Accrual accounting in performance measurement and the separation of ownership and control

Investment decisions tend to affect outcomes beyond the decision-maker’s tenure at the enterprise, and these outcomes, moreover, depend in part on the actions of the decision-maker’s successors. Separation between ownership and management, with hired managers compensated by accounting-based performance pay, solves the resulting incentive horizon problem. By contrast, the standard solution to “sell the firm to the agent” or the use of stock-based compensation creates incentives to invest inefficiently. Optimal managerial incentive pay may in fact show weak or even inverse correlation with stock price and cash flow. Even in enterprises managed by their owners, the prospect of implementing accounting-based incentive compensation and separating ownership from management in the future can induce efficient decision incentives at present. The separation of management from ownership must, however, coincide with the sale of the business to a new owner under an accounting-based earn-out agreement.