Accrual Accounting,Informational Sufficiency,and Equity Valuation

This paper studies accrual accounting and equity valuation in the context of a firm that makes repeated and overlapping investments in productive capacity. The analysis identifies a particular accrual accounting (depreciation) rule that is termed replacement cost accounting because the book value of existing capacity assets is set equal to the value that such assets would have if a competitive market were to exist for used assets. It is shown that replacement cost accounting aggregates past investment decisions of the firm without a loss of value‐relevant information. The intrinsic value of the firm can then be expressed as a function of current accounting data and certain parameters of the firm’s operating environment. Further, it is shown that replacement cost accounting is essentially the only accounting rule with this informational sufficiency property.     

UNANTICIPATED INFLATION, TAXATION, AND COMMON STOCKS

This paper focuses on the effects of unanticipated inflation on the market value of equity in a system with corporation tax and historic cost depreciation. It is shown that there exists a unique combination of debt and equity under which inflation neutrality is obtained, Whether or not unanticipated inflation hurts or benefits the stockholders in a particular firm depends upon a number of conditions. These include the depreciation rate of its assets relative to the amortization rate of its debt. Finally, the present tax system is contrasted with a fully indexed system involving replacement cost depreciation and indexation     

Depreciation Rules and the Relation between Marginal and Historical Cost

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.     

Investment-Based Cost Accounting as a Fundamental Basis of Decision-Oriented Management Accounting

Decision making concerns over cost allocations, especially common cost allocations, have a long history. They are well canvassed in Thomas (1969 ) and Wells (1978 ). This article revisits the cost allocation debate, albeit in a new setting, and rehearses arguments relevant to long- and short-term decision contexts. Here a means is proposed to address those problems, namely to adopt the investment-based approach to cost accounting. This approach draws on ideas of Hotelling (1925 ), Preinreich (1938 ) and Schneider (1961 ), and applies the notion of net present value in another setting, namely to cost accounting theory. Research has revealed no discussion of this in the Anglo-American literature. This article shows analytically that the investment-based approach offers a general basis for decision-oriented cost accounting, as it combines investment theory with cost accounting and thereby connects long-term with short-term decisions. While reviewing primarily European literature, it also examines several Anglo-American works. The analysis reveals how for three classical decision problems—production program planning, purchase order lot sizes, and break-even price limits—two different types of costs, namely depreciation and material costs, have to be based on cash flows and net present value. The proposed investment-based approach permits an examination of the extent to which cost accounting concepts and cost information are relevant to those decisions. This theoretical concept is used to derive pertinent cost dimensions and to solve traditional problems of cost allocation. A caution is that the investment approach is limited to decision facilitating cost accounting. Whether it may be possible to couple it with agency theory and its focus on decision influencing has not been explored and is an issue for further research.     

Corporate Tax Holidays and Investment

Governments of developing countries commonly adopt tax holidaysto encourage investment. This article evaluates the incentivesprovided by company income tax holidays and explains the importanceof the timing of depreciation allowances in determining theeffective tax rates and the cost of capital to firms consideringadditional investment during the holiday. If an asset is long-livedand depreciation allowances for tax purposes are accelerated,the tax holiday, by preventing depreciation deductions duringperiods of peak profits, may actually penalize a company forinvesting during the holiday. The closer the investment to theend of the holiday period, the more severe the penalty. If,instead, depreciation allowances may be deferred until afterthe holiday, this program of incentives is quite generous tothe firm. How these sharply contrasting results may emerge isillustrated through estimation of effective tax rates and usercosts of capital under tax holiday systems in Bangladesh, Côted'lvoire, Malaysia, Morocco, and Thailand.     

Accounting for Infrastructure Service Delivery by Government: Generational Issues

Infrastructure service provision by government creates huge distributional issues about service availability and performance over time and the relative funding burdens borne by successive generations of consumers across time. But providing financial disclosure on these issues through inter-generational accounting pre-supposes that accounting measurement is both generationally neutral (temporal neutrality) and does not legitimate any particular pattern of distribution. At the very least, accounting measurements of service provision costs should possess the attribute of distributional fairness. They should not bias the inter-generational allocation of cost or funding burdens. We argue that the forced application of inappropriate commercial accounting concepts of asset valuation, depreciation and capital maintenance does produce significant generational bias. More flexibility is required to produce the necessary accounting measurement attributes for financial disclosure on whether government has discharged its continuing accountability for inter-generational equity in burden sharing. We discuss three conceptual issues and illustrate the need for flexibility by proposing an alternative 'flow of obligations' approach which does not require reference to valuations of community service resources or arbitrary cost allocations under depreciation.     

Depreciation Need Not Be Arbitrary

Following Thomas (1969, 1974) the depreciation adjustment charged against accounting earnings is nowadays commonly presumed to be entirely arbitrary when it is viewed from a measurement perspective. This paper develops a statistical interpretation of accounting measurement to show that the depreciation calculation need not necessarily be viewed as incorrigible in Thomas's sense. A probability modelling approach is adopted to illustrate how the depreciation adjustment can be used to smooth accounting earnings over time. Depreciation is thus shown to have potentially useful estimation properties. The results have obvious policy implications regarding the objectives that depreciation and other accounting allocations might serve. They also have a bearing on fundamental questions regarding the nature of accounting measurement.     

The anticipated real interest rate,capital utilization and the cyclical pattern of real wages

This paper develops a channel through which increases in anticipated real interest rates can be ‘expansionary’ for current aggregate labor demand and current output supply. The key feature of the model is the introduction of a user cost of capital utilization which confronts the firm with the intertemporal problem of the optimal choices of capital utilization and depreciation. The resulting variation in capital utilization and capital services in response to fluctuations in the real rate of interest shifts the marginal product of labor and, thus, the demand for labor at the same time and in the same direction that Lucas-Rapping real interest rate effects operate on labor supply. The complete model places no a priori restrictions on the cyclical pattern of real wages, thus avoiding the countercyclical real wage prediction made by Keynes and various classical writers that is rejected by the data. Estimates of a labor demand schedule for the annual U.S. data reveal a significantly positive real interest rate effect.     

Optimal Smoothing of Profit Via Overhead Allocation

Income smoothing, as defined in Statistical Activity Cost Theory (SACT), is the rational statistical adjustment of periodic accounting earnings to reduce their time volatility around average long-term profit per period. This article demonstrates how overhead cost allocations can be applied to smooth accounting earnings optimally in accordance with this definition. Such an approach parallels earlier work, such as that by Lane and Willett (1997 , 1999 ), in which a depreciation formula was derived and applied for this purpose. In particular, it is shown that, to realize an income smoothing effect in profit making firms, the usual optimal strategy is to over-allocate costs, giving support to the accounting principle of conservatism.     

An Empirical Analysis of Thomas's Financial Accounting Allocation Fallacy Theory in a Financial Distress Context

Thomas (1969, 1974 and 1975) theoretically attacked the practice of incorporating major accounting allocations across time such as depreciation and deferred taxes in financial accounting. Instead, he advocated using accrual-based funds statements as alternatives to an income statement (preferably a net-quick-assets funds statement). This paper reports the results of analyses of Thomas's assertions by using the predictive ability criterion, and the ordinal four-state financial distress methodology developed by Ward (1994). Results generally support Thomas's assertions. A net-quick-assets operating flow and an operating flow variable adjusted for depreciation and amortisation and deferred tax allocations are both normally stronger predictors of financial distress than a net income variable. However, contrary to Thomas's theory, the change in inventory, a non-monetary item, appears to be an important predictor of financial distress one year before distress.     

Anticipated and unanticipated disturbances: The dynamics of the exchange rate and the current account

The pattern of correlation between the exchange rate and the current account is investigated in the context of an econometric portfolio-balance model with rational expectations. While exchange-rate appreciation (depreciation) is positively correlated with current account surpluses (deficits) in response to unanticipated disturbances, there can be either positive or negative correlation in response to anticipated disturbances. Using maximum likelihood methods, the model is estimated and the response to anticipated disturbances is simulated using data from the current flexible exchange-rate period. The exchange rate and the current account are found to be positively correlated in response to anticipated disturbances for Japan and the United States, and negatively correlated for Germany and the United Kingdom.     

The Relationship between Investment and Asset Life

Optimal investment in an asset and its optimal life are shown to be interrelated through operating cash flows and depreciation allowance, as well as book and salvage values upon termination; thus they are determined simultaneously. Asset life and investment are positively (negatively) related if delaying abandonment increases (reduces) the benefit of marginal investment. If investment and asset life are positively related, increased debt financing or allowable depreciation positively impact on them; otherwise, the impact is ambiguous in sign. Further, investment in a zero salvage value asset and its holding period increase with depreciation or leverage when (1) its cash flows form an annuity or (2) the firm employing it is tax-exempt.     

Accounting for “negative salvage”

Many businesses are overlooking a current cost of operation which should be matched against current revenues. This cost, really a bundle of related cost items, is incurred at the end of an asset's useful life. In the public utility sector the general term ascribed to this cost element is “negative salvage”. In this note some current examples of negative salvage are identified and some of the causes of negative salvage are discussed. The introduction of negative salvage into the classroom discussion of depreciation provides an interesting new example of the matching/allocation problem.     

Why Managers Use Cost Allocations: A Research Note

Using an experimental design, this paper investigates empirically the conditions under which managers use cost allocations for decision-making purposes. The paper focuses on decision-risk in the context of short-term decision-making when most capacity costs are unavoidable. Decision-risk is determined in this paper by a combination of two factors: uncertainty and irreversibility. Cost allocations can serve as a reference point for a decision maker to deal with decision-risk. Three hypotheses are formulated: (1) the combination of both uncertainty and decision irreversibility induces the use of cost allocations. However, (2) certainty or (3) decision reversibility alone are not expected to induce the use of cost allocations. The hypotheses were tested in an experiment, in which senior managers participated. The experimental results supported the hypotheses.     

Financial factors and firm growth: evidence from financial data on Taiwanese firms

We investigate the possible predictability of firm growth in Taiwan using cross-sectional data of financial factors for the years 1997 and 2003 via principal component analysis. Our results reveal that the 18 financial variables (sales growth rate, total assets, total sales, return on assets, return on equity, gross margin, operating cost minus depreciation divided by sales plus other trading income, acid test ratio, debt–equity ratio, time interest earned, average receivables per average daily sales, inventory, average payables per average daily sales, working capital, working capital as a fraction of total assets, long-term liabilities as a fraction of total assets, and sales as a fraction of net worth of the firm) that we employ bunch together into five different financial ratios for the years 1997 and 2003 that are stable between these years. These financial factors are short-term liquidity, return on investment, long-term liquidity, firm size and capital turnover. Regressing these ratio groups (extracted principal components) on firm growth, we find return on investment in the year 1997 was positively and significantly related to firm growth, while long-term solvency was negatively related to firm growth. In addition, smaller firms tended to grow faster. By 2003, larger firms grew faster than smaller ones and short-term liquidity was positively and significantly related to firm growth, while return on investment was no longer a significant determining factor. Our findings suggest that firms that finance internally or do not rely too heavily on indebtedness may end up growing slower during boom periods but they are the ones that survive and outperform after the bust.     

The effect of owner versus management control on the choice of accounting methods

This paper examines the relationship between the ownership control status of firms and the accounting methods they adopt. The arguments of Watts and Zimmerman's positive theory are integrated with those of managerial economists to generate the prediction that management controlled firms are more likely than owner controlled firms to adopt accounting methods which increase reported earnings. This prediction is inconsistent with Fama's hypothesis that the market for managerial talent will prevent management controlled firms from acting differently than owner controlled firms. This paper compares the depreciation methods used by a sample of management and owner controlled firms for financial reporting purposes. The comparison considers and controls for the factors of firm size, leverage, and the depreciation method used for tax reporting purposes. The comparison reveals that there is a significant difference in the depreciation methods adopted by management controlled and owner controlled firms for financial reporting purposes.     

The interaction among disclosures,competition, and an internal control problem

This paper studies the effect of an internal control problem on a firm's disclosure policy where firms compete in non-cooperative investment game, with each firm deciding to invest in its current technology or to invest in a non-proprietary innovation. By adopting the innovation, a firm earns higher revenues at the expense of its non-adopting rival. Each principal decides on a disclosure policy for its firm that entails releasing an agent's internal cost report of the firm's current technology to the rival firm. The agent has private information about the current technology's cost and an incentive to overstate the cost. An effect of disclosures is to increase coordination between the firms, which, without a control problem, increases firm profits. However, under the same conditions that disclosures were beneficial without the control problem, disclosures may be harmful to the principal with the control problem because increased coordination between the firms allows the agent to earn higher rents. Competition substitutes for commitment to an investment policy that limits the agent's rents and this disciplining role of competition is diminished with disclosures.     

Optimal Disbursement of a Sunk Resource and Decentralised Cost Allocation

We consider whether the allocation of the sunk cost of a central resource to operating divisions can be consistent with economically optimal resource consumption decisions. When it is recognised that the central resource is scarce, one may, in principle, defend the allocation of sunk cost, if it measures the opportunity cost of usage. However, typically it has been proposed that such allocations are, at best, a proxy for opportunity cost. Applying classical control theory techniques in a wide range of operating environments, we are able to identify cost allocations that exactly equal opportunity cost. Hence, for our model environment, we provide a rationale for sunk cost allocation in terms of guiding optimal decisions, in contrast to the traditional defence in terms of providing a proxy for opportunity cost. We demonstrate clearly how cost allocations are related to opportunity costs, and identify the circumstances under which the allocation of full costs or alternatively a fixed proportion (related to acquisition conditions) of costs, results in the implementation of economically optimal resource consumption decisions.     

A Case Study on Interest Adjusted Accounting Using EEI

It can be claimed that the failure of conventional accounting explicitly to recognise the cost of capital is a major shortcoming during periods of high interest rates. Another important problem stems from the apparently arbitrary and incorrigible allocations typically involved in the matching process. Grinyer has previously proposed a theoretical solution to these problems using an allocation algorithm he called ‘Earned Economic Income’ (EEI). This paper outlines and illustrates a practical development from the EEI concept by means of a case study which explains the calculations and estimates that were made when testing the approach in a firm manufacturing and trading in industrial textiles.     

INFLATION,INVESTMENT, AND DEBT

In this paper the effect of inflation on firms' investment and debt-financing decisions is examined. Inflation affects optimal investment and financing directly through the probability of accounting loss and the real value of depreciation and interest tax shields. In addition, when corporate and differential personal taxes cause investment and financing decisions to interact, inflation has indirect effects on these decisions through their interactions. In general, the overall effects of inflation on optimal investment and debt are ambiguous in sign. For tax-exempt firms, however, optimal investment and debt are independent of inflation. For firms that are always in a tax-paying position, higher inflation reduces optimal investment without affecting optimal debt. Furthermore, inflation causes total firm value to decrease if the depreciation rate exceeds the firm's debt/asset ratio.