Conservatism, Growth, and Return on Investment

58 Pages Posted: 7 Feb 2007

See all articles by Madhav V. Rajan

Madhav V. Rajan

Booth School of Business, University of Chicago

Stefan J. Reichelstein

Stanford University - Stanford Graduate School of Business; CESifo (Center for Economic Studies and Ifo Institute)

Mark T. Soliman

University of Southern California - Marshall School of Business

Multiple version iconThere are 2 versions of this paper

Date Written: December 2006

Abstract

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.

Keywords: cost accounting, financial analysis, financial statements, valuation

Suggested Citation

Rajan, Madhav V. and Reichelstein, Stefan J. and Soliman, Mark T., Conservatism, Growth, and Return on Investment (December 2006). Stanford University Graduate School of Business Research Paper No. 1956. Available at SSRN: https://ssrn.com/abstract=961855 or http://dx.doi.org/10.2139/ssrn.961855

Madhav V. Rajan (Contact Author)

Booth School of Business, University of Chicago

1101 East 58th Street
Chicago, IL 60637-1561
United States

Stefan J. Reichelstein

Stanford University - Stanford Graduate School of Business ( email )

655 Knight Way
Stanford, CA 94305-5015
United States
650-736-1129 (Phone)
650-725-7979 (Fax)

CESifo (Center for Economic Studies and Ifo Institute)

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Munich, DE-81679
Germany

HOME PAGE: http://www.CESifo.de

Mark T. Soliman

University of Southern California - Marshall School of Business ( email )

2250 Alcazar Street
Los Angeles, CA 90089
United States

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