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Conservatism in residual income models: theory and supporting evidence

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  • David Ashton
  • Pengguo Wang

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 of testing the effect of conservatism on valuation and linear information dynamics.

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  • David Ashton & Pengguo Wang, 2015. "Conservatism in residual income models: theory and supporting evidence," Accounting and Business Research, Taylor & Francis Journals, vol. 45(3), pages 387-410, April.
    • Handle: RePEc:taf:acctbr:v:45:y:2015:i:3:p:387-410
    DOI: 10.1080/00014788.2015.1009869
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    Cited by:

    1. Iris Bergmann & Wolfgang Schultze, 2018. "Accounting based valuation: a simultaneous equations model for forecasting earnings to proxy for ‘other information’," Review of Quantitative Finance and Accounting, Springer, vol. 50(4), pages 1057-1091, May.

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