Skip to main content
Log in

Controlling Investment Decisions: Depreciation- and Capital Charges

  • Published:
Review of Accounting Studies Aims and scope Submit manuscript

Abstract

This paper examines a multiperiod principal-agent model in which a divisional manager has superior information regarding the profitability of an investment project available to his division. The manager also contributes to the periodic operating cash flows of his division through personally costly effort. We demonstrate that it is optimal for the principal to delegate the investment decision and to base the manager's compensation on the residual income performance measure. Our analysis points to a class of depreciation rules and to a particular capital charge rate which together ensure that a profitable (unprofitable) project makes a positive (negative) contribution to residual income in every period. As a consequence, the compensation parameters for each period can be chosen freely so as to address the moral hazard problems without impacting the manager's investment incentives.

This is a preview of subscription content, log in via an institution to check access.

Access this article

Subscribe and save

Springer+ Basic
EUR 32.99 /Month
  • Get 10 units per month
  • Download Article/Chapter or Ebook
  • 1 Unit = 1 Article or 1 Chapter
  • Cancel anytime
Subscribe now

Buy Now

Price excludes VAT (USA)
Tax calculation will be finalised during checkout.

Instant access to the full article PDF.

Similar content being viewed by others

References

  • Antle, R. and G. Eppen. (1985). “Capital Rationing and Organizational Slack in Capital Budgeting.” Management Science, 163-174.

  • Arya, A., T. Baldenius and J. Glover. (1999). “Residual Income, Depreciation, and Empire Building.” Mimeo, Ohio State University.

  • Balachandran, S. (2000). “A Fundamental Analysis of Firms that Adopt Residual Income based Compensation Plans.” Mimeo, Columbia University.

  • Baldenius, T. (2002). “Delegated Investment Decisions and Private Benefits of Control.” Mimeo, Columbia University.

  • Baldenius, T. and S. Reichelstein. (2001). “Incentives for Efficient Inventory Management: The Role of Historical Cost.” Mimeo, Columbia University.

  • Baiman, S. and M. Rajan. (1995). “Centralization, Delegation and Shared Responsibility in the Assignment of Capital Investment Decision Rights.” Journal of Accounting Research 33, 135-164.

    Google Scholar 

  • Baron, D. and R. Myerson. (1982). “Regulating a Monopolist with Unknown Cost.” Econometrica 50, 911-930.

    Google Scholar 

  • Bernardo, A., H. Cai and J. Luo. (2000). “Capital Budgeting and Compensation with Asymmetric Information and Moral Hazard.” Journal of Financial Economics 61, 911-930.

    Google Scholar 

  • Bhareket, M. T. (2001). “Investment Decisions Under Capital Constraints: The Role of Revenue recognition in Performance Measurement.” Mimeo, Duke University.

  • Bromwich, M. and M. Walker. “Residual Income Past and Future.” Management Accounting Research 9, 391-419.

  • Christensen, P., G. Feltham and M. Wu. (2002). “Cost of Capital in Residual Income Measurement under Moral Hazard.” The Accounting Review 77:1, 1-23.

    Google Scholar 

  • Datar, S., S. Kulp and R. Lambert. (2000). “Balancing Performance Measures.” Forthcoming, Journal of Accounting Research.

  • Dearden, R. (1969). “The Case Against ROI Control.” Harvard Business Review May-June, 124-134.

  • Demski, J. and R. Dye. (1999). “Risk, Return, and Moral Hazard.” Journal of Accounting Research 37:1, 27-55.

    Google Scholar 

  • Dutta, S. (2002). “Capital Budgeting and Managerial Compensation: Incentive and Retention Effects.” Mimeo, University of California, Berkeley.

    Google Scholar 

  • Dutta, S. and S. Reichelstein. (1999). “Asset Valuation and Performance Measurement in a Dynamic Agency Setting.” Review of Accounting Studies 4, 235-258.

    Google Scholar 

  • Dutta, S. and X. Zhang. (2001). “Revenue Recognition in a Multiperiod Agency Setting.” Journal of Accounting Research 40.

  • Ehrbahr, A. and B. Stewart. (1999). “The EVA Revolution.” Journal of Applied Corporate Finance 12:2, 18-31.

    Google Scholar 

  • Feltham, G. and D. Xie. (1994). “Performance Measure Congruity and Diversity in Multitask Principal-Agent Relations.” The Accounting Review 69, 429-454.

    Google Scholar 

  • Fudenberg, D., B. Holmstrom and P. Milgrom. (1990). “Short-Term Contracts and Long-Term Agency Relationships.” Journal of Economic Theory 51, 1-31.

    Google Scholar 

  • Harris, M., H. Kriebel and A. Raviv. (1982). “Asymmetric Information, Incentives, and Intrafirm Resource Allocation.” Management Science 28:6, 604-620.

    Google Scholar 

  • Harris, M. and A. Raviv. (1996). “The Capital Budgeting Process: Incentives and Information.” Journal of Finance LI:4, 1139-1173.

    Google Scholar 

  • Harris, M. and A. Raviv. (1998). “Capital Budgeting and Delegation.” Journal ofFinancial Economics 50, 259-289.

    Google Scholar 

  • Holmstrom, B. and P. Milgrom. (1991). “Multitask Principal-Agent Analysis: Incentive Contracts, Asset Ownership, and Job Design.” Journal of Law, Economics, and Organization 7, 24-52.

    Google Scholar 

  • Ittner, C. and D. Larcker. (1998). “Innovations in Performance Measurement: Trends and Research Implications.” Journal of Management Accounting Research 6, 205-238.

    Google Scholar 

  • Kaplan, R. and A. Atkinson. (1989). Advanced Management Accounting. Prentice-Hall Press.

  • Laffont, J. J. and J. Tirole. (1993). A Theory of Incentives in Procurement and Regulations. MIT Press.

  • Lambert, R. (2001). “Contracting Theory and Accounting.” Journal of Accounting and Economics 32, 3-87.

    Google Scholar 

  • Melumad, N. and S. Reichelstein. (1987). “Centralization versus Delegation and the Value of Communication.” Journal of Accounting Research 23, 1-18.

    Google Scholar 

  • Mirrlees, J. (1986). “Optimal Taxation.” In K. J. Arrow, M. Intrilligator (eds.), Handbook of Mathematical Economics. North Holland.

  • Mishra, B. and I. Vaysman. (2000). “Delegating Investment Decisions.” Mimeo, University of Texas, Austin.

  • Myerson, R. (1981). “Optimal Auction Design.” Mathematics of Operations Research 6, 58-73.

    Google Scholar 

  • Poterba, J. and L. Summers. (1992). “Time Horizons of American Firms: New Evidence from a Survey of CEOs.” Mimeo, Harvard Business School.

  • Reichelstein, S. (1997). “Investment Decisions and Managerial Performance Evaluation.” Review of Accounting Studies 2, 157-180.

    Google Scholar 

  • Reichelstein, S. (2000). “Providing Managerial Incentives: Cash Flows versus Accrual Accounting.” Journal of Accounting Research 38:2, 243-269.

    Google Scholar 

  • Rogerson, W. (1997). “Inter-Temporal Cost Allocation and Managerial Investment Incentives: A Theory Explaining the Use of Economic Value Added as a Performance Measure.” Journal of Political Economy 105, 770-795.

    Google Scholar 

  • Solomons, D. (1965). Divisional Performance Measurement and Control. Homewood, Illinois: Irwin.

    Google Scholar 

  • Stewart, B. (1991). The Quest for Value. New York: Harper Collins Publishers.

    Google Scholar 

  • Stewart, B. (1994). “EVA: Facts and Fantasy.” Journal of Applied Corporate Finance Summer.

  • Wagenhofer, A. (2001). “Accrual-Based Compensation, Depreciation and Investment Incentives.” Mimeo, University of Graz, Austria.

    Google Scholar 

  • Wei, D. (2000). “Interdepartmental Cost Allocation and Investment Incentives.” Mimeo, INSEAD, Fontainebleau, France.

    Google Scholar 

  • Young, D. and S. O'Byrne. (2000). EVA and Value-Based Management: A Practical Guide. New York: McGraw-Hill Press.

    Google Scholar 

  • Young, D. (1998). “Groupe Schneider: Economic Value Added and the Measurement of Financial Performance.” Mimeo, INSEAD, Fontainebleau, France.

    Google Scholar 

Download references

Authors

Rights and permissions

Reprints and permissions

About this article

Cite this article

Dutta, S., Reichelstein, S. Controlling Investment Decisions: Depreciation- and Capital Charges. Review of Accounting Studies 7, 253–281 (2002). https://doi.org/10.1023/A:1020238405769

Download citation

  • Issue Date:

  • DOI: https://doi.org/10.1023/A:1020238405769

Navigation