Conservatism, Growth, and Return on Investment

Conservatism, Growth, and Return on Investment

By Madhav V. Rajan, Stefan J. Reichelstein, Mark Soliman
2006Working Paper No. 1956

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 firms 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
financial analysis, financial statements, valuation, cost accounting