Financial growth illustrated as trees emerging from charts.

Decoding Accrual Accounting: Are These Valuation Models the Key to Investment?

Beau Callahan in Business & Economy August 2025 • 4 min read.

"Explore accrual accounting valuation models and their impact on investment strategies. Find out if they truly unlock a firm's hidden worth or just add complexity to the market."

In the world of finance, determining the true value of a company is an ongoing quest. Investors and analysts are constantly seeking reliable tools and models to predict future performance and make informed decisions. One approach that has gained prominence is accrual accounting valuation. This method suggests that a company's worth is not solely based on its current assets but also on its future earnings potential, which are recognized through accruals.

Early work by Miller and Modigliani proposed that a firm's value is closely linked to its risk profile, particularly earnings and volatility. Inspired by this concept, researchers have developed accrual accounting valuation models that consider dividend policy irrelevance. These models, built upon the work of Feltham, Ohlson, and Penman, have profoundly impacted academic research and investment practices.

This article explores the world of accrual accounting valuation, reviewing popular models and offering insights to help investors and financial professionals understand their strengths and limitations. By demystifying complex concepts, it aims to provide a clearer picture of whether these models truly unlock a firm's hidden value or simply add another layer of complexity to the market.

Accrual Accounting Valuation: Unveiling the Models

Financial growth illustrated as trees emerging from charts.

Accrual accounting valuation models build on the idea that a company's value isn't just about what it owns today, but also what it's expected to earn in the future. These models use accrual accounting data—contemporaneous and future earnings, book values, and dividends—to formulate valuations. Two popular approaches are the Residual Income Model (RIV) and the Abnormal Book Growth (ABG) model.

The ABG model suggests that the abnormal growth of a company's book value is a primary indicator of its overall value. This model assumes a 'clean surplus' condition, where the change in book value equals the difference between earnings and dividends, net of capital contributions. However, in reality, this condition is often 'dirty' because publicly traded firms use accruals accounting according to U.S. GAAP. This discrepancy can introduce weaknesses into the model.

Residual Income Model (RIV): Predicts a firm's value equals its current book value plus discounted future residual earnings under the clean surplus condition.
Abnormal Earnings Growth Model (AEG): Predicts that a firm's value equals the present value of future expected earnings and the present value of capitalized abnormal earnings.

To address the clean surplus issue, Ohlson and Juettner-Nauroth proposed the Abnormal Earnings Growth (AEG) model, which doesn't rely on the clean surplus condition. Despite this advancement, concerns about the clean surplus assumption persist, highlighting the ongoing debate surrounding the relationship between a firm's value, residual earnings, and book value.

The Future of Accrual Accounting Valuation

Accrual accounting valuation models offer a unique lens for assessing a company's worth, but they are not without limitations. The reliance on clean surplus assumptions and the subjectivity involved in accrual accounting can introduce complexities and potential distortions.

Future research could focus on refining these models by incorporating elements of 'dirty' accounting, exploring alternative methods for discount rate selection, and examining the impact of earnings management. Empirical studies in new areas and applications in real-world valuation practices could further enhance the usefulness of these models.

Ultimately, the goal is not to dismiss accrual accounting valuation models but to appreciate their potential and strive for improvement. By understanding their strengths and weaknesses, investors and financial professionals can leverage these tools to make more informed decisions and navigate the ever-evolving landscape of financial valuation.

About this Article -

This article was crafted using a human-AI hybrid and collaborative approach. AI assisted our team with initial drafting, research insights, identifying key questions, and image generation. Our human editors guided topic selection, defined the angle, structured the content, ensured factual accuracy and relevance, refined the tone, and conducted thorough editing to deliver helpful, high-quality information.See our About page for more information.

This article is based on research published under:

DOI-LINK: 10.5296/ijafr.v8i1.12728, Alternate LINK

Title: Review And Comments On Accrual Accounting Valuation Models

Subject: General Medicine

Journal: International Journal of Accounting and Financial Reporting

Publisher: Macrothink Institute, Inc.

Authors: Min Liu, Rupert Rhodd

Published: 2018-02-27

Everything You Need To Know

What is the basic principle behind accrual accounting valuation models?

Accrual accounting valuation models assess a company's value by considering not only its current assets, but also its future earnings potential. These models use data from accrual accounting, including current and future earnings, book values, and dividends, to determine valuations. This method goes beyond simply looking at what a company owns today, to consider what it is expected to earn in the future. It recognizes that a company's true worth is tied to its ability to generate earnings over time.

What are some of the popular accrual accounting valuation models?

The Residual Income Model (RIV) and the Abnormal Book Growth (ABG) model are two primary examples of models used in accrual accounting valuation. The RIV predicts a firm's value by summing its current book value and the discounted future residual earnings, provided a clean surplus condition is met. The ABG model suggests that the abnormal growth of a company's book value is a key indicator of its value. The Abnormal Earnings Growth (AEG) model, proposed by Ohlson and Juettner-Nauroth, offers an alternative to the RIV and ABG, by not depending on the clean surplus condition.

What is the 'clean surplus' condition, and why is it important?

The clean surplus condition is an accounting assumption that states the change in book value equals the difference between earnings and dividends, net of capital contributions. If the condition is 'clean', it makes it easier to directly use the information from a company's financial statements. However, this assumption is often violated due to the use of accruals in publicly traded firms, making the models less reliable. This 'dirty' nature introduces weaknesses. The AEG model was developed to address this issue by not relying on the clean surplus condition.

How does the Abnormal Earnings Growth (AEG) model differ from the other models?

The Abnormal Earnings Growth (AEG) model is an alternative to the Residual Income Model (RIV) and Abnormal Book Growth (ABG) model. The AEG predicts that a firm's value equals the present value of future expected earnings plus the present value of capitalized abnormal earnings. The AEG is preferred by some since it doesn't rely on the clean surplus condition, which is often not met by real-world financial data. Both models have limitations and strengths, offering various methods to assess a company's worth.

Why are accrual accounting valuation models important, and what are their limitations?

Accrual accounting valuation models are important because they provide a more comprehensive view of a company's worth, going beyond current assets to include future earnings potential. However, these models are not without their limitations. The reliance on clean surplus assumptions and the inherent subjectivity in accrual accounting can complicate the valuation process, introducing potential distortions. Therefore, while valuable, they should be used with an understanding of their limitations and in conjunction with other valuation methods. This approach helps investors make well-informed investment decisions, understanding the complexities and the potential benefits of the model.