This paper analyzes the impact of signal-to-noise-ratios and the autocorrelation of a performance measure on the principal's welfare in dynamic agencies with renegotiation. We consider the impact of changes in the persistent, transitory, and reversible components of accounting earnings on its usefulness in valuation versus contracting. Increasing the persistent components and reducing the reversible components are generally desirable for valuation, but not for contracting. Eliminating transitory components of earnings is generally desirable for valuation, but not necessarily for contracting. We discuss the contracting implications of differences in the autocorrelations of accounting earnings versus stock returns.

Indjejikian and Nanda (J. Accounting and Economics 27 (1999) 177) establish that “lack of commitment” results in an expected economic loss, relative to a long-term full-commitment contract, if there is inter-period correlation of performance measures. They attribute this loss to a “ratchet effect”. We demonstrate the following. First, their proposed equilibrium is not sustained unless there is some form of limited commitment. Second, these limited commitment assumptions need not induce a “ratchet effect”. Third, the “ratchet effect” is neither necessary nor sufficient for an expected economic loss to occur—the loss is due to the principal's inability to commit ex ante to the second-period incentive rate.