Dynamic Investment Models in Accounting Research

Dynamic models of investment behavior are a natural setting for studying the desirable properties of accrual accounting rules. Dynamic Investment Models in Accounting Researchpresents three such models and discusses their applications to questions in accounting-based equity valuation and managerial performance measurement. The three models are closely related dynamic investment models. Section 2 studies the basic model where the firm periodically adjusts its capital stock in response to changing conditions in its product market, purchasing new capital goods when demand for its output improves and selling its existing capital goods when demand deteriorates. This model is perhaps the simplest variant of what is known as the neoclassical investment theory, and it captures one key feature of investment -- the mismatch in timing between investment costs and their associated economic benefits. Section 3 studies a vintage capital model in which the productivity of the firm’s capital goods is allowed to follow any arbitrary pattern. This section shows that the performance evaluation perspective on optimal accounting rules is generally less demanding than the equity valuation perspective. Section 4 reverts to the assumption of geometric productivity but relaxes the assumption of perfect reversibility. Section 4 demonstrates that, while replacement cost information is useful for equity valuation in both reversible and irreversible investment models, the nature of the relation between the firm’s equity value and the replacement cost of its assets is fundamentally different between the two settings.