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Research Paper No.

1886

Accrual Accounting for Performance Evaluation Sunil Dutta Stefan Reichelstein

February 2005

RESEARCH PAPER SERIES

Accrual Accounting for Performance Evaluation

Sunil Dutta Haas School of Business University of California, Berkeley

and

Stefan Reichelstein1 Graduate School of Business Stanford University

February 2005

1 For helpful comments and suggestions, we thank an anonymous reviewer, Stan Baiman, Bill Beaver, Ian Gow, Jack Hughes, Steve Penman (the editor), Dieter Pfa, Richard Saouma and seminar participants at Carnegie Mellon University, UCLA, the University of Vienna and the Utah Winter Accounting Conference.

Accrual Accounting for Performance Evaluation


Abstract
This paper examines alternative accrual accounting rules from an incentive and control perspective. For a range of common production, nancing and investment decisions we consider alternative asset valuation rules. The criterion for distinguishing among these rules is that the corresponding performance measure should provide managers with robust incentives to make present value maximizing decisions. Such goal congruence is shown to require intertemporal matching of revenues and expenses, though the specic form of matching needed for control purposes generally diers from gaap. The practitioner oriented literature on economic prot plans has made various, and at times conicting, recommendations regarding adjustments to the accounting rules used for external nancial reporting. Our goal congruence approach provides a framework for comparing and evaluating these recommendations.

Introduction

There is a long tradition in the accounting literature to view the rules of accrual accounting as design variables. Dierent strands of this literature have articulated a variety of criteria for comparing alternative accounting rules. For instance, Edwards and Bell (1961) identify environments in which accounting rules can be chosen so that a rms book value is equal to its fair market value at each point in time. Beaver and Dukes (1974) and Stauer (1971) examine how accruals can be chosen for an expected pattern of cash ows so that the resulting accounting rate of return remains constant over time. More recently, Ohlson and Zhang (1998) identify certain accounting rules as ecient if the resulting income and book value measures are sucient for determining a rms intrinsic value. In the management control literature, accrual accounting has consistently been viewed from a stewardship perspective. Accordingly, good accounting rules have the property that the resulting accounting-based performance metrics guide managers towards value increasing decisions. This perspective was central to Solomons (1965) pioneering study on divisional performance measurement. The debate about desirable accounting rules has recently been reinvigorated in connection with so-called Economic Prot Plans (EPP), many of which are variants of the familiar residual income concept.1 The proponents of epps recommend adjustments to gaap with the stated objective of obtaining accounting metrics that are more useful for internal performance evaluation.2 Yet, for the most part this debate has been lacking in formal criteria for comparing alternative rules and, as a consequence, no discernible consensus has emerged regarding the recommended accounting adjustments. In this paper, we invoke goal congruence criteria requiring that managers have incentives to make present value maximizing decisions regardless of their planning horizons, their disEconomic Value Added is probably the best known among these economic prot plans. The eva measure has been popularized (and trademarked) by Stern, Stewart & Co. Closely related concepts are being advocated under the labels Value Added (KPMG), Economic Prot (McKinsey), Cashow Return on Investment (Holt& Associates), and Cash Value Added (Boston Consulting Group). Ittner and Larcker (1998), Young and OByrne (2000) and Balachandran (2005) provide survey evidence on the adoption of these measures. 2 Stern, Stewart & Co. mention the possibility of as many as 164 accounting adjustments. See Ehrbar and Stewart (1999). Young (1998) and Simons (2000) illustrate the implementation of select adjustments for individual companies.
1

count rate or the particular compensation rules. As a consequence, proper accounting rules must reect value creation in a temporally consistent fashion; that is, managers do not face intertemporal tradeos when making long-term decisions that are desirable from the owners perspective.3 We focus on residual income as the managerial performance measure. This focus not only reects that most of the recently proposed and adopted epps are variants of the residual income measure, but also the ndings of recent theoretical research showing that among all accounting based performance measures residual income has certain uniqueness properties in achieving goal congruence.4 Our analysis is predicated on the notion that managers have superior information about the nancial consequences of a proposed transaction, while the accounting rules can rely only on general purpose information, e.g., an assets useful life.5 For a range of common production, nancing and investment decisions, we argue that private information held by management makes intertemporal matching of revenues and expenses essential.6 Yet, the specic form of matching needed for goal congruence diers from gaap in many instances. In connection with long-term construction projects, for example, we argue that the revenue recognition for a project should reect the underlying intertemporal pattern of relative progress towards project completion. To obtain goal congruence, however, the commonly used percentage of completion method needs to be modied so as to properly reect the time value of money. Specically, the estimate of the percentage of completion in a given period should be based on the ratio of that periods cost to the discounted value (rather than the undiscounted value) of the projects total cost. Of course, both methods require that the
3 The goal congruence requirement can be traced back to Solomons (1965) who argues we are entitled to judge them [the accounting rules] as if a dierent manager were in charge in each year in series. The question we have a right to ask is: How well does each years prot reect the success of that years manager? The criterion here seems to be that ideally the accounting rules should render managers planning horizon irrelevant. 4 See, for instance, Rogerson (1997) and Reichelstein (1997). 5 This asymmetric information perspective stands in contrast to earlier accounting literature which presumes symmetric and complete information about project payos. 6 Most of the recent work on goal congruent accounting rules has focused on the choice of depreciation rules in connection with capital investment problems. Papers in this category include Rogerson (1997), Reichelstein (1997, 2000), Pfeier (2002), Baldenius and Ziv (2003), Wei (2004), Bharket (2004), Mohnen (2004) and Bastian (2004). Our paper extends and unies the existing literature by delineating general features of goal congruent performance measures for a range of transactions.

accounting system be in a position to estimate the relative percentages of costs in dierent construction periods. A common criticism of gaap is its conservatism. While our analysis conrms that nancial accounting rules which call for the immediate expensing of intangible investments will not lead to goal congruence, we also argue that certain manifestations of conservatism are desirable from a performance measurement perspective. Specically, we nd that fair market values will generally exceed book values. This relation emerges because, by the conservation property of residual income, the dierence between the fair market value and the book value is just the present value of future residual incomes.7 Furthermore, goal congruent accounting generally requires that the (positive) present value of a transaction is apportioned across time periods in the residual income numbers. The management control literature has long pointed to the potential hazards of charging for costs that are sunk. We argue that managers should anticipate being charged in future periods for expenditures that will be sunk in those future periods but are not sunk initially when these expenditures are authorized. At the same time, sunk cost charges should not impair managements incentive to make decisions that are sequentially optimal in light of new information. In connection with abandonment options, such as multi-stage investment projects, our analysis advocates full cost rather than successful eorts accounting. Full cost accounting oers the possibility of intertemporal matching while treating past expenditures as sunk. Our ndings in those contexts generally dier both from gaap and the recommendations expressed in the practitioner oriented literature on Economic Prot Plans. Financial assets and liabilities commonly accrue interest under gaap. From a performance evaluation perspective, we argue that real assets should also be interest accruing if there is a lag between an initial cash expenditure and the time at which cash returns begin to arrive. In order to avoid intertemporal tradeos for the manager, upfront cash expenditures should not aect the managerial performance measure until such time as the corresponding cash returns are realized. With residual income, such interim neutrality is achieved provided
The conservation property of residual income, as observed by Preinreich (1937) and others, asserts the identity of discounted cash ows and discounted residual incomes. This identity has been central to the literature on equity valuation, see, for example, Feltham and Ohlson (1996).
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the upfront expenditures are capitalized and subsequent accrued interest is oset precisely by the capital charges in the interim periods. Proponents of Economic Value Added have advocated such accounting policy for what they term strategic investments.8 Goal congruence does not make it necessary to apportion the present value of a transaction across the useful life of the transaction. For certain transactions, such as credit sales, it is plausible that the accounting system has sucient information to recognize all value creation upfront. Conversely, goal congruence can be obtained by deferring the recognition of value creation. The corresponding performance measure would amount to the compounded value of past cash ows. We argue, however, that such backloading will be generally infeasible for a going concern and conict with the need for performance measures to eectively aggregate the consequences of multiple ongoing projects. The study of goal congruent performance measures naturally raises the question whether the corresponding accounting rules also emerge as part of second-best contracts in agency models. By construction, the advantage of goal congruence is that managerial incentives are invariant to the choice of compensation parameters and therefore these parameters can be chosen freely to address moral hazard problems. At the same time, though, second-best decision rules generally vary with the underlying agency problem. This would necessitate further adjustments to the performance measure, such as changes in the capital charge rate, in order to implement second-best incentive mechanisms. For some transactions, in particular those involving sequential information and decision making, future agency research will have to verify (or reject) the optimality of goal congruent performance measures. The remainder of the paper is organized as follows. The next section formalizes alternative notions of goal congruence. Sections 3 examines alternative accounting rules for select transactions including multi-year construction contracts, leases, asset disposals and r&d projects. Because of the linearity the residual income performance measure we may consider each of these transactions in isolation. Section 4 discusses the feasibility of obtaining the desired incentives by recognizing value creation either upfront or at the very end of the planning horizon. We conclude in Section 5.
8

See, for instance, Ehrbar (1998).

Goal Congruence

We consider a setting in which a business owner delegates decision-making to a better informed manager. The owners objective is the long-run value of the business as measured by the stream of expected cash ows, discounted at his cost of capital r. The corresponding discount factor is denoted by =
1 . 1+r

We represent the initial information at date 0 by

the state variable . This (multidimensional) variable represents the managers information regarding the future cash consequences resulting from current decisions. The actual cash ows in period t are determined by the managers decisions and by the realization of current and future state variables t . The initial information variables, , also include the managers beliefs regarding the realization of future state variables t . In some of the settings we examine, the manager makes multiple decisions based on new information that is received at some subsequent dates. Earlier research has shown that among all accounting-based performance measures residual income is unique in its ability to induce a manager to accept all positive NPV projects and only those.9 Accordingly, our analysis focuses on residual income calculated as accounting income less an interest charge for the capital employed by the business: RIt Inct r BVt1 . Here, BVt denotes book value of net assets interpreted as the sum of all asset values less the sum of all liabilities. Throughout our analysis, we conne attention to accounting rules that satisfy comprehensive income measurement(or the clean surplus relationship). Thus, with the exception of net dividends, i.e., dividends less capital contributions, all transactions which aect book value ow through the income statement. For simplicity, the owner is assumed to be the direct recipient of the rms net cash ows ct in each period. The requirement of comprehensive income measurement then reduces to: Inct = ct + BVt BVt1 .
9

See, for instance, Proposition 3 in Reichelstein (1997).

It is well known that, in contrast to accounting income, residual income is fundamentally compatible with present value maximization. Specically, the present value of cash ows is equal to the present value of residual incomes, regardless of the accrual accounting rules. This conservation property implies the following weak form of goal congruence: a risk-neutral manager has an incentive to maximize the present value of future cash ows provided she receives a constant share of each periods residual income and she discounts future payos at the same rate as the owner. A more demanding notion of incentive compatibility postulates that it is in the managers interest to make value maximizing decisions even if he is less patient than the owner (possibly because of a higher discount factor or a shorter planning horizon) and the compensation rules vary over time. Goal congruence then requires that the accrual accounting rules achieve proper matching of revenues and expenses so as to avoid intertemporal tradeos, that is, the desired decision increases the performance measure in some periods and decreases it in other periods. We distinguish between two alternative notions of goal congruence. Residual income, based on a particular set of accrual accounting rules, is said to create strong incentives for the manager to make a particular decision at date 0 if this decision maximizes: E[U (RI 1 , . . . , RI T )|] (1)

for any function U () that is weakly increasing in each of its T arguments.10 . The notation RI t reects that at date 0 the actual residual income in period t is uncertain and that the probability distribution of these variables depends on . The utility function U () is a reduced form representation of both the managers preferences and the underlying compensation scheme which links the managers pay to the stream of delivered residual incomes. Residual income, combined with a particular set of accrual accounting rules, is said to create robust incentives for the manager to make a particular decision at date 0 if this decision
For the most part we suppose that there is a known and nite horizon, though in some contexts it will be algebraically convenient to allow for T =
10

maximizes: E[

ki RI t |]
i=1

for arbitrary, non-negative constants kt . These weights reect both the managers discount factor and the bonus coecients attached to the periodic residual income gures. Clearly, strong goal congruence implies robust goal congruence as the latter concept essentially assumes risk neutrality on the managers part. To achieve robust goal congruence, the accounting rules will have to shield the manager from any incremental risk associated with the transaction under consideration. Both of the above criteria for goal congruence are demanding. Our perspective is that the designer does not know the managers preferences, possibly because the accounting rules have to be chosen before the specics of the managerial contracting problem become known. This perspective seems particularly compelling for larger multidivisional rms which seek to adopt a common set of internal accounting rules. The central implication of the goal congruence requirement is that the sequence of performance measures must avoid intertemporal tradeos, that is value maximizing decisions may not lower the performance measure in any individual period.

3
3.1

Accrual Accounting for Select Transactions


Multi-Year Construction Contracts

We examine multi-year construction contracts as an example of a transaction involving a sequence of cash outows followed by one terminal cash inow. Such transactions seem particularly important for rms that deliver big ticket items to their customers.11 Revenue from the contract is assumed to become veriable to all parties once the contract has been signed. In contrast, the manager is assumed to have superior information regarding the (expected) future production and delivery costs required to complete the contract.
Davis (1996) reports that Boeing abandoned Economic Value Added as a performance measure due to long delays in construction and lumpy order ows. In contrast, our message is that residual income coupled with suitable accrual accounting rules can be an eective measure in the face of long construction lead times.
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For nancial reporting purposes, revenues from long-term contracts are generally recognized according to the so-called percentage-of-completion method in which the total contract revenue is allocated over the duration of the contract. The share of revenue recognized in a given period is proportional to the amount of the contract completed in that period. The percentage of completion in a given period is usually approximated by the ratio of that periods cost relative to the expected total cost of the project. The percentage of completion method thus seeks to match a share of the total contract price with the associated cost in each period. This notion of matching is in stark contrast to the cash accounting treatment recommended by some eva proponents.12 To examine goal congruence in connection with long-term contracts, suppose the manager has the opportunity to accept a production or service contract which extends over T periods. Upon delivery of services the client agrees to pay p at date T .13 To deliver the goods and services specied in the contract, the rm will have to incur cash outlays in the amount of: ct = xt at date t for t {1, . . . , T }. While the cost parameter is known only to the manager, the intertemporal pattern of costs represented by the vector x (x1 , ..., xT ) is commonly known. For instance, it may be common knowledge that the costs of project completion increase at a particular rate over time. This information can therefore be used in the design of the accrual accounting rules. The contracts net present value is given by: N P V () = p
i=1 T T

i xi .

(2)

Under the commonly used percentage-of-completion method of revenue recognition, the amount of revenue recognized in period t is given by: Revt = p
12

xt T i=1

xi

(3)

According to Biddle, Bowen and Wallace (1999), one of the accounting adjustments proposed by Stern, Stewart & Co. is cash accounting for multi-year contracts. Savarese (1999) also recommends that assets under construction not be included in the capital base. Hofmann (2003) develops an agency model that compares the eciency properties of cash and accrual accounting for long-term projects. 13 Below we also consider the possibility of progress payments.

Since costs are expensed as incurred, the contribution to income in period t will be: Inct = p xt
t i=1

xi

xt =

xt
T i=1

xi

p
i=1

xi .

It is immediately seen that accounting income based on the percentage-of-completion method does not achieve goal congruence. Since
T T

p
i=1

xi > p
i=1

xi (T i) ,

the expression for the net present value of the project in (2) shows that some projects with negative npv will result in positive income in each period. This bias simply results from the fact that neither the performance measure nor the accounting rules reect the time value of money. Residual income mitigates this overinvestment problem because the revenues recognized in previous periods impose an additional capital charge. However, it is straightforward to verify that residual income based on the percentage-of-completion method will generally not deliver strong (and, a fortiori, neither robust) goal congruence.14 A modied revenue recognition rule, which we refer to as the present-value- percentageof-completion method, eliminates the time inconsistency of the percentage-of-completion method and generates robust incentives for the manager to accept all positive npv contracts and only those. Under the present-value-percentage-of-completion method, the amount of revenue recognized in period t is given by:

Revt = T p

T i=1

xt + r AVt1 , i xi

(4)

where AVt denotes the book value of receivables at date t. As revenues are recognized, the rm records a corresponding amount of receivables: AVt = AVt1 + Revt (5)

14 Depending on the vector (x1 , ..., xT ) and the weights ut , residual income based on the on percentageof-completion method may bias the manager in either direction, that is, towards accepting too many or too few projects.

for 1 t T with AV0 = 0. The revenue recognition rule in (4) diers from the conventional percentage of completion method in two respects: (i) it includes the amount of accrued interest on the beginning balance of the receivables, (ii) the amount of (non-interest) revenue in a given period is proportional to the ratio of the project cost incurred in that period relative to the discounted sum of all future costs. Thus the revenue recognition rule in (4) coincides with the conventional percentage of completion method only when the interest rate is zero, i.e., = 1. It will be convenient to dene the present value shares: zt Recursive substitution yields:
T t=1 T i=1

xt . i xi

(6)

Revt = T p [zT + (1 + r) zT 1 + + (1 + r)T 1 z1 ] = p

Thus, the present-value-percentage-of-completion method is a tidy revenue allocation scheme in that the sum of revenues recognized over the life of the project is equal to the nominal contract price, i.e., at that date because AVT =
T t=1

Revt = p. Furthermore, the value of receivables at the Revt = p. For the revenue recognition rule in (4), the

contract completion date is equal to the cash payment to be received from the customer
T t=1

contribution to accounting income is equal to: Inct = T p zt + r AVt1 xt Residual income then becomes: RIt = T p zt xt = zt T p = zt N P V ().
T i=1

i xi (7)

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Thus the present-value-percentage-of-completion method apportions the projects N P V so as to make the contribution to each periods residual income proportional to the net present value of the contract. Proposition 1 The present-value-percentage-of-completion method generates strong incentives for the manager to accept contracts with positive N P V , and only those. The above analysis demonstrates that the appropriate form of intertemporal matching of revenues and expenses involves linking revenue recognition to the amount of costs incurred in a given period. This form of matching is essentially the mirror image of the relative benet depreciation rule considered in connection with capital investment decisions.15 Under the relative benet depreciation rule for capital investments, the depreciation expense is matched with the relative benets of investment in each period. In contrast for long-term contracts, revenue recognition in each period is linked to the amount of costs incurred in a given period. The need for revenue recognition, rather than cost allocation, is driven by the nature of information asymmetry. While the cost of a long-term investment is commonly known at the outset, the manager has superior information regarding future benets. In contrast the sales price of a multi-year contract is commonly known and veriable, but the manager is privately informed about future costs.16
The relative benet depreciation rule, as proposed by Rogerson (1997), extends the concept of annuity depreciation to non-uniform cash ows. Specically, suppose a manager has available an investment opportunity which entails an initial cash outlay of b and generates cash inows in the amount of xt for each t {1, ..., T }.The relative benet depreciation charges {Dept }T are the unique solution to the equations: t=1 (Dept + r AVt1 ) = b zt . The left-hand-side of the above equations represent the sum of depreciation and capital charges for the residual income performance measure. As a consequence: RIt = xt zt b = zt N P V (). Proposition 2 extends to settings in which the project costs are uncertain (even from the perspective of the better informed manager). To see this, consider a situation in which the date t project requires cash outlay of ct = c xt + t in period t. The zero-mean random variable t represents the uncertainty of the projects cost in period t. The present value percentage of completion method of revenue recognition generates robust managerial incentives to accept (reject) all the projects with positive (negative) expected NPV. However strong incentives cannot be achieved in this setting since the managers choice impacts the variability of future cash ows.
16 15

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Our nding in Proposition 1 extends readily to situations in which the customer makes progress payments. In particular, suppose the customer has contractually agreed to pay pt in period t. The above results then apply without change provided that in the above analysis the real contract price, T p, is replaced by the present value of all progress payments, i.e., p0
T t=0

t pt .17

Proponents of Economic Prot Plans frequently claim that generally accepted nancial accounting rules, i.e., gaap, are too conservative for the purposes of performance measurement. This criticism has been particularly prominent in connection with the immediate expensing of certain costs such as those incurred for marketing and research & development. One notion of conservatism is that on average fair market values exceed book values.18 In our context, the market value of the contract at date t is simply the present value of the remaining cash ows, i.e., Mt = p
T t T

i=t+1

it xi .

It follows that Mt = (1 + r) Mt1 + xt and we obtain the following relation between market values and book values calculated according to (5). Corollary to Proposition 1. The present-value-percentage-of-completion method results in conservative accounting in so far as Mt > AVt , i.e., the fair value of the contract exceeds its book value at each point in time. To establish this claim, we note that by the conservation property of residual income Mt is equal to AVt plus the sum of future discounted residual incomes. This identity holds for all accounting rules provided income measurement is comprehensive. If revenue is recognized according to the present-value-percentage-of-completion method, we obtain the following characterization:
For instance, if the customer pays T p in cash at date 0, the rm records a liability customer advances in the same amount. This liability decreases by the corresponding amount of revenue recognized in each period, and becomes zero at the date of contract completion T . 18 See, for instance, Zhang (2000).
17

12

Mt = AVt +
i=t+1

it zi N P V ().

(8)

Thus the fair market value of the contract always exceeds the cumulative value of all recognized revenues precisely because the manager accepts only long-term contracts with positive NPV. The preceding observation is related to the question of how the Return on Assets measure (roa) evolves over time. According to (7), the present-value-percentage-of-completion method ensures that residual income in each period is proportional to the contract N P V . Therefore: ROAt Inct RIt N P V () + r = zt + r, AVt1 AVt1 AVt1 (9)

so that roa always exceeds the owners cost of capital r, provided the manager only accepted positive npv projects. The above equation holds for all interest rates, including the contracts internal rate of return. Denoting this rate by r , we obtain N P V (|r ) = 0 and thus the present-value-percentage-of-completion method has the property that the roas are constant over time and equal to the internal rate of return provided revenue recognition is based on the interest rate r .19 For capital investments, Young and OByrne (2000, Chapter 6) advocate the sinking fund depreciation method. Their argument is essentially based on equation (9): with uniform project cash ows the roas are constant under the sinking fund method and furthermore these rates of return are equal to what they term the projects economic rate of return, i.e., the internal rate of return. Since relative benet depreciation reduces to sinking fund depreciation with uniform cash ows, our goal congruence criterion seems to arrive at the same recommendation with regard to the choice of depreciation schedule.20 We note, however,
19 Conversely, it is true that if for some revenue recognition rule ROAt is equal to some constant c for all t, then c must be equal to the projects internal rate of return. This follows from the observation that, irrespective of the accounting rules, the accounting rate of return cannot be either consistently above or consistently below the internal rate of return. 20 Solomons (1965) was an early observer of the fact that the annuity (sinking fund) depreciation method achieves constant residual income numbers when a projects cash ows are uniform.

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that the constancy of the roas only obtains when the interest rate used in the calculation of the sinking fund depreciation charges is in fact the projects internal rate of return. Our analysis presumes that this rate is unknown to the party choosing the depreciation schedule. Still, if the sinking fund charges are based on the owners cost of capital, the projects npv will be reected in a time consistent manner in the roas, though they will not be constant over time.21 Earlier work has shown that residual income is some sense unique in its ability to achieve goal congruence. In particular, accounting income cannot achieve the same incentives provided the revenue recognition rule is tidy. This impossibility reects that accounting income cannot properly incorporate the time value of money. Given the residual income measure, the present-value-percentage-of-completion method is the only revenue recognition rule that achieves goal congruence. To see this, it suces to note that for the cut-o type , for whom the projects npv is zero, the contribution to residual income resulting from the contract must be zero in each period.

3.2

Long-Term Leases

A lease contract entitles a rm to use a capital asset in exchange for a stream of rental payments. Thus long-term leases are an example of a transaction involving a stream of both cash in- and outows. Once the rm enters into the lease contract, the lease payment obligations are assumed to be veriable by the accounting system. In contrast, the manager is assumed to have superior information regarding the (expected) cash benets that result from the use of the leased asset. For nancial reporting purposes, the two common methods of accounting for long-term leases are the capital and operating lease method. Under the former approach, the lease contract is considered a form of secured borrowing, and hence the related asset and debt are initially capitalized on the balance sheet. The rm is required to recognize depreciation
As mentioned in the Introduction, Beaver and Dukes (1974) and Stauer (1971) examine alternative cash ow- and depreciation patterns with the property that roa remains constant over time. In contrast to our framework, their analysis is predicated on complete and symmetric information about all project cash ows.
21

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expense on the asset and accrue interest expense on the debt in future periods. In contrast, under the operating lease method of accounting, lease payments are simply treated as a rental expense without any recognition of the asset or the debt. The terms of a lease contract determine whether it is to be treated as a capital or an operating lease for nancial reporting purposes. To examine the choice of accounting rule from a performance measurement perspective, suppose the manager has the opportunity to lease an operating asset for the next T periods. The leasing agreement is non-cancellable and requires cash payment of yt at date t for each t {1, ..., T }. The operating asset generates cash inows in the amount of xt over next T periods. If the rm enters into the lease contract, the contractually required payments {y1 , ..., yT } become commonly known. The net present value of the lease contract is given by:
T

N P V () =
t=1

t ( xt yt ).

The operating lease method essentially amounts to cash accounting so that Inct = RIt = xt yt . It is immediate that the operating lease method cannot achieve strong (and hence robust) goal congruence. In contrast, the capital lease method combined with a particular depreciation schedule is capable of generating strong goal congruence by apportioning the npv of the contract. Under the capital lease method, the rm records an asset and a long-term liability when it enters into the lease contract. Both the asset and the long-term debt are initially valued at the present value of future lease payments. Specically, the asset and liability values at date 0 are given by:
T

AV0 = LV0 =
t=1

t yt .

In each of the subsequent T periods, the rm recognizes a depreciation expense for the longterm asset and accrues an interest expense on the long-term liability. In period t, the book value of the liability increases by the amount of accrued interest, r LVt1 , and decreases by the amount of cash payment, yt . Thus, LVt = (1 + r) LVt1 yt . 15

Because of comprehensive income measurement, income is equal to cash inows less the sum of depreciation and interest expenses in each period, i.e., Inct = xt Dept r LVt1 . Since the net book value at the beginning of the period t is given by AVt1 LVt1 , residual income becomes: RIt = xt Dept r AVt1 . (10)

If the capitalized asset is depreciated according to according to the relative benet depreciation schedule, then Dept + r AVt1 = zt AV0 , and residual income becomes: RIt = xt zt AV0 = zt N P V (). Thus, the capital lease method combined with relative benet depreciation ensures that residual income reects in each period a share of the overall value added by the lease contract. Proposition 2 The capital lease method combined with the relative benet depreciation rule achieves strong goal congruence. For nancial reporting purposes, rms are required to capitalize only those leases that satisfy certain conditions. The non-cancellable long-term leases that fail to meet these conditions are treated as operating leases. For managerial performance evaluation purposes, however, our analysis advocates an accounting adjustment to this gaap rule in that all long-term leases should be capitalized in order to achieve goal congruence. While most eva advocates also favor capitalization of operating leases, some suggest that the impact of alternative lease methods on eva measurement is likely to be relatively small.22

3.3

Asset Disposals

A common rationale for the adoption of Economic Prot Plans is that managers will have incentives to dispose of under-performing assets because the performance measure includes
22

See, for instance, Young and OBryne (2000).

16

a charge for the opportunity cost of capital employed. In this subsection, we examine this claim by considering the incentive to divest of an asset which has been acquired in the past, possibly by a dierent manager. The relevant tradeo for the rm is to receive either an immediate cash inow from the sale of the asset, or to receive a stream of future cash inows generated by operating the asset in question. Under gaap, any dierence between the sales price and the assets book value is recorded as a gain (loss) in the income statement in the period in which the asset is sold. As discussed in Ehrbar (1999) and Young and OByrne (2000), however, this accounting treatment is problematic for performance evaluation purposes because it can provide management with incentives to hold on to under-performing assets.23 Instead, these authors recommend that any gain (loss) arising from the sale of an asset should be capitalized and deferred to future periods. However, the recommendations lack specic guidelines for amortizing the deferred gains or losses in subsequent periods. To model the accounting choice problem for asset disposals formally, suppose the rm owns an asset which was acquired T periods ago at a cost of b dollars. The asset generates an (innite) stream of geometrically declining cash ows: ci = i , (11)

where the decay factor is a commonly known constant, while the parameter is the managers private information.24 At date 0, the manager has the opportunity to sell the asset for p dollars in cash. We assume that p is private information and becomes public knowledge only if the sale transaction is completed. If the rm holds on to the asset, its continued operations generates cash ows in the amount of t+T for each t {1, }. Goal congruence requires that the manager sells the asset if and only if the sale price exceeds the present value of future operating cash
eva proponents have argued that, compared to income, residual income will create better incentives for reducing the amount capital tied up in a businesses. See Biddle, Bowen and Wallace (1999) and Balachandran (2005) for empirical evidence on this point. 24 As discussed below, the signicance of geometrically declining cash ows is that such a structure permits aggregation.
23

17

ows, i.e., p

i=1

i i+T 0.

For the class of geometrically declining cash ows in (11), it is natural to consider declining balance depreciation methods such that the depreciation expense in period t is given by: Dept = AVt1 , where (0, 1) denotes the decline factor.25 We note that if the decline factor is chosen as the complement of the cash ow decay factor (i.e., = 1 ), the corresponding (1 )-declining balance method is a special case of the relative benet depreciation schedule. To see this, we note that AVt = T +t b and follows that: Dept + r AVt1 = (1 + r) AVt1 = with zt
t+T i i i=1 i i=1

i =

. (1+r)

It

t T b = zt b, i i i=1

(12)

. Suppose now that the rm capitalizes the gain (loss) from the sale of

the asset (i.e., p AV0 ) and subsequently depreciates it using the (1 )-declining balance method. To verify that the manager has strong incentives to make the optimal asset disposal decision, we note that for the status quo (the asset is kept), equation (12) yields: RIt = t+T t AV0 . i i i=1 (13)

If the manager sells the asset and the resulting gain (loss) is recognized in future periods according to the (1 )-declining balance method, residual income becomes: RIts = (p AV0 ) t . i i i=1 (14)

Consequently, the incremental contribution of the assets sale to residual income in period t is given by: RIts RIt =
t (p i i+T ). i i i=1 i=1

Thus the residual income dierence is proportional to the net present value of the incremental proceeds from the sale (i.e., p
25

i i=1

i+T ) in each period.

Beaver and Dukes (1974) show that the if the decline factor is chosen to be equal to (1 ), the periodic accounting rate of return remains constant over the life of asset. As argued in Section 3.1, this implies that the accounting rate of return in each period is equal to the projects internal rate of return.

18

Proposition 3 Suppose cash ows decline geometrically over time at the rate and the existing asset is depreciated according to the (1 )-declining balance method. Strong goal congruence is achieved if the gain (loss) from the sale of the asset is capitalized and subsequently amortized according to the (1 )-declining balance method. Strong goal congruence entails two requirements in connection with asset disposals. First, the existing asset must be depreciated as planned, regardless of sale. This ensures that the book value of the existing asset is correctly viewed as irrelevant by the manager. Secondly, the sale price p is recorded as a deferred revenue liability with portions of this liability recognized according to the relative benet rule in subsequent years. This accounting policy ensures that the immediate cash inow p is eectively matched with the cash ows that would have been generated by the existing asset. Finally, the structure of geometrically declining cash ows makes it possible to satisfy both these requirements by considering the aggregate gain (loss), p AVT . Our nding in Proposition 3 is partly consistent with the recommendations made by Ehrbar (1999) and Young and OByrne (2000). As indicated above, these authors also advocate capitalization of the gains and losses from the sale of assets, p AV0 , but they do not make an explicit recommendation on how to amortize such deferred gains and losses. In our framework, a policy of not amortizing the gains or losses resulting from an asset disposal is goal congruent only if = 1, i.e., the asset is expected to generate a perpetuity of constant cash ows.

3.4

Research & Development

There is virtual agreement in the literature on performance evaluation that immediate expensing of r&d expenditures is likely to bias managers against undertaking r&d projects that pay o in the distant future. At the same time, opinions seem to dier on how to amortize the assets corresponding to past capitalized r&d expenditures. Without much economic justication, the literature on value based management and economic prot plans suggests a number of alternative amortization schedules, with ve-year straight line amortization being 19

mentioned most commonly.26 One of the distinguishing characteristics of r&d investments is that their benets are considered highly uncertain. An added dimension of unpredictability for r&d projects, beyond the usual volatility of cash ows, is that updated information may indicate that the project should be abandoned altogether. Development of a new drug is a case in point.27 We therefore view r&d projects as sequential investment problems. Ideally, the better informed manager will follow an optimal continuation policy, i.e., the rm continues with the project at date t only if new information indicates that the expected returns will cover the additional expenditures required to complete the project. To achieve goal congruence, the performance measure must then incorporate all expenditures required to complete the project. At the same time, adherence to an optimal continuation policy requires that the manager view all previous r&d expenditures as sunk. To present these issues in a formal model, we suppose that the manager has the opportunity to invest in a research and development project. In order to obtain future payos, the project requires two cash investments at dates 0 and 1, respectively. Following these two investments, the projects cash returns are given by: ct = f (, 1 ) xt for 2 t T . As before, the intertemporal weights xt are assumed to be commonly known at the outset. For instance, the xt s may increase early on as the new product is introduced and decline later due to competitive pressure. The protability parameter f (0 , 1 ) summarizes the managers entire private information about future cash ows. To include the possibility of sequential resolution of uncertainty, we assume that the manager learns the value of at date 0 (the beginning of the rst period) and 1 at date 1. The required investment amounts b0 and b1 are initially known only to the manager, though they become veriable to the
See, for instance, Simons (2000) in connection with the Vyaderm Pharmaceuticals case. Antle, Bogetoft and Stark (2002) and Friedl (2002) consider the possibility of sequential investment decisions. However, in their analysis issues of accrual accounting do not arise because the investment expenditures are assumed to be unveriable and the project returns are received at a single point in time. Friedl (2005) examines goal congruent performance measures when the manager has the option of delaying an investment decision.
27 26

20

accounting system as the respective project stages are implemented. If completion of the r&d eorts requires cash outlays of b0 and b1 , respectively, the owner would like to continue the project at the second stage if and only if:
T

V1 (, 1 )
t=2

f (, 1 ) xt t1 b1 0.

Because of this abandonment option, the r&d project should be initiated at date 0 if and only if V0 () E1 [ max{0, V1 (, 1 )}|] b0 0. The conditional expectation in the denition of the value function V0 () reects that the future realization of 1 may be correlated with the current . The performance measure is said to achieve robust sequential goal congruence if the manager has robust incentives to proceed with the project at date t, 0 t 1, whenever Vt () 0. From the discussion in the previous sections it is clear that goal congruence at the second stage will be attained only if the investment b1 is depreciated according to the relative benet rule. At the same time, the manager must view b0 as a sunk cost when making the date 1 investment decision. This implies that the second investment decision cannot have an impact on depreciation charges related to the earlier investment b0 . Goal congruence at the rst stage requires that the investment expenditure b0 be matched with the cash returns at dates 2 through T . To accomplish that, the compounded value of b0 (i.e., (1 + r) b0 ) must be depreciated according to the relative benet rule even if the manager decides to abandon the project at date 1. If both stages are completed, then the capitalized value of all r&d investments at date 1 is equal to b0 (1 + r) + b1 . Proposition 4 With multiple investment decisions, robust sequential goal congruence is achieved by a policy of amortizing the compounded value of all past investment expenditures according to the relative benet rule. The proof in the Appendix shows that, irrespective of his intertemporal preferences, the manager has an incentive to proceed with the project at both stages if and only if 21

V0 () 0 and V1 (, 1 ) 0.28 Clearly, the accounting treatment described here carries over to an arbitrary number of investment stages. If each stage requires funding in order for the project to yield any cash returns, the optimal project continuation policy is to keep investing at date t if and only if Vt (, 1 , ..., t ) 0. To achieve sequential goal congruence, it is essential that if the manager abandons the project at an intermediate date, all past expenditures will be amortized in exactly the same way that would have resulted if the project had been completed. In that sense, our analysis advocates full cost accounting (rather than successful eorts accounting) for r&d and other exploration activities. Unlike full cost accounting which considers failed eorts as necessary to achieve success and requires capitalization of all costs on the balance sheet, successful eorts accounting permits capitalization of only those investments that are brought to fruition.29 In our setting, successful eort accounting would dictate that the compounded initial investment b0 (1 + r) be written o immediately if the rm decides to abandon the r&d project at date 1. The problem with such treatment is that the manager would not view past investments as a sunk cost.30 Proposition 4 advocates that capitalized investment expenditures be treated as interestbearing and non-amortizing assets until such time as the project yields cash returns. While this recommendation is in conict with gaap, the rationale from an incentive perspective is clear. In order to avoid any intertemporal tradeos, the performance measure must be unaffected by the investment decision for those periods that represent the lag between investments and cash returns. Along similar lines, Ehrbar (1998) advocates that certain investments be treated as strategic, i.e., they are capitalized and accrue interest until amortization charges
We note, however, that it is impossible to obtain strong goal congruence in this setting because of the variability inherent in the second stage random variable 1 . A risk-averse manager can avoid the attendant risk exposure by not entering into the project at the rst stage. 29 Our nding here is in contrast to gaap which generally relies on successful eorts accounting. Oil and gas exploration costs are one exception since companies are permitted to use either the successful eort or the full cost method to account for their oil and gas exploration costs. Although the term successful eorts is often associated with the oil and gas industry, it can be applied more broadly. For instance, Young and OByrne (2000) argue that impairment losses recognized under SFAS 121 are an application of successful eort accounting. 30 Stewart (1991) also advocates full cost accounting for the purpose of performance measurement, though his reasoning diers from our argument that past expenditures must be viewed as sunk costs.
28

22

can be matched with cash inows. From an accounting measurement perspective, one may question the consistency of a policy of accruing interest on past capitalized investment expenditures only until such time as the project begins to yield cash returns. Specically, Proposition 4 prescribes dierent interest accrual policy depending on whether an asset is in the construction or the production phase. An alternative and equivalent approach is to treat real assets as interest bearing throughout their existence. However, this requires relaxation of the tidiness condition that the sum of the depreciation charges be equal to the beginning book value. When a real asset is treated as interest accruing, the appropriate boundary condition is that the assets book value must be zero at the end of its useful life. When the capitalized investment expenditures accrue interest at rate r, the asset value at date t becomes (1 + r) AVt1 Dept . Recursive substitution yields:
T T

AVT = AV1
t=2

Dept +
t=2

r AVt1 .

We note that the assets book value at date 1, AV1 is equal to b0 (1 + r) + b1 if the project is continued at the second stage, and b0 (1 + r) if the project is abandoned at date 2. The boundary condition AVT = 0 becomes:
T T

Dept = AV1 +
t=2 t=2

r AVt1 .

If the depreciation charges are chosen as Dept = AV1 zt , where again allocation zt component of residual income is exactly oset by the accrued interest, residual income is simply equal to cash inow minus the depreciation charge in each period and the resulting stream of residual income numbers is identical to the one obtained from the accounting rules given in Proposition 4.32 Thus a policy of accruing interest on real assets throughout their useful lives is compatible with managerial goal congruence provided depreciation schedules
Recall that the relative benet cost allocation charge zt is the sum of the relative benet depreciation charge and the interest charge r AVt1 . Since the relative benet depreciation charges are tidy (i.e., T T T t=2 Dept = AV1 ), it follows that t=2 zt AV1 = AV1 + t=2 r AVt1 . 32 A similar tension between the tidiness requirement and the accruing of interest emerges in the context
31
T i=2

xt , i1 xi

the boundary condition AVT = 0 will indeed be met.31 Since the capital charge

23

only have to meet the boundary condition AVT = 0 rather than the stronger condition that
T t=2

Dept = AV1 . It is worth noting that under this alternative interpretation of de-

preciation, straight-line depreciation, rather than the annuity method, emerges as the goal congruent solution with uniformly distributed project cash ows, i.e., when xt = x for each t.33

Essentiality of Accrual Accounting

A common characteristic of the accrual accounting rules identied in Propositions 1-4 is that value creating decisions increase the managers performance measure in every period of the projects useful life. Specically, we found that the residual income performance measure in each period is proportional to the net present value of the transaction: RIt = zt N P V (), with zt > 0 and
T t=1

t zt = 1. To apportion the value of the transaction in such a manner,

the accrual accounting rules must incorporate information about the intertemporal pattern of future cash ows, i.e., the distributional weights (x1 , ..., xT ). Since the availability of such forward looking information may be more plausible in some contexts than others, it is natural to explore alternative approaches for obtaining goal congruence. Neither strong nor robust goal congruence requires that the value of a transaction be apportioned across all periods, i.e., it is not necessary to have zt > 0 for all t. To avoid intertemporal tradeos from the managers perspective, it may be possible to frontload the performance measure by recognizing the entire present value of a transaction in the initial period. This would correspond to z1 = 1 and z2 = . . . zT = 0. For the settings examined in Section 3 above, such upfront recognition was informationally infeasible simply because
of multiyear construction contracts as examined in Section 3.1. The present-value-percentage-of-completion method in (4) is a tidy revenue allocation scheme, but it can achieve robust goal congruence only if the resulting receivables are treated as non-interest bearing assets. On the other hand, if receivables accrue T interest, the tidines requirement t=1 Revt = p will have to be relaxed. 33 The observation that annuity depreciation can alternatively be implemented by accruing interest on assets and applying straight line depreciation dates back to Dicksee (1903) and Hatteld (1908). We thank an anonymous reviewer for directing us to these references.

24

the accounting system was assumed to have only partial information about the proposed transactions, which was insucient to determine their present values.34 In certain contexts, it is plausible that the accounting system is in a position to recognize the full value of a transaction upfront. Long-term credit sales are a case in point. To illustrate, suppose the manager must choose the current periods production quantity q and a policy of credit and cash sales based on his (multidimensional) private information . The information embedded in pertains to the unit production cost c() and the rms sales opportunity set Y (q, ). A vector y (y1 , ..., yT ) is in the sales opportunity set if the manager can sign a contract that requires the customer to pay yt in period t for 1 t T . Given unit production costs, c() and the sales opportunity set Y (q, ), the owner would like the manager to choose production and credit sales so as to maximize:
T

N P V ()
t=1

t1 yt c() q.

subject to y Y (q, ). If the sales contract (y1 , ..., yT ) is observable and veriable at the initial date, the value of the transaction can be fully reected in the managers performance measure in the initial period. To do so, the rm records receivables at their fair values, i.e, the present values of contractually specied future cash ows. As a consequence, residual income is equal to npv() in the rst period and zero in all subsequent periods. Thus, the manager has incentives to adopt an optimal credit sales policy regardless of his planning horizon or discount rate.35 For some transactions there is no need to apportion the present value of the transaction across time periods because an initial cash outow must be matched with only a single subsequent cash inow. Production to inventory is provides an example of such a transaction. Specically, suppose a rm manufactures some product in the current period and then sells
Earlier accounting literature has abstracted from information asymmetries and advocated accrual accounting rules that eectively result in frontloading. For instance, Bierman (1961) suggests that depreciation be calculated so that the initial contribution to residual income is equal to the projects npv, while the changes to residual income are zero in all subsequent periods. 35 Dutta and Reichelstein (1999) prove that the fair value accounting for receivables is part of a second-best contracting solution in a dynamic agency setting. They show, however, that it may be necessary to deviate from fair value accounting when credit sales entail default risk.
34

25

this inventory over the next T periods. Prior to the initial production decision in period 1, the manager observes the realization of a state variable that determines current costs and future revenues. In particular, the rms incremental manufacturing cost is c() per unit of output and sales revenues in period t are Rt (st |). The present value maximizing decisions are an initial production quantity and subsequent sales quantities s () so as to maximize: t
T t=1

t1 Rt (st | ) c() st .

To achieve strong goal congruence in such a setting, it is not necessary for the accounting system to have any knowledge about the pattern of future sales. To match the cost of a unit of production with the revenue obtained in some future period, unknown to the accounting system, it suces to record inventory at its historical cost. Consistent with our observations in Section 3, however, inventory must be treated as an interest bearing asset. At the time a unit of inventory is sold, the corresponding expense in the income statement is its compounded historical cost. As a consequence, a unit of nished goods in inventory has no impact on residual income until such time as the unit is sold and in that period the contribution to residual income is proportional to the rms objective.36 A nal approach to strong or robust goal congruence would be to backload the managerial performance measure. In our earlier notation, this would correspond to a setting where z1 , . . . , zT 1 = 0 and zT = (1 + r)T . Like in the preceding inventory illustration, deferred value recognition does not require the accounting system to have any forward looking information about future cash ows. Keeping track only of realized cash ows, the managers performance measure would remain unaected in periods 1 through T 1, and be equal to the compounded value of the entire stream of realized cash ows in period T . A crucial requirement of backloading managerial performance measures is the choice of a terminal or settling up date. Identication of such a date appears virtually impossible
See Dutta and Zhang (2001) and Baldenius and Reichelstein (2005) for more general models of revenue recognition and inventory valuation. in particular, these papers consider the possibility that, following the initial production decision, managers may learn new information about attainable future sales revenues, e.g., inventory may become obsolete. The arrival of such new information provides a rationale for the use of the lower-of-cost-or-market rule instead of historical cost.
36

26

for a going concern with overlapping transactions and managers. Backloading may appear feasible for individual transactions, yet such an approach would amount to disaggregated performance measurement requiring that the cash ows from individual transactions and projects be identied separately. In contrast, implementation of the accrual accounting rules in Section 3 only requires verication of the aggregate cash ows which result from all ongoing projects.
37

To conclude this section, we ask whether the accounting rules identied in our goal congruence framework also emerge in models of second-best contracting in which managerial decisions are treated as endogenous.38 To introduce an explicit conict of interest into our framework, suppose that periodic cash ows depend on the managers choice of transactions and his unobservable eort choices. In the simplest variant, ct = at +mt (), where at denotes the managers eort and mt () denotes the baseline level of cash ow from the undertaken transaction. Since the parameter is unknown to the principal, higher cash ows can either be attributed to greater levels of eort at or a more favorable state . For the settings considered in Sections 3.1-3.3, the results in Dutta and Reichelstein (2002) can be adapted to show that it is optimal for the owner to oer a menu of contracts each one of which is linear in the residual income delivered in that period. Given the accrual accounting rules identied in Propositions 1-3 strong goal congruence implies that the managers incentives for undertaking a transaction are invariant to the periodic bonus coecients attached to the residual income numbers. As a consequence, these coecients can be chosen independently to solve the periodic moral hazard problems. To be compatible with an optimal contracting solution, however, the goal congruent solution must be modied futher. The better informed agent will earn informational rents on account of his private
Reichelstein (2000) develops a model in which the manager discounts future payos at a rate higher than the principal (owner). Absent accrual accounting, the principal can backload the managers performance measure by computing the compounded value of past cash ows. Due to the managers higher discount rate, such an approach is shown to result in higher agency costs than an accounting system which periodically matches revenues and expenses. 38 Parts of the recent agency literature have rationalized the use of residual income from a contracting perspective; see, for instance, Dutta and Reichelstein (1999, 2002), Dutta and Zhang (2001), Christensen, Feltham and Wu (2002), Dutta (2003) and Wagenhofer (2003), Mishra and Vaysman (2004). Lambert (2001) provides a survey of research on accounting based performance measures and contracting.
37

27

information and therefore the owner nds it optimal to reject transactions with low, yet positive, npv. To implement the corresponding second-best decisions in a decentralized fashion, the principal may base the residual income calculation on a hurdle rate which exceeds the true cost of capital, r.39 For the sequential investment models considered in Section 3.4, the optimality of the goal congruent performance measure identied in Proposition 4 requires further analysis. The preceding arguments apply without substantial change if the principal can extract upfront any informational rents the agent will earn on account of his private information, 1 , to be received at the second investment stage.40 However, if the extraction of rents is constrained, possibly because of limited liability constraints, the optimality of the performance measures in Proposition 4 remains an open question.

Concluding Remarks

For a range of common nancing, production and investment decisions, we have argued that accrual accounting is essential for obtaining performance measures that focus management on decisions that maximize present values. Our ndings are broadly consistent with the matching principle of accrual accounting. In contrast to gaap, though, we emphasize that the accrual accounting rules should be compatible with present value considerations. If the performance measure is to reect value creation in a time consistent fashion, real assets may have to accrue interest, just as nancial assets do under gaap. In order for managers to view past expenditures as sunk costs, we argue that the accounting rules for sequential investment projects should reect full cost rather than successful eorts. The ndings of this paper leave us in partial agreement with the recommendations made in the literature on epps. Our goal congruence framework suggests that making accounting adjustments so as to reect contemporaneous cash ows should not be a guiding principle.
Christensen, Feltham and Wu (2002) and Dutta and Reichelstein (2002) analyze the optimal hurdle rate when managers are risk averse and projects entail incremental risk. Their results show that the standard prescriptions in the value based management literature about calculating a risk adjusted cost of capital are generally not consistent with optimal incentive contracting. 40 See Pfeier and Schneider (2004) for a model with these features.
39

28

We see only limited use from invoking ad-hoc criteria like choosing depreciation and amortization charges so as to make return on assets constant over time. While we agree that from an incentive and control perspective gaap rules are too conservative in some contexts (e.g, the immediate expensing of r&d expenditures), incentive considerations will generally lead to conservatism in the sense that goal congruent accounting rules result in asset values below fair market values. The literature on value based management and economic prot plans has identied a range of transactions beyond the ones examined in this paper as candidates for accounting adjustments. These include the treatment of deferred taxes, goodwill, warranties and provisions for bad debt. Applying the framework of this paper to these transactions in future research may contribute to a more unied theory of accrual accounting for performance measurement. A recurring diculty in implementing epps at the divisional level is that some assets are shared by multiple divisions. Some rms treat these assets as centrally owned and impose periodic cost charges on the users. Alternatively, the asset may be divided upfront among the users for accounting purposes. Under either alternative, the goal congruence problem becomes signicantly more complex because of strategic interactions among the divisions at the initial acquisition stage. It would be desirable to adapt existing mechanism design models on the provision of public goods so as to arrive at a richer theory of cost allocations both across time periods and across organizational units. Recent accounting literature on multi period agency models has drawn attention to the importance of commitment on the part of the principal.41 For the most part, this emerging literature has compared the extremes of full commitment to long-term contracts against no commitment beyond short-term, i.e., one period, contracts. In many managerial compensation contexts it is conceivable that a principal can make partial commitments pertaining to particular performance measures, accounting rules and certain constraints on compensation. It remains to be explored how valuable such partial commitments are from an incentive and
Some of the recent papers include Indjejikian and Nanda (1999), Christensen, Feltham and Sabac (2003) and Dutta and Reichelstein (2003).
41

29

control perspective.

30

Appendix
Proof of Proposition 5: If the manager invests at both stages, the contribution to residual income in period t is given by RI1 = 0 and

RIt = xt f (, 1 ) zt [b1 + (1 + r) b0 ] for 2 t T . Here zt


T i=2

(15)

xt . xi i1

The expression for residual income in (15) reects

that the compounded value of all past expenditures is depreciated according to the relative benet rule. If the manager abandons the project at date 1, the contributions to residual income are: RI1 = 0 and

RIt = zt (1 + r) b0 . Thus there is an incentive to continue the project at date 1 if and only if:
T

(16)

xt f (, 1 ) zt b1 = zt [
i=2

f (, 1 ) xi i1 b1 ]

= zt V1 (, 1 ) 0, which shows robust goal congruence at date 1. Anticipating that the project will be continued at date 1 if and only if V1 (, 1 ) 0 the managers date 0 expectation of residual income in period t is:

E1 [RIt (, 1 )|] = E1 [max{0, zt V1 (, 1 )} zt 1 b0 |] = zt 1 E1 [ max{0, V1 (, 1 } b0 |] = zt 1 V0 ().

(17) (18) (19)

We conclude that the manager has strong incentives to invest at the rst stage if and only if V0 () 0. 31

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