Suppose you are applying the residual income valuation model to value a firm with extremely aggressive accounting. Suppose, for example, the firm has a substantially overvalued asset on the balance sheet. (Perhaps the firm has a large amount of goodwill on the balance sheet from a prior acquisition and has delayed recording a necessary impairment charge that would write off the value of the goodwill.) As a consequence of this extremely aggressive accounting, the firm reports assets and equity at book values that is much higher than their respective economic values. Explain why the residual income value estimates will not be distorted by aggressive accounting. How does the residual income valuation model correct for the effects of aggressive accounting and overstated book values of equity?
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