Accounting Conservatism and the Valuation of Accounting Numbers: Evidence on the Feltham-Ohlson (1996) Model

Abstract

We empirically investigate the effects of accounting conservatism on (1) the stock market valuation of operating assets in the context of the Feltham-Ohlson (1996) model and (2) the weight on operating assets in the Feltham-Ohlson abnormal operating earnings dynamics (hereafter referred to as the LIM conservatism parameter). Consistent with the Feltham-Ohlson (1996) model, we find that accounting-based conservatism proxies are positively related to the valuation weight on operating assets. Furthermore, the accounting-based conservatism proxies have incremental explanatory power even after controlling for (1) size, (2) book value (or sales) growth, and (3) leverage. These results are robust with respect to alternative empirical specifications of the valuation model and the choice of proxies for accounting conservatism. We also find, consistent with prior research but not with the Feltham-Ohlson model, that the sign of the LIM conservatism parameter is on-average negative. We provide evidence on the types of firms for which the linear information dynamics appears to hold better or worse. More specifically, the firms with negative values of the parameter are significantly smaller, less profitable and experiencing lower growth rates than firms with positive values of the parameter. Moreover, the relation between accounting-based conservatism proxies and the LIM conservatism parameter is fairly strong for the subsample of firms with high levels of profitability.