University of Illinois at Urbana-Champaign

Review of Accounting Studies, 2018, vol. 23, issue 4, No 13, 1715-1753

Abstract: Abstract This paper studies, in a dynamic agency setting, how incentives and contractual efficiency are affected by leading indicators of firms’ future financial performance. In our two-period model, a leading indicator variable provides a noisy forecast of the uncertain return from the manager’s long-term effort, and both contracting parties cannot refrain from renegotiating contract terms based on updated information. We find that the leading indicator can reduce the manager’s long-term effort incentive, as it allows the firm owner to capture more of the resulting return through renegotiated wages (i.e., the manager is held up). By reducing the uncertainty about future aggregate cash flows, the leading indicator also exacerbates the “ratchet” effect and discourages the manager’s short-term effort. In equilibrium, as the leading indicator becomes more accurate in forecasting future cash flows, the first-period contract attaches higher explicit weights to both the forward-looking leading indicator and backward-looking cash flow, and yet the manager may find it optimal to reduce both the short- and long-term efforts. We further show that with a more accurate leading indicator variable, the explicit incentive on the lagging cash flow may increase more than that on the leading indicator, and the equilibrium firm profit may decrease and diverge from the manager’s equilibrium efforts.

Keywords: Leading indicator variables; Holdup problem; Ratchet effect (search for similar items in EconPapers)
JEL-codes: D82 D86 M41 (search for similar items in EconPapers)
Date: 2018
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DOI: 10.1007/s11142-018-9461-3

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