encyclopedia of accounting (colin clubb)

THE BLACKWELL ENCYCLOPEDIA OF MANAGEMENT
ACCOUNTING
Colin Clubb / TheBlackwell Encyclopediaof Management: Accounting Final Proof30.11.2004 5:27pm page i
THE BLACKWELL ENCYCLOPEDIA OF MANAGEMENT
SECOND EDITION
Encyclopedia Editor: Cary L. Cooper
Advisory Editors: Chris Argyris and William H. Starbuck
Volume I: Accounting
Edited by Colin Clubb (and A. Rashad Abdel-Khalik)
Volume II: Business Ethics
Edited by Patricia H. Werhane and R. Edward Freeman
Volume III: Entrepreneurship
Edited by Michael A. Hitt and R. Duane Ireland
Volume IV: Finance
Edited by Ian Garrett (and Dean Paxson and Douglas Wood)
Volume V: Human Resource Management
Edited by Susan Cartwright (and Lawrence H. Peters, Charles R. Greer, and Stuart A.
Youngblood)
Volume VI: International Management
Edited by Jeanne McNett, Henry W. Lane, Martha L. Maznevski, Mark E. Mendenhall,
and John O’Connell
Volume VII: Management Information Systems
Edited by Gordon B. Davis
Volume VIII: Managerial Economics
Edited by Robert E. McAuliffe
Volume IX: Marketing
Edited by Dale Littler
Volume X: Operations Management
Edited by Nigel Slack and Michael Lewis
Volume XI: Organizational Behavior

Edited by Nigel Nicholson, Pino G. Audia, and Madan M. Pillutla
Volume XII: Strategic Management
Edited by John McGee (and Derek F. Channon)
Index
Colin Clubb / TheBlackwell Encyclopediaof Management: Accounting Final Proof30.11.2004 5:27pm page ii
S E C O N D E D I T I O N
ACCOUNTING
Edited by
Colin Clubb
Warwick Business School,
University of Warwick
THE BLACKWELL
ENCYCLOPEDIA
OF MANAGEMENT
First edition edited by
A. Rashad Abdel-Khalik
Colin Clubb / TheBlackwell Encyclopediaof Management: Accounting Final Proof30.11.2004 5:27pm page iii
# 1997, 1999, 2005 by Blackwell Publishing Ltd
except for editorial material and organization # 2005 by Colin Clubb
BLACKWELL PUBLISHING
350 Main Street, Malden, MA 02148-5020, USA
108 Cowley Road, Oxford OX4 1JF, UK
550 Swanston Street, Carlton, Victoria 3053, Australia
The right of Colin Clubb to be identified as the Author of the Editorial Material in this Work has been asserted in
accordance with the UK Copyright, Designs, and Patents Act 1988.
All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted,
in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, except as permitted
by the UK Copyright, Designs, and Patents Act 1988, without the prior permission of the publisher.
First published 1997 by Blackwell Publishers Ltd
Published in paperback in 1999 by Blackwell Publishers Ltd

Second edition published 2005 by Blackwell Publishing Ltd
Library of Congress Cataloging-in-Publication Data
The Blackwell encyclopedia of management. Accounting/edited by
Colin Clubb.
p. cm. — (The Blackwell encyclopedia of management ; v. 1)
Rev. ed. of: The Blackwell encyclopedic dictionary of accounting
/edited by Rashad Abdel-Khalik. 1998.
Includes bibliographical references and index.
ISBN 1-4051-1827-X (hardcover : alk. paper)
1. Accounting—Dictionaries. I. Clubb, Colin. II. Blackwell
encyclopedic dictionary of accounting. III. Series.
HD30.15 .B455 2005 vol. 1
[HF5621]
658’.003 s—dc22
[657’.003 s]
2004024923
ISBN for the 12-volume set 0-631-23317-2
A catalogue record for this title is available from the British Library
Set in 9.5/11pt Ehrhardt
by Kolam Information Services Pvt. Ltd, Pondicherry, India
Printed and bound in the United Kingdom
by TJ International, Padstow, Cornwall
The publisher’s policy is to use permanent paper from mills that operate a sustainable forestry policy, and which has been
manufactured from pulp processed using acid-free and elementary chlorine-free practices. Furthermore, the publisher
ensures that the text paper and cover board used have met acceptable environmental accreditation standards.
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Colin Clubb / TheBlackwell Encyclopediaof Management: Accounting Final Proof30.11.2004 5:27pm page iv
Contents

Preface vi
About the Editors viii
List of Contributors ix
Dictionary Entries A–Z 1
Index 423
Colin Clubb / TheBlackwell Encyclopediaof Management: Accounting Final Proof26.11.2004 10:54pm page v
Preface
Accounting practice encompasses a wide variety of organizational activities which include the
recording of financial transactions and events in the firm’s books, the use of financial information
for management decision-making and control purposes, and the preparation and audit of financial
statements prepared for external users such as investors, customers, and employees. There are many
textbooks available which provide introductory, intermediate, and advanced treatments of the tech-
nical and managerial issues raised by such accounting activities. The current volume cannot possibly
aim to provide in depth coverage of the vast range of activities which comprise modern accounting
practice. Instead, it aims to provide a way in to the expanding accounting research literature which in
recent years has come to provide a variety of perspectives on the big issues confronting accounting
practice. I briefly consider some of these perspectives here.
Some of the contributions to the volume focus on particular financial reporting, auditing, or
management accounting topics and outline alternative possible approaches or treatments within
(and perhaps beyond) existing conventions or rules. The information contained in the main financial
statements (the balance sheet, the profit and loss account, and the cash flow statement) is discussed;
important aspects of financial reporting such as the treatment of employee stock options, pensions
accounting, and the treatment of taxation are analyzed; comparative analysis of the use of statistical and
judgmental methods in auditing is provided: and the nature of costing systems required to generate
product cost information in modern production environments are described. While these contribu-
tions to the volume throw important light on important technical developments in the broad account-
ing arena, they also draw attention to the choices that must be made by accounting regulators, auditors,
and managers in determining what is an appropriate treatment of a particular item in a company’s
financial statements, an effective audit procedure or the ‘‘optimal’’ approach to product costing. The
fact that these choices can have profound effects on management decision-making and on the fortunes

(and decisions) of important corporate stakeholders or constituencies indicates the fundamental
managerial, economic, and social importance of developing understandings of the broader implications
of accounting practice.
The need to understand the implications of accounting practices for the decisions taken by managers
and investors, and the implications of these decisions for broader economic and social well-being,
provides important motivation for accounting research with economic, organizational, social, and
historical focus. Several of the volume contributions consider the usefulness of accounting from an
economic perspective, for example, by reviewing the large literature on the relationship between share
price performance and financial statement information such as reported profit, dividends, cash flow,
and R&D spending. Much of the empirical work in this area draws on valuation theory, providing
interesting evidence on the extent to which accounting provides (or at least reflects) fundamental
information used by the capital markets to value corporate securities. In addition to valuation theory,
economic perspectives based on agency theory and information economics have been used to provide
insights into the problems of designing performance evaluation systems which encourage ‘‘optimal’’
managerial decision-making and the problems of structuring of audit contracts to provide a high level
of audit quality from an investor viewpoint. The volume provides a range of contributions that
Colin Clubb / TheBlackwell Encyclopediaof Management: Accounting Final Proof26.11.2004 10:58pm page vi
demonstrate the importance and practical relevance of insights from applying economic analysis to the
analysis of accounting issues.
While the financial focus of much of what is usually regarded as accounting practice leads naturally
to the application of economic perspectives in the analysis of such practice, there has been a growing
appreciation in the research literature that accounting is implicated in organizational and social
processes which affect the distribution of resources between stakeholders in the organization and
which affect the impact of an organization on society. A number of entries therefore focus on the
problems of implementing profit driven decision tools, such as discounted cash flow, in the context of
organizational and environmental uncertainty and the issues raised by the design of internal perform-
ance evaluation systems to facilitate managerial decisions consistent with broader stakeholder object-
ives in private and public sector organizations. The ability of auditors to act impartially as guardians of
the investor interest in companies and the relationship of financial reporting and auditing to the law is
critically examined. The relative importance of profitability and alternative organizational objectives

has been an important theme in much recent research and this is reflected in articles which consider the
current and historical status of social and environmental reporting as a managerial practice. The
organizational and social roles of accounting is a theme reflected in many entries, emphasizing the
importance of a more explicit recognition by managers and stakeholders of the interaction between
accounting practice and organizational decision-making. Diversity of theoretical perspective and
emphasis among researchers, however, can make comparisons of research in this area a difficult issue.
To conclude, this volume aims to provide the reader with a range of articles that highlight
important issues in accounting practice and the contributions that research can make to the under-
standing and development of practice. These articles can only provide a general indication of the
variety of perspectives and analyses conducted in the various areas and it is therefore hoped that they
will encourage (and guide) further enquiry by the reader. By leading to a greater appreciation of the
conceptual foundations of different accounting practices and the sometimes ambiguous economic,
organizational, and social implications of these practices, it is hoped that this volume will help the
reader to develop a deeper view of the usefulness of accounting as a mechanism for achieving economic
and social goals.
Colin Clubb
Colin Clubb / TheBlackwell Encyclopediaof Management: Accounting Final Proof26.11.2004 10:58pm page vii
Preface vii
About the Editors
Editor in Chief
Cary Cooper is based at Lancaster University as Professor of Organizational Psychology. He is the
author of over 80 books, is past editor of the Journal of Organizational Behavior and Founding
President of the British Academy of Management.
Advisory Editors
Chris Argyris is James Bryant Conant Professor of Education and Organizational Behavior at
Harvard Business School.
William Haynes Starbuck is Professor of Management and Organizational Behavior at the Stern
School of Business, New York University.
Volume Editor
Colin Clubb is Professor of Accounting at Warwick Business School. He is an editorial board member

of the Journal of Business Finance and Accounting and has published research articles in a wide range of
major accounting and finance journals.
Colin Clubb / TheBlackwell Encyclopediaof Management: Accounting Final Proof26.11.2004 10:59pm page viii
Contributors
A. Rashad Abdel-khalik
Fisher School of Accounting, University of
Florida
Mohammad J. Abdolmohammadi
Bentley College
Walter Aerts
University of Antwerp
Anwer Ahmed
Syracuse University School of Management
Thomas Ahrens
London School of Economics
Bipin B. Ajinkya
Fisher School of Accounting, University of
Florida
Mimi L. Alciatore
University of Houston
K. B. Ambanpola
Nanyang Technological University, Singapore
Simon Archer
University of Surrey
A. J. (Tony) Arnold
University of Exeter
Stephen K. Asare
Fisher School of Accounting, University of
Florida
Hollis Ashbaugh

formerly of University of Wisconsin–Madison
Frances L. Ayres
University of Oklahoma
Kashi R. Balachandran
Stern School of Business,
New York University
Richard Barker
Judge Institute of Management,
University of Cambridge
Lynn Barkess
University of New South Wales
Sasson Bar Yosef
The Hebrew University, Jerusalem
Vivien Beattie
University of Glasgow
Martin Benis
New York University
Alnoor Bhimani
London School of Economics
and Political Science
Andrew P. Black
Consultant
Jane Bozewicz
Babson College
Niamh Brennan
University College Dublin
Gae
´
tan Breton
UQAM, Canada

Jane Broadbent
Royal Holloway, University of London
Peter Brownell
The University of Melbourne
Colin Clubb / TheBlackwell Encyclopediaof Management: Accounting Final Proof26.11.2004 11:03pm page ix
Barry Bryan
Auburn University
Per N. Bukh
Aarhus School of Business
Jeffrey L. Callen
Rotman School of Management, University of
Toronto
Christopher S. Chapman
Saı
¨
d Business School, University of Oxford
Andreas Charitou
University of Cyprus
C. S. Agnes Cheng
University of Houston
Frederick D. S. Choi
New York University
David Citron
Cass Business School, City University
Tom Clausen
University of Illinois at Urbana–Champaign
Colin Clubb
Warwick Business School, University of
Warwick
Angelo Ditillo

L. Bocconi University, Milan
Peter Easton
The University of Notre Dame
Aasmund Eilifsen
Norwegian School of Economics and Business
Administration
Samir M. El-Gazzar
Pace University
Patricia Fairfield
Georgetown University
Haim Falk
Rutgers University
M. Ali Fekrat
Georgetown University
John Forker
Queen’s University Belfast
Pascal Frantz
London School of Economics
Thomas J. Frecka
University of Notre Dame
Sonja Gallhofer
University of Aberdeen
Begon
˜
a Giner
University of Valencia
James Godfrey
James Madison University
Jayne M. Godfrey
Monash University

David Gwilliam
London School of Economics
Susan Haka
Michigan State University
Jim Haslem
University of Dundee
Joanna L. Ho
University of California, Irvine
John Holland
University of Glasgow
Shahed Imam
Judge Institute of Management, University of
Cambridge
Christopher D. Ittner
The Wharton School, University of
Pennsylvania
Cynthia Jeffrey
Iowa State University
Steven J. Kachelmeier
McCombs School of Business, University of
Texas at Austin
Colin Clubb / TheBlackwell Encyclopediaof Management: Accounting Final Proof26.11.2004 11:03pm page x
x List of Contributors
Paul J. M. Klumpes
Nottingham University Business School
Ans Kolk
University of Amsterdam
Richard Laughlin
Kings College, University of London
Peter Lee

Nanyang Business School, Nanyang
Technological University, Singapore
Margarita Maria Lenk
Colorado State University
Steven B. Lilien
Baruch College, City University of New York
Gilad Livne
London Business School
Marc F. Massoud
Claremont McKenna College and Claremont
Graduate School
Stuart McLeay
University of Wales, Bangor
Brendan McSweeney
Royal Holloway,
University of London
William Messier
University of Florida
Roger H. G. Meuwissen
University Maastricht
Falconer Mitchell
University of Edinburgh
Sven Modell
Stockholm University
Hans Peter Mo
¨
ller
RWTH, Aachen
Shane Moriarity
University of Oklahoma

Jan Mouritsen
Copenhagen Business School
Christopher J. Napier
University of Southampton
Michael Newman
University of Houston
Hugo Nurnberg
City University of New York–Baruch College
John O’Hanlon
Management School, Lancaster University
Ken Peasnell
Management School, Lancaster University
Stephen H. Penman
Columbia Business School, Columbia University
Peter F. Pope
Lancaster University
Brenda A. Porter
Victoria University of Wellington
Bill Rees
University of Amsterdam
Diane H. Roberts
University of San Francisco
Joshua Ronen
Stern School of Business, New York University
William Ruland
Baruch College, City University of New York
Oded Sarig
Arison School of Business (Israel) and The
Wharton School, University of Pennsylvania
(US)

R. W. Schattke
University of Colorado
Herbert P. Schoch
Macquarie University, New South Wales
Prem Sikka
University of Essex
Colin Clubb / TheBlackwell Encyclopediaof Management: Accounting Final Proof26.11.2004 11:03pm page xi
List of Contributors xi
John K. Simmons
University of Florida
Roger Simnett
University of New South Wales
Douglas J. Skinner
University of Michigan Business School
Ira Solomon
University of Illinois at
Urbana-Champaign
Theodore Sougiannis
University of Illinois and ALBA
Andrew W. Stark
Manchester Business School, University of
Manchester
Melita Stephanou-Charitou
Middlesex University and Intercollege
Herve
´
Stolowy
HEC School of Management, Paris,
France
Aris Stouraitis

City University of Hong Kong
Norman C. Strong
University of Manchester
Tomo Suzuki
Saı
¨
d Business School,
University of Oxford
Aida Sy
University of Sorbonne, Paris
Richard H. Tabor
Auburn University
Pearl Tan
Nanyang Business School, Nanyang
Technological University, Singapore
Teoh Hai Yap
Nanyang Technological University, Singapore
Alison Thomas
PricewaterhouseCoopers
Tony Tinker
City University of New York, Baruch College
Steven Toms
University of York
Ken T. Trotman
University of New South Wales
Wim A. Van der Stede
University of Southern California
Julie Walker
University of Queensland
Martin Walker

University of Manchester
Eamonn Walsh
University College Dublin
Peter Walton
Open University Business School
Trevor A. Wilkins
National University of Singapore
Marleen Willekens
Katholieke Universiteit Leuven
Yong Li
Warwick Business School
Teri L. Yohn
McDonough School of Business, Georgetown
University
Steven Young
Lancaster University Management School,
Lancaster University
Ian Zimmer
University of Queensland
Colin Clubb / TheBlackwell Encyclopediaof Management: Accounting Final Proof26.11.2004 11:03pm page xii
xii List of Contributors
A
accounting and capitalism
Steven Toms
The ‘‘Enron stage of capitalism’’ (Prashad, 2002)
illustrates how an accounting scandal, with ser-
ious implications for financial reporting and
regulation, may also be an exemplar of the polit-
ical and economic processes governing the evo-
lution of global capitalism. Accounting is, as the

debates reviewed below illustrate, fundamen-
tally implicated in the development of capitalism
through all its stages of development, notwith-
standing how these are labeled and defined. Ac-
counting history is therefore more than simply
recording the evolution of a set of technical
procedures beginning with Paccioli’s Summa de
Arithmetica, Geometria, Proportioni et Proportio-
nalita in 1494 and ending with the latest pro-
nouncement of the Financial Accounting
Standards Board. Instead, accounting is impli-
cated in transformations in ownership, with war
and social upheaval, as well as with more stable
phases of capitalist development. As these rela-
tionships have been increasingly acknowledged,
historical perspectives have begun to occupy a
significant position within the discipline of ac-
counting itself, set within a broader interdiscip-
linary social science research agenda, employing
the full range of methodological perspectives.
This entry provides an overview of the alterna-
tive approaches employed and the debates that
have arisen. It ends with a summary of their
contribution to our understanding of financial
reporting within its social and historical context.
Accounting history, like all history, might be
said to have historical explanation as its objective
(Keenan, 1998). Historical analysis might
therefore be employed to trace the first use of
accounting techniques, perhaps the earliest

example being the household economy and pri-
vate estates of ancient Egypt, dating back to the
Middle Kingdom, thereby providing context for
their present-day use (Ezzamel, 2002).
An early and important example of accounting
being used to define the key features of a specif-
ically capitalist enterprise dates back to Sombart
in 1915, who argued that double entry book-
keeping (DEB) allowed the essential ideas of
the capitalistic economic system to be fully de-
veloped: the creation of economic wealth and
economic rationality as applied to business cal-
culations (Most, 1979). Sharing the ‘‘whig’’ in-
terpretation prevalent in the wider discipline of
history, early accounting historians believed
there was a progressive development of account-
ing techniques from their DEB origins (e.g.,
Littleton, 1933).
The chief characteristics of ‘‘traditional’’ ac-
counting history – economic rationality, history
as progress, and an excessive focus on DEB –
form the basis of subsequent critiques and in
turn a reference point for subsequent develop-
ments in accounting history. Yamey (1964)
questioned the ‘‘Sombart thesis,’’ arguing that
there was no substantial evidence for the utility
of DEB from the perspective of capitalistic eco-
nomic decision-making. Pollard (1965), with ref-
erence to a large number of empirical studies,
confirmed that many entrepreneurs in the in-

dustrial revolution had neither the ability nor
the access to sufficient expertise to set up ac-
counting systems that would have provided the
basis for rational calculations.
While maintaining the central assumption of
economic rationality, Watts and Zimmerman in
a series of studies developed the positivist ap-
proach to consider aspects of financial reporting
beyond mere DEB. For example, they recog-
nized that principal–agent theory and efficient
market theory, which became central to the
Colin Clubb / TheBlackwell Encyclopediaof Management: Accounting Final Proof29.11.2004 2:12pm page 1
mainstream accounting research agenda in the
1970s, also had important historical contexts.
With reference to accounting practice in the
unregulated nineteenth century and before,
they showed that accounting functioned in con-
junction with contracting arrangements to align
agents’ incentives with shareholders and was
sufficient to explain the major aspects of modern
financial reporting practice, but in the absence
of modern regulatory requirements (Watts
and Zimmerman, 1979). Positivism has been
extended by other researchers to examine how
changes in accounting regulation have affected
wealth distribution between managerial and
ownership groups, for example to examine the
impact of the Securities Acts of 1933 and 1934
(Chow, 1983).
Such research has obvious utility, since pre-

sent day regulators do not have the ability to test
the impact of legislative changes on a ‘‘what if’’
basis. Hypotheses such as what happens to ac-
counting disclosure if each shareholder is given
one vote regardless of the size of the holding, are
only tested through recourse to history (Toms,
1998). However, this justification for positivism
is at the same time its major weakness, since such
historical research proves that voluntary ac-
counting disclosure is socially contingent and
does not emerge merely as the result of market
incentives. The major claims of the positivists,
that efficient capital markets are a substitute for
accounting regulation or that accounting regula-
tion may prevent the efficient operation of cap-
ital markets, are therefore open to question when
examined against the historical evidence.
Consequently, whereas the positivist ap-
proach has successfully extended the research
agenda away from merely DEB, its axioms have
been the focus of much of the critique from the
so-called ‘‘new accounting history.’’ For these
new accounting historians, accounting is to be
understood in the context in which it operates.
Accounting is therefore no longer a neutral set of
techniques to assist decision-makers, rational or
otherwise, nor explained purely as a mediating
device between competing economic interests,
but is instead a means of control, historically
rooted in the context of power relations. Such

applications of context to accounting history are
derivative of the work of the French philoso-
pher, Michel Foucault. Napier (1989) reviews
the principal components of the application of
Foucault’s approach to contextual accounting
history. These are first the shift from sovereign
power to disciplinary power, the former based
on physical control and the latter on surveil-
lance. The shift occurred around 1800, and
created a new social role for accounting.
A second component is Foucault’s notion of
archeology, or the emergence of forms of dis-
course, including accounting and the institu-
tional and legal norms that make them possible.
The third element is genealogy, or the complex
of dispersed historical events and subsequent
transitions that give significance to accounting
practice. Accounting and accountability are
therefore the extension of the utilitarian ‘‘panop-
ticon,’’ assisting the task of social surveillance
and therefore the exercise of power, while ac-
counting transitions are unintended outcomes
produced by the strategic actions of a number
of different participants. The Foucauldian ap-
proach has obvious applications for management
accounting, which has attracted the majority of
subsequent accounting research, but is equally
important in attempts to interpret accountability
relationships and institutional processes (Burch-
ell, Clubb, and Hopwood, 1985) and the histor-

ical development of DEB as a rhetorical device
for legitimating capitalist practices (Miller and
Napier, 1993).
A similar approach, which focuses on rela-
tions of power but does not necessarily reject
the economic, or the rationality, elements of
the traditional approach is the political economy
of accounting (PEA) perspective. According to
the PEA view, accounting is located in the social
relations of production and, accordingly, must
reflect the location of power within society and
the conflict that exists in society (Cooper and
Sherer, 1984). At certain important stages in the
development of capitalism, therefore, including
cases such as Enron, powerful managerial groups
have used accounting to further their own ends
at the expense of outside investors. Typically,
such purposes have been served by deliberate
restrictions on disclosure or manipulation of
the figures that do appear. Prior to the Wall
Street Crash and the creation of the Securities
and Exchange Commission, economic concen-
tration and the rise of the trusts led to a
concentration of power in the hands of a small
Colin Clubb / TheBlackwell Encyclopediaof Management: Accounting Final Proof29.11.2004 2:12pm page 2
2 accounting and capitalism
group of men, so that accounts became relatively
useless from the investors’ perspective (Merino
and Neimark, 1982). As Britain industrialized,
similar concentrations of power, in railways, coal

and iron, and later in banking and shipping,
created opportunities for entrepreneurial and
managerial groups to mislead outside investors
using accounting reports (Edwards, 1989).
In a series of studies, Tinker (e.g., Tinker,
1985) goes beyond observing managerial
manipulation to offer a distinct and radical per-
spective to show how accounting is a social adju-
dicator and tool in the hands of the powerful and
is used to impose their agenda on weaker social
groups. Since long before the Enron scandal,
Tinker has been examining how accounting is
implicated in the downsizing of state functions
and consequent wealth redistributions. Tinker’s
approach is radical and Marxist, illustrating how
accounting is deeply implicated in capitalist
relations.
The rise of the capital market underpins one
further important aspect of the PEA approach.
Again from a radical and Marxist perspective,
although differing from Tinker, Bryer offers an
alternative political economy hypothesis of
powerful shareholders and investor groups as
the social instigators of modern accounting.
According to this view, the collective interests
of capital dominate managers who assume
the role of mere ‘‘functionaries’’ as capital
becomes ‘‘socialized’’ (Bryer, 1993). Conse-
quently, modern accounting appears as a re-
sponse to the interests of collective capital.

This relationship is only one aspect of Bryer’s
approach and of all contributors, he goes fur-
thest in arguing that accounting history and
accounting theory are central to any project
aimed at understanding the workings of capital-
ism and its social and economic history. In a
series of papers, Bryer questions and reinter-
prets all the major perspectives referred to
above. DEB is therefore not merely a rational
set of techniques nor merely a rhetorical device,
but originates as a calculative mentality designed
continuously to calculate the return of capital
employed, using consistent rules to identify ob-
jective asset values, mirroring the circuits of
capital set out by Marx. In this formulation
Bryer goes beyond both the economic rationality
of the traditionalists and the social constructiv-
ism of the Foucauldians, arguing that accounting
is socially rational, and is explained by reference
to the social relations of production, that is the
degree to which labor has an independent means
of subsistence and capitalists have pooled their
capital (Bryer, 2004).
Unsurprisingly, Bryer’s perspective is contro-
versial and has generated considerable debate
and criticism from traditionalists and conven-
tional accounting theorists, Foucauldians, and
other Marxists. From the conventional stand-
point, if the objectives of financial reporting
are derived from the social relations of produc-

tion, then accounting is essentially performing
a stewardship function and is at variance with
the proclaimed objective of the FASB, which is
to assist economic decision-making (Samuelson,
1999). For the new accounting historians, the
focus of criticism is Bryer’s quest for objective
accounting rooted in the classical economic trad-
ition that does little to expose intricacies of
the complex power relations that exist in society
and the large organizations that new methods
of accounting give rise to (Macve, 1999). Finally,
from the viewpoint of other Marxists,
for example Tinker, the assumed objective of
accounting ‘‘to hold management accountable
to total social capital,’’ that is, to the capital
markets in Bryer’s framework, has been dis-
missed as an ‘‘enigmatic assertion’’ (Tinker,
1999: 644).
Although these debates are unlikely to be re-
solved soon, their extent and intensity is perhaps
testimony in itself to the importance of the topic.
It is perhaps the best possible illustration of how
complex a topic accounting becomes as soon as it
is defined as more than simply a set of tech-
niques. Whichever of the above views is be-
lieved, it is clear that accounting lies at the
heart of capitalism as an economic system. To
understand capitalism one must understand
accounting and to understand accounting one
must understand capitalism. As the above dis-

cussion suggests, debates framed in a historical
context address major areas of concern about the
fundamentals of financial reporting that are of
great interest to regulators and practicing
accountants today. If the research agenda for
accounting is as wide as the agenda for research
into the origins, development, and workings of
capitalism itself, the perspectives introduced
Colin Clubb / TheBlackwell Encyclopediaof Management: Accounting Final Proof29.11.2004 2:12pm page 3
accounting and capitalism 3
here will continue to be an important reference
point as accounting matures as a profession and
as an academic discipline.
Bibliography
Bryer, R. A. (1993). The late nineteenth-century revolu-
tion in financial reporting: Accounting for the rise of
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accounting-based equity valuation
Peter F. Pope
Dividend-Based Valuation
Basic finance theory provides a well-established
framework for valuing a firm’s equities (or
shares). The value of a firm’s equity is equal to
the present value of the dividends expected to be
paid to equity holders over the lifetime of the
firm (including any terminal dividend paid in

liquidation or takeover), discounted at the re-
quired risk-adjusted rate of return on equity.
Assuming the firm is never liquidated, the divi-
dend discount model expresses the value of a
share as:
P
t
¼
X
1
t¼t
E
t
[d
tþt
]
(1 þ r)
tþt
DDM
where p
t
is the value of a share at time 0, d
t
is the
dividend paid at the end of period t, E
t
[.] de-
notes expectations at time t, and r is the required
rate of return on the firm’s equity. The theoret-
ical models described here assume either risk

neutrality, in which case discounting is at the
risk-free rate of interest, or that risk adjustment
can be accomplished satisfactorily by using a
risk-adjusted cost of equity. However, Feltham
and Ohlson (1999) build on risk-adjusted valu-
ation techniques in the finance literature to
argue that the theoretically correct approach to
dealing with risk in accounting-based valuation
Colin Clubb / TheBlackwell Encyclopediaof Management: Accounting Final Proof29.11.2004 2:12pm page 4
4 accounting-based equity valuation
is to adjust numerator terms for risk by taking
expectations using risk-neutral probabilities
(i.e., using certainty equivalents).
The Dividend Discount Model (DDM) can
be adapted for practical use in various ways. For
example, to side-step difficulties in forecasting
dividends over very long horizons, a finite fore-
casting horizon can be established and the value
of all dividends beyond the horizon summarized
in a single estimate of the share price at the
horizon date. Thus, for example, assuming a
four year forecasting horizon the value of the
firm’s equity can be written as:
P
t
¼
X
4
t¼1
E

t
[d
tþt
]
(1 þ r)
t
þ
E
t
[P
tþ4
]
(1 þ r)
4
DDM
Ã
where E
t
[P
tþ4
] is the expected share value at the
end of period t þ 4. Alternatively, dividends may
be assumed to grow at a constant rate g < r,in
which case the closed-form Gordon growth
model of firm valuation can be obtained:
P
t
¼
E
t

[d
tþ1
]
r À g
To the extent that dividends are predictable
and stable, DDM can be a reliable valuation
framework. However, dividends are distribu-
tions of wealth by a firm to shareholders. Divi-
dend policy is subject to managerial discretion
and can vary considerably over time. Conse-
quently, valuation errors can arise because divi-
dends are difficult to forecast, especially over
relatively long forecast horizons, and estimation
of terminal values is especially problematic.
However, despite practical implementation dif-
ficulties associated with DDM, it is nevertheless
an important theoretical construct. As we will
see, it forms the basis for recent developments in
accounting-based valuation methodology. It is
used as a fundamental assumption in ‘‘rational’’
valuation models because it reflects the funda-
mental no-arbitrage condition,
E
t
[P
tþ1
þ d
tþ1
] ¼ (1 þ r)P
t

:
Alternative approaches to equity valuation em-
phasize wealth creation attributes rather than
prospective wealth distributions. Valuation
models focusing on wealth creation naturally
use accounting numbers as inputs.
Earnings-Based Valuation
A widely used practical valuation technique is to
estimate firm value as a multiple of current (or
prospective) earnings. Formally, this valuation
approach treats accounting earnings as if they are
‘‘permanent.’’ Kothari (1992), Kothari and
Sloan (1992), and others show that if earnings
follow a random walk and are fully distributed as
dividends, value can be written as:
PEM P
t
¼
x
t
r
where x
t
is earnings for period t. The price–
earnings valuation multiple is one over the re-
quired rate of return on equity.
The permanent earnings model underlies
much of the market-based accounting research
literature. From a practical valuation perspec-
tive, the main attraction of PEM is its relative

simplicity. However, its limitations are primarily
related to the strong and unrealistic assumptions
that must be made concerning earnings dynam-
ics and dividend policy. Specifically, earnings
are known to contain transitory elements; and
earnings are expected to grow depending on
economic factors, accounting conservatism and
dividend (or retention) policy.
Practitioners inclined towards the use of
earnings multiples are known to take account
of earnings growth. In particular, the price–
earnings–growth (PEG) ratio, equal to the
price–earnings ratio divided by the short-term
earnings growth rate, is a commonly used heur-
istic for stock recommendations. Easton (2004)
provides formal analysis of the relation between
equity values, earnings, and earnings growth
rates, based on Ohlson and Juettner-Nauroth
(2001). Starting from DDM, Easton shows that
the value of a share can be restated in terms of
earnings as follows:
PEGM P
t
¼
E
t
[x
tþ1
]
r

þ
1
r
X
1
t¼1
E
t
[agr
tþt
]
(1 þ r)
t
where agr
tþt
¼ x
tþtþ1
þ rd
tþt
À (1 þ r)x
tþt
is
the abnormal growth in earnings in period
t þ t. Comparison of PEM and PEGM shows
Colin Clubb / TheBlackwell Encyclopediaof Management: Accounting Final Proof29.11.2004 2:12pm page 5
accounting-based equity valuation 5
two main differences. First, expected earnings in
t þ 1 replace actual earnings in the first capital-
ized earnings term – the value of the equity is
‘‘anchored’’ to capitalized earnings. Second, that

the share value also includes a component re-
lated to the expected abnormal growth in earn-
ings over the (infinite) forecast horizon.
Abnormal growth in earnings is defined relative
to a benchmark of normal accounting earnings
that would be expected given earnings in the
previous period, and after adjusting for distribu-
tions of earnings through dividends.
Similar to DDM, Easton (2004) shows that it
is possible to simplify the general model PEGM
into a closed form valuation model expressed in
terms of information observable at time t,by
assuming a constant long run rate of change in
the abnormal growth rate for earnings, Dagr,as
follows:
P
t
¼
E
t
[x
tþ1
]
r
þ
E
t
[agr
tþ1
]

r(r À Dagr)
PEGM
Ã
Whether or not it is realistic to make such an
assumption will depend on the economic cir-
cumstances of a firm and the accounting recog-
nition rules it employs.
The PEGM model takes account of potential
growth (or decline) in future earnings due to
economic factors, including retention/dividend
policy, and accounting recognition rules.
Residual Income-Based Valuation
Preinreich (1938), Edwards and Bell (1961),
Peasnell (1982), Ohlson (1989, 1995), and Fel-
tham and Ohlson (1995, 1996) have demon-
strated how DDM can be recast in terms of
accounting numbers by exploiting the stylized
clean surplus relation. This states that the
change in book equity value is equal to clean
surplus earnings (i.e., comprehensive income)
less dividends:
b
t
À b
tÀ1
¼ x
t
À d
t
CSR

where b
t
is book equity at time t, x
t
is earnings
for period t and d
t
represent net dividends paid
by the firm (i.e. total dividends paid less any new
equity capital contributions). Note that while
earnings based valuation models in the previous
section tend to focus on per share valuation,
residual income valuation focuses on valuing
the total equity value of the firm (i.e. the total
value of all its equity shares). Throughout this
section, all variables therefore refer to total
(rather than per share) amounts.
The DDM for the firm as a whole (where total
equity value is expressed as the present value of
expected net dividends) can be rewritten using
CSR to give the well-known residual income
valuation model:
RIV P
t
¼ bv
t
þ
X
1
t¼1

E
t
[x
a
tþt
]
(1 þ r)
t
where x
a
t
is abnormal earnings (or residual
income) at time t, defined as earnings less a
cost of capital charge (i.e. x
a
t
¼ x
t
À rÁb
tÀ1
).
Under RIV the value of the firm is ‘‘anchored’’
to the firm’s book value and the target for fore-
casting becomes abnormal earnings.
An interesting feature of RIV (and other valu-
ation models that subsume RIV such as the
Ohlson (1995) linear information model dis-
cussed below) is that although firm value is a
function of variables based on the accounting
system, it works for any form of accounting as

long as clean surplus accounting holds. It would
work, for example, if an accounting system
reports earnings equal to cash flow (i.e., accruals
are zero). RIV is also consistent with mark-
to-market accounting because if assets are
recorded at fair value then expected abnormal
earnings are zero and P
t
¼ bv
t
.
DDM and RIV all rely on the same no-
arbitrage assumption and are equivalent given
the additional clean surplus accounting assump-
tions. Both models should be equally reliable in
valuing a firm’s equity, if applied using consist-
ent assumptions and forecasts (Lundholm and
O’Keefe, 2001a, 2001b; Penman, 1998, 2001).
However, as in the case of DDM, fundamental
valuation models are also subject to a forecasting
horizon problem requiring truncation of fore-
casts at some arbitrary horizon and necessitating
estimation of a projected terminal value. Bernard
(1995) and Penman and Sougiannis (1998) pre-
sent evidence consistent with RIV being more
accurate in finite horizon practical applications
because intrinsic value estimates are anchored
to book value. The sensitivity of intrinsic
value estimates to errors in the terminal value
Colin Clubb / TheBlackwell Encyclopediaof Management: Accounting Final Proof29.11.2004 2:12pm page 6

6 accounting-based equity valuation
calculation appears to be lower for RIV because
terminal value equals the discounted value of
abnormal earnings beyond the forecast horizon
in this case, and abnormal earnings are likely to
mean revert towards zero in a competitive econ-
omy. (For further tests of the empirical perform-
ance of these models, see Francis, Olsson, and
Oswald, 2000; Lee, Myers, and Swaminathan,
1999.)
Linear Information Models
Unbiased accounting Aside from anchoring valu-
ation to book value, RIV points to the import-
ance of forecasts in valuation and suggests
a further forecasting role for financial statement
numbers. Abnormal earnings forecasts can
be derived using traditional financial statement
analysis techniques to forecast earnings and book
value. Alternatively, statistical models can
be built that exploit persistence in abnormal
earnings and predictability by other accounting
numbers. If accounting items are informative
as forecasting instruments, they will be relevant
and priced in valuation. Garman and Ohlson
(1980) and Ohlson (1989, 1995) were the
first papers to demonstrate the possibility of
deriving closed form valuation linear models in
accounting fundamentals known at the valuation
date.
The best-known linear information model

(LIM) is that of Ohlson (1995), who assumes
that the forecasting target in RIV, abnormal
earnings, follows the linear abnormal following
earnings dynamic process:
x
a
tþ1
¼ vx
a
t
þ v
t
þ e
1tþ1
v
tþ1
¼ gv
t
þ e
2tþ1
O95 LIM
where v
t
is ‘‘other information’’ reflected in
market value at time t which is reflected
in accounting numbers in future periods, ! is a
parameter capturing the persistence of abnormal
earnings, g is a parameter capturing the persist-
ence of ‘‘other information,’’ and e
1tþ1

, e
2tþ1
are
zero expectation disturbance terms. Ohlson
(1995) shows that assuming DDM, CSR, and
LIM1 leads to the following closed form linear
valuation function:
P
t
¼ b
t
þ a
1
x
a
t
þ a
2
v
t
O95 VAL1
where a
1
¼ v = (R À v), a
2
¼ R = (R À v)
(R À g), R ¼ 1 þ r. VAL1 shows that as the
persistence of abnormal earnings increases,
the valuation multiple on abnormal earnings in-
creases.

Equivalently, Ohlson (1995) also shows that
the value of the equity can be written as a
weighted average of a stock measure of value,
book equity, and a flow measure of value, capit-
alized earnings, adjusted for dividends, as
follows:
P
t
¼ (1 À k)b
t
þ k(jx
t
À d
t
) þ a
2
v
t
O95-VAL2
where k ¼ (R À 1)!=(R À !) and j ¼ R=
(R À 1). As the persistence of abnormal earnings
increases, the valuation multiple on earnings
increases and that on book value decreases.
Ohlson (1995) demonstrates that his model
displays three noteworthy properties. First, a
dollar of dividends reduces next period earnings
by r dollars. Second, a dollar dividend reduces
the value of the firm by one dollar. Thus, the
model is consistent with the Miller and Modi-
gliani (1961) dividend irrelevance proposition.

Third, the accounting system implied by the
model is unbiased, in the sense that any differ-
ences between market value and book value are
expected to asymptote to zero in the long run.
This final property stems from the fact that
abnormal earnings mean revert to zero in the
long run under O95–LIM.
The Ohlson (1995) model implies no direct
role for financial statement items beyond
‘‘bottom line’’ earnings and book value numbers.
Yet financial statements contain many line item
disclosures. In a related paper, Ohlson (1999)
shows how the valuation expressions O95–
VAL1 and O95–VAL2 change when earnings
contain a transitory component that is irrelevant
in forecasting abnormal earnings, is unpredict-
able, and is irrelevant in valuation. Effectively,
valuation expressions are identical in form to
O95–VAL1 and O95–VAL2, with core (abnor-
mal) earnings, excluding the irrelevant earnings
component, replacing (abnormal) earnings and
the irrelevant component being netted off
against dividends in O95–VAL2. Subsequently,
Pope and Wang (2004) have shown that similar
valuation expressions involving the use of core
earnings as the relevant earnings construct for
Colin Clubb / TheBlackwell Encyclopediaof Management: Accounting Final Proof29.11.2004 2:12pm page 7
accounting-based equity valuation 7
valuation are applicable even when the irrelevant
non-core earnings component is predictable (see

also Stark, 1997).
Conservative accounting The Ohlson (1995)
model does not reflect the possibility that ac-
counting recognition rules are influenced by
application of the conservative (or prudence)
principle. Balance sheet conservatism (or uncon-
ditional conservatism) leads to/involves under-
statement of (abnormal) earnings when a firm is
growing. Accounting-based valuation must take
account of the conservatism attribute of account-
ing, if biased valuation estimates are to be
avoided.
Feltham and Ohlson (1995) present a valu-
ation model allowing for conservatism in the
accounting for operating assets, based on modi-
fied linear information dynamics where expected
abnormal earnings depend on operating assets at
the beginning of the period as well as terms
similar to the first equation in O95–LIM:
ox
a
tþ1
¼ v
11
ox
a
t
þ v
12
oa

t
þ v
1t
þ e
1tþ1
oa
tþ1
¼ v
22
oa
t
þ v
2t
þ e
2tþ1
v
1tþ1
¼ g
1
v
1t
þ e
3tþ1
v
2tþ1
¼ g
2
v
2t
þ e

4tþ1
FO95 LIM
where ox
a
t
is abnormal operating earnings de-
fined as ox
t
À r(oa
tÀ1
), ox is operating earnings,
oa
t
is book value of operating assets, !
11
is the
persistence parameter on abnormal operating
earnings, !
12
is a parameter correcting for ac-
counting conservatism, !
22
is the expected rate
of growth in net operating assets, v
1t
and v
2t
are
other information variables relating to future
abnormal earnings and future net operating

assets respectively, with persistence parameters
g
1
and g
2
respectively and jg
1
j < 1, jg
2
j < 1, and
e
1tþ1
, e
2tþ1
, e
3tþ1
and e
4tþ1
are zero expectation
disturbance terms. Feltham and Ohlson show
that given FO95–LIM, the value of the firm’s
equity can be written as follows:
P
t
¼ b
t
þ a
1
ox
a

t
þ a
2
oa
t
þ b
1
v
1t
þ b
2
v
2t
FO95 VAL1
where a
1
¼ !
11
= (R À !
11
), a
2
¼ !
12
R=(R À !
11
)
(R À !
22
), b

1
¼ R = (R À!
11
)(R À g
1
), b
2
¼ a
2
=(RÀg
2
). This expression is similar in form to
O95–VAL1, but with additional terms involving
information on operating assets. Feltham and
Ohlson (1995) also derive a weighted average
valuation expression similar to O95–VAL2 con-
taining a conservatism adjustment depending on
operating assets:
P
t
¼ (1 À k)b
t
þ k(jx
t
À d
t
) þ a
2
oa
t

þ b
1
v
1t
þ b
2
v
2t
FO95 VAL2
where k is defined as in Ohlson (1995). Equity
value depends on abnormal earnings and their
persistence, as in Ohlson (1995), but also in-
cludes a conservatism adjustment related to op-
erating assets which increases with accounting
conservatism and the expected rate of growth of
operating assets. The dividend irrelevance prop-
erty of the Ohlson (1995) model is reflected in
the valuation coefficient on dividends being
equal to the valuation coefficient book value
minus one. The assumptions relating to the sep-
aration of financial assets and operating assets
mean that such dependence between valuation
weights is not present in the Feltham and Ohl-
son (1995) model. The Pope and Wang (2004)
model does not distinguish between financial
assets and operating assets and derives abnormal
earnings dynamics consistent with conservative
accounting and dividend irrelevance.
Feltham and Ohlson (1996) adopt a different
approach to modeling accounting conservatism

within a LIM framework. They focus on the
dynamics of cash flow fundamentals: operating
cash flow and cash investments. Their cash flow
dynamics LIM is as follows:
cr
tþ1
¼ g cr
t
þ k ci
t
þ v
1t
þ e
1tþ1
ci
tþ1
¼ vci
t
þ v
2t
þ e
2tþ1
FO96-LIM
where cr
t
is operating cash receipts, ci
t
is cash
investments, g captures the persistence of cash
receipts, k captures the impact of cash invest-

ments on future cash receipts, ! reflects
growth in cash investments, and all other vari-
ables are defined similarly as above. In this
model the present value of future cash flows
generated from $1 of cash investment is the
present value of a declining perpetuity and
equals k=(R À g). Feltham and Ohlson charac-
terize accounting accruals in terms of a depreci-
Colin Clubb / TheBlackwell Encyclopediaof Management: Accounting Final Proof29.11.2004 2:12pm page 8
8 accounting-based equity valuation
ation charge based on opening book value of
operating assets; i.e., dep
tþ1
¼ (1 À d)oa
t
,
where d is the depreciation policy parameter.
Assuming no financial assets or liabilities, clean
surplus accounting and FO96–LIM, they
show that the following valuation expression
follows:
P
t
¼ oa
t
þ a
1
ox
a
t

þ a
2
oa
tÀ1
þ a
3
ci
t
FO96-VAL1
where
a
1
¼ Fg, a
2
¼ FR(g À d),
a
3
¼ (Fk À 1)R=(R À v)
and F ¼ (R À g)
À1
:
This valuation expression is similar to FO95–
VAL1 in that the value of the firm depends on
operating assets and abnormal operating earn-
ings, but there are two differences. First, the
third term representing an adjustment for
accounting conservatism is based on lagged
operating assets. If accounting depreciation
equals economic depreciation then g > d and
a

2
> 0. If accounting is conservative then
g ¼ d and a
2
¼ 0. The second difference is the
presence of the final term. This reflects the net
present value of cash investments in operating
assets.
Feltham and Ohlson (1996) also show that an
equivalent weighted average form of valuation
expression applies:
P
t
¼ (1 À k)oa
t
þ k(jox
t
À c
t
) þ a
2
oa
tÀ1
þ a
3
ci
t
FO96-VAL2
They further show that the model can be
modified to include other non-accounting infor-

mation about future cash receipts and cash in-
vestments; and to include the possibility that
depreciation policy may depend on other infor-
mation events. Resulting valuation expressions
include additional terms based on other infor-
mation variables, but are generally similar to
FO96–VAL1 and FO96–VAL2.
A significant amount of recent empirical re-
search has focused on the forecasting ability of
linear information models for abnormal earnings
and the properties of intrinsic value estimates
based on linear information models in relation
to current and future market values – see, for
example, Ahmed et al. (2000), Bar-Yosef et al.
(1996), Begley and Feltham (2002), Callen and
Morel (2001), Choi et al. (2004), Dechow et al.
(1999), Morel (1999, 2003), Myers (1999). Fur-
ther discussion is beyond the scope of this chap-
ter. See also Richardson and Tinaiker (2004) for
a recent review of these and other related empir-
ical studies.
Conclusions
When one considers recent developments in
pricing models for other securities (e.g., deriva-
tives), it is remarkable that progress in the de-
velopment of accounting-based equity valuation
models has been so slow. While the residual
income valuation model has been known to re-
searchers for many years, a rigorous framework
for understanding how current period account-

ing fundamentals might be linked to equity value
has only started to emerge as a result of the
seminal papers based on linear information
models of Ohlson (1989, 1995) and Feltham
and Ohlson (1995, 1996). Anecdotal evidence
suggests that residual income-based valuation
approaches are now being adopted and adapted
by practicing analysts. However, I believe that
considerable theoretical development work
remains to be done before a comprehensive ac-
counting-based valuation framework can be
claimed.
The residual income-based valuation ap-
proach underlying several models described
here has important limitations. First, it is highly
stylized, having only two accounting inputs –
earnings and book value. It is silent on the po-
tential roles in the valuation process for the
numerous line items contained in financial state-
ments and accompanying footnotes. Second, as
Ohlson (2000) points out, residual income-based
valuation is unlikely to be valid on a per share
basis because the clean surplus assumption will
not hold at this level if issuance of new dilutive
shares is expected. Further, residual income-
based valuation will only work at the total firm
level if changes in equity capital are accounted
for at fair value. This requirement would not be
satisfied under current accounting rules for
equity transactions such as pooling of interests

Colin Clubb / TheBlackwell Encyclopediaof Management: Accounting Final Proof29.11.2004 2:12pm page 9
accounting-based equity valuation 9
acquisitions and executive stock options. Thus,
practical application of the residual income valu-
ation framework will require care. At the same
time, the residual income framework can pro-
vide an insightful framework within which to
analyze accounting policy issues. For example,
Landsman et al. (2004) analyze accounting for
executive stock options accounting through a
residual income valuation lens and produce
results suggesting that all current policy pre-
scriptions fail to produce accounting numbers
that are directly useful for valuing current equity
claims.
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acounting-based estimates of
the expected rate of return on equity capital
Peter Easton
The reintroduction of the residual income valu-
ation model by Ohlson (1995) and the develop-
ment of the abnormal growth in earnings model
by Ohlson and Juettner-Nauroth (2001) (here-
after, OJ, 2001) has been the impetus for a bur-
geoning empirical literature that reverse
engineers these models to infer markets’ expect-
ations of the rate of return on equity capital. The
obvious advantage of this reverse engineering
approach is that the estimates of the expected
rate of return are based on forecasts rather than
extrapolation from historical data. Prior to the
development of these approaches, researchers
and valuation practitioners relied on estimates
based on historical data (estimated via the
market model, the empirical analogue of the
Sharpe–Lintner capital asset pricing model,
or variants of the Fama and French (1992)
three-factor model).

The practical appeal of these accounting-
based valuation models (particularly the abnor-
mal growth in earnings model) is that they focus
on the two attributes that are most commonly at
the heart of valuation analyses carried out by
practicing equity analysts: forecasts of earnings
and forecasts of earnings growth. The following
discussion (which relies heavily on Easton, 2004)
provides an intuitive development of the abnor-
mal growth in earnings valuation model that has
many of the essential elements of the OJ (2001)
model. Gode and Mohanram (2003) and Easton
(2004) rely on the essential elements of the OJ
(2001) model to develop methods for estimating
the expected rate of return on equity capital that
is implied by market prices and forecasts of
earnings and earnings growth.
The Abnormal Growth in Earnings
Model
The key elements of the abnormal growth in
earnings valuation model are: (1) forecasts of
next period’s accounting earnings, (2) forecasts
of short-run growth in accounting earnings from
this base, and (3) expected growth in accounting
earnings beyond the short forecast horizon. The
difference between accounting earnings and eco-
nomic earnings characterizes the role of account-
ing earnings in valuation.
The derivation of the abnormal growth in
earnings valuation model begins with the no

arbitrage assumption:
P
0
¼ (1 þ r)
À1
[P
1
þ dps
1
] (1)
Colin Clubb / TheBlackwell Encyclopediaof Management: Accounting Final Proof29.11.2004 2:12pm page 11
acounting-based estimates of the expected rate of return on equit y capital 11
where P
0
is current, date t ¼ 0, price per share,
P
1
is expected, date t ¼1, price per share, dps
1
is
expected dividends per share, at date t¼1, r is
expected rate of return, and r > 0 is a fixed
constant. Although equation (1) may be viewed
as a succinct statement of the no arbitrage as-
sumption, it may also be viewed as a definition of
expected return (r) even in a world where arbi-
trage opportunities exist. Even under this alter-
nate view the analysis that follows calculates the
internal rate of return based on prevailing prices
and expectations of expected pay-offs.

The central valuation role of forecasts of next
period’s accounting earnings is introduced by
adding (and subtracting) capitalized expected
accounting earnings, eps
1
=r to equation (1) and
focusing on the term that remains when capital-
ized accounting earnings is separately identified.
Adding and subtracting capitalized accounting
earnings yields:
P
0
¼ eps
1
=r À [eps
1
=r À (1 þ r)
À1
(P
1
þ dps
1
)] (2)
If expected accounting earnings (eps
1
) is equal to
economic earnings (which may be defined as
rP
0
), the term in square brackets must be equal

to zero – in other words, next period’s expected
earnings are sufficient for valuation. However, if
eps
1
does not equal economic earnings, valuation
based on accounting earnings requires forecasts
beyond the next period.
The role of two period ahead forecasts of
accounting earnings, may be seen by rewriting
equation (2):
P
1
¼ eps
2
=r À [eps
2
=r À (1 þ r)
À1
(P
2
þ dps
2
)] (3)
Substituting (3) into (2) yields:
P
0
¼ eps
1
=r þ r
À1

(1 þ r)
À1
agr
1
þ (1 þ r)
À2
r
À1
[rdps
2
À (1 þ r)eps
2
] þ (1 þ r)
À2
P
2
(4)
where
agr
1
¼ [eps
2
þ rdps
1
À (1 þ r)eps
1
] (5)
agr
1
is expected abnormal growth in accounting

earnings insofar as it is expected (period 2) cum-
dividend accounting earnings (ceps
2
¼ eps
2
þ
rdps
1
) less the normal accounting earnings that
would be expected given earnings of period
1 (that is, (1 þ r)eps
1
). This abnormal growth in
earnings reflects the effects of generally accepted
accounting practices that lead to a divergence of
accounting earnings from economic earnings.
To see this, note that if eps
1
and eps
2
were
equal to economic earnings, agr
1
would be zero
and the ratio of expected earnings-to-price
would be equal to the expected rate of return.
An Example
Consider Diageo plc (the company that manu-
factures Guinness and other well-known bever-
ages), which was trading at a price per share of

£7.40 at the end of its fiscal year (June 30) 2003.
If Diageo’s expected rate of return was 10 per-
cent, its expected economic earnings for 2004
and 2005 would have been 74p and 81.4p, re-
spectively. If accounting earnings (eps
1
and eps
2
)
were equal to economic earnings in these years,
agr
1
¼ 81:4pÀ 1:1(74 p) ¼ 0 and eps
1
would be
sufficient for valuation (that is, £7.40 ¼ 74p/
0.1). Yet analysts were forecasting accounting
earnings for 2004 and 2005 of 51p and 55p.
The forecast of dividends for 2004 was 27p so
that cum-dividend accounting earnings for
2005 (ceps
2
) was 55 p þ 0:1(27 p) ¼ 57:7p
and agr
1
¼ 57:7pÀ 1:1(51 p) ¼ 1:6 p. In other
words, the difference between expected cum-
dividend accounting earnings and expected eco-
nomic earnings in 2004 and 2005 implies ac-
counting earnings growth of 1.6p more than

the expected rate of return on equity capital.
I will return to this example.
The Horizon
The valuation role of expected accounting earn-
ings beyond the two-year forecast horizon may
be seen by recursively substituting for
P
2
, P
3
, P
4
, etc., in (4) to yield:
P
0
¼ eps
1
=r þ r
À1
X
1
t¼1
(1 þ r)
À1
agr
t
(6)
That is, equation (6) shows that the present
value of the agr
t

-sequence explains the differ-
ence between price and capitalized expected
accounting earnings.
Equation (6) may be modified to accommo-
date a finite forecast horizon by defining a
Colin Clubb / TheBlackwell Encyclopediaof Management: Accounting Final Proof29.11.2004 2:12pm page 12
12 acounting-based estimates of the expected rate of return on equity capital