Management Accounting Section Midyear Meeting

Measurement Error, Manipulation, and the Value of Ignoring Short-Term Performance

• In Event: Analytical Models I

Abstract

This paper studies the effect of measurement error and manipulation on a principal's preference for whether or not to use a short-term performance measure for firing an agent, whose competence is unknown. The short-term performance measure is an imperfect signal of the firm's unobservable long-term value, but is subject to manipulation, which, if successful, results in a favorable performance measure. A competent agent's successful manipulation is beneficial because it reduces inefficient firing, but an incompetent agent's successful manipulation is costly because of inefficient retention. A more informative signal about the competent agent's performance can either increase or decrease inefficient firing, depending on whether the agent's manipulation is successful. Thus, the principal prefers to ignore short-term performance when the signal about the competent agent's performance is neither accurate nor inaccurate. A more informative signal about the incompetent agent's performance can either increase or decrease inefficient retention, depending on whether the agent's manipulation is successful, and, thus, has a non-monotonic effect on the value of ignoring short-term performance. The results have implications for understanding how short-term performance evaluation can be detrimental to an organization's long-term value due to the costs of the firing and retention errors.

Author

• Naomi Rothenberg, University of Alberta