Issues With Accounting Returns

Issues With Accounting Returns

Should we trust #accountingreturns, mainly when investing or valuing a company?

I believe the answer depends on the information we rely on in the accounting statements.

For example, suppose you are looking at coming up with a measure of return that can be useful in forecasting future performance. In that case, we cannot take accounting returns at face value for the following reasons:

1)The first is that the accounting return estimated for a single period may not be a good measure of investment returns over the long term. For instance, if a firm does an acquisition five years back and does an impairment, the book value of the equity gets reduced, which may boost the ROIC. This is because the impairment means that the company has written off the deal, acknowledging that it has made a wrong decision. Still, since the ROIC shoots up, analysts are confused that the company has a track record of generating excess returns. The other typical instance is a restructuring charge a firm took earlier, resulting in a lower book value of equity and a higher return on capital for the latest financial year.

2)The second reason is that any systematic accounting or tax rules quirks will imprint the return computations. For instance, analysts earlier considered leases as operating expenses. Still, with the latest amendments to consider leases as a financial liability (debt), companies need to amend their accounting returns which may distort the actual #ROIC/ROE measurement.

In my view, one should never take accounting earnings and book value as a given but modify those numbers to get a more useful measure of the returns earned by a firm on its investments. The objective should not be calculating last year’s return with absolute precision but coming up with a return that can be useful in forecasting future performance.

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