Conservatism, Growth, and the Role of Accounting Numbers in the Fundamental Analysis Process

In this study, the author evaluates the effects of conservative accounting for research and development (R&D) and past growth in R&D on two phenomena that are pertinent to the fundamental analysis process: (1) the relation between aggregate earnings (deflated by price) and contemporaneous stock return, and (2) the association between estimates of value derived from the residual income valuation model (i.e., RIV estimates) and equity market value. He shows that the conservative treatment of R&D affects the earnings/return relation only for firms that experience high growth in R&D during the return interval of interest. He also demonstrates that the effect of conservative accounting for R&D on the association between RIV estimates and equity market values is increasing in past growth in R&D.