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Leading indicator variables and managerial incentives in a dynamic agency setting

  • Qintao Fan
  • Wei Li
Article

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 

JEL Classification

D82; D86; M41 

Notes

Acknowledgments

We thank Clara Chen, Sunil Dutta, Jonathan Glover, Michael Raith, Naomi Rothenberg, Joyce Tian, Michael Williamson, the participants of the 2016 Management Accounting Section Mid-year meeting, the research seminar participants at Hong Kong Polytechnic University, University of Houston, University of Illinois at Urbana-Champaign, and University of Oregon for helpful comments and discussions. We are also indebted to Stefan Reichelstein (editor) and two anonymous referees for many detailed and constructive comments.

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Copyright information

© Springer Science+Business Media, LLC, part of Springer Nature 2018

Authors and Affiliations

  1. 1.School of Accounting, Lundquist College of BusinessUniversity of OregonEugeneUSA
  2. 2.Department of Accountancy, Gies College of BusinessUniversity of Illinois at Urbana-ChampaignChampaignUSA

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