Effects of Accounting-Method Choices on Subjective Performance-Measure Weighting Decisions: Experimental Evidence on Precision and Error Covariance

Performance-measure weights for incentive compensation are often determined subjectively. Determining these weights is a cognitively difficult task, and archival research shows that observed performance-measure weights are only partially consistent with the predictions of agency theory. Ittner et al...

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Bibliographic Details
Published in:The Accounting review 2005-10, Vol.80 (4), p.1163-1192
Main Authors: Krishnan, Ranjani, Luft, Joan L., Shields, Michael D.
Format: Article
Language:English
Subjects:
Accounting methods
Agency theory
Business accounting
Capital costs
Cognition & reasoning
Cognitive models
Cost efficiency
Covariance
Decision making models
Economic psychology
Enterprises
Error rates
Experiments
Financial performance
Incentives
Measurement
Performance metrics
Production costs
Reasoning
Statistical models
Term weighting
Unit costs
Variance
Variance analysis
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Summary:Performance-measure weights for incentive compensation are often determined subjectively. Determining these weights is a cognitively difficult task, and archival research shows that observed performance-measure weights are only partially consistent with the predictions of agency theory. Ittner et al. (2003) have concluded that psychology theory can help to explain such inconsistencies. In an experimental setting based on Feltham and Xie (1994), we use psychology theories of reasoning to predict distinctive patterns of similarity and difference between optimal and actual subjective performance-measure weights. The following predictions are supported. First, in contrast to a number of prior studies, most individuals' decisions are significantly influenced by the performance measures' error variance (precision) and error covariance. Second, directional errors in the use of these measurement attributes are relatively frequent, resulting in a mean underreaction to an accounting change that alters performance measurement error. Third, individuals seem insufficiently aware that a change in the accounting for one measure has spillover effects on the optimal weighting of the other measure in a two-measure incentive system. In consequence, they make performance-measure weighting decisions that are likely to result in misallocations of agent effort.
ISSN:0001-4826
1558-7967
DOI:10.2308/accr.2005.80.4.1163