The pricing of conservative accounting and the measurement of conservatism at the firm-year level

Abstract

This paper analyzes the relation between equity prices and conditional conservatism and introduces a new measure of conservatism at the firm-year level. We show that the asymmetric properties of conservative accounting, the existence of non-accounting sources of information, and the properties of GAAP related to special items combine to generate a nonlinear relation between unexpected equity returns and earnings news (the shock to expected current and future earnings). Based on this model, we construct a conservatism ratio (CR) defined as the ratio of the current earnings shock to earnings news. CR measures the proportion of the total shock to expected current and future earnings recognized in current year earnings. Ranking firms according to CR, we show empirically that higher CR firms have more leverage, increased volatility of returns, more incidence of losses, more negative accruals, and increased volatility of earnings and accruals, consistent with the literature on conservative accounting.

Conditional conservatism and cost of capital

“…This, in turn, may lead to greater uncertainty, greater volatility of future prices, lower market values and increased cost of capital. Callen, Segal and Hope (2009). Unless otherwise indicated, the following variables are measured at the end of the fiscal year.…”

“…Momentum is the buy and hold return for the 11-month period ending one month prior to at the end of the year. Conservatism is the monthly decile ranks of the three-year average of the firm-year specific proxy of conditional conservatism developed by Callen, Segal and Hope (2009). Parameter estimates are time-series averages of the parameters from the 348 monthly cross-sectional regressions.…”

“…Using a large sample of US firms for the period 1975 to 2003, we create and validate a firm-specific measure of conservatism (Conservatism) based on the work of Callen, Segal and Hope (2009). We use this proxy in asset-pricing regressions to test whether more conditionally conservative firms experience lower expected stock returns.…”

Accounting conservatism and firm investment efficiency

“…In our main tests, we use the firm level measure of conservative reporting timely loss recognition proposed by Khan and Watts (2009). Our results are robust to the use of alternative proxies based on Callen et al (2010) and Givoly and Hayn (2000). We incorporate in our tests measures of financial reporting quality to ensure that we isolate the incremental economic consequences of conservatism.…”

Estimation and Empirical Properties of a Firm-Year Measure of Accounting Conservatism

“…These expressions are both explicit (e.g., Ryan, 2006, p.3), 2 and implicit (by researchers proposing such measures e.g., Callen et al, 2008). Despite the demand, there is as yet no well articulated firm-year conservatism flow measure.…”