Approximate Error In Using Accounting Rates of Return to Estimate Economic Returns

Further Notes on Estimating Economic Returns From Published Accounting Statements

“…An empirical investigation of this bound is made, and it is found to be robust but too conservative to be practically useful. The empirical evidence supports the need for analysts to make a Brief and Lawson (1991) correction for valuation errors. The paper also presents new results on the bias in the ARR over a single period, showing how accounting profitability measures can be used in economic analysis whatever system of accounting measurement is used.…”

“…The comparable' boundaries using Brief and Lawson (1991) Table 2 would be -24% < IRR < 35 % , based on assumptions that the opening and closing market to book ratios were in the range (0.5,3), and the difference between the growth in the book values and the IRR did not exceed 15%.…”

“…The early literature on this issue, e.g., Harcourt (1965), Solomon (1966), Livingston and Salamon (1970), Stauffer (1971) and Fisher and McGowan (1983) draws such dismal conclusions on the perils of this endeavour as to virtually undermine its intellectual credentials. However, due to the insights of Kay (1976), Peasnell (1982), Kay and Meyer (1986), Steele (1986)and Brief and Lawson (1991) scholars are now less pessimistic about the conditions under which accounting measures can be used for valid economic analysis. The early literature investigating the relationship between ARR And IRR modelled the problem of a firm investing in individual projects and a mix of projects under alternative assumptions about depreciation policy and growth.…”

“…The IRR is found to be a weighted average of ARRs plus an error term which depends on opening and closing valuation differences. The behaviour of this error term has recently been investigated by Brief and Lawson (1991) who develop an approximation involving the growth in book values and the market to book ratios. Their analysis confirms Fisher and McGovern's (1983) findings that even over short periods of time the size of the error term can be huge.…”

Commonalities Between Added Value Ratios and Traditional Return on Capital Employed

“…'Other proposals that have appeared in the literature include: replacing ROCE by a cash recovery ratio (Ijiri, 1980;Salamon, 1982); using time-series observations of ROCE weighted in an appropriate manner (Kay, 1976;Brief and Lawson, 1991); and computing a pseudo-internal rate of return from ROCEs (Brief and Lawson, 1992). All are forms of ROCE, in the sense of being ratios of earnings to capital (cash earnings to gross outlay in the case of the cash recovery ratio).…”