Accounting for Fixed Assets and Investment Efficiency: A Real Options Framework

Abstract

In a perfect world, a manager's investment in fixed assets would increase with the assets' profitability. However, when managers privately know their project profitability and care about their company’s short-term share price, managers of less profitable firms face the temptation to overinvest in order to pool with strong firms. This creates pressure on strong firms to overinvest to the point where weak firms cease to find it worthwhile to mimic strong firms. I show that, when firms have abandonment options, the willingness of a weak firm's manager to mimic depends on the expected future resale value of the fixed assets. An impairment policy (prohibiting write-ups) reduces the value of abandonment options, which are particularly important for weak firms. The reduced value of the abandonment options decreases the amount of overinvestment required by strong firms to separate themselves from weak firms. I also show that allowing firms to choose depreciation schedules improves investment efficiency: in equilibrium, strong firms choose faster depreciation. Last, in the staged-investments setting, I show that an impairment policy also mitigates underinvestment at an initial stage. These findings rationalize the current accounting standards for fixed assets and contribute to related policy debates on accounting measurement.

Keywords: accounting for fixed assets, conservatism, investment efficiency, abandonment options, staged investments, real options

JEL Classification: G31, M41, M48