ABSTRACT
General conditions are derived under which accounting ratios, such as the conventionally defined accounting rate of return, deviate from the economic rate of return for a firm. Cash revenue streams of arbitrary time-shape, non-depreciable capital, and corporate income taxes are considered. The sign and magnitude of the bias in the accounting rate of return depend upon the depreciation schedule, the revenue time-stream, the firm’s growth rate, and its capital structure.
There exists a unique depreciation schedule for which the accounting rate of return is unbiased. However, where the firm’s capital structure involves working capital, “exact” depreciation yields a biased accounting rate of return. Thus accounting and economic criteria are irreconcilable unless an intuitively unattractive generalization of “depreciation” for financial assets is introduced.
Where pretax and taxable income differ, the error in the accounting rate of return may no longer converge to zero as the growth rate increases. Regulated utilities and mining companies are particularly susceptible to this error component.
