Accounting Earnings Processes,Inter-temporal Incentives and Their Implications for Valuation

Accounting measures such as levels and changes in residual earnings are widely used for performance evaluation and executive compensation (Healy, 1985). Quite often, these compensation contracts are of the linear form. In a multiperiod agency setting with hidden actions, where the agent's effort influences the random evolution of a general model of residual earnings, we show that linear compensation contracts based on weighted sum of the levels and changes of residual earnings are indeed optimal. We characterize the contract explicitly and show that the weights are determined by the earnings persistence parameter. Residual earnings are known to be important for valuation too (Ohlson, 1995; Easton and Harris, 1991). In our setting, we demonstrate that residual earnings are also sufficient for valuation. This implies that residual earnings can be used to align incentive goals with valuation objectives. In essence, our paper provides the theoretical underpinnings for linear contracts based on residual earnings and their implications for valuation.