Get access

Depreciation Rules and the Relation between Marginal and Historical Cost

Authors

  • MADHAV V. RAJAN,

    1. Graduate School of Business, Stanford University. We are grateful to Ray Ball (the editor), Hans-Ulrich Kuepper, Julia Nasev, Jim Ohlson, Steve Penman, Florin Sabac, and an anonymous reviewer for detailed comments on this manuscript. We also acknowledge helpful comments by seminar participants at the following institutions: Carnegie Mellon, Chicago-Minnesota Theory Conference, City University (London), European School of Management and Technology (Berlin), Harvard Business School, Interdisciplinary Accounting Conference (Copenhagen), Michigan, Stanford, Stockholm School of Economics, Vienna and Washington. Finally, we received valuable research assistance from Ian Gow, Alexander Nezlobin, and Yanruo Wang.
    Search for more papers by this author
  • STEFAN REICHELSTEIN

    1. Graduate School of Business, Stanford University. We are grateful to Ray Ball (the editor), Hans-Ulrich Kuepper, Julia Nasev, Jim Ohlson, Steve Penman, Florin Sabac, and an anonymous reviewer for detailed comments on this manuscript. We also acknowledge helpful comments by seminar participants at the following institutions: Carnegie Mellon, Chicago-Minnesota Theory Conference, City University (London), European School of Management and Technology (Berlin), Harvard Business School, Interdisciplinary Accounting Conference (Copenhagen), Michigan, Stanford, Stockholm School of Economics, Vienna and Washington. Finally, we received valuable research assistance from Ian Gow, Alexander Nezlobin, and Yanruo Wang.
    Search for more papers by this author

ABSTRACT

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.

Ancillary