Conservatism in Residual Income Models: Theory and Supporting Evidence

Accounting and Business Research, 2015

Posted: 22 Jan 2015

See all articles by Pengguo Wang

Pengguo Wang

Xfi, University of Exeter

David J. Ashton

University of Bristol - Department of Economics

Date Written: January 21, 2015

Abstract

In this paper, we develop a framework for evaluating the impact of conservative accounting on the structure of residual income models of equity valuation. We explore specific examples of both unconditional and conditional conservatism and observe a common mathematical structure. We proceed to generalise our model and identify the joint dependency of conservatism and the persistence of abnormal earnings on the weights attached to book values, earnings and dividends. We are able to show theoretically the likely numerical impact of conservatism on price-earnings ratios and under valuations produced by residual income models. We investigate empirically the interaction between conservatism and persistence and find they accord well with the theory developed. We briefly discuss the implications for testing of the effect of conservatism on valuation and linear information dynamics.

Keywords: Accounting conservatism, Equity valuation, Residual income models, Linear information dynamics

JEL Classification: M41, G12

Suggested Citation

Wang, Pengguo and Ashton, David John, Conservatism in Residual Income Models: Theory and Supporting Evidence (January 21, 2015). Accounting and Business Research, 2015, Available at SSRN: https://ssrn.com/abstract=2553177

Pengguo Wang (Contact Author)

Xfi, University of Exeter ( email )

Streatham Court
Exeter, EX4 4PU
United Kingdom

David John Ashton

University of Bristol - Department of Economics ( email )

8 Woodland Road
Bristol BS8 ITN
United Kingdom
+44 (0)117 928 8423 (Phone)

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