The last two decades have witnessed considerable interest in designing performance evaluation systems that align managers’ interests with shareholder value. A number of studies (Lambert and Larcker 1987; Sloan 1993; Natarajan 1996) have examined the use of accounting performance measures such as earnings and cash flows in top management compensation contracts. The focus of these studies has been on how firms incentivize managers using outcome-based measures and how firms reward managers for achieving higher outcomes. These studies suggest that the widespread use of outcome-based accounting performance measures is due to the fact that they motivate managers to take both revenue-increasing and expenditure-decreasing actions that directly contribute to shareholder wealth.

Expenditure on input resources such as labor, materials, and information generates both current as well as future value. From an efficient contracting point of view, it is necessary to both reduce the unproductive part of current operating expenditure and to motivate managers to invest in activities that create future value. A major limitation of income-based compensation schemes is that exclusively relying on them may lead to managers scaling back or reducing expenditure in activities that have the potential to create future value. Relatively fewer accounting studies have examined how and whether firms take into account the future value-creation potential of input resource expenditure while designing incentive schemes and whether the resulting schemes indeed induce managers to focus on value-enhancing actions. 1