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

Jeffrey L. Callen (), Dan Segal () and Ole-Kristian Hope ()
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Jeffrey L. Callen: University of Toronto
Dan Segal: University of Toronto
Ole-Kristian Hope: University of Toronto

Review of Accounting Studies, 2010, vol. 15, issue 1, No 5, 145-178

Abstract: 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.

Keywords: Conservatism special items; Linearity; Return decomposition; Conservatism ratio (search for similar items in EconPapers)
JEL-codes: G14 M41 (search for similar items in EconPapers)
Date: 2010
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DOI: 10.1007/s11142-009-9087-6

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