Question

Explain why historical cost-based net income is superior to current value-based net income as a performance measure for the purposes of managerial compensation.

Answer 1

It should be noted that management due to their status, is in a dominant position to influence financial statements disregarding various internal controls. If we will calculate net income on the basis of current value rather than historical cost then management may try to show the assets and various other item with an increased amount which will lead to a larger amount of unrealized gain. It may be possible that their compensation is linked to the performance of the company i.e. profit of the company, thus such a practice by management will increase profit of the company when actually it has not earned that much profit and ultimately it will lead to an increased management compensation which will lead to the loss for the company.

Also, they may try to show more values of asset on the name of current value in order to show a strong balance sheet and thus trying to fulfill their various purposes and also to take extension of their term of management by showing strong performance of the company on account of increased balance sheet size. Thus, ultimately it will lead to window dressing of whole financial statements of the company.

That is why historical based net income is superior to current value based net income as a performance measure for the purposes of managerial compensation.