A robust model to estimate a firm's average economic return

Theoretical studies question the ability of financial statement information to provide evidence about a firm's economic performance, as the mathematical relation between a firm's accounting and economic returns becomes intractable when economic depreciation is defined endogenously-as a function of the firm's cash flow stream-and when its internal rate of return (IRR) and investment growth rate have not been constant. This paper derives a new equation, called the average internal rate of return (AIRR) estimation model, in which a firm's AIRR is estimated as a function of its current-year accounting return, its current-year asset growth rate, a measure of accounting conservatism, and a term that identifies the firm's historical investment growth rate trend. Because the model allows economic depreciation to be defined exogenously, non-constant returns and growth rates can be aggregated across investment cohorts, allowing a firm's accounting return to be reconciled to its average economic return. One such exogenous schedule-called competitive market depreciation-is used to illustrate the model's implications. The AIRR estimation model empowers analysts to identify the direction and magnitude of the potential difference between a firm's accounting and economic return created by fixed asset depreciation, accounting accruals, and the immediate expensing of intangible assets.