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Valuation: Accounting for Risk and the Expected Return
Author(s) -
Penman Stephen
Publication year - 2016
Publication title -
abacus
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 0.632
H-Index - 45
eISSN - 1467-6281
pISSN - 0001-3072
DOI - 10.1111/abac.12067
Subject(s) - earnings response coefficient , valuation (finance) , economics , cash flow , accounting , accounting information system , fair value , actuarial science , earnings , econometrics
Under accounting principles, the recognition of earnings is path‐dependent and the path depends on risk and its 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.