Review of Accounting Studies, 6, 267–274, 2001
2001 Kluwer Academic Publishers. Manufactured in The Netherlands.
Discussion of: “When Capital Follows Proﬁtability:
Non-linear Residual Income Dynamics”
The Ohio State University, Fisher College of Business, 2100 Neil Ave, Columbus, OH 43210 and The University
My discussion of Biddle, Chen, and Zhang (2001) will focus on a core issue in that paper:
the distinction between economic value added and accounting value added.
This distinction is central to understanding and interpreting non-zero residual income. In
general, this understanding helps in the implementation of the residual income valuation
model (see, for example, Penman (2000)) and, in particular, it matters in the interpretation of
observed non-zero residual income in empirical research (for example, Biddle et al. (2001)).
Since Biddle et al. (2001) do not distinguish between the two components of residual income
in their empirical analyses, it is not possible to determine whether their observed relations
reﬂect the effects of accounting rules or positive NPV opportunities.
I show how the two components of residual income may be formally deﬁned within the
Feltham and Ohlson (1996) model. This model may be used as a foundation for empir-
ical analyses of the effects of accounting rules and non-zero NPV investments on future
residual income and current economic goodwill (that is, the present value of future residual
Economic value is added if a ﬁrm invests in a positive NPV project. In other words,
“economic value added” is the value created when the decision to invest in a positive NPV
project is implemented. Under historic cost accounting, this value added will be reﬂected in
positive future residual income and positive current goodwill.
I use the term “accounting
value added” to describe the positive future residual income that may be expected to arise
in the absence of positive NPV projects due to the application of accounting principles to
(1) cash receipts/disbursements during the current period, and (2) changes in the value of
the assets used to generate these cash receipts/disbursements. A key point is that positive
future residual income (that is, positive current goodwill) may be due to either economic
value added, accounting value added, or both.
The terms “accounting value added” and “economic value added” are couched in the
residual income framework. They rely on comparison of the accountants measure of ex-
pected rate of return (that is, expected earnings divided by beginning-of-period book value
of common equity—ROCE) and the markets measure of the expected rate of return (r).
In other words, these terms refer to an apparent excess compared with the norm (that is,
ROCE > r). Expected ROCE will be different from r if (1) the accounting measure of
expected value added (that is, earnings) differs from the market’s estimate of expected
value added (that is, price change plus dividends), (2) book value differs from the market’s
estimate of value, and/or (3) the ﬁrm invests in positive NPV projects. (1) and (2) lead to
accounting value added; (3) leads to economic value added.