NEW YORK – For decades a company’s book rate of return was considered a key measure of profitability. Accountants in every market from Wall Street to Tokyo have long held the metric as an indicator of an investment’s success. But new Columbia Business School research challenges the status quo to find that when conservative accounting is widely applied, book rate of return does not convey the profitability of investment but rather the risk and expected return to investing. Perception can hide reality.
The new study Connecting Book Rate of Return to Risk and Return: The Information Conveyed by Conservative Accounting finds that while the book rate of return is often viewed as positively associated with risk and expected stock returns, conservative accounting actually causes the book rate of return to be negatively associated with risk and expected return. That is because many risky investments in R&D, for example are charged against earnings rather than booked as assets on the balance sheet. This accounting is particularly prevalent in modern tech companies where stock prices often soar while they are reporting low book rates of return. Investors are warned: These firms are riskier than their more traditional brick and mortar predecessors whose assets are on the balance sheet.
The study samples all U.S. companies on Compustat files from 1963–2013 that have stock price and returns. Financial companies were excluded because they practice fair value accounting and utilities were excluded as their book rate of return is subject to regulation. The tests found that when conservative accounting is applied widely, not only are earnings depressed by expensed investments but booking earnings from these expensed investments deferred also; earnings are at risk until the uncertainty from the risk has been resolved. The findings confirm book rate of return as a source of information about risk and its resolution, not profitability.
"As our economy continues to evolve, economists need to adapt their metrics to truly capture value and profitability," said Stephen Penman, the George O. May Professor of Financial Accounting at Columbia Business School, co-author of the research. "Book rate of return – an accounting measure – simply doesn’t recognize profitability when conservative accounting is taken into consideration, which means investors aren’t seeing the full picture conveyed by company financials."
While past research has shown how conservative accounting effects book rate of return as a metric for profitability, the study by Penman and co-author Professor Xiao-Jung Zhang of the University of California Berkeley, is the first to correlate it with risk. These findings have strong implications for investors looking to interpret the accounting aspects of risk and profit. It also serves as a new way to assess corporate managers and their investment decision making. The research can lead to future studies to look at measures of investment risk beyond capital asset pricing models, betas and stock returns, all of which have been fallen short for decades.
"This greatly effects the modern corporation that don’t have too many assets to show on their balance sheets as most of their investments are on their income statements instead," said Penman. "Conservative accounting works under the doctrine that if things are risky, you should be prudent," continued Penman. "Companies with low ROE like Amazon and Facebook for many years and Twitter and Uber now are impacted as they expense their investments to develop brands, supply chains, software, and human capital; they look 'asset light' but they are risky."
To learn more about the cutting-edge research being conducted at Columbia Business School, please visit www.gsb.columbia.edu.
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