A contracting perspective on earnings quality

• Published in: Journal of accounting & economics Vol. 39; no. 2; pp. 265 - 294
• Main Authors: Christensen, Peter O., Feltham, Gerald A., Şabac, Florin
• Format: Journal Article
• Language: English
• Published: Amsterdam Elsevier B.V 01-06-2005; Elsevier; Elsevier Sequoia S.A
• Series: Journal of Accounting and Economics
• Subjects: Accruals; Business management; Business studies; Contracting; Correlation analysis; Earnings; Earnings quality; Economic models; Economic performance; Employees; Labour relations; Management compensation; Managers; Measurement; Performance measure autocorrelation; Personnel management; Principal-agent theory; Rates of return; Signalling; Stock returns; Studies; Valuation; United States > US; Management compensation; Accruals; Performance measure autocorrelation; Contracting; J33; M41; D80; M43; Earnings quality
• ISSN: 0165-4101; 1879-1980
• DOI: 10.1016/j.jacceco.2004.06.002

This paper analyzes the impact of signal-to-noise-ratios and the autocorrelation of a performance measure on the principal's welfare in dynamic agencies with renegotiation. We consider the impact of changes in the persistent, transitory, and reversible components of accounting earnings on its usefulness in valuation versus contracting. Increasing the persistent components and reducing the reversible components are generally desirable for valuation, but not for contracting. Eliminating transitory components of earnings is generally desirable for valuation, but not necessarily for contracting. We discuss the contracting implications of differences in the autocorrelations of accounting earnings versus stock returns.