Valuation Weights and Accounting Conservatism

Abstract

In this paper we develop a general framework for evaluating the impact of conservative accounting on the structure of residual income models of equity valuation. This affords a theoretical understanding of the signs and sizes of the valuation weights observed in regression studies of the relationship between prices, book values, earnings and dividends. We proceed to generalize our model of conservatism and are able to show theoretically the likely numerical impact of conservatism on book values, price-earnings ratios and under valuations produced by residual income models. The analysis also affords an understanding of the limitations of empirical investigations of conservatism using linear information dynamics and hence to explain the failure of many such studies to detect conservatism.