Accounting Returns Revisited: Evidence of Their Usefulness in Estimating Economic Returns

Abstract

Shareholders, managers, and researchers rely on estimates of a firm's past investment returns when evaluating its performance, and estimating its value. In this paper, we revisit the question of whether accounting rates of return (ARR)-computed from financial statement data-are appropriate surrogates for a firm's realized internal rate of return (IRR). Although some authors argue accounting numbers are useless for this purpose, many managers and researchers employ accounting returns as a measure of firm profitability. We derive a model showing that a firm's ARR and historical growth rate define the range in which its IRR on past investments is likely to fall. Using panel data, we find ARR is close to IRR for a large number of firms. In addition, we identify conditions under which a firm's ARR is likely to be a misleading proxy for IRR. Given the theoretical relation we derive between ARR and IRR and the empirical linkage we observe, previous research results demonstrating the value relevance of accounting information are predictable.

Keywords: profitability, accounting rate of return, economic rate of return, growth rate

JEL Classification: G31, M21, M41