Conservatism in residual income models: theory and supporting evidence

PublishedArticle"This is an Accepted Manuscript of an article published by Taylor & Francis in Accounting and Business Research on 29 May 2015, available online: http://wwww.tandfonline.com/10.1080/00014788.2015.1009869."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