Depreciation Choice and Future Operating Performance

Abstract

In this study we test the argument that information asymmetry and the problems of adverse selection provide incentives for managers to use accounting choices to signal relatively higher future prospects. Specifically, we contend that firms use accelerated depreciation to credibly signal higher future earnings and cash flows, consistent with signaling theory. Compared to straight-line depreciation, accelerated depreciation reduces earnings in the earlier years of asset lives and produces more variability in earnings. Despite these drawbacks, hundreds of firms voluntarily use accelerated depreciation for at least some of their depreciable assets. Our results indicate that the use of accelerated depreciation foreshadows higher future earnings and cash flows for horizons of one, two, and three years ahead.