Asset Valuation and Performance Measurement in a Dynamic Agency Setting

This paper examines the choice of asset valuation rules from a managerial control perspective. A manager creates value for a firm through his effort choices. To support its operating activities, the firm also engages in financing activities such as credit sales to its customers. Since such financing activities merely change the pattern of cash flows across periods, an optimal compensation scheme must shield the manager from the risk associated with the financing activities. We show that residual income combined with fair value accounting for receivables eliminates this risk and provides an optimal performance measure. In contrast, compensation schemes based only on realized cash flows can be optimal only under exceptional circumstances. We also consider a setting in which there is sufficiently disaggregated information about periodic cash flows so as to eliminate not only the risk associated with financing activities but also the risk associated with customer defaults. The principal then wants to depart from fair value accounting.