Accrual Accounting, Informational Sufficiency, and Equity Valuation



    1. Stern School of Business, New York University. This paper is a chapter from my dissertation that I completed at the Stanford University Graduate School of Business. I would like to thank my academic advisor, Stefan Reichelstein, for his continuous support, guidance, and encouragement. I am also grateful to Bill Beaver, Anne Beyer, Ilan Guttman, Jack Hughes, Maureen McNichols, Jim Ohlson, Joe Piotroski, Madhav Rajan, Haresh Sapra (the editor), Dan Taylor, and an anonymous referee for their comments and suggestions. This paper benefited from comments from seminar participants at Carnegie-Mellon University, Columbia University, Dartmouth College, INSEAD, New York University, University of California, Berkeley, University of California, Los Angeles, and University of Southern California. Last, but not least, I wish to acknowledge the advice and patient support of Nikolai Nezlobin and Polina Nezlobin.
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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 that 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. The intrinsic value of the firm can then be expressed as a function of current accounting data and certain parameters of the firm’s operating environment. Further, it is shown that replacement cost accounting is essentially the only accounting rule with this informational sufficiency property.