Asset Valuation and Performance Measurement in a Dy- namic Agency Setting

This paper examines the choice of asset valuation rules from a managerial control perspective. A manager creates value for a rm through his e ort choices. To support its operating activities, the rm also engages in nancing activities such as credit sales to its customers. Since such nancing activities merely change the pattern of cash ows across periods, an optimal compensation scheme must shield the manager form the risk associated with the nancing 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 ows can be optimal only under exceptional circumstances. We also consider a setting in which there is su ciently disaggregated information about periodic cash ows so as to eliminate not only the risk associated with nancing activities but also the risk associated with customer defaults. The principal then wants to depart from fair value accounting. A rm's periodic cash ow appears to be an imperfect measure of value added in most business environments. This paper studies a multiperiod agency model in which the manager's unobservable action contributes to the rm's cash ow in each period. In addition, cash ow is a ected by nancing activities which result because the rm's ordinary transactions involve receivables (payables), e.g., the rm makes credit sales. For incentive contracting