On the validity of accounting rates of return in cross-sectional analysis: Theory, evidence, and implications

Salamon, Gerald L.

doi:10.1016/0278-4254(88)90038-5

Cited by 28 publications

(28 citation statements)

References 14 publications

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“…Some organizations, like the OECD, have also used ROI measures for country-wide comparisons of profitability; see, for instance, Chan-Lee and Sutch (1985). 2 Earlier studies exploring the connection between IRR and ROI include Solomons (1961), Solomon (1966), Fisher and McGowan (1983), Salamon (1985Salamon ( , 1988, Bar-Yosef and Lustgarten (1994) and Stark (2004). 3 Feltham and Ohlson (1996), Ohlson and Zhang (1998) and Zhang (2000) refer to accounting as conservative if on average market values exceed book values.…”

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confidence: 99%

Conservatism, growth, and return on investment

2007

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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.

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confidence: 99%

Conservatism, growth, and return on investment

2007

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“…Naturally, as Salamon (1985) has pointed out, estimates derived from the CRR approach, and, indeed, the approach described above based on cash inflows, are conditional on the assumed shape of the cash flow profile associated with a unit investment in the cash flow profile (because the true cash flow profile is, in general, unknown). Further, it is sometimes possible to amalgamate equations (2) and (3) into a single equation relating r to g , N , CRR, and other parameters of the assumed cash flow profile (as in, for example, Salamon 1982, 1988and Gordon and Hamer, 1988. In general, however, such equations need to be solved by iterative procedures and, hence, the advantages of being able to compress equations (2) and (3) into a single equation are small from a practical point of view.…”

Section: Cash Recovery Rates and Definitions Of Corporate Economic Pementioning

confidence: 99%

“…For example, Stark (1987a) has shown that the CRR, as defined theoretically in the models of the firm used by Ijiri and Salamon, is generally impossible to observe when definitions of cash recovery and investment taken from Ijiri (1 978) are used. Lee and Stark (1 987) have further pointed out that the system of cash recoveries and investment flows defined in Ijiri (1978) is inappropriate for use in capital budgeting, casting further doubt on the definition of the CRR used in the empirical exercises in Ijiri (1978Ijiri ( , 1979Ijiri ( , 1980 and Salamon (1982Salamon ( , 1985Salamon ( , 1988. Lee and Stark (1987) and Stark (1987b) suggest the use of conventional cash flow definitions in applying the CRR approach.…”

Section: Introductionmentioning

confidence: 95%

“…The cash recovery rate (CRR) approach is one such method of estimating corporate economic performance (where the term economic performance is taken to mean, in this context, the economic, or internal, rate of return (IRR) being earned by the firm), and was first developed by Ijiri in a series of papers (Ijiri 1978(Ijiri , 1979(Ijiri , 1980. Subsequent to Ijiri's work, Gordon and Hamer (1988), Griner and Stark (1988a) and Salamon (1982Salamon ( , 1985Salamon ( , 1988 have *This paper was inspired initially by a question asked by Dick Brief, in private correspondence dated February 19, 1988, as to what assumptions the use of the cash recovery rate makes about our knowledge about a firm's past, present and future cash flows. Hopefully the analysis of the paper provides some answers to this question.…”

Section: Introductionmentioning

confidence: 98%

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On Testing the Assumptions of the Cash Recovery Rate Approach to the Estimation of Economic Performance

Stark

1989

Accounting and Business Research

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The first purpose of this paper is to investigate the necessary (as opposed to sufficient) assumptions underlying the CRR approach to the estimation of corporate economic performance. By so doing, the general circumstances in which an estimate of corporate economic performance based on CRRs will exactly equal a firm's IRR are identified. It is pointed out that these necessary assumptions are related to the concept of corporate economic performance being invoked (within the general idea that we are trying to estimate a firm's internal rate of return). Second;there is a drawing out of the empirical implications, as to the behaviour of corporate cash flows and CRRs, of the necessary assumptions for the CRR approach to produce an estimate of economic performance equal to a firm's IRR for each of these definitions of corporate economic performance. In particular, it is argued that these empirical implications depend upon the specific manner in which the CRR approach is applied in practice. A third purpose of the paper is to provide some empirical evidence as to whether an example of the practice of using the CRR approach employs data consistent with the necessary assumptions for this particular approach to be valid outlined in the paper. In fact, it turns out that this might not be the case. The evidence casts light on the extent to which CRR-based estimates of corporate economic performance are likely to be reasonable proxies of firms' IRRs.

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“…It also biases profit, as income statement accounts for current R&D outlays instead of economic amortization of previous R&D investments (e.g., Fisher and McGowan, 1983;Salamon, 1985Salamon, , 1988. Thus, accounting for R&D can bias the nominator (earnings) or denominator (equity) of the ROE.…”

Section: Related Literature and Hypothesis Developmentmentioning

confidence: 99%