Providing Managerial Incentives : Cash Flows Versus Accrual Accounting

This paper examines a multi-period agency model in which a manager makes investment decisions in each period. Performance measures based only on realized cash flows are essentially uninformative about value creation at any intermediate point in time. If the principal has access to additional project information which allows for a proper matching of a project's periodic cash flows with a share of the original investment cost, then the value created by the manager can be assessed at intermediate points in time. Such matching can be achieved by means of an accrual accounting system with properly structured depreciation charges. We establish that performance evaluation based on accrual accounting data results in lower agency costs than performance evaluation based on realized cash flows only