Review of Accounting Studies

, Volume 12, Issue 2–3, pp 325–370

Conservatism, growth, and return on investment

  • Madhav V. Rajan
  • Stefan Reichelstein
  • Mark T. Soliman
Article

Abstract

Return on Investment (ROI) is widely regarded as a key measure of firm profitability. The accounting literature has long recognized that ROI will generally not reflect economic profitability, as determined by the internal rate of return (IRR) of a firm’s investment projects. In particular, it has been noted that accounting conservatism may result in an upward bias of ROI, relative to the underlying IRR. We examine both theoretically and empirically the behavior of ROI as a function of two variables: past growth in new investments and accounting conservatism. Higher growth is shown to result in lower levels of ROI provided the accounting is conservative, while the opposite is generally true for liberal accounting policies. Conversely, more conservative accounting will increase ROI provided growth in new investments has been “moderate” over the relevant horizon, while the opposite is true if new investments grew at sufficiently high rates. Taken together, we find that conservatism and growth are “substitutes” in their joint impact on ROI.

Keywords

Return on investment Conservatism Economic profitability 

JEL Classifications

G31 M41 

References

  1. Ball, R., & Shivakumar, L. (2005). Earnings quality in UK private firms: Comparative loss recognition timeliness. Journal of Accounting Research, 39, 83–128.Google Scholar
  2. Bar-Yosef, S., & Lustgarten, S. (1994). Economic depreciation, accounting depreciation, and their relation to current cost accounting. Journal of Accounting, Auditing & Finance, 9, 41–60.Google Scholar
  3. Basu, S. (1997). The conservatism principle and the asymmetric timeliness of earnings. Journal of Accounting and Economics, 24, 3–37.CrossRefGoogle Scholar
  4. Beatty, A. (2006). Discussion of “asymmetric timeliness of earnings, market-to-book and conservatism in financial reporting”. Journal of Accounting and Economics, forthcoming.Google Scholar
  5. Beaver, W., & Dukes, R. (1974). δ-Depreciation methods: Some analytical results. Journal of Accounting Research, 9, 391–419.Google Scholar
  6. Beaver, W., & Ryan, S. (2004). Conditional and unconditional conservatism. Review of Accounting Studies, 38, 127–148.Google Scholar
  7. Botosan, C., & Plumlee, M. (2002). A re-examination of disclosure level and the expected cost of equity capital. Journal of Accounting Research, 40, 21–40.CrossRefGoogle Scholar
  8. Botosan, C., & Plumlee, M. (2005). Assessing alternative proxies for the expected risk premium. The Accounting Review, 80, 21–53.Google Scholar
  9. Brief, R. (2002). Conservative accounting and earnings quality. Working paper, New York University.Google Scholar
  10. Chan-Lee, J. H., & Sutch, H. (1985). Profits and rates of return in OECD countries. Working Papers, 20: OECD Publishing. doi: 10.1787/468348310348.Google Scholar
  11. Cheng, Q. (2005). What determines residual income? The Accounting Review, 80, 85–112.Google Scholar
  12. Danielson, M., & Press, E. (2003). Accounting returns revisited: Evidence of their usefulness in estimating economic returns. Review of Accounting Studies, 8, 493–530.CrossRefGoogle Scholar
  13. Dechow, P., Sloan, R., & Soliman, M. (2004). Implied equity duration: A new measure of equity risk. Review of Accounting Studies, 9, 197–228.CrossRefGoogle Scholar
  14. Dhaliwal, D. S., Krull, L. K., Li, O. Z., & Moser, W. J. (2005). Dividend taxes and implied cost of equity capital. Journal of Accounting Research, 43, 675–708.CrossRefGoogle Scholar
  15. Dutta, S., & Reichelstein, S. (2005). Accrual accounting for performance evaluation. Review of Accounting Studies, 10, 527–552.CrossRefGoogle Scholar
  16. Easton, P. (2004). PE ratios, PEG ratios, and estimating the implied expected rate of return on equity capital. The Accounting Review, 79, 73–96.Google Scholar
  17. Easton, P., & Monahan, S. (2005). An evaluation of accounting-based measures of expected returns. The Accounting Review, 80, 501–538.Google Scholar
  18. Easton, P., Taylor, G., Shroff, P., & Sougiannis, T. (2002). Using forecasts of earnings to simultaneously estimate growth and the rate of return on equity investment. Journal of Accounting Research, 30, 657–676.CrossRefGoogle Scholar
  19. Fairfield, P., Whisenant, S., & Yohn, T. (2003). Accrued earnings and growth: Implications for future profitability and market mispricing. The Accounting Review, 78, 353–371.Google Scholar
  20. Fama, E., & French, K. (1993). Common risk factors in the returns on stocks and bonds. Journal of Financial Economics, 43, 153–193.CrossRefGoogle Scholar
  21. Fama, E., & French, K. (1995). Size and book-to-market factors in earnings and returns. Journal of Finance, 50, 131–155.CrossRefGoogle Scholar
  22. Fama, E., & French, K. (2007). Profitability, investments and average returns. Journal of Financial Economics, forthcoming.Google Scholar
  23. Fama, E., & MacBeth, J. (1973). Risk, return and equilibrium: Empirical tests. Journal of Political Economy, 81, 607–636.CrossRefGoogle Scholar
  24. Feltham, G., & Ohlson, J. (1996). Uncertainty resolution and the theory of depreciation measurement. Journal of Accounting Research, 34, 209–234.CrossRefGoogle Scholar
  25. Fisher, F., & McGowan, J. (1983). On the misuse of accounting rates of return to infer monopoly profits. American Economic Review, 96, 82–97.Google Scholar
  26. Gaver, J. J., & Gaver, K. M. (1993). Additional evidence on the association between the investment opportunity set and corporate financing, dividend, and compensation policies. Journal of Accounting and Economics, 16, 125–160.CrossRefGoogle Scholar
  27. Gebhardt, W., Lee, C., & Swaminathan, B. (2001). Toward an implied cost of capital. Journal of Accounting Research, 39, 135–176.CrossRefGoogle Scholar
  28. Givoly, D., & Hayn, C. (2000). The changing time-series properties of earnings, cash flows and accruals: Has financial reporting become more conservative? Journal of Accounting and Economics, 29, 287–320.CrossRefGoogle Scholar
  29. Gjesdal, F. (2004). A steady state growth valuation model: A note on accounting and valuation. Working paper, NHH, University of BergenGoogle Scholar
  30. Greenball, M. (1969). Appraising alternative methods of accounting for accelerated tax depreciation: A relative accuracy approach. Journal of Accounting Research, 7, 262–289.CrossRefGoogle Scholar
  31. Guay, W. R. (1999). The sensitivity of CEO wealth to equity risk: An analysis of the magnitude and determinants. Journal of Financial Economics, 53, 3–71.CrossRefGoogle Scholar
  32. Guay, W. R., Kothari, S. P., & Shu, S. (2005). Properties of implied cost of capital using analysts’ forecasts. Working paper, University of Pennsylvania.Google Scholar
  33. Hail, L., & Leuz, C. (2006). International differences in the cost of equity capital: Do legal institutions and securities regulation matter? Journal of Accounting Research, 44, 485–532.CrossRefGoogle Scholar
  34. Iman, R. L., & Conover, W. J. (1979). Use of the rank transform in regression. Technometrics, 21, 499–509.CrossRefGoogle Scholar
  35. Lev, B., Sarath, B., & Sougiannis, T. (2005). R&D reporting biases and their consequences. Contemporary Accounting Research, 22, 977–1026.CrossRefGoogle Scholar
  36. Loughran, T., & Ritter, J. (2000). Uniformly least powerful tests of market efficiency. Journal of Financial Economics, 55, 361–389.CrossRefGoogle Scholar
  37. Monahan, S. (2005). Conservatism, growth and the role of accounting numbers in the fundamental analysis process. Review of Accounting Studies, 10, 227–260.CrossRefGoogle Scholar
  38. Mueller, D. (1986). Profits in the long-run. New York: Cambridge University Press.Google Scholar
  39. Newey, W. K., & West, K. D. (1987). A simple, positive semi-definite, heteroskedasticity and autocorrelation consistent covariance matrix. Econometrica, 55, 703–708.CrossRefGoogle Scholar
  40. Nissim, D., & Penman, S. (2001). Ratio analysis and equity valuation: From research to practice. Review of Accounting Studies, 6, 109–154.CrossRefGoogle Scholar
  41. Ohlson, J., & Gao, Z. (2006). Earnings, earnings growth and value. Foundations and Trends in Accounting, forthcomingGoogle Scholar
  42. Ohlson, J., & Zhang, X. J. (1998). Accrual accounting and equity valuation. Journal of Accounting Research, 36, 85–111.CrossRefGoogle Scholar
  43. Pastor, L., Sinha, M., & Swaminathan, B. (2006). Estimating the intertemporal risk-return tradeoff using the implied cost of capital. Working paper, University of Chicago.Google Scholar
  44. 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.CrossRefGoogle Scholar
  45. Penman, S. (2003). Financial statement analysis for security valuation. New York: McGraw Hill Press.Google Scholar
  46. Penman, S., & Zhang, X. J. (2002). Accounting conservatism, the quality of earnings, and stock returns. The Accounting Review, 77, 237–264.Google Scholar
  47. Reichelstein, S. (1997). Investment decisions and managerial performance evaluation. Review of Accounting Studies, 2, 157–180.CrossRefGoogle Scholar
  48. Richardson, S., Sloan, R., Soliman, M., & Tuna, I. (2006). The implications of accounting distortions and growth for accruals and profitability. The Accounting Review, 81, 713–743.Google Scholar
  49. Rockafellar, R. T. (1970). Convex analysis. Princeton: University Press.Google Scholar
  50. Rogerson, W. (1997). Inter-temporal cost allocation and managerial investment incentives: A theory explaining the use of economic value added as a performance measure. Journal of Political Economy, 105, 770–795.CrossRefGoogle Scholar
  51. Salamon, G. (1985). Accounting rates of return. The American Economic Review, 75, 495–504.Google Scholar
  52. Salamon, G. (1988). On the validity of accounting rate of return in cross-sectional analysis: Theory, evidence and implications. Journal of Accounting and Public Policy, 7, 267–292.CrossRefGoogle Scholar
  53. Scherer, F. (1982). The breakfast cereal industry. In W. Adams (Ed.), The structure of American industry. New York: Macmillan.Google Scholar
  54. Skogsvik, K. (1998). Conservative accounting principles, equity valuation and the importance of voluntary disclosures. British Accounting Review, 30, 361–381.CrossRefGoogle Scholar
  55. Solomon, E. (1966). Return on investment: The relation of book yield to true yield. In Research in accounting measurement. American Accounting AssociationGoogle Scholar
  56. Solomons, D. (1961). Economic and accounting concepts of income. The Accounting Review, 36, 374–383.Google Scholar
  57. Stark, A. (2004). Estimating economic performance from accounting data – A review and synthesis. The British Accounting Review, 36, 321–343.CrossRefGoogle Scholar
  58. Stauffer, T. (1971). The measurement of corporate rates of return. Bell Journal of Economics, 2, 434–469.CrossRefGoogle Scholar
  59. Vuolteenaho, T. (2002). What drives firm-level stock returns? Journal of Finance, 57, 233–264.CrossRefGoogle Scholar
  60. Watts, R. L. (2003). Conservatism in accounting part I: Explanations and implications. Accounting Horizons, 17, 207–221.Google Scholar
  61. Zhang, X. J. (2000). Conservative accounting and equity valuation. Journal of Accounting and Economics, 29, 125–149.CrossRefGoogle Scholar
  62. Zhang, X. J. (2001). Accounting conservatism and the book rate of return. Working paper, Haas School of Business, U.C. Berkeley.Google Scholar

Copyright information

© Springer Science+Business Media, LLC 2007

Authors and Affiliations

  • Madhav V. Rajan
    • 1
  • Stefan Reichelstein
    • 1
  • Mark T. Soliman
    • 1
  1. 1.Graduate School of BusinessStanford UniversityStanfordUSA

Personalised recommendations