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This paper examines whether "you get what you pay for" in firms that implement residual income (RI)-based compensation. Specifically, this paper explores differences in investment patterns of firms that implement RI-based compensation plans conditional on whether the firms switched from earnings or return on investment (ROI)-based compensation. I find that the pattern of investment for firms switching to RI from earnings-based compensation is opposite to that of firms switching from ROI-based compensation. Changes in investment within each individual subgroup yield weaker, mixed results. In addition, this paper documents that delivered RI increases in firms that implement RI. My paper contributes to the literature on the investment effects of RI by examining the relevance of a set of arguments that have been made in management accounting textbooks since 1965. These arguments are still found in current textbooks and are commonly taught to students in graduate level managerial accounting classes. The arguments help us to examine a natural experiment in which we can better specify the conditions under which RI use is expected to be associated with changes in investment.
Key words: residual income; performance measurement; incentives; investment decisions; economic value added
History: Accepted by Stefan Reichelstein, accounting; received September 24, 2003. This paper was with the author 7 ½ months for 2 revisions.
1. Introduction
This paper examines whether investment differs for firms switching to residual income (RI)-based compensation from earnings versus return on investment (ROI)-based compensation plans. Prior empirical research (Wallace 1997, Kleiman 1999) presumed that firms implementing RI switched from earnings-based plans, hypothesized that investment should decrease, and found mixed results. The hypothesis of prior research is consistent with discussions about the incentives provided by earnings versus RI, commonly found in accounting textbooks (from Solomons 1965 to Horngren et al. 2000). Yet these same texts also compare incentives provided by ROI and argue that in certain situations investment might increase for firms switching from ROI to RI. This paper explores whether such a difference is relevant in explaining the mixed results of prior research.
This paper identifies 181 firms that have implemented RI-based compensation plans. It examines changes in investment for the pooled sample of implementing firms and finds no evidence of changes in investment associated with the implementation of RI. It then...