Question

Will specific accounting methods affect our valuation using the RIM? For example, would a GAAP change requiring companies to capitalize R&D affect our valuations? Assume no change in R&D productivity.

Answer 1

Residual Inocme Method (RIM): Residual Income Method is one of the approaches used to value of the firm's income. It is valuation of the firm's income after considering the cost of capital of business. It means the cost of equity.Cost of bonds or debentures is considered while calculating the net income in the profit and loss account, while cost of equity is considered in calculating the residual income.

So, when changes in the accounting method such as requiring companies to capitalize Resarch and Development (R&D) instead of taking it as an expense, the net income of the firm is increased. This is because, instead of taking the whole amount of R&D as an expense, R&D is capitalized and ammortization is made. Hence, the net income of the firm is increased due to decrease in the expense. As a result, the Residual income of the firm is also increased by using the Residual Income Method (RIM). SO, we can say, changes in accounting methods affect the valuations by using RIM.