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The Role of Transitory Earnings for Managerial Effort Allocation to Intangibles

There is a concern about the ability of earnings to adequately reflect managerial efforts to intangible-based activities. Agency theory suggests that when core earnings relay little information about managerial effort to certain activities, effort allocation will be insufficient. Risk averse managers consider costs of investing in RD they can send signals about the future and security prices reflect information about them. This means that even though the accounting system creates weak value relevant core earnings concerning intangibles, if transitory earnings can provide some additional information, they can play a vital incentive role. For example, unsuccessful prior intangible investments or obsolete inventory would be reported as transitory earnings (e.g., disposal of a poorly performing line of operation, asset write-downs, inventory write-offs), which can send signals to markets about managerial effort to tackle problems. These can be useful to convey information about managerial efforts exerted on intangibles. I show that under these conditions, market-based compensation helps to mitigate inefficient effort allocation to intangible-based activities. However, the reflection of transitory earnings in market-based compensation can also encourage earnings management. Managers may allocate their effort to a nonproductive activity such as shifting operating expenses to non-operation expenses to avoid a sharp decline in security price or/and meet analyst forecasts. Such activities do not increase economic value. Thus, the ability of transitory earnings to produce proper managerial effort allocation has to be weighed against the possibility of encouraging earnings manipulation.