Abstract
Accounting information is used for measuring firm performance in various financial applications—a practice supported by empirical studies demonstrating the value relevance of accounting numbers, but disputed by theoretical papers arguing that a firm's accounting rate of return (ARR) serves poorly as a proxy for its internal rate of return (IRR). We derive a new model of the ARR–IRR relation, and describe how the conservatism of GAAP constrains a firm's IRR to fall in a range bounded by its historical growth rate and ARR. Using cross-sectional data, we demonstrate that economic returns can be estimated from accounting numbers for many firms. We link empirical results to underlying economic theory, and thus contribute to understanding why accounting information is value relevant.
Similar content being viewed by others
References
American Institute of Certified Public Accountants. (1970). Business Combinations, APB Opinion No. 16. New York: AICPA.
Ball, R. and P. Brown. (1968). “An Empirical Evaluation of Accounting Numbers.” Journal of Accounting Research 6, 159-178.
Beaver, W. (1968). “The Information Content of Annual Earnings Announcements.” Empirical Research in Accounting: Selected Studies. Supplement to the Journal of Accounting Research 6, 67-92.
Beaver, W. (1998). Financial Reporting: An Accounting Revolution. 3e. Upper Saddle River, NJ: Prentice Hall.
Beaver, W., R. Lambert and D. Morse. (1980). “The Information Content of Security Prices.” Journal of Accounting and Economics 2, 3-28.
Brief, R. and R. Lawson. (1991). “Approximate Error in Using Accounting Rates of Return to Estimate Economic Returns.” Journal of Business Finance and Accounting 18, 13-20.
Collins, D. and S.P. Kothari. (1989). “An Analysis of Intertemporal and Cross-sectional Determinants of Earnings Response Coefficients.” Journal of Accounting and Economics 11, 143-182.
Danielson, M. and T. Dowdell. (2001). “The Return-Stages Valuation Model and the Expectations within a Firm's P/B and P/E Ratios.” Financial Management 30, 93-124.
Feltham, G. and J. Ohlson. (1995). “Valuation and Clean Surplus Accounting for Operating and Financial Activities.” Contemporary Accounting Research 11, 689-731.
Financial Accounting Standards Board. (1974). Statement of Financial Accounting Standards No. 2: Accounting for Research and Development Costs. Stamford, CT: FASB.
Financial Accounting Standards Board. (1995). Statement of Financial Accounting Standards No. 121: Accounting for the Impairment of Long-lived Assets and for Long-lived Assets to Be Disposed Of. Norwalk, CT: FASB.
Financial Accounting Standards Board. (2001). Statement of Financial Accounting Standards No. 144: Accounting for the Impairment or Disposal of Long-lived Assets. Norwalk, CT: FASB.
Fisher, F. (1988). “Accounting Data and the Economic Performance of Firms.” Journal of Accounting and Public Policy 7, 253-260.
Fisher, F. and J. McGowan. (1983). “On the Misuse of Accounting Rates of Return to Infer Monopoly Profits.” American Economic Review 73, 82-97.
Heckman, J. (2001). “Micro Data, Heterogeneity, and the Evaluation of Public Policy: Nobel Lecture.” Journal of Political Economy 109, 673-748.
Hotelling, H. (1925). “A General Mathematical Theory of Depreciation.” Journal of the American Statistical Association 20, 340-353.
Klein, B. and K. Leffler. (1981). “The Role of Market Forces in Assuring Contractual Performance.” Journal of Political Economy 89, 615-641.
Kormendi, R. and R. Lipe. (1987). “Earnings Innovations, Earnings Persistence, and Stock Returns.” Journal of Business 60, 323-345.
Lev, B. and T. Sougiannis. (1996). “The Capitalization, Amortization, and Value-Relevance of R&D.” Journal of Accounting & Economics 21, 107-138.
Ohlson, J. (1995). “Earnings, Book Values, and Dividends in Equity Valuation.” Contemporary Accounting Research 11, 661-687.
Peasnell, K. (1996). “Using Accounting Data to Measure the Economic Performance of Firms.” Journal of Accounting and Public Policy 15, 291-303.
Penman, S. (1996). “The Articulation of Price-Earnings Ratios and Market-to-Book Ratios and the Evaluation of Growth.” Journal of Accounting Research 34, 235-259
Penman, S. and X.-J. Zhang. (2002). “Accounting Conservatism, the Quality of Earnings, and Stock Returns.” Accounting Review 77, 237-264.
Salamon, G. (1985). “Accounting Rates of Return.” American Economic Review 75, 495-504.
Salamon, G. (1988). “On the Validity of Accounting Rates of Return in Cross-sectional Analysis: Theory, Evidence, and Implications.” Journal of Accounting and Public Policy 7, 267-292.
Stewart III, G. Bennett. (1991). The Quest for Value. New York: Harper Business.
Weaver, S. (2001). “Measuring Economic Value Added: A Survey of the Practices of EVA® Proponents.” Journal of Applied Finance 11, 50-60.
White, G., A. Sondhi, and D. Fried. (2003). The Analysis and Use of Financial Statements. 3e. New York: John Wiley & Sons.
Zhang, X.-J. (2000). “Conservative Accounting and Equity Valuation.” Journal of Accounting and Economics 29, 125-149.
Author information
Authors and Affiliations
Corresponding author
Rights and permissions
About this article
Cite this article
Danielson, M.G., Press, E. Accounting Returns Revisited: Evidence of their Usefulness in Estimating Economic Returns. Review of Accounting Studies 8, 493–530 (2003). https://doi.org/10.1023/A:1027368116754
Issue Date:
DOI: https://doi.org/10.1023/A:1027368116754