Accrual-based compensation, depreciation and investment decisions

Abstract

The paper studies the usefulness of accruals relative to cash flows for performance measurement in short-term contracts, if an agent undertakes activities with long-term and short-term consequences. It characterizes an optimal depreciation method for incentive purposes, and shows that it is not consistent with traditional depreciation methods. Rather, it aligns the performance measure with the expected long-term consequences of the investment, and shifts away compensation risk from the agent. The paper also identifies conditions under which accruals outperform cash flows as a performance measure even if the agent can manipulate the depreciation method.