| Observable accounting-based and market-based estimators are the two most widely-used proxies for the unobservable true underlying firm performance. However, the validity of accounting-based measures as an indicator of firm performance was challenged. Previous studies documented a weak association between reported earnings and stock returns, which led to arguments that the fundamental measurement process of our current accounting and reporting system distorted and adversely affected the informativeness of accounting-based information. In this study, I focus on assessing the viability of accounting-based measures as an indicator of firm performance.; By the very different nature of accounting-based and market-based firm performance measures, the weak association between these two types of measures are not unexpected. I suggest both are valid estimators of performance but from different perspectives: Accounting-based measures capture historical performance while market-based measures capture future performance. To reconcile the difference, I classify firms into three groups: growing, stable, and declining. I predict that the different perspectives of these two types of measures converge and should have a close and strong relationship for firms in the stable group, but not for the other two groups. I also predict, if the relationship is known, that stable firms comparably would rely less on market-based performance measures as a basis for compensation of their executives.; Using the statistical techniques of factor analysis and LISREL (linear structural relationships) analysis on my sample firms, the results are consistent with the first conjecture that accounting-based and market-based measures of firm performance have a close and strong relationship for stable firms. As firms are not in a steady state, historical performance has little association with its future counterpart and thus accounting-based and market-based measures diverge.; Contingency tables were constructed to test the second conjecture that there are greater use of market-based compensation plans among growing firms and declining firms than stable firms. The analyses provide mixed results. It could be that the relationship found above is not an important factor for designing executives' compensation packages. |
