Raffi J. Indjejikian

Aggregate performance measures in business unit manager compensation: The role of intrafirm interdependencies

The purpose of this paper is to investigate the determinants of the extent to which the incentive compensation of business unit managers is based on aggregate performance criteria measured at an organizational level higher than a managers business unit level. We present a simple agency model of a multidivisional firm to show that the use of aggregate performance measures relative to more localized performance measures is an increasing function of intrafirm interdependencies. Using proprietary compensation data from Hewitt Associates LLC, we test whether the relative use of aggregate performance measures is related to our empirical proxies for intrafirm interdependencies and find evidence consistent with our predictions. Management accounting textbooks usually emphasize the controllability principle within the framework of responsibility accounting as the basis for

Accounting income, stock price, and managerial compensation

Abstract This paper employs an agency model where a manager has a two-dimensional action choice to study how the information content of earnings affects the design of compensation contracts based on earnings and price. Price is modeled as an endogenous variable that reflects all available information, including earnings. Two settings are contrasted. In the first, earnings and price reflect the same underlying information about firm value, while in the second, earnings reflect a subset of the information reflected in price. It is shown that differences in information content substantially alter the characteristics of compensation contracts based on earnings and price.

Private Predecision Information, Performance Measure Congruity, and the Value of Delegation*

We use a linear contracting framework to study how the relation between performance measures used in an agents incentive contract and the agents private predecision information affects the value of delegating decision rights to the agent. The analysis relies on the idea that available performance measures are often imperfect representations of the economic consequences of managerial actions and decisions, and this, along with gaming possibilities provided to the agent by access to private predecision information, may overwhelm any benefits associated with delegation. Our analytical framework allows us to derive intuitive conditions under which delegation does and does not have value, and to provide new insights into the linkage between imperfections in performance measurement and agency costs.

Discussion of Accounting Information, Disclosure, and the Cost of Capital

LLV motivate their study in two ways. First, they suggest that it would be helpful to better understand the link between accounting information and the cost of equity capital because institutions such as the SEC and FASB that regulate financial reporting take into account, or at least are concerned about, the capital market consequences of new or existing accounting standards. Second, they suggest that it would be helpful to clarify the role of accounting information in large economies where only certain types of risks are priced because investors likely demand the types of accounting information that help them better assess those risks. Since the CAPM provides a time-honored theory for the pricing of risk, LLV begin their analysis by recasting the CAPM into a form that explicitly highlights the role of public information; that is, they express means, variances, and covariances that define the CAPM in their conditional form, conditional on public information. They then show that, under some simplifying assumptions, a firms expected return or cost of equity capital can be expressed as

Reply to: dynamic incentives and responsibility accounting: a comment

Abstract Christensen et al. (Dynamic incentives and responsibility accounting: a comment, J. Account. Econ. 35 (2003) 423) examine Indjejikian and Nanda (J. Account. Econ. 27 (1999) 177) and suggest that our characterization of the inefficiency arising from limited commitment as a “ratchet effect” phenomenon is misplaced. In this reply, we describe the ratchet effect as commonly understood in the literature, clarify the role of contractual commitments in our analysis, and then illustrate why both the substance and interpretation of our original results continue to be appropriate.

Rational Information Leakage

Empirical evidence suggests that information leakage in capital markets is common. We present a trading model to study the incentives of an informed trader e.g., a well-informed insider to voluntarily leak information about an assets value to one or more independent traders. Our model shows that, although leaking information dissipates the insiders information advantage about the assets value, it enhances his information advantage about the assets execution price relative to other informed traders. The profit impact of these two effects are countervailing. When there are a sufficient number of other informed traders, the profit impact from enhanced information dominates. Hence, the insider has incentives to leak some of his private information. We label this rational information leakage and discuss its implications for the regulation of insider trading. This paper was accepted by Mary Barth, accounting.

Dual Purpose Measures

We examine a firms choice of a measurement system designed to serve two distinct objectives; provide forward-looking information about future firm productivity and ex post information about past managerial performance. A firm can have two separate measurements, one for each purpose, or a single measure that simultaneously serves both objectives. In a two-period principal-agent model, we illustrate how implicit incentives can lead firms to prefer a single dual-purpose measure.

Spillover effects of internal control weakness disclosures: The role of audit committees and board connections

We find that firms are less likely to report an internal control material weakness (as mandated by the Sarbanes-Oxley Act) in a given year if one of their audit committee members is concurrently on the board of a firm that disclosed a material weakness within the prior three years. We find a similar spillover effect for financial restatement disclosures. The spillover from material weakness disclosures is evident only if a shared director has more experience with the disclosing firm or can channel more information about the disclosed material weakness. Our findings suggest that prior director experiences outside the firm influence the work of audit committees inside the firm. One rationale is that a director’s prior experience with an adverse disclosure helps diffuse important insights and serves as a catalyst for improvements in a firm’s internal control and financial reporting practices. An alternative explanation, which we cannot dismiss, holds that a director’s prior experience helps a firm to under-report material weaknesses and financial restatements without any attendant improvements in the underlying practices.

Performance Monitoring and Incentives in Hierarchies

We consider a principal-multi agent model that features a three-tier hierarchy, defined as a setting where the principal contracts with an agent-manager and delegates to the manager some authority to contract with other agents. A key highlight is that incentive compensation, performance monitoring, and the hierarchical structure (the extent to which contracting authority is delegated to the manager) are simultaneously determined. In general, we find that productivity and monitoring exhibit opposite patterns in a hierarchy. That is, at higher hierarchical levels effort incentives are higher but performance monitoring and pay-for-performance sensitivity is lower, even for agents who are otherwise comparable. For instance, we find that agents working for the agent-manager are less productive even though they are monitored more intensively than comparable agents elsewhere in the hierarchy. The flip side is that an agent-manager entrusted with authority to evaluate others is (implicitly) motivated to be more productive even though such authority reduces the need to monitor his performance. The choice of a hierarchical structure then balances the benefits of a more productive (but less monitored) manager against the costs of less productive (but more monitored) lower-level workers. Overall, our findings contribute to the growing literature that documents complementarities among organizational design choices.