The Impact of Accounting Distortions on Performance and Growth Measures

Abstract

This study examines the impact of accounting distortions (i.e., conservatism or aggression) on performance and growth measures in both steady and non-steady states. First, I demonstrate the effect of accruals reversal and highlight the scenarios where accounting distortions understate or overstate net income, book value of equity, accounting return on equity, and residual income. Second, I show how equity growth, income growth, residual income growth, assets growth, and revenue growth relate to one another. While these growth measures are attributable to changes in real activities, they can also be fictitiously created by varying the distortions level. Third, my analysis shows that the departure of P/B ratio from one can be a reliable indication of accounting distortions only after controlling for economic rent and mis-pricing errors. These implications are insensitive to whether accounting distortions are conditional or unconditional.

Keywords: Earnings management, Conservatism, Aggressiveness, Accounting distortions, Growth, Valuation, Abnormal accruals

JEL Classification: G12, M41