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Conservatism Correction in Linear Information Models

50 Pages Posted: 13 Sep 2007  

Stefan Henschke

University of Cologne

Carsten Homburg

University of Cologne

Julia Nasev

University of Cologne

Date Written: November 1, 2007

Abstract

Recent research concerned with enhancing conservatism corrections of linear information models (LIMs) reports a decrease in bias as compared to the Ohlson (1995) model. However, inaccuracy is not significantly reduced. These findings raise two questions: First, are LIMs able to capture unconditional conservatism? Second, if conservatism can be captured, then why is accuracy not markedly improved? With regard to the first question, we find that conservatism is captured when the Feltham/Ohlson (1995) model is estimated according to the modification suggested by Choi/O'Hanlon/Pope (2006). On average, one dollar of unrecorded reserves, measured as the estimated reserve by Penman/Zhang (2002), results in a correction of market value forecasts of approximately one dollar. Furthermore, our results suggest no improvement of the conservatism corrections for the following cases: (1) disaggregating book value into operating and financial assets and (2) estimating the Feltham/Ohlson (1995) model via the valuation function. Regarding the second question, we argue that the failure of the models to markedly reduce inaccuracy is the consequence of forcing the models to value different firms on the basis of the same conservatism coefficient. We therefore suggest an estimation procedure, in which LIM parameters are estimated separately for different conservatism levels. Our implementation reduces median inaccuracy from 36.8% to 21.1%, which is comparable to implementations of the residual income model based on analyst forecasts.

Keywords: Accounting Conservatism, Residual Income Valuation, Feltham-Ohlson Model, Linear Information Model, Equity Valuation

JEL Classification: C22, G12, M41, M44

Suggested Citation

Henschke, Stefan and Homburg, Carsten and Nasev, Julia, Conservatism Correction in Linear Information Models (November 1, 2007). AAA 2008 Financial Accounting and Reporting Section (FARS) Paper. Available at SSRN: https://ssrn.com/abstract=1014099 or http://dx.doi.org/10.2139/ssrn.1014099

Stefan Henschke (Contact Author)

University of Cologne ( email )

Albertus-Magnus-Platz
Cologne, 50923
Germany
+49 221 470 4494 (Phone)
+49 221 470 5012 (Fax)

Carsten Homburg

University of Cologne ( email )

Albertus-Magnus-Platz
Cologne, 50923
Germany

Julia Nasev

University of Cologne ( email )

Albertus-Magnus-Platz
Cologne, 50923
Germany
+492214706830 (Phone)
+492214705012 (Fax)

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