Jing Liu
University of California, Los Angeles
john hughes
University of California, Los Angeles
mingshan zhang
University of California, Los Angeles
Abstract: Inflation poses problems in equity valuation under historical cost accounting. Operating assets tend to be understated and allocated costs of those assets are mismatched with revenues; i.e., revenues reflect current (general) price levels whereas allocated costs reflect past price levels. In this paper, we model accounting and equity valuation under inflation. Specifically, we consider three related questions: 1) How might one account for the effects of general price level changes in a manner that leads to a parsimonious equity valuation based only on earnings and book values? 2) How is the value relevance of accounting numbers influenced by alternative inflation accounting policies? 3) Why do accounting standards in some countries (or time periods) require price level adjusted financial statements, but not in other countries? We address these questions by extending Feltham and Ohlsons (1996) model for depreciation measurement to an inflationary environment.
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