Conservatism, Growth and the Role of Accounting Numbers in the Equity Valuation Process

Abstract

This study extends our understanding of the impact that conservative accounting has on the equity valuation role of firms' summary accounting numbers. In particular, I evaluate the effect of conservative accounting for research and development (R&D) and past growth in R&D on the relation between aggregate earnings (deflated by price) and contemporaneous stock return and the usefulness of earnings and equity book values for developing estimates of equity market value. I find that the capitalization of R&D improves the value relevance of aggregate earnings only for firms with high past growth in R&D. Moreover, the deleterious effects of the conservative treatment of R&D on the value relevance of estimates of equity market value based on the discounted residual income model are increasing in the level of past growth in R&D. My results contribute to the extant literature by providing more precise evidence regarding the magnitude of the benefits (in terms of value relevance) associated with capitalizing R&D costs. In addition, my results provide us with a deeper understanding of how accounting measurement rules and firms' economic fundamentals interact to determine the valuation role of firms' financial statement numbers.