Valuation: Accounting for Risk and the Expected Return

Stephen Penman

Columbia Business School, Columbia University

New York

*Email: [email protected]. Thanks to Matt Lyle, Steven Monahan, Scott Richardson, and
Theodore Sougiannis for comments.

Electronic copy available at: http://ssrn.com/abstract=2673551

 Valuation: Accounting for Risk and the Expected Return

Abstract.
Under accounting principles, the recognition of earnings is path dependent and the path depends
on risk resolution: Under the so-called realization principle, earnings are not booked until
uncertainty is resolved. In asset pricing terms, the principle means that earnings cannot be
recognized until the firm can book a low-beta asset such as cash or a near-cash discounted
receivable. If the risk to which this accounting responds is priced risk, the accounting indicates
the expected return. This paper connects accounting under this principle to risk and return,
summarizes the supporting empirical evidence, and examines the implications for research on the
implied cost of capital, cash-flow betas, asset pricing models that imbed accounting numbers,
and papers that assume an autoregressive model for the earnings path to infer the expected
return. The accounting that captures risk and its resolution also has implications for the unsolved
issue of specifying the appropriate accounting for accounting-based valuation models and,
indeed, for financial accounting standards.

Electronic copy available at: http://ssrn.com/abstract=2673551

 Valuation: Accounting for Risk and the Expected Return

Accounting-based valuation substitutes book values and/or earnings for dividends in equity

valuation. While research in this area has had an impact on text books and, to a lesser extent, on

practice, important issues remain to be resolved.1 These outstanding issues involve both the

numerator in the standard valuation model―expected payoffs―and the denominator―the rate at

which the expected payoffs are discounted.

For the numerator, the so-called residual income model replaces expected dividends with

book value and expected earnings by assuming clean-surplus accounting. However, clean-

surplus accounting is purely an accounting operation that articulates income statements and

balance sheets, with no prescription for how the accounting numbers are to be measured. Indeed,

an infinite-horizon residual income model―the only version of the model that necessarily

equates calculated value to that given by expected dividends for going concerns―is cynical

about the accounting involved: fair value accounting, historical cost accounting, and even

random numbers are tolerated, with no discrimination between them.2 The Ohlson-Juettner

(2005) model dispenses with book values, but the so-called earnings that remain in the model are

just a primitive with limited definition.

Clearly, something more has to be put on the table before we have a model that can be

embraced with some confidence. As all clean-surplus accounting yields the same value for

infinite horizons, the specification of the accounting must have to do with valuation over finite

1
Demirakos et al. (2004), Hand et al. (2015), and Pinto et al. (2015) survey the use of valuation models in practice.
2
This is understood when it is claimed (correctly) that discounted cash flow valuation (cash accounting) and
accrual-accounting residual income valuation converge with infinite forecasting horizons.

1
forecasting horizons. That satisfies an important requirement: Practical valuation must work with

finite-horizon forecasts. Valuation that requires elusive forecasts for the very-long run—for the

years, 2030, 2040, and even 2020—is hardly practical; in the long run, we are all dead. And

finite-horizon forecasting connects to valuation theory where investing is characterized as

substituting current consumption for consumption at some future (finite) point in time (for

example, at retirement). The investor seeks an accounting where forecasts for finite periods

convey the value and the risk of consumption at a finite point of time in the future.3

The denominator issue has received relatively less attention in accounting research,

though it is the key issue in asset pricing research in finance. In the Ohlson (1995) paper that

spurred much accounting research in the area, the discount rate is assumed to be the risk-free

rate, notifying the reader that the paper has to do with the numerator, not the denominator. There

is some subsequent research on how accounting conveys information about the discount rate but,

for the main part, students in financial statement valuation classes are told to get the “cost of

capital” from finance courses, only to find that, as a practical matter, asset pricing research does

not have a good handle on the problem either.

This paper focuses primarily on the denominator: How does accounting convey

information about the discount rate? But, in so doing, a solution for the numerator issue

surfaces. Indeed, the numerator and denominator issues are linked: Accounting for the

denominator implies the accounting for the numerator.

3
Penman (1997 and 2015) demonstrates how the accounting affects valuation and its errors with finite-horizon
forecasting.

2
 The paper revolves around a key idea. For accountants, the idea is readily appreciated, for

it surfaces in the basic “Accounting Principles” class we all had. In that class, the professor

began by contrasting accrual accounting with cash accounting; you keep the accounts for your

tennis club (and your government) on a cash basis, but businesses use accrual accounting. He or

she then characterized accrual accounting as recognizing periodic earnings that are different from

cash flows; life-time earnings equal life-time cash flows, but the allocation to periods differs.

Then followed a statement of the key principle under which historical cost accounting recognizes

periodic earnings: Under uncertainty, earnings are not recognized until the uncertainty has

largely been resolved. This “realization principle” is typically applied when the firm has a secure

customer and “receipt of cash is reasonably certain”. Accordingly, accrual accounting is driven

by principles based on risk and its resolution (fair value accounting aside); recognized earnings

report the resolution of risk, while anticipated earnings are not recognized because there is risk

that the expectation will not be realized―customers may not materialize. With this as the driving

principle, earnings recognition is not just about conveying news about future cash flows, but also

about risk resolution―”discount-rate news” as well as “cash-flow news” in the parlance of

finance. It is this principle that is central to connecting accounting information to risk and the

expected return. And it is this principle that provides pointers for resolving both the numerator

and denominator issue.

This paper is a “thought piece”, raising a number of insights but not providing definitive

solutions; you will not get an estimate of the “cost of capital” from this paper. Nevertheless, the

insights provide a commentary and criticism on existing research that strives to that end,

including “implied cost of capital” estimates, “cash-flow betas”, the application of the

Voulteenaho (2002) model, the connection of the discount rate to accounting numbers in

3
empirical asset pricing, and the attribution of “accounting anomalies” to risk or abnormal returns.

In doing so, the paper promotes a tentative research agenda.

RAISING THE ISSUES

Accounting-based valuation is grounded in no-arbitrage valuation theory that prices a sequence

of expected dividends. Given no-arbitrage and a few other mild assumptions,


d  Cov(d , Yt )
Pt 


t 1 Rtf
, (1)

where Pt is the current price, dτ is expected dividends τ periods ahead conditional on information

at time t, Ytτ is the time-t conditional discount factor for expected cash flows for period τ, a

random variable common to all assets, and Rtf is the term structure of (one plus) the spot riskless

interest rates from t to τ. (Here and elsewhere, all variables subscripted for periods greater than t

are expected values.) See Rubinstein (1976) and Breeden and Litzenberger (1978).

The risk adjustment in the numerator of equation (1) is given by the infinite sequence of

expected dividends for each τ and their periodic covariance with the economy-wide random

variable, Ytτ. However, under Miller and Modigliani (1961) (M&M) assumptions, the sequencing

of dividends over τ up to any finite future point in time is irrelevant to current value. Further,

with dividends a matter of payout policy and no necessary relation to real activity, there is no

necessary relation with Ytτ. Indeed, a particular payout policy―zero dividends, for example

―could imply Cov(dτ, Ytτ) = 0 for all τ up to the liquidating dividend (and going concerns are not

expected to liquidate).

4
 Accounting-based valuation is offered as a way of finessing this issue. Given clean-

surplus accounting such that dτ = Earningsτ – (Bτ – Bτ-1) where B is the book value of common

equity, the corresponding valuation to model (1) is given by Feltham and Ohlson (1999):


RE  Cov( RE , Yt )
Pt  Bt 


t 1 Rtf
. (1a)

Residual earnings, REτ = Earningsτ – iτ-1.Bτ-1, with iτ-1 the riskless spot rate. Price is thus given by

Bτ and the (discounted) sequence of expected earnings and dividends (that imply expected book

values). However, the dividend sequence is irrelevant to this valuation under M&M assumptions

and accounting principles under which dividends do not affect the calculation of earnings but are

paid out of book value (see Ohlson 1995). Christensen and Feltham (2009) elaborate on this

valuation.

These expressions discount for risk in the numerator, with the discount varying overtime.

However, the evaluation of the discount presents us with a difficult practical problem: the Ytτ

variable is a mathematical construct whose existence is implied by the no-arbitrage assumption

but has no economic content without further structure. Given this difficulty, practical valuation

resorts to the expediency of applying a discount rate in the denominator of a valuation model, with

that discount rate given by the risk-free rate plus a premium for risk (often referred to as the

expected return). The “dividend discount model” replaces model (1):


d
Pt 

 R
t 1

p
, (2)
t

where Rtp is the discount rate for period τ given by the sequence of (one plus) periodic risk-

adjusted expected returns from t+1 to τ. Corresponding, given clean-surplus accounting,

5
 
RE
Pt  Bt   p
t 1 Rt

. (2a)

Residual earnings is now defined as REτ = Earningsτ – ERτ.Bτ-1, where ERτ is the expected return

for period τ. A further expediency sets the expected return as a constant over time, but at some

cost: If risk varies with the sequencing of earnings and its covariance with Ytτ, as in equation (1a),

this feature is suppressed. Indeed, the notion of a constant discount rate is suspect from first

principles; if the discount rate is time-varying, the assumption of a constant discount rate is

inconsistent with the no-arbitrage assumption on which valuation theory is based, and one

presumes that the discount rate varies with interest rates, risk preferences, the evolution of the firm

(and maybe information in accounting reports). Ang and Liu (2004) demonstrate the valuation

errors when time-varying discount rates are assumed to be constant.

Models (1a) and (2a) are the foundation of accounting-based valuation. However, apart

from the clean-surplus equation, not much has been put on the table. Importantly, the accounting

for earnings and book value in these valuations is unspecified. As mentioned in the introduction,

these models exhibit a value-irrelevance property with respect to the numerator accounting; the

form of the accounting does not matter. However, the accounting also bears on the discount for

risk, as the risk adjustment depends on the sequence of expected earnings and Ytτ. Accrual

accounting generates that sequence, for it involves an allocation of earnings to periods, τ. Thus,

the form of the accrual accounting is pertinent to the risk assessment. To stress the point, random

numbers for earnings, with zero covariance with Ytτ, would have no implication for the risk

discount. Just as the sequence of dividends and their covariance with Ytτ has no necessary bearing

on value or the risk discount, so might the accounting without further specification.

6
 A FRAMEWORK TO EVAUATE THE ISSUES

A simple identity that connects the expected return to accounting numbers serves as a starting

point. By the clean-surplus relation (CSR), expected dividends, dτ = Earningsτ – (Bτ – Bτ-1) for

all τ. Substituting for dividends in the expression for the stock return (with firm subscripts

omitted), the sequence of expected stock returns for future periods is given by

P  d  P 1 Earnings P  B  ( P 1  B 1 )
ER    , (3)
P 1 P 1 P 1

τ = t+1, t+2, t+3, …. . That is, the expected stock return for any year is equal to the expected

forward earnings yield plus the expected change in premium over the year denominated in the

expected beginning-of-period price.4 With the current price, Pt, set to obey the no-arbitrage

condition, Pt+1 + dt+1 = (1+ERt+1)Pt , and so, recursively, for all τ. Thus Pτ-1 (and Pt) discounts

expectations on the right-hand side for the risk surrounding those expectations.

Penman, Reggiani, Richardson, and Tuna (2015) introduce equation (3) as a starting

point for identifying the earnings-to-price ratio and the book-to-price ratio as characteristics that

relate to expected returns. The expression is a tautology, but nevertheless serves to yield some

insights. To gain these insights, we first establish certain properties (see also Penman and Zhang

(2015):

4
This identity has long been recognized for realized returns, for example in Easton, Harris, and Ohlson
(1992). We adapt it here to apply to expected returns.

7
P1. Dividend irrelevance. Under M&M assumptions, dividends reduce price one-to-one,

leaving cum-dividend returns unaffected. Correspondingly, dividends do not affect the

right-hand side of equation (3) if

(i) dividends do not affect contemporaneous earnings, and

(ii) Pτ + dτ – (Bτ + dτ) = Pτ – Bτ

Accordingly, ERτ is not affected by dividends. Condition (i) is satisfied if equity

dividends are not charged to earnings. Condition (ii) is satisfied if dividends reduce book

value one-for-one (as they do price under M&M). Both conditions are satisfied under

GAAP and IFRS accounting.

P2. Earnings measurement induces a change in premium. Given P1,

Pτ – Bτ – (Pτ-1 – B τ-1) = ΔPτ + dτ – (ΔBτ + dτ).

And, given CSR,

ΔBτ + dτ = Earningsτ

Thus, for a given ERτ (and thus a given ΔPτ + dτ), a change is premium is induced by the

measurement of earnings given P1; lower earnings, for example, imply an increase in

premium.

P3. An expected change in the premium implies expected earnings growth. If earnings

Earnings
are measured such that ER  and thus Pτ – Bτ – (Pτ-1 – B τ-1) = 0, then,
P 1

Earnings 1 P 1
ER 1  ( . ) ER . Setting dτ = 0,
P Earnings

8
 1
Earnings 1  ER 1 (1  ) Earnings
ER

That is, earnings are expected to grow at a rate equal to the (time varying) expected

return.5 It follows that, if earnings are expected to grow at rate different from the

expected return, Pτ – Bτ – (Pτ-1 – B τ-1) ≠ 0, and Pτ – Bτ – (Pτ-1 – B τ-1) ≠ 0 implies expected

earnings growth at a rate different from the expected return. See also Shroff (1995).

P1 grounds the analysis in no-arbitrage valuation theory. Under M&M, the expected

return that reconciles successive price expectations (with no arbitrage) is insensitive to the timing

of dividends, and P1gives accounting conditions under which ERτ expressed in terms of

accounting numbers exhibit this property. P2 brings the point on accounting measurement to the

fore: The relationship between ERτ and accounting depends on how accounting is measured. P3

establishes a benchmark accounting where expected earnings equal expected returns (with no

expected change in premium) and there can be no expected earnings growth beyond the

“normal” rate equal to the ERτ+1. More generally, earnings below this “normal” earnings implies

expected earnings growth with a corresponding increase in the premium. Put differently, Pτ -1 is

based on the expectation of all subsequent (life-long) earnings, so the lower is the expected

period-τ component of those earnings, the higher must be the subsequent expected earnings

relative to the period-τ earnings. Viewed in terms of P/E ratio, with no expected change in

Earnings 1
premium, ERτ = implies the expected forward P/E = , that is, a “normal” P/E
P 1 ER

5
If Earningsτ = Earningst+1, all τ, the accounting is sometimes referred to as “permanent income accounting”
whereby Earningst+1 is sufficient for forecasting all future earnings. One can show that, if Earningsτ = Earningst+1,
all τ, then ERτ = ERt+1, all τ, that is, the expected return is constant over time. Setting dτ = 0 is for simplicity; dτ ≠ 0
reduces Earningsτ+1, but, with the dividends reinvested at the rate, ERτ+1, cum-dividend earnings are unaffected,
given P1.

9
(without expected earnings growth). According, ERτ can be represented in terms of a sequence

of expected earnings yields and price-denominated expectations of subsequent earnings growth.

However, if one is seeking information from the accounting that informs about the

expected return, not much has been put on the table. Any measurement of earnings satisfies

equation (3): A lower expected earnings yield, the first term on the right-hand side, merely

implies an offsetting change in premium, with ERτ of the left-hand side unaffected. Indeed,

accrual accounting that determines the earnings in any one period can be arbitrary, without

economic substance. Equation (3) is, after all, a tautology. Just as CSR (alone) gives no

resolution to the numerator issue, nor does it to the denominator issue; CSR just involves a

substitution of earnings and book value for dividends, but “earnings” and “book values” are

nothing more than names without more specification as to the their measurement.

If the sequence of ERτ is to be informed by the accounting, one requires more structure on

the accounting. That structure must communicate risk that results in a discount in the

denominating price, Pτ-1, (and thus the current price, Pt) to yield a higher ERτ that reflects that

risk. That is, the portion of expected life-long earnings to be recognized in period τ must

communicate the ERτ for that period. That, again, is an accounting measurement issue, for

accounting measurement is simply (!) an allocation of earnings to periods under specified accrual

accounting principles.

ACCOUNTING FOR RISK AND THE EXPECTED RETURN

We consider two alternative prescriptions for accounting for earnings and book values and

examine how information about risk is conveyed under both.

A. Mark-to-Market Accounting

10
 Earnings
Set Bτ = Pτ, all τ. Then, Pτ – Bτ – (Pτ-1 – B τ-1) = 0, and ERτ = by equation (3). Bt
P 1

(current reported book value) is equal to the present value of expected cash flows, so imbeds

both expected cash flows and the discount rate. Thus, like Pt to which it equates, Bt is not

informative about the discount rate; the investor looks for information that informs about risk in

Pτ, but Bt cannot supply it. Further, realized Earningst (equal to the cum-dividend change in book

value) also conveys no information; earnings and price changes imbed revisions in both expected

cash flows and future ERτ―so-called cash-flow news and discount-rate news―but not ERτ. Just

as price changes convey little information about future ERτ, neither does earnings.6 And, the ERτ

Earnings Earnings Earnings

= tautology remains: The expected earnings yield, = = ERτ, but
P 1 P 1 B 1

no information about ERτ is supplied by the accounting. In short, there is no accounting for risk

and the expected return.7

These points are best demonstrated in the case of a marked-to-market bond. That

accounting sets Pτ – Bτ – (Pτ-1 – B τ-1) = 0, and appropriately so, for a bond cannot have expected

Earnings
growth. Accordingly, ERτ = , with the earnings yield determined via the effective
P 1

interest method. However, effective interest is inferred from the bond price and the bond yield it

6
Just as one might infer the expected return from a (long) time series of shocks to prices, so might one do so from
shocks to book values (earnings) under mark-to-market accounting, provided that the expected return were a
constant over that observation period. But this is doubtful with changing discount rates where shocks reflect both
cash-flow news and discount-rate news.

7
Cochrane (2011) makes the same point about fair value accounting.

11
implies via an internal rate-of-return calculation. The accounting does not supply the expected

earnings yield from which the ERτ can be inferred; rather it is the other way around.

While mark-to-market accounting (or fair value accounting) is somewhat hypothetical for

equities―its application is quite limited in practice― it serves as a benchmark for examining

accounting principles that depart from fair value accounting.

B. Mark-to-Market Accounting for Financing Activities and Historical Cost Accounting for
Operating Activities
Set the accounting for book value such that Pτ – Bτ ≠ 0. Separate price and book value associated

with operating (business) activities and financing (net borrowing) activities while honouring the

following balance sheet equations:

P  P NOA  P ND
B  NOA  ND

P NOA is the price of the operating activities (enterprise price), NOAτ (net operating assets) is the

book value of operating activities (enterprise book value), and P ND and NDτ are the price and

book value of the net debt, respectively. Marking net debt to market implies the following two

properties:

P4. Financing leverage does not affect the premium or the change in premium if net debt

is marked to market: if ND  P ND , then Pτ – Bτ = P NOA  NOA .

The ND  P ND condition is not precisely met under GAAP, but is approximately so except

when there is a significant change in interest rates or credit risk (and these changes are

presumably close to zero in expectation).

12
P5. Financing leverage impacts the expected return via the expected earnings yield. By the
cash conservation equation of accounting, free cash flow (the net cash from operations),

FCFτ = dτ + Fτ where Fτ is cash flow to net debtholders. As P  P  P , ERτ can thus

NOA ND

be expressed as

P  d  P 1 P NOA  FCF  P NOA P ND  F  P ND

1 )
ER   1
 
P 1 P 1 P 1

 P NOA   P ND 
  ERNOA      ERND   
 P   P 

 ERNOA 
P ND
1

P 1

ERNOA  ERND 

P NOA  FCF  P NOA

1 is
where ERNOA  the expected return for operations,
P NOA
1

P ND  F  P ND
1 P ND
ER 
ND
 is the expected return for net debt, and 1
is the amount of
P ND
1 P 1

leverage. This, of course, is the Modigliani and Miller (1958) leverage equation underlying
the standard weighted-average cost-of-capital calculation.

A similar arithmetic expresses the expected earnings yield as the accounting analog to this
expected return. As Earningsτ = OIτ – Net Interestτ (where OIτ is earnings from operations),
ND
accounting for net debt such that NDτ = P implies

Earnings OI ND 1  OI Net Interest 

 NOA   NOA  
P 1 P 1 P 1  P 1 ND 1 

where OINOA
 is the forward unlevered earnings yield and Net Interest is the firm’s net
P 1 ND 1

borrowing rate as reported in the financial statements. See Penman, Reggiani, Richardson,

and Tuna (2015). Thus, leverage that increases the expected return to equity on the left-

hand side of equation (3) also increases the expected earnings yield on the right-hand side

13
 of that equation. With no effect on the premium under P4, the leverage contribution to the

expected return is captured via the earnings yield.

P4 and P5 describe how the effect of leverage on the expected return is conveyed through

the accounting. It is quite instructive, for it provides an insight in to how the risk in operations

might also be conveyed through the accounting. Property 6 introduces the idea:

P6. Leverage increases expected earnings growth. By the same arithmetic for the

expressions in P5,

gEarnings 
OI  Net Interest
OI 1  Net Interest 1
 gOI 
Earnings 1

Net Interest 1 OI
g t  gNet Interest 

for all τ, where gτ indicates a growth rate in period τ and the respective superscripts indicate

the subject of the growth. Thus leverage increases expected earnings growth provided

expected growth in income from operations is greater than that for net interest (a

“favorable” leverage” condition that is expected for a going concern.).

Here is the insight: Typically one views expected earnings growth as increasing price and thus

decreasing the earnings-to-price (E/P) ratio (increasing the P/E ratio). However, while leverage

increases expected earnings growth, leverage has no effect on equity price under Modigliani and

Miller (1958) conditions. The growth from leverage that might otherwise add to price is risky

growth so is discounted in the price; expected growth and risk cancel to leave the price

unchanged.8

8
Penman (2013, Chapter 14) provides numerical examples.

14
 And so to the question: Could it be that expected earnings growth associated with

operating activities is also discounted in the price to yield a higher ERτ? If, like leverage,

expected earnings growth is discounted because it is risky, that growth does not add to price.

And, if the denominating price, Pτ-1, in equation (3) remains unchanged, ERτ will increase with

the added numerator growth.

Although redundant, the point can be made via a simple valuation model with a constant

expected return and constant growth rate. Given full payout, the valuation,

Earnings t 1
Pt  (4)
ER  g

yields the same valuation as a discounted dividend valuation (and an equivalent valuation to the

Gordon version of the dividend discount model).9 Thus,

Earnings t 1
 ER  g . (4a)
Pt

The standard view is that expected growth, g, adds to price and thus decreases the E/P ratio (and

increases the P/E ratio). But, that is only so if ER is held constant while g varies. If ER increases

with g, one for one, in equation (4a), then price does not change. The way this works with

9
The full payout assumption is unimportant. Payout (retention) other than full payout adds to earnings
growth, g, but does not add value under M&M conditions, nor does it affect the premium of price over
book value under P1. The valuation in equation (4) isolates the growth that potentially affects price and
the expected return, r, and at the same time is M&M consistent. Penman, Reggiani, Richardson, and Tuna
(2015) connect growth to the expected return via the Ohlson-Juettner (2005) model that generalizes the
Gordon model by maintaining M&M properties for all payouts.

15
leverage has been demonstrated. With respect to operating activities, further information that

connects growth to risk is needed. Can accounting supply that information?

Under P2 and P3, growth is generated by earnings measurement, so a positive answer to

this question would require accounting principles for the measurement of earnings such that two

conditions are satisfied:

(a) Earnings are measured such that the expected growth generated by earnings

measurement is at risk, and

(b) That risk is priced risk.

Condition (a) appears to be satisfied under GAAP and IFRS accounting principles for

recognizing earnings:

P7. The realization principle. Under uncertainty, GAAP and IFRS historical cost

accounting defers the recognition of earnings until the uncertainly has largely been

resolved.

Deferring earnings to the future reduces recognized earnings and, for a given Pτ-1, increases

subsequent expected earnings, that is, it increases expected earnings growth. Further, under the

principle, the earnings that are deferred are at risk, uncertain as to their realization.

Correspondingly, realized earnings represent the outcome of the risk, risk resolved. Pt (current

price) is the expectation of all future earnings but the timing of those earnings to periods, τ, is

dictated by accrual accounting principles and the governing principle is the realization principle

that is a reaction to uncertainty.

16
 Indeed, under this principle, accounting can be seen as a system that tracks the resolution

of uncertainty over time: Earnings is recognized and book value added only when uncertainty is

resolved, while the recognition of earnings still at risk is deferred to the future. Accordingly, the

sequence of future ERτ in equation (3) can be represented as a sequence based on expected

earnings realization but also earnings deferred. The deferral establishes prior probabilities for the

Bayesian and realization revise those priors.

The deferral principle is applied with revenue recognition rules that (usually) require the

firm to have a firm customer, with receipt of cash to be “reasonably certain”: Expected future

sales are not recognized, even though they may be anticipated in the price, because they are at

risk of not being consummated.10 However, the uncertainty principle is also applied in expensing

investments that are particularly risky―R&D, promotion, start-up costs, investment in software,

distribution and supply chain development, employee training, to name a few. This so-called

conservative accounting reduces reported earnings but increases expected future earnings (from

expected sales with no amortization of investment expenditure), that is, earnings growth.11 But

the growth is risky: The payoff to the R&D etc. may not be realized. Feltham and Ohlson (1995)

and Zhang (2000) recognize the property whereby conservative accounting depresses earnings

and creates expected earnings growth, but with a constant discount rate. P7 opens up the prospect

that this accounting may have implications for the discount rate.12 Penman and Zhang (2015)

10
New IASB and FASB proposals for revenue recognition require satisfaction of a contract, and contract resolution
appears to have the feature of removing uncertainty.
11
“Conservative accounting” is characterized in different ways in the literature. It is used here to mean any
accounting that results in price greater than book value which, in turn, implies that expected earnings in price are
recognized (and added to book value) with a delay.
12
A special case involves conservative accounting for investment with no change in the premium: If there is no
growth in investment, earnings (and the premium) are not affected, even though conservative accounting is applied
to the investment. So, for example, earnings are not affected by the expensing of R&D if there is no growth in R&D;
in steady state, earnings are the same whether R&D is expensed immediately or capitalized and amortized. With

17
elaborate.13 The accounting for earnings is path dependent and the path depends on risk and its

resolution.

It is far less clear whether condition (b) on the pricing of risk is satisfied. However, asset

pricing theory demonstrates that it is satisfied for leverage: Levered betas are higher than

unlevered betas. Accordingly, the increase in expected earnings growth from leverage is at risk

from market-wide shocks. Thus, it is not farfetched to imagine that shocks to expected earnings

(growth) might be sensitive to economy-wide shocks such as shocks to GDP. The realization

principle implies an effect on betas: In asset pricing terms, earnings are not recognized (and

added to book value) until the firm can book a low-beta asset such as cash or a near-cash

receivable; there is a different beta exposure with unrecognized earnings versus realized

earnings.

Asset pricing theory (and valuation theory more generally) is built on the principle of no-

arbitrage, and a no-arbitrage argument further supports the idea that the realization principle ties

to priced risk. In holding stocks, investors bear risk that the expected return may not be realized,

and thus require a return commensurate with the risk. But, when they sell stocks and invest the

cash proceeds in the risk-free asset―they realize the return―the risk is reduced, and so is the

expected return (to the risk-free rate). A stock is a claim on the expected earnings of a firm, so

when the firm realizes those expected earnings into cash or a near-cash asset on shareholders’

behalf, the investors’ risk and expected return are correspondingly reduced. On a consolidated

respect to risk, this steady-state property―the so-called cancelling error property of accounting―occurs when the
reduction of earnings from expensing new risky investment is exactly offset by the realization of earnings from
earlier investments.
13
Penman, Reggiani, Richardson, and Tuna (2015) demonstrate many of the properties in this section with
examples, including a case where expected growth is priced to yield a higher expected return.

18
basis, the firm’s accounts are part of the shareholders’ accounts, so it makes no difference if the

shareholder “realizes” or the firm “realizes” on the shareholder’s behalf― the shareholders (the

100 percent owners) have the claim to the same cash. A no-arbitrage condition so dictates

(frictions aside). The idea of realization as risk resolution also resonates with the economics

underlying valuation theory: It is future consumption that is at risk in investing, and it is

(realized) cash that buys consumption. Again, no-arbitrage applies: Cash payout has no effect on

cum-dividend value under M&M, so cash held in the firm has the same consumption value as

cash on personal account.14

These points aside, under asset pricing theory condition (b) would require the risk that is

recognized in the realization principle to be non-diversifiable risk. That is, the expected growth

created under the principle would have to be growth that can be shocked by factors common to

all stocks. (Of course, it remains an open question as to whether idiosyncratic risk is also priced.)

One would love to have a property 8 that links the deferred earnings (growth) to priced risk and

thus the expected return. That is too ambitious (for me) given we do not have a generally

accepted asset pricing model for priced risk and return and, if we did, linking accounting

operations to risk factors and their sensitivities is a challenging task.15 It would involve an

identification of Ytτ and the covariance terms in model (1a) that discounts the sequence of

expected earnings realizations.

14
Realization typically results in a receivable rather than cash, but receivables are discounted to a cash equivalent
value for the risk of not receiving the cash, at least in principle.
15
Ohlson (2008) lays out a model where permanent income accounting with a constant expected return (as defined
in P3) is modified to yield a constant growth rate that equates to the risk premium (and, in turn, implies an expected
increase in premiums of price over book value). The paper envisions an allocation of life-long expected earnings to
periods with this feature, but is silent on the transaction analysis and accrual accounting principles that could induce
earnings growth that is tied to risk.

19
 However, there is evidence that suggests that this accounting conveys information about

risk that is priced in the market.

EVIDENCE

Penman and Reggiani (2013) shows that average returns are related to the extent to which

earnings are expected to be recognized in the short term versus the long term. Penman, Reggiani,

Richardson, and Tuna (2015) show that portfolios with higher expected earnings growth are at a

higher risk of that growth not being realized and that higher growth also has higher sensitivity to

market-wide shocks to growth. Ellahie, Katz, and Richardson (2014) reports similar findings at

the aggregate (country) level. Penman and Zhang (2015) find that firms where higher earnings

growth is created by earnings deferrals under conservative accounting yield higher average stock

returns. Correspondingly, expected earnings, so deferred, have higher variance around them and

higher sensitivity to shocks to aggregate earnings. Based on P7, Penman and Yehuda (2015)

extract a measure of the change in ERt from financial statements (“discount-rate news”) and

show that the market indeed prices this information as if it is news about expected returns.

All these results could be attributed to market inefficiency, of course. But that would be

cavalier; the connection to risk via the realization principle cannot be dismissed lightly. The

predicted returns in the papers just cited are not from data dredging with a search for t-statistics;

rather the tests are structured with an understanding of how accounting connects to risk. That

said, condition (b) remains an open question. That qualification must be kept in mind in reading

what follows.

IMPLICATIONS FOR EXISTING RESEARCH

20
This analysis provides a commentary on a number of streams of accounting and finance research

that attempt to connect risk and expected returns to accounting numbers. While the commentary

is negative at points, it is provided in the spirit of improving the research. One requires a sense of

balance: While points of theory should be recognized and implemented if possible, rough-and-

ready approaches should not be dismissed out of hand if fine points are not operational.

The Implied Cost of Capital (ICC)

A long stream of research has attempted to infer expected returns from forecasts of accounting

numbers. That research reduces model (2a) such that, in the simplest form,

RE1
Pt  Bt  . (5)
ER  g

The expected return, a constant called the “implied cost of capital” (ICC), is then calculated as

the internal rate of return that reconciles forecasts of forward earnings and a constant growth

rate, g, to observed Pt – Bt. Variations include two or more years of forecasted earnings with a

growth rate applied at the longer forecast horizons or (in Gebhardt, Lee, and Swaminathan,

2001) with an assumption that book rates of return will decline to an industry benchmark over

time. Other papers, such as Gode and Mohanram (2003), reverse engineer the Ohlson-Juettner

(2005) model with a constant growth rate. See Easton (2007) and Easton and Monahan (2015,

this issue) for review and commentary. Note that, as this expected return is inferred from price, it

cannot be inserted in model (2a) to calculate price. For that, one needs (accounting) information

that is independent of price.

Some papers have shown that ICC measures are somewhat related to conjectured risk

measures such as beta, leverage, and industry membership, in Gebhardt, Lee, and Swaminathan

21
(2001) and Botosan and Plumlee (2005), for example. However, the research has been largely

unsuccessful in predicting average returns, a failure in validation. Guay, et al. (2011) and Easton

and Monahan (2005) discuss. This state of affairs is quite remarkable given that many

accounting numbers (with less pretense to being the expected return) readily predict returns (and

robustly so), for example, E/P, book-to-price (B/P), accruals, growth in assets, and a number of

financing variables, to name a few. This predictive ability could be attributed to market

inefficiency, but the ICC is the implied internal rate of return implicit in the current price so

should similarly identify market mispricing. The problem is more likely to be in the approach

and/or the inputs. Much is at stake; a considerable amount of research on disclosure, earnings

quality, audit quality, regulatory institutions, and corporate governance mechanisms rides on the

effect of these features on the “cost of capital” as measured by the ICC. This research seems to

have taken on a life of its own with broad acceptance that ICC measures the cost of capital.

Much of the critique of ICC estimates focuses on using analysts’ forecasts as an input.

The Lewellen (2010) critique stresses this issue, among others. Mohanram and Gode (2013) and

Wang (2013) demonstrate some improvement in dealing with it. Other papers such as Hou, van

Dijk, and Zhang (2012) and Li and Monhanram (2014) replace analysts’ forecasts with forecasts

estimated from accounting data, with some success. Lee, So, and Wang (2014) propose a

framework for evaluating alternative ICC estimates. The review below focuses on the approach

rather than the inputs.

First, the assumption of a constant expected return (and estimating the cost of capital)

based on forecasted earnings is doubtful if ERτ varies with the expected time-varying realization

of earnings as uncertainty is resolved. For example, if ERτ is time varying, the ICC estimated

with the input of a long-term earnings growth rate, g, may be a poor predictor of short-term

22
expected returns, perhaps explaining the inability of ICC estimates to forecast year-ahead

returns.16

Second, the typical assumption of the same growth path for all firms is likely to be

violated; indeed, estimating different growth rates over firms, as in Nekrasov and Ogneva

(2011), shows improvement in predicting returns. This point is well recognized, but our analysis

adds a further dimension: If expected growth is connected to risk and the expected return under

the realization principle, ER and g in model (5) are connected; a higher g implies a higher ER.

Failure to distinguish different growth rates across firms may thus fail to distinguish different

risk. And failure to input a growth rate commensurate with the indicated risk confounds the ICC

estimate. Further, the joint estimation of ER and g in Easton, Taylor, Shroff and Sougiannis

(2002) as if they were independent inputs to a valuation is suspect if growth is risk. The

connection of growth, risk, and the expected return in P5 and P6 makes the point: Leverage

increases both expected earnings growth and risk, and also ERτ. The realization principle

suggests that this might also apply to operations.

Cash-flow Betas

A number of papers have attempted to calculate so-called “cash-flow betas”. See Cohen, Polk,

and Vuolteenaho (2009), Campbell, Polk, and Vuolteenaho (2010), and Nekrasov and Shroff

(2009), for example. The labelling is confusing because these “fundamental betas” are actually

estimated slope coefficients from regressions of firm return on equity (ROE) on market-wide

16
This point complements the criticism of Hughes, Liu, and Liu (2009) that, with time-varying expected returns, the
internal rate of return is not the expected return.

23
ROE, not cash flows. The estimation is an admirable attempt to come to grips with the

covariance term in model (1a).

However, there are accounting issues that frustrate the endeavor. In the inter-temporal

Merton (1973) asset pricing model, investment opportunities are linked to the state of the

economy.17 Under conservative accounting, earnings in the numerator of ROE are reduced with

growth in risky investment. If firms increase that investment in good times when market-wide

ROE is up, they will reduce the firm ROE, inducing a negative correlation between ROE and

market-wide ROE (and thus will appear to have lower rather than higher risk). Similarly, firms

may reduce investment in bad times, increasing ROE when market-wide ROE is down.

Conservative accounting, with its generation of risky expected growth, signals higher risk, but

induces a lower correlation between ROE and market-wide ROE. There is also the issue of

estimating one covariance over periods where discount rates may vary and the composition of

deferred and realized earnings differs from period to period to indicate those changing discount

rates. With reference to P3, cash-flow beta estimates are appropriate with constant premiums

Earnings
over time (no growth). In that case ERτ = , all τ.18
P 1

Applications of the Vuolteenaho (2002) Model

A string of papers embrace the Voulteenaho (2002) model to decompose stock returns into

components that are attributed to expected returns, cash-flow news, and expected-return news

17
Also, under Cochrane (1991) Q-theory, firms invest in good states when discount rates are low.

18
Equation (3) Earnings and is covariance with the market earnings yield, rather than ROE, as the way to
P 1
estimate “cash flow betas”.

24
and to connect accounting numbers to each component. The model is implemented in a vector

autoregressive (VAR) scheme to estimate the linear dependencies in the time series evolution of

indicator variables and returns and, in turn, to identify the three return components from

residuals from the modeling. In Lyle, Callen, and Elliott (2013) and Lyle and Wang (2015), the

model has also been applied to estimate the expected return from accounting data as an

alternative to ICC calculations, and with success in predicting returns out of sample. Unlike the

analysis in this paper, the modeling has the appealing feature of explicitly connecting accounting

numbers to the expected return and its variation. The Callen (2015) paper in this issue lays out

the scheme and supplies references to papers that employ it. Easton and Monahan (2005 and

2015) evoke the model in evaluating ICC estimates.

Like equation (3), the clean-surplus relation is evoked to state the Voulteenaho tautology,

tying ROE and book-to-price to the expected return. However, an additional assumption is

implicit in the auto-regressive modeling. In some papers, log(Pτ) – log(Bτ) is assumed to

converge to zero in the long-run. And/or, ROE is assumed to evolve according to an

autoregressive parameter to equal the expected (stock) return, ERτ in the long run. See Lyle and

Wang (2015) and Lyle, Callen, and Elliott (2013), for example. Chattopadyhay, Lyle, and Wang

(2015) allow for the expectation Pτ - Bτ to be non-zero but constant in the long run. However,

they maintain the autoregressive assumption such that growth in book value and market value

converge linearly to zero over time and ROE is anchored on the long-run expected return.

Modelling the evolution of log premiums is curious for, unlike Pτ – Bτ, log premiums are

affected by dividends, so P1 (and M&M) are violated.19 But, further, P2 demonstrates that the

19
This is more than just a passing comment. Modeling that violates a foundational principle of modern finance is
called into question unless it is justified by a relaxation of one of the assumptions in M&M.

25
evolution of the premium, Pτ – Bτ, is dictated by the accounting for earnings, and the

autoregressive assumption for the evolution of this premium imbeds a specific accounting. If Pτ –

Bτ = 0 in expectation, we have the “unbiased accounting” of Ohlson (1995). The assumption

might be modified such that Pτ - Bτ > 0 in the long run, but the path to the long-run is critical. P3

shows that expected earnings growth implies an expansion of premiums: Pτ − Bτ – (Pτ-1 − Bτ-1) >

0. So, for the typical case of Pt – Bt > 0, an autoregressive assumption where the premium

declines (linearly) over all τ, does not admit earnings growth that implies an increase in

premiums, nor does it accommodate the conservative accounting of P7 that yields that growth, so

pervasive in GAAP and IFRS. In short, the modeling does not admit a path-dependent evolution

of earnings tied to risk resolution.

The Ohlson (1995) paper with unbiased accounting was supplemented with the Feltham

and Ohlson (1995) paper with “biased accounting” under which Pτ – Bτ > 0 in expectation, all τ,

and the (conservative) accounting involved can yield expected growth (and, correspondingly, an

expansion of price premiums over book value). See also Zhang (2000). Under that accounting,

ROE does not correspond to the expected return in expectation. The growth (and increasing

premium) generated by conservative accounting reduces earnings in the numerator of ROE such

that ROE increases (to a level well in excess of the expected return) as the firm matures with

subsequent realization of the deferred earnings (and then only if the risk pays off). Consider

Microsoft, Apple, Google, and Infosys, mature firms with high ROE (and, more so, RNOA),

compared to a new firm, Twitter with a low ROE due to expensing investments but similarly a

low book-to market. The anchoring of expected ROE to the expected return is justified as driven

by “the forces of competition”, but ROE is an accounting measure driven by the realization

principle and conservative accounting. There is nothing in that accounting that anchors ROE to

26
the expected return in expectation. To the contrary: Rather than a high ROE indicating higher

risk and expected return, with both declining over time, the accounting indicates that a lower

ROE affected by conservative accounting, indicates a higher risk, with risk and the expected

return declining as ROE increases with earnings realizations.

Penman and Zhang (2015) elaborate and present supporting evidence based on an

analysis of the actual accounting rather than an assumed parameter for the dynamics. Based on

the realization principle, Penman and Yehuda (2015) extract measures of discount-rate news

directly from financial statements that look quite different from those estimated via the

Vuolteenaho model. The measures satisfy a set of validation tests; in contrast, the discount-rate

news and cash-flow news component of returns estimated with the autoregressive scheme fail

consistency requirements that must be satisfied for such news.

On a more general level, both theory and empirical papers often assume a “process” for

the evolution of earnings―an AR(1) process is common. Papers on the time-series properties of

earnings, earnings persistence, as well as those that connect accounting numbers to prices come

to mind. But an assumed process implies an assumption about accounting principles for

recognizing earnings over time, and that implied assumption may not be appropriate if the model

is applied to GAAP or IFRS data generated under different accounting principles.

One might well ask, given the critique here, why estimates of the expected return from

the Voulteenaho model predict actual returns out of sample. That raises another issue.

ROE, Risk, and the Expected Return

In the Vuolteenaho model, ROE surfaces as an indicator of expected returns, with a higher ROE

indicating higher returns, ceteris paribus. More generally, ROE and similar measures of

27
profitability have been shown to be positively related to returns, in Novy-Marx (2012) and Ball,

Linnainmaa, and Nikolaev (2015), for example. The explanation offered rests on the standard

risk return tradeoff: Higher risk requires higher returns, so the positive association between ROE

and returns is because higher ROE is the reward for taking on risk. The applications of the

Vuolteenaho model formalize this intuition by anchoring ROE to the expected return. Apparently

in response to these observations, Fama and French (2015) have developed a “five-factor model”

that adds a measure of ROE to other factors to explain stock returns.

However, in these papers, book-to-market (B/P) is included in the ceteris paribus

condition, so the positive relationship between ROE and returns is conditional on B/P. But, E/P =

E/B × B/P = ROE × B/P, so adding ROE to a predictive regression that also includes B/P

recovers E/P, and E/P is the first term that connects accounting numbers to the expected return in

equation (3). Indeed, in the no-growth case (with no change in premiums), ERτ is equal to the

forward earnings yield, so one would expect ROE and B/P to predict returns (jointly) in this case

if current ROE is a good indicator of forward ROE (which it is). But this is not because ROE is

an indicator of risk and return but because ROE, in combination with B/P, yields E/P that

indicates risk and return (in the no-growth case).

However, the no-growth case is not typically for equities so the specification is not

complete without an indicator of growth that connects to risk. Equation (3) indicates that the

appropriate specification is to include E/P and then add variables that indicate risky expected

earnings growth. B/P is identified as such a variable, in Penman, Reggiani, Richardson, and Tuna

(2015). If ROE were positively related to expected returns, it would have to be that, conditional

on E/P, ROE also indicates risky growth. However, under the accounting principles in P7,

growth is induced with lower current earnings due to earnings deferrals and lower earnings imply

28
lower ROE (via the numerator). Thus a lower ROE, rather than a higher ROE, indicates risk and

a higher expected return if the risk indicted by the accounting is priced risk. The tests in Penman

and Zhang (2015) provide support: Unconditionally, there is no relation between ROE and

returns but, conditional on E/P, ROE robustly predicts returns negatively, with the relationship

considerably stronger for ROE that are affected by conservative accounting. Further, the

(deferred) earnings predicted by ROE are at higher risk of not being realized and are particularly

sensitive to market-wide shocks to earnings.

Fama and French Connection of Discount Rates to Accounting Numbers

Fama and French (2006) connect expected returns to accounting numbers via the following

equation, derived by applying the clean-surplus relation to substitute for dividends in the

dividend discount model (2a) with a constant discount rate, r:

Pt 
 E ( Earnings  ( B  B 1 ) /(1  r ) t
 t 1
,
Bt Bt

 E (Earnings )
 t 1
where r is the expected return, a constant. They refer to the term, , as
Bt

B  B 1
profitability (rate of return on book value), and the change in book value, , as growth
Bt

in investment. Reverse-engineering the expression, they conclude that r is increasing in B/P

holding the expected book rate of return and expected investment growth constant, increasing in

the expected book rate of return holding B/P and expected investment growth constant, and

decreasing in expected investment growth holding B/P and expected book rate of return constant.

These comparative statics motivate the five-factor model in Fama and French (2015).

29
 However, the comparative statics are inconsistent with how accounting works. One

cannot vary B/P while holding book rate of return (profitability) constant, because both reflect

the accounting for book value. High book rate of return means low B/P, ceteris paribus, by

construction of the accounting. As indicated immediately above, this is strictly so in the case of

no growth: r = E/P, by equation (3) and E/P = E/B ×B/P (where E/B is profitability). Thus, the

expected return is given by E/P rather than B/P and E/B as separate inputs. Indeed, B/P and E/B

can be any value (but the mirror image of each other because of the common effect of the

accounting for book value), yet still yield the same E/P. The same critique applies to the claim

that r is increasing in profitability holding B/P constant (as discussed above). On the connection

of “investment” to the expected return, there is a mislabeling that voids the interpretation:

Growth in book value in the formula is not investment. Rather, Bτ – Bτ-1 = Earningsτ + dτ. Thus,

as dividends are not relevant under P1, growth in book value is driven by earnings and the

profitability that involves those earnings. So, profitability cannot be held constant while looking

at the effect of growth in book value on r.

The Fama and French comparative statics appear to support the view, standard in asset

pricing, that expected returns are negatively related to growth―as in the standard “value” versus

“growth” spread where “growth” yields lower returns than “value”. In contrast, P7 suggests that

the expected return is positively related to growth. The Fama and French formulation does not

admit the period-to-period growth envisioned in P7. With the infinite summation over expected

future earnings in their model, the earnings expectation relative to current book value is for life-

long earnings, with no allocation to periods. In contrast, P7 focuses on the allocation of earnings

to the short-term versus the long-term that introduces expected earnings growth. The “value” and

“growth” labels do not stand up to scrutiny, as explained in Penman and Reggiani (2014).

30
 A RE-THINK OFANOMALIES RESEARCH

Considerable empirical research connects accounting numbers to average stock returns, among

them earnings-to-price (E/P), book-to-price (B/P), accruals, investment, growth in assets, and a

number of financing variables. In asset pricing research, the tendency has been to attribute these

“anomalies” to risk and expected return, while accounting research tends to attribute them to

mispricing. In the absence of a validated, generally accepted asset pricing model, the attribution

will not be resolved, but the introduction of the realization principle as the driver behind

accounting numbers requires a re-think on the part of those who ascribe returns that are predicted

by accounting numbers to abnormal returns.

Consider three very popular “anomalies”: accruals, investment, and growth in net

operating assets (ΔNOA).20 Under P4, a change in premium is explained by ΔNOAτ, the

accounting for operating activities: If ND  P ND , Δ(Pτ – Bτ) = Δ P NOA – ΔNOAτ. Accordingly,

expected earnings growth that induces the change in premium is determined by the accounting

for NOA.21 If that growth is connected to priced risk, then the ΔNOA anomaly is explained:

higher (lower) ΔNOA implies lower (higher) expected growth and correspondingly lower

(higher) risk and average returns, as observed. And, as ΔNOA = Investment + Other Accruals (a

fixed accounting relation), then the investment and accrual anomalies are similarly explained.

High accruals are associated with lower returns, but high accrued earnings come from realized

earnings (driven by the sales-account receivable accrual and expense matching), and realized

20
The original papers appear to be Sloan (1996), Titman, Wei, and Xie (2004), Fairfield, Whisenant, and Yohn
(2003), respectively.
21
P2 ascribes the premium to the measurement of earnings. As financing does not affect premiums, that
measurement pertains to operating income (OI). As OI = Free Cash Flow + ΔNOA by the clean-surplus relation for
operating activities, the measurement of earnings is determined by ΔNOA. (Correspondingly, it can be shown that
free cash flow does not affect premiums.)

31
earnings imply the resolution of risk and lower expected returns. Investment opportunities are at

risk, and that risk is priced under a Merton inter-temporal asset pricing model. Realization of

investment and booking it to the balance sheet is the resolution of that risk, so yields lower

returns, as observed. However, conservative accounting also operates: If the investment is

deemed too risky, the investment is expensed immediately, yielding lower ΔNOA ceteris paribus

and expected earnings growth. If that growth is risky, the conservative accounting (that is a

response to risk) should be associated with higher average returns, as observed in Penman and

Zhang (2015).

In short, these anomalies are consistent with rational pricing if the realization principle

aligns with the evolution of risk and the expected return. The evidence in Penman and Zhu

(2014) suggests so.

THE NUMERATOR ISSUE

As indicated in the introduction to the paper, practical valuation requires not only information

about the discount rate, the denominator issue, but also the specification of the accounting for the

numerator. The residual income model, based solely on the clean-surplus relation, is agnostic

about the numerator issue. However, the analysis that deals with the denominator issue also

directs the accounting for the numerator; a discount rate for any period, τ, must refer to the risk

that the expected payoff for that τ may not eventuate.

The residual income models in equations (1a) and (2a) require (1) a division of the value

in Pt between Bt and expected earnings not yet recognized and (2) the allocation of those total

earnings not yet recognized to each future period, τ. Both issues concern the allocation of

32
earnings to periods―the present versus the future and inter-temporally (in expectation) in the

future.

Book value is not discounted in the model, so must involve numbers that do not have to

be discounted for risk. As Bt is accumulated earnings recognized to date net of accumulated net

dividends (that include net share isues), our analysis suggests that those earnings in book value

are realized earnings where the uncertainty about outcomes has been resolved. Assets are added

to the balance sheet only at cost (with no added value for the expected earnings that might

accrue). If, ex post, expected earnings imply carrying values higher than the value in those

earnings, the balance sheet is written down. Further, if the outcome to the investment is highly

uncertain, conservatism applies such that the asset is expensed and not put on the balance sheet.

This accounting, along with the recognition of operating liabilities, yields a balance sheet that

will only be affected if earnings are realized in the future, and a balance sheet that has low

probability (ex ante) of being written down. On point (2), the identification of expected earnings

to each τ, is based on the timing of their expected realization such that they are sequenced with

the τ indexed covariance term in model (1a) that discounts for the risk that earnings realization

may be affected by common shocks.

With this accounting, the residual income model is now really an “accounting-based

valuation model”. It has the feature of accommodating risk. It has the feature of anchoring a

valuation on a book value that contains little risk apart from leverage transparently reported on

the balance sheet; there is nothing in the balance sheet that can come back and hit you later― no

“water in the balance sheet” as a fundamentalist would say. And it has the feature of identifying

where the risk of the business lies―the risk of earnings not being realized.

33
 ACCOUNTING POLICY

If accounting is to serve the investor, these points have implications for accounting policy, a

topic in which Abacus has shown a keen interest over the years. There are also implications for

the current debate about fair value accounting versus historical cost accounting. Fair value

accounting is said to be more timely, for it projects the future cash flows, while historical cost

recognizes the information in price with a lag. However, in the comparison of the two accounting

measurements earlier, historical cost accounting conveys the risk in investing while fair value

accounting fails to do so. In fact, fair value accounting (even if ideally implemented) does not

project future cash flows but rather the (discounted) present value of expected cash flow. As

anyone carrying out practical valuations knows, the identification of the discount rate is

problematical, but the information about risk that might supply this aspect of fair value

accounting would be lost with fair value accounting. While other issues enter the debate, this is

one to consider.

This raises the prospect that “good accounting” is less timely accounting, in contrast to

the standard view that accounting is deficient for not being timely. Accounting that recognizes

the earnings expectations in price with a lag informs the investor if that delay it tied to risk and

its resolution. Research has typically seen accounting as providing information about expected

cash flows―cash-flow news―but the investor also requires discount-rate news. After all, equity

value is based, not only on expected cash flows but also the rate at which the cash flow are to be

discounted. Indeed, the objectives in the Conceptual Framework of the IASB ad FASB state that

accounting information should provide investors with information to assess “the amount, timing,

and uncertainty of future net cash flows.” Historical cost accounting with a realization principle

tied to the resolution of uncertainty satisfies the objective.

34
 Earnings recognition under historical cost accounting is often presented as a matter of

recognizing revenue under the realization principle and then matching associated expenses

against the revenue to determine the earnings. That matching involves holding costs on the

balance sheet then taking them to the income statement under an amortization rule. Conservative

accounting that expenses investment costs immediately violates matching, bringing calls for the

“intangible assets” so expensed to be capitalized and amortized. However, the analysis here

suggests that the mismatching with conservative accounting conveys information about risk and

its resolution that would be lost with such capitalization of risky investments. This accounting

accords with the FASB’s Statement of Financial Accounting Concepts No. 2 (1975) which

defines conservative accounting as “a prudent reaction to uncertainty.”22 In justifying the

immediate expensing of R&D under FASB Statement No. 2, the FASB focused on the

“uncertainty of future benefits.” In IAS 38, the IASB applied the criterion of “probable future

economic benefits” to distinguish between “research” (which is expensed) and “development”

(which is capitalized and amortized). An understanding of conservative accounting suggests the

“matching principle” should not be embraced as matter of accounting principle if one wishes to

convey information about the amount and uncertainty of future cash flows.

In fact, mismatching is inevitable and the policy question in how to design the

mismatching. Matching is a principle that can only be implemented under certainty: If one

knows both the amount and timing of future revenues, one can match expenses with those

revenues perfectly, but even then only if the association of expenses with revenues can be

identified. Under uncertainty, the accountant is faced with a choice between capitalizing risky

22
The 2010 and 2015 IASB Discussion Papers on the Conceptual Framework dispense with the notion of
conservatism in favor of “neutrality” and define prudence as “caution when making judgments under conditions of
uncertainty”.

35
investment with an uncertain amortization rate to achieve the matching or expensing it

immediately. In both cases, the settling up against the accounting comes with the resolution of

uncertainty. If investment is capitalized and revenues fail to materialize, mismatching occurs ex

post with write-offs of carrying values against revenues to which the impairment does not apply.

Implicitly, the write-offs recognize that, on an ex post basis, assets have been inappropriately

recognized on the balance sheet. With the expensing of risky investments, mismatching is

implemented immediately but with the risk now communicated ex ante. So the policy question is

whether the accounting should communicate risk ex ante or ex post. Prudent (conservative)

accounting would suggest that former. Fair value accounting is a third alternative, again with risk

communicated (too late) ex post as fair values are shocked when it is recognized that expected

earnings built into the fair value will not materialize.

DISCOUNTED EARNINGS

The task of identifying the economy-wide Ytτ variable and the covariance term in model (1a) is

challenging, as research in asset pricing has found. Enhanced valuation models add further

structure to interpret Ytτ; for example, in consumption-based models it represents investors’

marginal utility of consumption at τ relative to time t which (with further assumptions) is

couched in terms of aggregate consumption. As a matter of measurement this is problematic, and

thus the recourse to the practical expedient of model (2a). However, calculating a risk premium

for the discount rate remains a challenge, one that has been pursued relentlessly in asset pricing.

But a tantalizing idea surfaces: What if accounting could be designed with an earnings

calculation, RE* = REτ – Cov(REτ, Ytτ)? That is, the discount for risk in the numerator of model

(1a) is built into the earnings measurement (such that expected earnings require no discount for

36
risk). The realization principle and conservative accounting appear to imbed this feature: In the

presence of risk, earnings are reduced―discounted for the risk―and deferred contingently to the

future. If the deferred earnings are realized with risk resolution, the recognized earnings indicate

lower risk. It is not clear whether an accounting could be calibrated that captures the risk but,

given the difficulty of the alternative―identifying Ytτ and covariances―the idea is worthy of

consideration.

In any case, the following conjecture is on the table: If GAAP or IFRS already discounts

earnings for risk, the covariance discount that is directed by model (1a) may be redundant, at

least to some extent. If we see a company with earnings prospects but with current earnings

depressed by conservative accounting, is that not a risky company? Amazon and Twitter look

like that sort of firm. They presumably have high earnings expectations but have low or negative

earnings and low ROE from the expensing of investments (as of the date of writing). That is

information that the expected earnings are at risk, they may not materialize. On the other hand,

Coca-Cola reports a high ROE in the order of 25 percent because the investment in promoting its

brand has paid off with realized earnings; it has a beta of 0.4.

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