In Practice Dealing with Accounting Returns

Accounting rates of return, such as return on equity and capital, are subject to abuse and manipulation. For instance, decisions on how to account for acquisitions (purchase or pooling), choice of depreciation methods (accelerated versus straight line), and whether to expense or capitalize an item (research and development) can all affect reported income and book value. In addition, in any specific year, the return on equity and capital can be biased upwards or downwards depending upon whether the firm had an unusually good or bad year. To estimate a fairer measure of returns on existing projects, we would recommend the following:

1. Normalize the income, before computing returns on equity or capital. For Aracruz, in the analysis above, using the average income over the last 3 years, instead of the depressed income in 1996 provides returns on equity or capital that are much closer to the required returns.

2. Back out the effects of cosmetic earnings effects caused by accounting decisions, such as the one on pooling versus purchase. This is precisely why we should consider Disney's income prior to the amortization of the Capital Cities acquisition in computing returns on equity and capital.

3. If there are operating expenses designed to create future growth, rather than current income, capitalize those expenses and treat them as part of book value, while computing operating income, prior to those expenses. This is what we did with Bookscape, when we capitalized operating leases and treated them as part of the capital base, and looked at earnings before interest, taxes and operating leases in computing return on capital.

Lessons From The Intelligent Investor

Lessons From The Intelligent Investor

If you're like a lot of people watching the recession unfold, you have likely started to look at your finances under a microscope. Perhaps you have started saving the annual savings rate by people has started to recover a bit.

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