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Earnings forecasting and equity valuation under conservative accounting

Xiao-Jun Zhang, 1998
Faculty Advisor: James Ohlson
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This dissertation studies conservative accounting within a theoretical context. The purpose of the study is to understand how conservatism affects the way accounting data is used in earnings forecasting and equity valuation.

The analysis is carried out in two steps. First, without specific modeling of transactions and accounting rules, we examine how conservatism affects the relation between accounting data and firm value. Such analysis is based solely on basic accounting and economic principles, and it is intended to capture the general impact of conservative accounting. Second, by focusing on accounting concepts of asset valuation, we specifically model conservative accounting rules and obtain sharper insights regarding how conservatism impacts the prediction of future earnings and book rate of return.

The dissertation proceeds as follows. In Chapter 2 we analyze the general impact of conservative accounting on the relation between accounting data and firm value. The study builds on some basic accounting and economic principles, including the clean surplus relation, the assumption that present value of expected future cash flows determines market value, and a measure of asymptotic growth.

Chapter 3 deals with the modeling of transactions and accounting rules. We analyze how different properties of the accounting rules map into different relations between accounting data and equity value. The study focuses on the set of efficient' accounting rules which effectively summarize all value-relevant information into the two key bottom line' numbers-earnings and book value. The analysis serves two purposes for our study of conservative accounting. First, it sets up a benchmark of unbiased accounting rules which include both market-to-market and permanent income accounting. Second, it brings the concepts of asset valuation into focus. The asset valuation rules specify how earnings and book value beget future expected earnings, and such rule are the focal points of our analysis regarding earnings-shifting with conservative accounting.

The last chapter, Chapter 4, studies the concepts of asset valuation under conservative accounting and examines how growth in book values affects future earnings and book rate of return (ROE). We show that conservative asset valuation can be characterized in terms of earnings-shifting toward future periods. Such shifting of earnings generally causes the book rate of return to exhibit mean-reverting property, and the mean' and the speed' of reverting to the mean are affected by the growth in book value. (Abstract shortened by UMI.)

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