Accrual Accounting in Performance Measurement and the Separation of Ownership and Control

The value implications of managerial decisions depend on uncertain future events and decisions by the manager's successors, often far beyond the manager's own tenure. In this context, performance pay based on accrual accounting can incentivize efficient decisions even when managers' actions are not fully observable. The optimal compensation scheme is not equivalent to selling the firm to the manager, implying that stock-based compensation fails to attain incentive alignment and providing a rationale for the separation of ownership and management commonly seen in practice. Performance 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. The change in management must, however, coincide with the sale of the business to a new owner under an accounting-based earn-out agreement.