Profitability, Growth, Conservatism, and the Reliability of Accounting Numbers

Despite 30 years of research in the area, the jury still is out on whether profitability assessed using financial statements is a good measure of the underlying economic returns. Prior research shows that the combina-tion of accounting conservatism and growth can cause divergence between accounting and economic prof-itability, yet analysts, managers, and researchers continue to use accounting information when evaluating historical performance, and as a starting point for estimating future cash flows. In this study, we quantify the combined impact of growth and conservatism on financial statement information using a comprehen-sive measure of conservatism that considers the impact of accounting-policy decisions on the carrying value of both tangible and intangible investments. We observe that accounting information—despite its imperfections—reliably identifies firms with superior economic performance. Distortions generated by differences in growth or accounting policies are not large enough to break the link between accounting and economic profitability. This finding is especially relevant in light of the increasing integration of global accounting standards. Care must be taken to preserve the ability of financial statements to convey informa-tion about economic profitability when adopting and implementing new standards