accrual accounting for performance evaluation

7/30/2019 Accrual Accounting for Performance Evaluation

1/38

Research Paper No. 1886

Accrual Accounting for Performance Evaluation

Sunil Dutta

Stefan Reichelstein

February 2005

R E S E A R C H P A P E R S E R I E S


2/38


Sunil Dutta

Haas School of Business

University of California, Berkeley

and

Stefan Reichelstein1

Graduate School of Business

Stanford University

February 2005

1For helpful comments and suggestions, we thank an anonymous reviewer, Stan Baiman, Bill Beaver, Ian

Gow, Jack Hughes, Steve Penman (the editor), Dieter Pfaff, Richard Saouma and seminar participants atCarnegie Mellon University, UCLA, the University of Vienna and the Utah Winter Accounting Conference.


3/38


Abstract

This paper examines alternative accrual accounting rules from an incentive and control per-

spective. For a range of common production, financing 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 specific form of matching needed for control

purposes generally differs from gaap. The practitioner oriented literature on economic profit

plans has made various, and at times conflicting, recommendations regarding adjustments

to the accounting rules used for external financial reporting. Our goal congruence approach

provides a framework for comparing and evaluating these recommendations.


4/38

1 Introduction

There is a long tradition in the accounting literature to view the rules of accrual accounting

as design variables. Different 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 firms book value is equal

to its fair market value at each point in time. Beaver and Dukes (1974) and Stauffer (1971)

examine how accruals can be chosen for an expected pattern of cash flows so that the

resulting accounting rate of return remains constant over time. More recently, Ohlson and

Zhang (1998) identify certain accounting rules as efficient if the resulting income and book

value measures are sufficient for determining a firms 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 Profit Plans (EPP), many of whichare variants of the familiar residual income concept.1 The proponents ofepps 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 dis-

1Economic Value Added is probably the best known among these economic profit plans. The eva measurehas been popularized (and trademarked) by Stern, Stewart & Co. Closely related concepts are being advo-cated under the labels Value Added (KPMG), Economic Profit (McKinsey), Cashflow Return on Investment(Holt& Associates), and Cash Value Added (Boston Consulting Group). Ittner and Larcker (1998), Youngand OByrne (2000) and Balachandran (2005) provide survey evidence on the adoption of these measures.

2Stern, Stewart & Co. mention the possibility of as many as 164 accounting adjustments. See Ehrbarand Stewart (1999). Young (1998) and Simons (2000) illustrate the implementation of select adjustmentsfor individual companies.

1


5/38

count rate or the particular compensation rules. As a consequence, proper accounting rules

must reflect value creation in a temporally consistent fashion; that is, managers do not face

intertemporal tradeoffs 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 reflects that most of the recently proposed and adopted epps are variants of

the residual income measure, but also the findings 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 aboutthe financial 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, financing and investment decisions, we argue that private information held by

management makes intertemporal matching of revenues and expenses essential.6 Yet, the

specific form of matching needed for goal congruence differs from gaap in many instances.

In connection with long-term construction projects, for example, we argue that the rev-

enue recognition for a project should reflect 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 modified so as to properly reflect the time

value of money. Specifically, 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

3The goal congruence requirement can be traced back to Solomons (1965) who argues we are entitledto judge them [the accounting rules] as if a different manager were in charge in each year in series. Thequestion we have a right to ask is: How well does each years profit reflect the success of that years manager?

The criterion here seems to be that ideally the accounting rules should render managers planning horizonirrelevant.4See, for instance, Rogerson (1997) and Reichelstein (1997).5This asymmetric information perspective stands in contrast to earlier accounting literature which pre-

sumes symmetric and complete information about project payoffs.6Most 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), Pfeiffer (2002), Baldenius and Ziv (2003), Wei (2004), Bharket (2004), Mohnen(2004) and Bastian (2004). Our paper extends and unifies the existing literature by delineating generalfeatures of goal congruent performance measures for a range of transactions.

2


6/38

accounting system be in a position to estimate the relative percentages of costs in different

construction periods.

A common criticism ofgaap is its conservatism. While our analysis confirms that finan-

cial 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. Specifically, we find that fair market

values will generally exceed book values. This relation emerges because, by the conservation

property of residual income, the difference between the fair market value and the book value

is just the present value of future residual incomes.

7

Furthermore, goal congruent account-ing 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 costrather than successful efforts accounting. Full cost

accounting offers the possibility of intertemporal matching while treating past expenditures

as sunk. Our findings in those contexts generally differ both from gaap and the recommen-

dations expressed in the practitioner oriented literature on Economic Profit Plans.

Financial assets and liabilities commonly accrue interest under gaap. From a perfor-

mance 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 toarrive. In order to avoid intertemporal tradeoffs for the manager, upfront cash expenditures

should not affect the managerial performance measure until such time as the corresponding

cash returns are realized. With residual income, such interim neutrality is achieved provided

7The conservation property of residual income, as observed by Preinreich (1937) and others, asserts theidentity of discounted cash flows and discounted residual incomes. This identity has been central to theliterature on equity valuation, see, for example, Feltham and Ohlson (1996).

3


7/38

the upfront expenditures are capitalized and subsequent accrued interest is offset 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 transac-

tion across the useful life of the transaction. For certain transactions, such as credit sales, it

is plausible that the accounting system has sufficient information to recognize all value cre-

ation 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 flows. We argue, however, that such backloading will be generally infea-sible for a going concern and conflict with the need for performance measures to effectively

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 alterna-

tive notions of goal congruence. Sections 3 examines alternative accounting rules for select

transactions including multi-year construction contracts, leases, asset disposals andr&d

projects. Because of the linearity the residual income performance measure we may con-

sider 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.

8See, for instance, Ehrbar (1998).

4


8/38

2 Goal Congruence

We consider a setting in which a business owner delegates decision-making to a better in-

formed manager. The owners objective is the long-run value of the business as measured

by the stream of expected cash flows, discounted at his cost of capital r. The corresponding

discount factor is denoted by = 11+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

flows 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 ex-

amine, 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 resid-

ual 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 confine 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

affect book value flow through the income statement. For simplicity, the owner is assumedto be the direct recipient of the firms net cash flows ct in each period. The requirement of

comprehensive income measurement then reduces to:

Inct = ct + BVt BVt1.

9See, for instance, Proposition 3 in Reichelstein (1997).

5


9/38

It is well known that, in contrast to accounting income, residual income is fundamentally

compatible with present value maximization. Specifically, the present value of cash flows

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 flows provided she

receives a constant share of each periods residual income and she discounts future payoffs

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 (possiblybecause 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 tradeoffs, 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(RI1, . . . ,RIT)|] (1)for any function U() that is weakly increasing in each of its T arguments.10. The notationRIt reflects that at date 0 the actual residual income in period t is uncertain and that theprobability distribution of these variables depends on . The utility function U() is a

reduced form representation of both the managers preferences and the underlying compen-

sation 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 incentivesfor the manager to make a particular decision at date 0 if this decision

10For the most part we suppose that there is a known and finite horizon, though in some contexts it willbe algebraically convenient to allow for T =

6


10/38

maximizes:

E[

Ti=1

ki RIt|]for arbitrary, non-negative constants kt. These weights reflect both the managers discount

factor and the bonus coefficients attached to the periodic residual income figures. Clearly,

strong goal congruence implies robust goal congruence as the latter concept essentially as-

sumes risk neutrality on the managers part. To achieve robust goal congruence, the ac-

counting 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 specifics of the managerial contracting problem become known. This

perspective seems particularly compelling for larger multidivisional firms 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 tradeoffs,

that is value maximizing decisions may not lower the performance measure in any individual

period.

3 Accrual Accounting for Select Transactions

3.1 Multi-Year Construction Contracts

We examine multi-year construction contracts as an example of a transaction involving

a sequence of cash outflows followed by one terminal cash inflow. Such transactions seem

particularly important for firms that deliver big ticket items to their customers.11 Revenue

from the contract is assumed to become verifiable 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.

11Davis (1996) reports that Boeing abandoned Economic Value Added as a performance measure dueto long delays in construction and lumpy order flows. In contrast, our message is that residual incomecoupled with suitable accrual accounting rules can be an effective measure in the face of long constructionlead times.

7


11/38

For financial reporting purposes, revenues from long-term contracts are generally recog-

nized 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 pe-

riods 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 someeva

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 specified in the contract, the firm 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() = T p Ti=1

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

xtTi=1 xi . (3)

12According 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 assetsunder construction not be included in the capital base. Hofmann (2003) develops an agency model thatcompares the efficiency properties of cash and accrual accounting for long-term projects.

13Below we also consider the possibility of progress payments.

8


12/38

Since costs are expensed as incurred, the contribution to income in period t will be:

Inct = p xtti=1 xi

xt =xtTi=1 xi

p

Ti=1

xi

.

It is immediately seen that accounting income based on the percentage-of-completion

method does not achieve goal congruence. Since

p Ti=1

xi > p Ti=1

xi (Ti),

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 reflect 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 modified revenue recognition rule, which we refer to as the present-value- percentage-

of-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

xt

Ti=1

i xi+ r AVt1, (4)

where AVt denotes the book value of receivables at date t. As revenues are recognized, thefirm records a corresponding amount of receivables:

AVt = AVt1 + Revt (5)

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

9


13/38

for 1 t T with AV0 = 0. The revenue recognition rule in (4) differs 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 define the present value shares:

zt xtTi=1

i xi. (6)

Recursive substitution yields:

Tt=1

Revt = T p [zT + (1 + r) zT1 + + (1 + r)

T1 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., Tt=1 Revt = p. Furthermore, the value of receivables at thecontract completion date is equal to the cash payment to be received from the customer

at that date because AVT =T

t=1 Revt = p. For the revenue recognition rule in (4), the

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

Ti=1

i xi

= zt N P V(). (7)

10


14/38

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 incen-

tives 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 relativebenefit depreciation rule considered in connection with capital investment decisions.15 Under

the relative benefit depreciation rule for capital investments, the depreciation expense is

matched with the relative benefits 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 benefits. In

contrast the sales price of a multi-year contract is commonly known and verifiable, but the

manager is privately informed about future costs.16

15The relative benefit depreciation rule, as proposed by Rogerson (1997), extends the concept of annuitydepreciation to non-uniform cash flows. Specifically, suppose a manager has available an investment oppor-tunity which entails an initial cash outlay of b and generates cash inflows in the amount of xt for eacht {1,...,T}.The relative benefit depreciation charges {Dept}Tt=1 are the unique solution to the equations:(Dept + r AVt1) = b zt. The left-hand-side of the above equations represent the sum of depreciation andcapital charges for the residual income performance measure. As a consequence:

RIt = xt zt b = zt NPV().

16Proposition 2 extends to settings in which the project costs are uncertain (even from the perspective ofthe better informed manager). To see this, consider a situation in which the date t project requires cashoutlay of ct = c xt + t in period t. The zero-mean random variable t represents the uncertainty ofthe projects cost in period t. The present value percentage of completion method of revenue recognitiongenerates robust managerial incentives to accept (reject) all the projects with positive (negative) expectedNPV. However strong incentives cannot be achieved in this setting since the managers choice impacts thevariability of future cash flows.

11


15/38

Our finding 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 Profit Plans frequently claim that generally accepted financial

accounting rules, i.e., gaap, are too conservative for the purposes of performance mea-

surement. 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 flows, i.e.,

Mt = p Tt

Ti=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:

17For instance, if the customer pays T p in cash at date 0, the firm records a liability customer advancesin the same amount. This liability decreases by the corresponding amount of revenue recognized in eachperiod, and becomes zero at the date of contract completion T.

18See, for instance, Zhang (2000).

12


16/38

Mt = AVt +T

i=t+1

it zi N P V(). (8)

Thus the fair market value of the contract always exceeds the cumulative value of all recog-

nized 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 mea-

sure (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

AVt1

RIt

AVt1+ r = zt

N P V()

AVt1+ r, (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 flows 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 benefit depreciation reduces to sinking fund depre-

ciation with uniform cash flows, our goal congruence criterion seems to arrive at the same

recommendation with regard to the choice of depreciation schedule.20 We note, however,

19Conversely, it is true that if for some revenue recognition rule ROAt is equal to some constant c forall 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 orconsistently below the internal rate of return.

20Solomons (1965) was an early observer of the fact that the annuity (sinking fund) depreciation methodachieves constant residual income numbers when a projects cash flows are uniform.

13


17/38

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 reflected 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 pro-

vided the revenue recognition rule is tidy. This impossibility reflects that accounting incomecannot 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 suffices to note that for the cut-off 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 firm 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 outflows. Once the firm enters into the lease contract, the lease payment

obligations are assumed to be verifiable by the accounting system. In contrast, the manager

is assumed to have superior information regarding the (expected) cash benefits that result

from the use of the leased asset.

For financial reporting purposes, the two common methods of accounting for long-term

leases are the capital and operating lease method. Under the former approach, the leasecontract is considered a form of secured borrowing, and hence the related asset and debt

are initially capitalized on the balance sheet. The firm is required to recognize depreciation

21As mentioned in the Introduction, Beaver and Dukes (1974) and Stauffer (1971) examine alternativecash flow- and depreciation patterns with the property that roa remains constant over time. In contrast toour framework, their analysis is predicated on complete and symmetric information about all project cashflows.

14


18/38

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 financial

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 inflows in the amount of xt over nextT periods. If the firm 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:

N P V() =Tt=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 particulardepreciation schedule is capable of generating strong goal congruence by apportioning the

npv of the contract.

Under the capital lease method, the firm 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. Specifically, the asset and liability values at

date 0 are given by:

AV0 = LV0 =T

t=1t yt.

In each of the subsequent T periods, the firm recognizes a depreciation expense for the long-

term 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


19/38

Because of comprehensive income measurement, income is equal to cash inflows 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 benefit depreci-

ation 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 benefit depreciation ensures that

residual income reflects in each period a share of the overall value added by the lease contract.

Proposition 2 The capital lease method combined with the relative benefit depreciation rule

achieves strong goal congruence.

For financial reporting purposes, firms are required to capitalize only those leases that

satisfy certain conditions. The non-cancellable long-term leases that fail to meet these con-

ditions 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 Profit Plans is that managers will have

incentives to dispose of under-performing assets because the performance measure includes

22See, for instance, Young and OBryne (2000).

16


20/38

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 different manager. The relevant tradeoff for the firm is to receive either an

immediate cash inflow from the sale of the asset, or to receive a stream of future cash inflows

generated by operating the asset in question.

Under gaap, any difference 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 withincentives 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 specific guidelines for amortizing the deferred

gains or losses in subsequent periods.

To model the accounting choice problem for asset disposals formally, suppose the firm

owns an asset which was acquired T periods ago at a cost of b dollars. The asset generates

an (infinite) stream of geometrically declining cash flows:

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 as-

sume that p is private information and becomes public knowledge only if the sale transaction

is completed. If the firm holds on to the asset, its continued operations generates cash flows

in the amount of t+T for each t {1, }. Goal congruence requires that the managersells the asset if and only if the sale price exceeds the present value of future operating cash

23eva proponents have argued that, compared to income, residual income will create better incentives forreducing the amount capital tied up in a businesses. See Biddle, Bowen and Wallace (1999) and Balachandran(2005) for empirical evidence on this point.

24As discussed below, the significance of geometrically declining cash flows is that such a structure permitsaggregation.

17


21/38

flows, i.e.,

p

i=1

i i+T 0.

For the class of geometrically declining cash flows 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 flow decay factor (i.e., = 1 ), the

corresponding (1 )-declining balance method is a special case of the relative benefit

depreciation schedule. To see this, we note that AVt = T+t b and

i=1i i =

(1+r). It

follows that:

Dept + r AVt1 = (1 + r) AVt1 =t

i=1i i

T b = zt b, (12)

with zt t+T

i=1ii

. Suppose now that the firm 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

i=1i i AV

0. (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:

RIst = (p AV0) t

i=1i i

. (14)

Consequently, the incremental contribution of the assets sale to residual income in period t

is given by:

RIst RIt = t

i=1i i

(p i=1

i i+T).

Thus the residual income difference is proportional to the net present value of the incremental

proceeds from the sale (i.e., p

i=1i i+T) in each period.

25Beaver and Dukes (1974) show that the if the decline factor is chosen to be equal to (1 ), theperiodic accounting rate of return remains constant over the life of asset. As argued in Section 3.1, thisimplies that the accounting rate of return in each period is equal to the projects internal rate of return.

18


22/38

Proposition 3 Suppose cash flows 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 subse-

quently 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 benefit rule in subsequent years. This accounting policy

ensures that the immediate cash inflow p is effectively matched with the cash flows that

would have been generated by the existing asset. Finally, the structure of geometrically

declining cash flows makes it possible to satisfy both these requirements by considering the

aggregate gain (loss), p AVT.

Our finding 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 donot 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 flows.

3.4 Research & Development

There is virtual agreement in the literature on performance evaluation that immediate ex-

pensing ofr&d expenditures is likely to bias managers against undertaking r&d projects

that pay off in the distant future. At the same time, opinions seem to differ on how to amor-

tize the assets corresponding to past capitalized r&d expenditures. Without much economic

justification, the literature on value based management and economic profit plans suggests a

number of alternative amortization schedules, with five-year straight line amortization being

19


23/38

mentioned most commonly.26

One of the distinguishing characteristics of r&d investments is that their benefits are

considered highly uncertain. An added dimension of unpredictability for r&d projects,

beyond the usual volatility of cash flows, 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 firm 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 performancemeasure 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 oppor-

tunity to invest in a research and development project. In order to obtain future payoffs,

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 xts may increase early on as the new product is introduced and

decline later due to competitive pressure. The profitability parameter f(0, 1) summarizes

the managers entire private information about future cash flows. 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 first period) and 1 at date 1. The required investment amountsb0 and b1 are initially known only to the manager, though they become verifiable to the

26See, for instance, Simons (2000) in connection with the Vyaderm Pharmaceuticals case.27Antle, 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 investmentexpenditures are assumed to be unverifiable 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 delayingan investment decision.

20


24/38

accounting system as the respective project stages are implemented.

If completion of the r&d efforts requires cash outlays ofb0 and b1, respectively, the owner

would like to continue the project at the second stage if and only if:

V1(, 1) T

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 definition of the value function V0() reflects 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 benefit

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 animpact on depreciation charges related to the earlier investment b0. Goal congruence at the

first 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 benefit 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 benefit 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


25/38

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 anal-

ysis advocates full cost accounting (rather than successful efforts accounting) for r&d and

other exploration activities. Unlike full cost accounting which considers failed efforts asnecessary to achieve success and requires capitalization of all costs on the balance sheet, suc-

cessful efforts accounting permits capitalization of only those investments that are brought

to fruition.29 In our setting, successful effort accounting would dictate that the compounded

initial investment b0 (1 + r) be written off immediately if the firm 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 interest-

bearing and non-amortizing assets until such time as the project yields cash returns. While

this recommendation is in conflict with gaap, the rationale from an incentive perspective is

clear. In order to avoid any intertemporal tradeoffs, the performance measure must be unaf-

fected 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

28We note, however, that it is impossible to obtain strong goal congruence in this setting because of thevariability 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 first stage.29Our finding here is in contrast to gaap which generally relies on successful efforts accounting. Oil and

gas exploration costs are one exception since companies are permitted to use either the successful effort orthe full cost method to account for their oil and gas exploration costs. Although the term successful effortsis often associated with the oil and gas industry, it can be applied more broadly. For instance, Young andOByrne (2000) argue that impairment losses recognized under SFAS 121 are an application of successfuleffort accounting.

30Stewart (1991) also advocates full cost accounting for the purpose of performance measurement, thoughhis reasoning differs from our argument that past expenditures must be viewed as sunk costs.

22


26/38

can be matched with cash inflows.

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. Specifically, Proposition 4 prescribes different

interest accrual policy depending on whether an asset is in the construction or the pro-

duction phase. An alternative and equivalent approach is to treat real assets as interest

bearing throughout their existence. However, this requires relaxation of the tidiness condi-

tion 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 theassets 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:

AVT = AV1 T

t=2

Dept +T

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:

Tt=2

Dept = AV1 +Tt=2

r AVt1.

If the depreciation charges are chosen as Dept = AV1 zt, where again allocation zt

xtT

i=2i1xi

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

component of residual income is exactly offset by the accrued interest, residual income is

simply equal to cash inflow 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

31Recall that the relative benefit cost allocation charge zt is the sum of the relative benefit depreciationcharge and the interest charge r AVt1. Since the relative benefit depreciation charges are tidy (i.e.,T

t=2Dept = AV1), it follows that

Tt=2

zt AV1 = AV1 +T

t=2r AVt1.

32A similar tension between the tidiness requirement and the accruing of interest emerges in the context

23


27/38

only have to meet the boundary condition AVT = 0 rather than the stronger condition

that Tt=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 flows, i.e., when xt = x for each

t.33

4 Essentiality of Accrual Accounting

A common characteristic of the accrual accounting rules identified in Propositions 1-4 is that

value creating decisions increase the managers performance measure in every period of the

projects useful life. Specifically, 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 andT

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 flows, i.e., the distributional weights (x1,...,xT). Since the availability ofsuch 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 tradeoffs 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 = . . . z T = 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-completionmethod in (4) is a tidy revenue allocation scheme, but it can achieve robust goal congruence only if theresulting receivables are treated as non-interest bearing assets. On the other hand, if receivables accrueinterest, the tidines requirement

Tt=1

Revt = p will have to be relaxed.33The observation that annuity depreciation can alternatively be implemented by accruing interest on

assets and applying straight line depreciation dates back to Dicksee (1903) and Hattfield (1908). We thankan anonymous reviewer for directing us to these references.

24


28/38

the accounting system was assumed to have only partial information about the proposed

transactions, which was insufficient 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 firms

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:

N P V() T

t=1

t1 yt c() q.

subject to y Y(q, ). If the sales contract (y1,...,yT) is observable and verifiable at the

initial date, the value of the transaction can be fully reflected in the managers performance

measure in the initial period. To do so, the firm records receivables at their fair values, i.e,the present values of contractually specified future cash flows. As a consequence, residual

income is equal to npv() in the first 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 outflow must be matched with only a single

subsequent cash inflow. Production to inventory is provides an example of such a transaction.

Specifically, suppose a firm manufactures some product in the current period and then sells

34Earlier accounting literature has abstracted from information asymmetries and advocated accrual ac-counting rules that effectively result in frontloading. For instance, Bierman (1961) suggests that depreciationbe calculated so that the initial contribution to residual income is equal to the projects npv, while the changesto residual income are zero in all subsequent periods.

35Dutta and Reichelstein (1999) prove that the fair value accounting for receivables is part of a second-bestcontracting solution in a dynamic agency setting. They show, however, that it may be necessary to deviatefrom fair value accounting when credit sales entail default risk.

25


29/38

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 firms 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 st () so as to maximize:

Tt=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 suffices 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 finished 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 firms objective.

36

A final approach to strong or robust goal congruence would be to backload the manage-

rial performance measure. In our earlier notation, this would correspond to a setting where

z1, . . . , z T1 = 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 infor-

mation about future cash flows. Keeping track only of realized cash flows, the managers

performance measure would remain unaffected in periods 1 through T 1, and be equal to

the compounded value of the entire stream of realized cash flows in period T.

A crucial requirement of backloading managerial performance measures is the choice of

a terminal or settling up date. Identification of such a date appears virtually impossible

36See Dutta and Zhang (2001) and Baldenius and Reichelstein (2005) for more general models of revenuerecognition and inventory valuation. in particular, these papers consider the possibility that, following theinitial 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 thelower-of-cost-or-market rule instead of historical cost.

26


30/38

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 flows from individual transactions and

projects be identified separately. In contrast, implementation of the accrual accounting rules

in Section 3 only requires verification of the aggregatecash flows which result from all ongoing

projects. 37

To conclude this section, we ask whether the accounting rules identified 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 conflict of interest into ourframework, suppose that periodic cash flows depend on the managers choice of transactions

and his unobservable effort choices. In the simplest variant, ct = at+mt(), where at denotes

the managers effort and mt() denotes the baseline level of cash flow from the undertaken

transaction. Since the parameter is unknown to the principal, higher cash flows can either

be attributed to greater levels of effort 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 offer a menu of contracts

each one of which is linear in the residual income delivered in that period. Given the

accrual accounting rules identified in Propositions 1-3 strong goal congruence implies that

the managers incentives for undertaking a transaction are invariant to the periodic bonus

coefficients attached to the residual income numbers. As a consequence, these coefficients

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 modified

futher. The better informed agent will earn informational rents on account of his private

37

Reichelstein (2000) develops a model in which the manager discounts future payoffs at a rate higher thanthe principal (owner). Absent accrual accounting, the principal can backload the managers performancemeasure by computing the compounded value of past cash flows. Due to the managers higher discount rate,such an approach is shown to result in higher agency costs than an accounting system which periodicallymatches revenues and expenses.

38Parts of the recent agency literature have rationalized the use of residual income from a contractingperspective; 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.

27


31/38

information and therefore the owner finds 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 identified 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.

5 Concluding Remarks

For a range of common financing, 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 findings are broadly consistent with thematching 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 reflect value creation in a time consistent fashion, real assets may

have to accrue interest, just as financial 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 reflect full cost rather than successful efforts.

The findings 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 reflect contemporaneous cash flows should not be a guiding principle.

39Christensen, Feltham and Wu (2002) and Dutta and Reichelstein (2002) analyze the optimal hurdle ratewhen managers are risk averse and projects entail incremental risk. Their results show that the standardprescriptions in the value based management literature about calculating a risk adjusted cost of capital aregenerally not consistent with optimal incentive contracting.

40See Pfeiffer and Schneider (2004) for a model with these features.

28


32/38

We see only limited use from invoking ad-hoc criteria like choosing depreciation and amor-

tization 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 ofr&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 profit plans has identified a

range of transactions beyond the ones examined in this paper as candidates for account-

ing adjustments. These include the treatment of deferred taxes, goodwill, warranties andprovisions for bad debt. Applying the framework of this paper to these transactions in fu-

ture research may contribute to a more unified theory of accrual accounting for performance

measurement.

A recurring difficulty in implementing epps at the divisional level is that some assets are

shared by multiple divisions. Some firms 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 significantly 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 compensa-tion 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

41Some of the recent papers include Indjejikian and Nanda (1999), Christensen, Feltham and Sabac (2003)and Dutta and Reichelstein (2003).

29


33/38

control perspective.

30


34/38

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] (15)

for 2 t T. Here zt xt

T

i=2xii1

. The expression for residual income in (15) reflects

that the compounded value of all past expenditures is depreciated according to the relative

benefit rule. If the manager abandons the project at date 1, the contributions to residual

income are: RI1 = 0 and

RIt = zt (1 + r) b0. (16)

Thus there is an incentive to continue the project at date 1 if and only if:

xt f(, 1) zt b1 = zt [

T

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|] (17)

= zt 1 E1[ max{0, V1(, 1} b0|] (18)

= zt 1 V0(). (19)

We conclude that the manager has strong incentives to invest at the first stage if and

only if V0() 0.

31


35/38

References

Antle, R., Bogetoft, P. and A. Stark (2000), Incentive Problems and Investment Timing

Options, mimeo, Yale University.

Anctil, R., J. Jordan and A. Mukherji (1996), Asymptotic Optimality of Residual Income

Maximization, Review of Accounting Studies, 2, 207229.

Arya, A., T. Baldenius, and J. Glover (1999), Residual Income, Depreciation, and Empire

Building, mimeo, Ohio State University.

Balachandran, S. (2005), How Does Residual Income Affect Investment: The Role of Prior

Performance Measures, Management Science, forthcoming.Baldenius, T. (2003), Delegated Investment Decisions and Private Benefits of Control, The

Accounting Review, Vol. 78:4, 909-930.

Baldenius, T. and S. Reichelstein (2005), Incentives for Efficient Inventory Management:

The Role of Historical Cost, Management Science, forthcoming.

Baldenius, T. and A. Ziv (2003), Performance Evaluation and Corporate Income Taxes,

Review of Accounting Studies, Vol. 8, 283-309.

Bastian, N. (2004), Deferred Taxes in Residual Income Compensation, mimeo, Stanford

University.

Beaver, W. and R. Dukes (1974), -Depreciation Methods: Some Analytical Results Jour-

nal of Accounting Research, 9, 391-419.

Bhareket,M, T. (2004), Investment Decisions Under Capital Constraints: The Role of Rev-

enue Recognition in Performance Measurement, mimeo, Duke University.

Biddle, G., Bowen, and J.Wallace (1999), Evidence on EVA, Journal of Applied Corporate

Finance, 12(2), 69-79.

Bierman, H. (1961), Depreciable Assets-Timing of Expense Recognition, The Accounting

Review, Vol. 36, 613-618.

Bromwich, M. and M. Walker, (1998) 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 Mea-

surement under Moral Hazard,The Accounting Review, 77(1), 1-23.

32


36/38

Christensen, P., Feltham, G. and F. Sabac (2002), Correlated Performance Measures in Dy-

namic Incentives with Limited Commitment, mimeo, University of British Columbia.

Christensen, P., Feltham, G. and F. Sabac (2003), Dynamic Incentives and Responsibility

Accounting: A Comment Journal of Accounting and Economics, 35, 423-436.

Davis, S. (1996), Cash Flow and Performance Measurement: Managing for Value, Finan-

cial Executives Research Foundation, Morristown, N. J.

Dutta, S. (2003), Capital Budgeting and Managerial Compensation: Incentive and retention

Effects, The Accounting Review,78(1), 71-93.

Dutta, S. and S. Reichelstein (1999), Asset Valuation and Performance Measurement in aDynamic Agency Setting, Review of Accounting Studies, Vol. 4, 235258.

Dutta, S. and S. Reichelstein (2002), Controlling Investment Decisions: Depreciation and

Capital Charges Review of Accounting Studies, Vol. 7, 253-281.

Dutta, S. and S. Reichelstein (2003), Leading Indicator Variables, Performance Measure-

ment and Long-Term versus Short-Term Contracts Journal of Accounting Research,

Vol 41, 837-866.

Dutta, S. and X. Zhang (2001), Revenue Recognition in a Multiperiod Agency Setting,

Journal of Accounting Research, Vol. 40,.

Dicksee, A.L. (1903), Advanced Accounting, Gee and Co., London.

Ehrbar, A. (1998), The Real Key to Creating Wealth, John Wiley& Sons, New York.

Edwards, E. and P. Bell (1961), The Theory and Measurement of Business Income, Univer-

sity of California Press, Berkeley.

Ehrbahr, A. and B. Stewart (1999) The EVA Revolution,Journal of Applied Corporate

Finance, 12(2), 18-31.

Feltham, G. and J. Ohlson (1996), Uncertainty Resolution and the Theory of DepreciationMeasurement Journal of Accounting Research, Vol. 34:2, 209-234.

Friedl, M, G. (2002), Growth options, Organizational Slack and Managerial Investment

Incentives, mimeo, University of Munich.

Friedl, M, G. (2005), Incentive Properties of Residual Income When There is an Option to

Wait, Schmalenbach Business Review, Vol. 57, 3-21.

33


37/38

Hattfield, H.R.. (1909), Modern Accounting, D. Appleton and Co.

Hofmann, C. (2003), Gestaltung von Erfolgsrechnungen zur Steuerung langfristiger Pro-

jekte, mimeo, University of Hannover.

Indjejikian, R. and D.J. Nanda (2001), Dynamic Incentives and Responsibility Accounting

Journal of Accounting and Economics, 27, 177-201.

Ittner, C. and D. Larcker (1998),Innovations in Performance Measurement: Trends and

Research Implications, Journal of Management Accounting Research, 6, 205-238.

Kieso, D. and J. OWeygandt (1998), Intermediate Accounting, John Wiley, New York.

Lambert, R. (2001), Contracting Theory and Accounting, Journal of Accounting and Eco-nomics, 32 ,3-87.

Martin, J. and W. Perry (2000), Value Based Management. Harvard University Press.

Mishra, B. and I. Vaysman (2004), Delegating Investment Decisions, mimeo, INSEAD.

Mohnen, A. (2004), Managerial Performance Evaluation with Residual Income- Limited

Investment Budget and NPV Maximization, mimeo, University of Cologne, Germany.

Preinreich (1938),Valuation and Amortization, Econometrica, 6, 219-231.

Ohlson, J. and X.J. Zhang (1998), Accrual Accounting and Equity Valuation Journal of

Accounting Research, 36, 85-111.

Pfeiffer, T. (2000), Good News and Bad News for the Implementation of Shareholder-Value

Concepts in Decentralized Organizations , Schmalenbach Business Review, 52, 68-91.

Pfeiffer, T. and G. Schneider (2004), Capital Budgeting and Rationing: Ex-ante versus

Ex-post Hurdle Rates, mimeo, University of Vienna.

Reichelstein, S. (1997), Investment Decisions and Managerial Performance Evaluation,

Review of Accounting Studies, 2, 157-180.

Reichelstein, S. (2000), Providing Managerial Incentives: Cash Flows versus Accrual Ac-counting, Journal of Accounting Research, 38(2), 243269.

Rogerson, W. (1997), Inter-Temporal Cost Allocation and Managerial Investment Incen-

tives: A Theory Explaining the Use of Economic Value Added as a Performance Mea-

sure, Journal of Political Economy, 105, 770-795.

Simons, R. (2000), Vyaderm Pharmaceuticals , Harvard Business School Case.

34


38/38

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

Illinois.

Stauffer, T. (1971), The Measurement of Corporate Rates of Return, Bell Journal of

Economics, 2(2), 434469.

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

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

Summer.

Young, D. and S. OByrne (2000), EVA and Value-Based Management: A Practical Guide,

McGraw-Hill Press, New York.Young, D., (1998), Groupe Schneider: Economic Value Added and the Measurement of

Financial Performance, mimeo, INSEAD, Fontainebleau, France

Wagenhofer, A. (2003), Accrual-Based Compensation, Depreciation and Investment Incen-

tives, European Accounting Review, Vol 12:2, 287-309.

Wei, D. (2004), Interdepartmental Cost Allocation and Investment Incentives, Review of

Accounting Studies, Vol. 9, 97-116.

Zhang, X.J. (2000), Conservative Accounting and Equity Valuation, Journal of Accounting

and Economics, 29, 125-149.

35

accrual accounting for performance evaluation

Documents