Toronto Metropolitan University

AFA 706

Holmström’s Agency Model
 Basing manager’s compensation on 2 variables is better
than on 1 variable, unless the 2 variables are perfectly
correlated.
 Holmström’s model implies that net income and share price
taken together better reflects current manager effort than
either variable alone.
 Share price is jointly observable and is based on more information
than just accounting information.
 Share price may be less subject to manager bias and recognition lag
than net income.
 However, net income may less subject than share price to volatility
created by economy-wide events.
 What characteristics a performance measure (here net
income and share price) should have if it is to contribute to
efficient compensation contracts?
(Partly from Scott, W.R. and O’Brien P.C. (2020). Financial Accounting Theory [PowerPoint slide,
Chapter 9, p. 26], Pearson Canada)
3
 Precision
 The extent to which the value of the performance measure is
accurate in predicting the payoff from current manager effort (greater
precision means less noise).
 Increases the efficiency by reducing the manager compensation risk
 Sensitivity
 The extent to which the expected value of the performance measure
responds to manager effort (higher sensitivity means less bias).
 Increases the efficiency by strengthening the connection between
manager effort and the Performance measure.
 Often there is a trade off between sensitivity and precision
 e.g., current value accounting may be more sensitive than historical
cost, but less precise.
(Partly from Scott, W.R. and O’Brien P.C. (2020). Financial Accounting Theory [PowerPoint slide,
Chapter 9, p. 27], Pearson Canada)
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Holmström’s Agency Model (Cont’d)
Reconciliation of Efficient Securities
Market Theory With Economic
Consequences
 Contract incompleteness and rigidity mean that new
accounting standards matter to managers
 This does not conflict with efficient securities market
theory.
 Market efficiency implies that new accounting standards with
cash flow effects concern managers.
 Contract and agency theories imply all new standards concern
managers (including ones without cash flow effects).
 Thus contract and agency theories explain why accounting
standards matter to managers even when markets are efficient.
(Scott, W.R. and O’Brien P.C. (2020). Financial Accounting Theory [PowerPoint slide,
Chapter 9, p. 29], Pearson Canada)