• Selected
• Entire List

Abstract:
This paper examines inventory management from an incentive perspective. We show that when a manager has private information about future attainable revenues, the residual income performance measure based on historical cost can achieve optimal (second-best) incentives with regard to managerial effort as well as production and sales decisions. The LIFO (last-in-first-out) inventory flow rule is shown to be preferable to the FIFO (first-in-first-out) rule for the purpose of aligning incentives. Our analysis also finds support for the lower-of-cost-or-market inventory valuation rule in situations where the manager receives new information after the initial contracting stage.

Inventory management, historical cost accounting, decentralization, agency theory

Abstract:
This paper examines inventory management from an incentive and control perspective. We demonstrate that the residual income performance measure based on historical cost accounting provides managers with incentives to make optimal production and inventory depletion decisions. The lower-of-cost-or-market rule is shown to be effective in situations where inventory may become obsolete due to unexpected demand shocks. Our analysis also considers settings in which the unit variable cost of production can be lowered by initial investments. Proper incentives require that the depreciation charges for these initial fixed costs are independent of the actual production and sales quantities. Therefore, a variable costing format, rather than an absorption costing format, is essential for the purpose of managerial performance evaluation.

Abstract:
This paper examines transfer pricing in multinational firms when individual divisions face different income tax rates. Assuming that a firm decouples its internal transfer price from the arm's length price used for tax purposes, we analyze the effectiveness of alternative pricing rules under both cost- and market-based transfer pricing. In a tax-free world, Hirshleifer (1956) advocated that the internal transfer price be set equal to the marginal cost of the supplying division. Extending this solution, we argue that the optimal internal transfer price should be a weighted average of the pre-tax marginal cost and the most favorable arm's length price. When the supplying division sells the intermediate product in question also to outside parties, the external price becomes a natural candidate for the arm's length price. We argue that for internal performance evaluation purposes firms should generally not value internal transactions at the prevailing market price if the supplying division has monopoly power in the external market. By imposing intracompany discounts, firms can alleviate attendant double marginalization problems and, at the same time, realize tax savings which take advantage of differences in income tax rates. Our analysis characterizes optimal intracompany discounts as a function of the market parameters and the divisional tax rates.

transfer pricing, multinationals, taxes, decentralization

Abstract:
This paper examines a multi-period agency model in which a manager makes investment decisions in each period. Performance measures based only on realized cash flows are essentially uninformative about value creation at any intermediate point in time. If the principal has access to additional project information which allows for a proper matching of a project's periodic cash flows with a share of the original investment cost, then the value created by the manager can be assessed at intermediate points in time. Such matching can be achieved by means of an accrual accounting system with properly structured depreciation charges. We establish that performance evaluation based on accrual accounting data results in lower agency costs than performance evaluation based on realized cash flows only.

Abstract:
This paper examines a multi-period agency model in which a manager makes investment decisions in each period. Performance measures based only on realized cash flows are essentially uninformative about value creation at any intermediate point in time. If the principal has access to additional project information which allows for a proper matching of a project's periodic cash flows with a share of the original investment cost, then the value created by the manager can be assessed at intermediate points in time. Such matching can be achieved by means of an accrual accounting system with properly structured depreciation charges. We establish that performance evaluation based on accrual accounting data results in lower agency costs than performance evaluation based on realized cash flows only.

Abstract:
This paper examines alternative accrual accounting rules from an incentive and control perspective. 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.

Managerial performance measures, accrual accounting, incentive contracts, economic theory, economics of organizations, cost

Abstract:
Firms frequently value internal transactions at external market prices subject to an intracompany discount. These discounts are generally explained by cost differences between internal and external sales. In a model where the supplying division has monopoly power in the external market, we find that cost differences are neither necessary nor sufficient for intracompany discounts to be desirable. The imposition of discounts always increases the divisional profits of the buying division, but may also lower the divisional profits of the selling division. We derive conditions for discounts to enhance firm-wide profit. We also study the sensitivity of the optimal discount to cost differences between internal and external transactions. Under certain conditions, market-based transfer prices subject to optimally chosen discounts perform well. If the buying division sells its final product in a competitive market and if demand and cost parameters are positively correlated, then market-based transfer pricing induces the divisions to engage in transactions which are nearly efficient from the corporate perspective.

Abstract:
This paper develops a multiperiod principal-agent model in which a manager must be given incentives to undertake investments and to exert personally costly effort. Investments are soft (e.g., intangible assets) and therefore entail measurement errors for the accounting system as it seeks to separate investments from operating expenditures. This separation is of no concern to the stock market which draws on its own information about future cash flows resulting from current investments. The firm's stock price, however, reflects all value relevant information, parts of which are not incentive relevant. Optimal incentive provisions must combine forward looking market information with backward looking accounting information. Under certain conditions, optimal performance measures can be expressed as a weighted average of economic value added (residual income) and market value added.

Performance measurement, managerial compensation

Abstract:
We examine alternative performance measures for a manager who has superior information about the profitability of an investment project and contributes to periodic operating cash flows through his efforts. We find that residual income based on a suitably chosen depreciation schedule is an optimal performance measure. To address the underlying agency problem, the charge for capital in the calculation of residual income must be based on a hurdle rate that exceeds the principal's cost of capital. We also establish that proper matching of periodic operating cash flows with a share of the initial investment cost (via depreciation charges) is essential if the performance measure is to support optimal incentive provisions for a sufficiently wide class of agency problems.

Abstract:
This paper examines the choice of asset valuation rules from a managerial control perspective. A manager creates value for a firm through his effort choice each period. To support its operating activities, the firm also engages in financing transactions such as credit sales to its customers. These financing transactions merely change the pattern of cash flows across periods but have no effect on the value of the firm. An optimal compensation scheme must therefore shield the manager from the risk associated with such transactions. If the firm operates an accrual accounting system in which receivables are capitalized at their fair values, we show that residual income eliminates this risk and provides an optimal performance measure. On the other hand, compensation schemes based only on realized cash flows can be optimal only under exceptional circumstances.

The paper also considers a setting in which the principal can observe not only the aggregate cash flow, but also the amount of realized bad debt losses each period. In this setting, an optimal compensation scheme must also shield the manager from the default risk associated with credit transactions. We demonstrate that this can be achieved if receivables are valued according to the allowance method that leads to a proper matching of sales revenues and bad debt expenses each period.

Abstract:
Investment decisions frequently require coordination across multiple divisions of a firm. This paper explores a class of capital budgeting mechanisms in which the divisions issue reports regarding the anticipated profitability of proposed projects. To hold the divisions accountable for their reports, the central office ties the project acceptance decision to a system of cost allocations comprised of depreciation and capital charges. If the proposed project concerns a common asset that benefits multiple divisions, our analysis derives a sharing rule for dividing the asset among the users. Capital charges are based on a hurdle rate determined by the divisional reports. We find that this hurdle rate deviates from the firm's cost of capital in a manner that depends crucially on whether the coordination problem is one of implementing a common asset or choosing among multiple competing projects. We also find that more severe divisional agency problems will increase the hurdle rate for common assets, yet this is generally not true for competing projects.

capital budgeting, hurdle rates, decentralization, agency problems

Abstract:
Return on Investment (ROI) is widely regarded as a key measure of firm profitability. The accounting literature has long recognized that ROI will generally not reflect economic profitability, as determined by the internal rate of return (IRR) of a firm's investment projects. In particular, it has been noted that accounting conservatism may result in an upward bias of ROI, relative to the underlying IRR. We examine both theoretically and empirically the behavior of ROI as a function of two variables: past growth in new investments and accounting conservatism. Higher growth is shown to result in lower levels of ROI provided the accounting is conservative, while the opposite is generally true for liberal accounting policies. Conversely, more conservative accounting will increase ROI provided growth in new investments has been "moderate" over the relevant horizon, while the opposite is true if new investments grew at sufficiently high rates. Taken together, we find that conservatism and growth are "substitutes" in their joint impact on ROI.

Conservatism, Growth, Return on Investment

Abstract:
This paper develops a multiperiod agency model to study the use of leading indicator variables in managerial performance measures. In addition to the familiar moral hazard problem, the principal faces the task of motivating a manager to undertake "soft" investments. These investments are not directly contractible, but the principal can instead rely on leading indicator variables which provide a noisy forecast of the investment returns to be received in future periods. Our analysis relates the role of leading indicator variables to the duration of the manager's incentive contract.

With short-term contracts, leading indicator variables are essential in mitigating a "holdup" problem resulting from the fact that investments are sunk at the end of the first period. With long-term contracts, leading indicator variables will be valuable if the manager's compensation schemes are not stationary over time. The leading indicator variables then become an instrument for matching the future investment return with the current investment expenditure. We identify conditions under which the optimal long-term contract induces larger investments and less reliance on the leading indicator variables in comparison to short-term contracts. Under certain conditions, though, the principal does better with a sequence of one-period contracts than with a long-term contract.

Abstract:
This paper develops a multiperiod agency model to study the use of leading indicator variables in managerial performance measures. In addition to the familiar moral hazard problem, the principal faces the task of motivating a manager to undertake "soft" investments. These investments are not directly contractible, but the principal can instead rely on leading indicator variables which provide a noisy forecast of the investment returns to be received in future periods. Our analysis relates the role of leading indicator variables to the duration of the manager's incentive contract.

With short-term contracts, leading indicator variables are essential in mitigating a "holdup" problem resulting from the fact that investments are sunk at the end of the first period. With long-term contracts, leading indicator variables will be valuable if the manager's compensation schemes are not stationary over time. The leading indicator variables then become an instrument for matching the future investment return with the current investment expenditure. We identify conditions under which the optimal long-term contract induces larger investments and less reliance on the leading indicator variables in comparison to short-term contracts. Under certain conditions, though, the principal does better with a sequence of one-period contracts than with a long-term contract.

Abstract:
Multidivisional firms frequently rely on external market prices in order to value internal transactions across profit centers. This paper examines the transfer pricing problem in a setting in which an upstream division has monopoly power in selling a proprietary component both to a downstream division within the same firm and to external customers. When internal transfers are valued at the prevailing market price, the resulting transactions are distorted by double marginalization. We ask whether the imposition of intracompany discounts can alleviate or even eliminate the effects of double marginalization. When the production capacity of the upstream division is effectively unconstrained, we find that discounts will increase the firm's overall profit only under certain conditions. At the same time, it is impossible for any discount rule to induce prices and sales quantities that fully maximize the firm's corporate profit. In contrast, if the production capacity of the selling division is constrained, suitably chosen discounts will always improve the firm's overall profit relative to a policy under which internal transfers are valued at the market price. With constrained capacity, we identify conditions under which discounts set inversely to the external price elasticity of demand can fully eliminate the double marginalization problem and thereby achieve efficient decentralization.

Abstract:
Multidivisional firms frequently rely on external market prices in order to value internal transactions across profit centers. This paper examines the transfer pricing problem in a setting in which an upstream division has monopoly power in selling a proprietary component both to a downstream division within the same firm and to external customers. When internal transfers are valued at the prevailing market price, the resulting transactions are distorted by double marginalization. We ask whether the imposition of intracompany discounts can alleviate or even eliminate the effects of double marginalization. When the production capacity of the upstream division is effectively unconstrained, we find that discounts will increase the firm's overall profit only under certain conditions. At the same time, it is impossible for any discount rule to induce prices and sales quantities that fully maximize the firm's corporate profit. In contrast, if the production capacity of the selling division is constrained, suitably chosen discounts will always improve the firm's overall profit relative to a policy under which internal transfers are valued at the market price. With constrained capacity, we identify conditions under which discounts set inversely to the external price elasticity of demand can fully eliminate the double marginalization problem and thereby achieve efficient decentralization.

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 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 the 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.

capital budgeting, residual income, depreciation, hurdle rate, agency problems

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 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 the 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.

capital budgeting, residual income, depreciation, hurdle rate, agency problems

Abstract:
Return on Investment (ROI) is widely regarded as a key measure of firm profitability. The accounting literature has long recognized that ROI will generally not reflect economic profitability, as determined by the internal rate of return (IRR) of a firm's investment projects. In particular, it has been noted that accounting conservatism may result in an upward bias of ROI, relative to the underlying IRR. We examine both theoretically and empirically the behavior of ROI as a function of two variables: past growth in new investments and accounting conservatism. Higher growth is shown to result in lower levels of ROI provided the accounting is conservative, while the opposite is generally true for liberal accounting policies. Conversely, more conservative accounting will increase ROI provided growth in new investments has been "moderate" over the relevant horizon, while the opposite is true if new investments grew at sufficiently high rates. Taken together, we find that conservatism and growth are "substitutes" in their joint impact on ROI.

cost accounting, financial analysis, financial statements, valuation

Abstract:
The reported cost of a product frequently contains historical cost components that reflect past investments in productive capacity. We examine a setting wherein a firm makes a sequence of overlapping capacity investments. Earlier research has identified particular accrual accounting (depreciation) rules with the property that, on a per unit basis, the historical cost of a product captures precisely its marginal cost. Relative to this benchmark, we investigate and characterize the direction and magnitude of the bias in reported historical cost that results from alternative depreciation rules, including in particular straight-line depreciation in conjunction with partial direct expensing. In addition, we demonstrate that for a reasonable range of parameter specifications the resulting bias is rather small. Finally, we apply our framework to two specific settings. First, in a regulatory context, we establish the extent to which the Accounting Profit Margin is indicative of a firm's pricing power in the product market. Second, we model an internal control scenario in which a manager's performance is evaluated using residual income, and identify the distortions in investment levels that result from the use of alternative depreciation rules.

depreciation, historical cost, accounting cost, economic cost, marginal cost

Abstract:
This study examines the changes in electricity prices that are likely to result if in the future coal-fired power plants are regulated for their CO2 emissions. We focus on carbon capture and storage (CCS) technologies that new power plants may adopt either because of a direct regulatory requirement or because the market price of CO2 emission permits is sufficiently high. Our analysis takes explicitly into account that in some jurisdictions the supply of electricity at the wholesale level (generation) is organized competitively, while in other jurisdictions a regulated monopolist (utility) provides both generation and distribution services. We find that for both the competitive and the regulated monopoly scenario an emission price in the range of $25-30 per tonne of CO2 would make it advantageous for coal-fired plants to adopt CCS capabilities rather than buy emission permits. The resulting increases in the retail price of electricity are projected to be near 25%. In contrast to the competitive power supply scenario, these price increases materialize only gradually, in fact almost linearly, over 30 years for the scenario of a regulated utility. This delay in price increases reflects that for regulated firms prices are principally based on historical cost rather than current cost.

electricity price under CO2 regulation, carbon capture and storage, economics of power plants

Abstract:
This study examines the changes in electricity prices that are likely to result if in the future coal-fired power plants are regulated for their CO2 emissions. We focus on carbon capture and storage (CCS) technologies that new power plants may adopt either because of a direct regulatory requirement or because the market price of CO2 emission permits is sufficiently high. Our analysis takes explicitly into account that in some jurisdictions the supply of electricity at the wholesale level (generation) is organized competitively, while in other jurisdictions a regulated monopolist (utility) provides both generation and distribution services. We find that for both the competitive and the regulated monopoly scenario an emission price in the range of $25-30 per tonne of CO2 would make it advantageous for coal-fired plants to adopt CCS capabilities rather than buy emission permits. The resulting increases in the retail price of electricity are projected to be near 25%. In contrast to the competitive power supply scenario, these price increases materialize only gradually, in fact almost linearly, over 30 years for the scenario of a regulated utility. This delay in price increases reflects that for regulated firms prices are principally based on historical cost rather than current cost.

cost accounting, regulations, environmental protection

Abstract:
We consider a bilateral trading problem in which one or both parties makes relationship-specific investments before trade. Without adequate contractual protection, the prospect of later holdups discourages investment. We postulate that the parties can sign noncontingent contracts prior to investing, and can freely renegotiate them after uncertainty about the desirability of trade is resolved. We find that such contracts can induce one party to invest efficiently when either a breach remedy of specific performance or expectation damages is applied. Specific performance can also induce both parties to invest efficiently, provided a separability condition holds. In contrast, expectation damages is poorly suited to solve bilateral investment problems.

Abstract:
In bilateral trading problems, the parties may be hesitant to make relationship-specific investments without adequate contractual protection. We postulate that the parties can sign noncontingent contracts prior to investing, and can freely renegotiate them after information about the desirability of trade is revealed. We find that such contracts can induce one party to invest efficiently when courts impose either a breach remedy of specific performance or expectation damages. Moreover, specific performance can induce both parties to invest efficiently if a separability condition holds. Expectation damages, on the other hand, is poorly suited to solve bilateral investment problems.

Abstract:
The reported cost of a product frequently contains historical cost components that reflect past investments in productive capacity. We examine a setting wherein a firm makes a sequence of overlapping capacity investments. Earlier research has identified particular accrual accounting (depreciation) rules with the property that, on a per unit basis, the historical cost of a product captures precisely its marginal cost. Relative to this benchmark, we investigate and characterize the direction and magnitude of the bias in reported historical cost that results from alternative depreciation rules, including in particular straight-line depreciation in conjunction with partial direct expensing. In addition, we demonstrate that for a reasonable range of parameter specifications the resulting bias is rather small. Finally, we apply our framework to two specific settings. First, in a regulatory context, we establish the extent to which the Accounting Profit Margin is indicative of a firm's pricing power in the product market. Second, we model an internal control scenario in which a manager's performance is evaluated using residual income, and identify the distortions in investment levels that result from the use of alternative depreciation rules.

Abstract:
Managerial bonus payments are frequently determined by both objective and subjective indicators of managerial performance. By its very nature, subjective information is not verifiable for contracting purposes. The inclusion of such information in managerial bonus schemes therefore requires a principal to retain discretion in authorizing actual bonus payments. At the same time, the principal must be able to commit to an overall bonus pool which will be paid out either inside or outside the agency. Our analysis examines the structure of optimal bonus pool arrangements. The non-verifiability of the subjective indicators changes many of the predictions obtained in traditional agency settings with verifiable performance indicators. In particular, our results address the contractual value of additional information variables, the desirability of compressed incentive schemes and the nature of relative performance evaluation in settings with multiple agents.

discretion, bonus pools, subjective performance measurement

Abstract:
The paper Asymmetric Information, Incentives and Intrafirm Resource Allocation, by Harris, Kriebel and Raviv (H.K.R.), was published in the June 1982 issue of Management Science. In this article, written as part of this journal's 50-year anniversary celebration, we highlight the significance of H.K.R.'s paper for research in managerial accounting. We first formulate and solve a continuous version of H.K.R.'s model in order to illustrate the key assumptions and findings of their paper. We then review several strands of the resource allocation literature in managerial accounting that have taken their inspiration, either directly or indirectly, from the work of H.K.R.

Intrafirm resource allocation, Managerial Incentives, Asymmetric Information

Abstract:
When consumers' willingness-to-pay increases by a uniform amount, the change in the resulting monopoly price is generally indeterminate. Our analysis identifies sufficient conditions on the underlying demand curve which predict both the sign and the magnitude of the resulting price change.

monopoly pricing, comparative statics, log-concavity

Abstract:
This paper examines the choice of asset valuation rules from a managerial control perspective. A manager creates value for a firm through his effort choices. To support its operating activities, the firm also engages in financing activities such as credit sales to its customers. Since such financing activities merely change the pattern of cash flows across periods, an optimal compensation scheme must shield the manager from the risk associated with the financing activities. We show that residual income combined with fair value accounting for receivables eliminates this risk and provides an optimal performance measure. In contrast, compensation schemes based only on realized cash flows can be optimal only under exceptional circumstances. We also consider a setting in which there is sufficiently disaggregated information about periodic cash flows so as to eliminate not only the risk associated with financing activities but also the risk associated with customer defaults. The principal then wants to depart from fair value accounting.

Abstract:
This paper studies an incomplete contracting model to compare the effectiveness of alternative transfer pricing mechanisms. Transfer pricing serves the dual purpose of guiding intracompany transfers and providing incentives for upfront investments at the divisional level. When transfer prices are determined through negotiation, divisional managers will have insufficient investment incentives due to "hold-up" problems. While cost-based transfer pricing can avoid such "hold-ups", it does suffer from distortions in intracompany transfers. Our analysis shows that negotiation frequently performs better than a cost-based pricing system, though we identify circumstances under which cost-based transfer pricing emerges as the superior alternative.

Abstract:
This paper considers incentive provisions for a manager who makes investment decisions. The manager's performance measure can be based on current accounting information, cash flow, depreciation, book value, and current investment. We argue that Residual Income is the unique (linear) performance measure that achieves goal congruence, i.e., the manager accepts all positive NPV projects, and only those. If the manager has the same discount rate as the owner, the depreciation rules remain indeterminate. However, if the manager's discount rate assumes potentially a whole range of values, then a particular depreciation policy combined with Residual Income is the unique way to achieve goal congruence.

Abstract:
This paper studies incentives in hierarchical organizations. Benchmark performance is given by the optimal revelation mechanism in which the principal communicates and contracts directly with all agents. We analyze under what conditions a general multi-tier hierarchy can replicate the performance of the optimal revelation mechanism. We find that replication is possible if the hierarchical arrangement of the agents is consistent with the underlying production structure, and the organization sets up a suitable internal accounting system. Specifically, each department manager is given a budget by his superior for a specific departmental task. Performance is then measured by the difference between the budget and actual cost incurred by the department.