Accrual Accounting, Informational Sufficiency, and Equity Valuation

This paper studies accrual accounting and equity valuation in the context of a firm that makes repeated and overlapping investments in productive capacity. The analysis identifies a particular accrual accounting (depreciation) rule which is termed replacement cost accounting because the book value of existing capacity assets is set equal to the value that such assets would have if a competitive market were to exist for used assets. It is shown that replacement cost accounting aggregates past investment decisions of the firm without a loss of value-relevant information. In particular, the intrinsic value of the firm can then be expressed as a function of current accounting data and projections of growth in the firm’s output market. Further, it is shown that replacement cost accounting is essentially the only accounting rule with this informational sufficiency property. In many environments of interest, standard depreciation rules, such as the straight-line rule, will not coincide with replacement cost accounting. Nonetheless, even informationally insufficient accounting rules are shown to be useful to investors. In particular, the analysis in this paper characterizes a best value estimator and derives upper bounds on the valuation errors associated with alternative accounting rules. ∗Ph.D. Candidate in Accounting, email: [email protected]. I would like to thank my academic advisor, Stefan Reichelstein, for his continuous support, guidance, and encouragement. I am also grateful to William Beaver, Anne Beyer, Ilan Guttman, Maureen McNichols, Joseph Piotroski, Madhav Rajan, and Daniel Taylor for their comments and suggestions. Last but not least, I wish to acknowledge the advice and patient support of Nikolai Nezlobin and Polina Nezlobin.