Reference no: EM132903132

Problem - Effects of Conservative Accounting on Residual Income Valuation - Suppose you are applying the residual income valuation model to value a firm with extremely conservative accounting. Suppose, for example, the firm is following U.S. GAAP or IFRS, but the firm does not recognize a substantial intangible asset on the balance sheet. (Perhaps the firm has expensed substantial amounts of R&D expenditures that have led to valuable intellectual property or substantial amounts of advertising expenses that have created a valuable brand name.) As a consequence of this conservative accounting, the firm reports assets and equity at book values that are much lower than their respective economic values. Explain why the residual income value estimates will not be distorted by conservative accounting. How does the residual income valuation model correct for the effects of conservative accounting and understated book values of equity?