Accrual-Based Compensation, Depreciation and Investment Decisions

Abstract

The paper studies incentive effects of accruals used for performance measurement in short-term contracts, if an agent undertakes activities with long-term and short-term consequences. The paper characterizes the optimal depreciation method and shows that it is not consistent with the traditional matching principle. Rather, it aligns the performance measure more with the expected long-term consequences of the investment, and shifts risk away from the agent. The paper also identifies conditions under which it is preferable to let the agent select the depreciation versus using cash flows for performance measurement.

JEL Classification: D82, G31, M41, M44, L20