Inter-Temporal Cost Allocation and Investment Decisions

Innovation and Economic Growth

Article Snapshot

Author(s)

William Rogerson

Source

Journal of Political Economy, Vol. 116, No. 5, pp. 931-950, October 2008

Summary

This paper uses a formal model to determine a superior accounting method for firms making investments.

Policy Relevance

The accounting rule presented in the paper provides a simple tool for incentivizing managers to compute and select an optimal level of investment over time.

Main Points

 

 

 

 

 

  • Firms often must make large, irreversible investments in long-lived productive assets like factory equipment.
  • It is difficult to evaluate firm performance when these investments are made, but a common accounting technique spreads the cost of the asset over the periods of its use.
  • This method has not been studied or rigorously legitimized despite its widespread use.
  • An accounting rule called “Relative Replacement Cost” (RRC) stipulates, roughly, that the cost of a deteriorating asset should be spread over its useful life in proportion to the cost of replacing the surviving asset in each period. The time-adjusted value of these costs should be equal to the asset’s purchase price.
  • Using the RRC rule, a firm can invest optimally simply by choosing investments in each period that will maximize the next period’s accounting income.
  • Further, the RRC income can be used as a target to robustly incentivize a knowledgeable manager to act responsibly.

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