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 substan...

Suppose you are applying the residual income valuation model to value a firm with extremely conservative accounting.

Question:

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. or IFRS but the firm does not recognize a substantial intangible asset on the balance sheet. (Perhaps the firm has expensed substantial amounts of research and development expenditures that have lead to valuable intellectual property or substantial amounts of advertising that have created a valuable brand name). As a consequence of this extremely 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?

GAAP
Generally Accepted Accounting Principles (GAAP) is the accounting standard adopted by the U.S. Securities and Exchange Commission (SEC). While the SEC previously stated that it intends to move from U.S. GAAP to the International Financial Reporting Standards (IFRS), the...