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.
Conservatism special items, Linearity, Return decomposition, Conservatism ratio
Accounting | Corporate Finance
Financial Performance Analysis
Review of Accounting Studies
SEGAL, Dan; Callen, Jeffrey L.; and Hope, Ole-Kristian.
The pricing of conservative accounting and the measurement of conservatism at the firm-year level. (2010). Review of Accounting Studies. 15, (1), 145-178. Research Collection School Of Accountancy.
Available at: http://ink.library.smu.edu.sg/soa_research/801
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