Depreciation Rules and the Relation Between Marginal and Historical Cost

49 Pages Posted: 27 Apr 2009

See all articles by Madhav V. Rajan

Madhav V. Rajan

Booth School of Business, University of Chicago

Stefan J. Reichelstein

Stanford University - Stanford Graduate School of Business; CESifo (Center for Economic Studies and Ifo Institute)

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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.

JEL Classification: M40, M41, M46, G34, D40

Suggested Citation

Rajan, Madhav V. and Reichelstein, Stefan J., Depreciation Rules and the Relation Between Marginal and Historical Cost. Available at SSRN: https://ssrn.com/abstract=1378293 or http://dx.doi.org/10.1111/j.1475-679X.2009.00334.x

Madhav V. Rajan (Contact Author)

Booth School of Business, University of Chicago

1101 East 58th Street
Chicago, IL 60637-1561
United States

Stefan J. Reichelstein

Stanford University - Stanford Graduate School of Business ( email )

655 Knight Way
Stanford, CA 94305-5015
United States
650-736-1129 (Phone)
650-725-7979 (Fax)

CESifo (Center for Economic Studies and Ifo Institute)

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Munich, DE-81679
Germany

HOME PAGE: http://www.CESifo.de

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