Accounting and economic rates of return: a dynamic econometric investigation.
| Autor | Zeidan, Rodrigo M. |
| Cargo | Texto en Portuguese |
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Introduction
The search for the best financial performance measure is an open question in the finance literature, with a plethora of different measures having surfaced to try to yield the best answer to this pressing problem. Measures like Q-tobin's (for more, see Wernerfelt and Montgomery (1988)), Economic Value Added (EVA) and Refined Economic Value Added (REVA) (Bacidore et al., 1997), alongside the usual accounting and economic measures like return over assets, net present value and internal rate of return are all attempts at giving good information on firm performance.
There are many approaches to try to answer questions relative to measuring firm performance, and one with a particular interesting history involves the differences between economic and accounting rates of return. Seminal papers date back to Solomon (1966), Kay (1976), Fisher and McGowan (1983) and Salamon (1985). The main conclusion is that there are differences between accounting and economics definition and the measurement of rates of return. The differences arise from many sources--important ones include, but are not limited to: advertising and research and development are considered investment from an economic viewpoint, but both are costs or expenses in financial statements; and accounting depreciation is arbitrary, be it straight-line depreciation or reducing balance methods.
Since then, many papers have dealt with empirical measures of economic and accounting rates of return (see e.g., Verma (1990), Bosch (1989), Chang et al. (1994), Baber and Kang (1996), Kelly (1996a,b), Feenstra and Wang (2000), Taylor (1999) and Salvary (2005)). Some of these studies used the differences between accounting and economic rates of return as a route towards the measurement of the real economic rate of return whereas others investigated the relationship between them.
Disenchantment with the utilization of accounting rates of return for economic analysis became evident with the emergence of the New Empirical Industrial Organization (NEIO), that proposed indirect strategies of identifying market conduct without the need of marginal cost observability (see Bresnahan (1989) for an early account of the literature). Nevertheless, the use of improved rates of return remains relevant in different contexts as, for example, in the case of regulatory schemes that rely heavily on accounting data such as cost-plus and earnings sharing regimes.
The economic role of accounting data is still unresolved. For instance, Ball (2008) posits many different open questions in this line of research. The main motivation of the paper is to abandon the usual short-term concerns on the differences between accounting and economic measures of return and focus on the long-term relationship between these measures. The idea is that for economic analysis, especially market regulation, long-term concerns are more relevant than short-term ones, like market valuation. Instead of focusing on short-terms concerns, by shifting the focus to the long-term relationship between economic and accounting data one can conclude by the validity of using accounting measures in economic analysis. If the differences between accounting and economic measures prevail in the long-run, efficiency in market regulation can be improved by focusing solely on accounting information for long-run strategies instead of the implementation of highly complex schemes to measure the return of regulated firms.
The investigation of the relationship between accounting and economic rates of return and therefore the contribution of the present paper can be also motivated in at least two levels: (1)
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Studies that attempt to assess differences between accounting rates of return (ARRs) and economic measures of return such as internal rates of return (IRRs) are either purely theoretical (Kay, 1976, Salamon, 1985, Feenstra and Wang, 2000) or based on case studies (Fisher and McGowan, 1983, Taylor, 1999). Salamon (1988) did a cross-section study, but we propose a systematic approach using panel data for quoted Brazilian industrial firms.
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The conditional IRRs (Salamon, 1985) are conceptually a good proxy of the unobserved real economic rate of return. We consider a Granger causality test to verify if there is informational content between ARRs and IRRs. Robust results would indicate that ARRs are a good proxy for the conditional IRRs and thus to the unobserved real economic rate of return. ARRs and IRRs could present a co-movement in the long-run because the sources of the difference between them could be negligible in the long-run, hence ARRs would yield sufficient information on the underlying IRRs in a Granger test setting. The main hypothesis is to test this assumption, i.e., if ARRs Granger cause the IRRs. (2) The Granger causality test has already been used successfully in the context of Brazilian financial reports by Costa Jr. et al. (2007). In their paper the author found marginal evidence that accounting returns cause stock returns.
The paper is organized as follows. Section 2 introduces the conceptual aspects related to the calculation of the conditional IRRs necessary for the test, and the set of accounting rates of return to be considered. Section 3 presents the data construction procedures and the results for the Granger causality tests. Section 4 brings some final comments.
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Accounting and Economic Rates of Return: Conceptual Aspects
2.1 The conditional IRRs
The main problem when trying to establish the long term relationship between accounting rates of return (ARRs) and the internal rate of return (IRR) is arriving at the correct IRR to compare to the ARRs. Letting [Y.sub.n] be the revenue stream and [I.sub.n] the investment, the IRR of a project is defined as the rate r that solves:
[Y.sub.0] - [I.sub.0] + [Y.sub.1] - [I.sub.1]/1 + r + ... + [Y.sub.n] - [I.sub.n]/[(1 + r).sup.n] = 0 (1)
The IRR is then the rate that equals the present value of the investment with the cash flow that it generates, thus turning the present value of the investment zero. It is the change in the present value of the investment that can be considered as the economic deprecation (Schmalensee, 1989) since depreciation distributes the value of investment over time. Thus the IRR can be considered a good proxy for the real unobserved economic return, since a project would only be viable if its IRR would be higher than a control parameter--usually the cost of capital.
Although conceptually easy to follow, empirical measurement of the IRR is not simple to do. Three are the main reasons:
* Equation 1 is a n-polynomial with n possible solutions. Thus for non-conventional cash flows there would be multiple IRRs with no possible way to determine which one would be the proxy for the economic rate of return (Ross et al., 1998);
* Investment projects with the same IRR may not be interchangeable since investment decisions consider other aspects such as uncertainty or the need for initial investment. Thus a project that needs less investment should be preferable to a project with the same IRR but higher initial investment;
* Financial reports have many idiosyncrasies and it is difficult to retrieve which information is essential to build [Y.sub.n] and [I.sub.n].
Different approaches have been built to analyze the different behaviors of economic and accounting rates of return, always with the goal of determining if accounting rates of return are a good surrogate to economic rates of return. Particularly interesting approaches can be found in Baber and Kang (1996)--they find that accounting rates of return are higher than their implied internal rates of return for the US pharmaceutical industry, and Kelly (1996a,b), where the author finds that the ARR is an unreliable substitute for the IRR, using 44 Australian corporations between 1968 and 1990. Following previous work, we investigate the relationship between the ARR and IRR by trying, first, to develop a reliable IRR surrogate.
Salamon (1982, 1985) and Taylor (1999) tried to estimate the...
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