Revenue Investment, Accounting Conservatism and the Valuation of Loss Making Firms
47 Pages Posted: 19 Jan 2004
Date Written: October 3, 2003
Abstract
The proportion of listed firms reporting accounting losses has increased greatly since the 1970s. The perception that accounting losses always indicate a loss of economic value is no longer widely held. It is now accepted that many loss making firms report losses because of investments that cannot be capitalized under present accounting rules. Charges against income caused by investments are called 'revenue investments' in this study. Two aspects of the valuation of loss making firms are investigated. Firstly, a method of distinguishing firms that have made revenue investments from firms that are suffering 'real' economic losses is developed. The findings show that loss making firms can be categorized, and that the accounting and economic characteristics of firms differ over these categories. Secondly, the impact of revenue investment on the residual income valuation model is examined. The findings show that revenue investment means that book value is not sufficient to specify the stream of normal returns on the firm's investments. The Ohlson (1995) model is used to show that decomposition of residual income leads to a better valuation model and that current and past losses are associated with value creation for firms that practice revenue investment.
JEL Classification: M41, M43, M44, G12
Suggested Citation: Suggested Citation
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