Over-investment and under-investment in firms that implement residual income-based compensation

This dissertation investigates the investing and performance of firms that use residual income based compensation plans. The management accounting literature has long discussed the merits of incentives based on residual income (RI, net operating profit after tax less a charge for capital employed) relative to those based on earnings and return on investment measures in terms of “over-investment” and “under-investment” (Solomons 1965, Horngren, Foster and Datar 2000). This dissertation is the first to examine these phenomena empirically. In studying the investing of RI-implementing firms, I hypothesize firms that switch to RI from earnings based compensation are addressing an over-investment problem, and should decrease new investment and increase the distribution of cash to shareholders. In contrast firms that switch to RI from return on investment based compensation are addressing an under-investment problem, and should increase new investment and decrease the distribution of cash. I find, as hypothesized, that firms switching from earnings have statistically significant decreases in investment, and increases in the distribution of cash. In contrast, I find that firms switching from return on investment have statistically insignificant increase in investment and a decrease in the distribution of cash. A test comparing these two groups of firms shows that investment and distribution of cash are significantly different between these two sub-samples.; In studying the performance of RI-implementing firms, I hypothesize firms that address over-investment successfully should increase delivered RI and return on investment; firms that address under-investment successfully should increase delivered RI and decrease return on investment. Moreover, if addressing over-investment and under-investment improves efficiency, the implementation of RI should be associated with positive abnormal returns to shareholders. I find delivered RI increases for implementing firms while return on investment increases for firms addressing over-investment and is not significant for firms addressing under-investment. The concurrent changes in investing, repurchases, RI and return on investment, of firms switching from earnings, relative to those switching from return on investment, are consistent with the predictions of a theory about the incentive effects of RI vs. Earnings vs. Return on Investment commonly taught in MBA-level management accounting courses. Further, RI implementation is positively associated with abnormal returns to shareholders.