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.
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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
- return on investment
- economic profit
- measuring profitability
- value relevance
- accounting information