Accounting-based downside risk, cost of capital, and the macroeconomy

Abstract

We hypothesize that earnings downside risk, capturing the expectation for future downward operating performance, contains distinct information about firm risk and varies with cost of capital in the cross section of firms. Consistent with the validity of the earnings downside risk measure, we find that, relative to low earnings downside risk firms, high earnings downside risk firms experience more negative operating performance over the subsequent period, are more sensitive to downward macroeconomic states, and are more strongly linked to earnings attributes and other risk-related measures from prior research. In line with our prediction, we also find that earnings downside risk explains variation in firms' cost of capital, and that this link between earnings downside risk and cost of capital is incremental to several earnings attributes, accounting and risk factor betas, return downside risk, default risk, earnings volatility, and firm fundamentals. Overall, this study contributes to accounting research by demonstrating the key valuation and risk assessment roles of earnings downside risk derived from firms' financial statements, also shedding new light on the link between accounting and the macroeconomy.

Financial Reporting in Hyperinflationary Economies and the Value Relevance of Accounting Amounts: Hard Evidence From Zimbabwe

“…Li et al (2014) find that combining firm-level geographic segment data with country GDP growth forecasts leads to improvements in forecasting firm profitability. Konchitchki et al (2016) demonstrate that the sensitivity of a firm to downward macroeconomic conditions has implications for its stock valuation. Other studies focus on the micro to macro link, that is, whether aggregate accounting data contain macroeconomic news that can be informative about GDP growth (Konchitchki and Patatoukas 2014a, b), stock market valuation (Patatoukas 2014) and monetary policy (Gallo et al 2016).…”

How cost of capital is changing: The effect of accounting information

“…Other studies such as Konchitchki, Luo, Ma, and Wu (2016) indicate a negative correlation between the costs of capital and information. Though, this proposition explains that there is a positive correlation in circumstances where stock price volatility affects the financial information.…”

The Asymmetric Effect of Reporting Flexibility on Priced Risk

“…In another related paper, Konchitchki et al. [2016] examine an alternative form of asymmetric risk: earnings downside risk (“EDR”). They use a “root lower partial moment framework” to examine the relative variability of below‐expectation and above‐expectation earnings.…”

“…Although Konchitchki et al. [2016] do not examine the relation between reporting flexibility and EDR, they do document that EDR is associated with earnings' statistical properties such as “smoothness,” persistence, and predictability.…”