Connecting Book Rate of Return to Risk and Return: The Information Conveyed by Conservative Accounting

This paper investigates how book rate of return under GAAP relates to risk and the required return for investing. A standard view sees the book rate of return as a measure of profitability to be compared to the required return to evaluate the success of an investment. A contrasting view sees the book rate of return as indicative of the required return, consistent with the standard risk-return tradeoff. There clearly is some sorting out to do. The book rate of return is an accounting measure, so the interpretation of the measure requires an understanding of how accounting impinges on the book return as an indicator of risk and/or a measure of profitability. This paper supplies that understanding, along with empirical documentation.