Conservatism, growth, and return on investment
Madhav V. Rajan Æ Stefan Reichelstein Æ Mark T. Soliman
Published online: 24 April 2007
Ó Springer Science+Business Media, LLC 2007
Abstract Return on Investment (ROI) is widely regarded as a key measure of ﬁrm
proﬁtability. The accounting literature has long recognized that ROI will generally
not reﬂect economic proﬁtability, as determined by the internal rate of return (IRR)
of a ﬁrm’s investment projects. In particular, it has been noted that accounting
conservatism may result in an upward bias of ROI, relative to the underlying IRR.
We examine both theoretically and empirically the behavior of ROI as a function of
two variables: past growth in new investments and accounting conservatism. Higher
growth is shown to result in lower levels of ROI provided the accounting is con-
servative, while the opposite is generally true for liberal accounting policies.
Conversely, more conservative accounting will increase ROI provided growth in
new investments has been ‘‘moderate’’ over the relevant horizon, while the opposite
is true if new investments grew at sufﬁciently high rates. Taken together, we ﬁnd
that conservatism and growth are ‘‘substitutes’’ in their joint impact on ROI.
Keywords Return on investment Conservatism Economic proﬁtability
JEL Classiﬁcations G31 M41
Return on Investment (ROI) is arguably the most prevalent measure of proﬁtability.
In ﬁnancial statement analysis, ROI is a key proﬁtability metric along with the
M. V. Rajan (&) S. Reichelstein M. T. Soliman
Graduate School of Business, Stanford University, Stanford, CA, USA
M. T. Soliman
Rev Acc Stud (2007) 12:325–370