The Role of the Accounting Rate of Return in Financial Statement Analysis

Abstract

Synopsis and Introduction The accounting rate of return (ARR) is “not only a central feature of any basic text on financial statement analysis but also figures commonly in the evaluation by investment analysts of the financial performance of firms” (Whittington 1988, 261). Notwithstanding the prominence given to this financial ratio (Foster 1986, 77–79), many writers have warned that the ARR lacks economic significance and can be a very misleading measure of profitability. Fisher and McGowan (1983, 90), for example, conclude that “there is no way in which one can look at accounting rates of return and infer anything about relative economic profitability.” In the same vein, Rappaport (1986, 31) states flatly that the comparison of the ARR with the cost of capital is “clearly like comparing apples with oranges.” The limitations of using ARRs to estimate the economic rate of return have been discussed over the last 25 years; for example, Harcourt (1965), Solomon (1966), Kay (1976), Fisher and McGowan (1983), Salamon (1985), Edwards et al. (1987), and Brief and Lawson (1991). This research has focused mainly on the question of whether the ARR is a good proxy for the economic return and the literature contains virtually no discussion of other ways in which the ARR might be used in financial analysis. An important exception is Peasnell (1982b) who presents a common analytical framework connecting conventional economic concepts of value and yield and accounting models of profit and return. However, even here, the main emphasis is on the relationship between accounting and economic rates of return. This emphasis is quite evident in Peasnell’s concluding comment 236that “it is difficult to assign economic significance to accounting yields except either (1) as surrogate measures of IRR or (2) when they are defined in terms of entry- or exit-market prices” (379–80). A different slant on the economic significance of ARRs is presented here where the focus is on the use of the ARR in the valuation process, not in the determination of profitability. The purpose is to show that an expression for an accounting-based measure of discounted cash flows (DCF) can be derived in terms of the ARR. Thus, quite apart from the question of whether or not the ARR is an accurate estimate of the economic rate of return, this financial ratio has a key role to play in the valuation process. The results have both analytical and practical significance. On an analytical level, the derivations can be viewed as basic “bookkeeping relationships” that are associated with a double-entry system. On the more practical side, while the DCF techniques currently used in practice “are largely accounting-based valuation approaches” (DeAngelo 1990, 100), the use of accounting data in DCF valuations is very indirect. Present practice is to “use historical accounting relationships to forecast future earnings, from which future cash flows are estimated” and, in addition, to estimate terminal values “from projections of future earnings” (p. 100). However, instead of basing DCF valuations on cash flows which are derived from accounting data, a more direct method of analysis is to base the DCF valuations directly on accounting data. Understanding how accounting data can be used in DCF analysis leads to a greater appreciation of the general nature of accounting and provides a compelling reason to give the ARR a more prominent place in financial statement analysis.