Conservatism Measures that Control for the Effects of Economic Rents on Stock Returns
University of Texas at Austin - Red McCombs School of Business
University of Oregon - Charles H. Lundquist School of Business
February 22, 2013
Review of Quantitative Finance and Accounting, Forthcoming
Recent studies show that regression-based estimates of accounting conservatism reflect both differences in the asymmetric recognition of bad news and differences in asset composition. In particular, a firm’s market value and returns reflect both assets-in-place and expected future rents, while book values tend to reflect only assets-in-place. We propose two tests that remove the effect of asset composition on cross-sectional comparisons of accounting conservatism. First, a test based on a ratio of regression coefficients allows for valid cross-sectional comparisons of conservatism relative to overall news recognition. Second, in some cases, researchers can separately identify and make cross-sectional comparisons of the fraction of good news recognized and the fraction of bad news recognized. The estimates in this second scenario use a regression of earnings on returns interacted with a book-to-market ratio. We validate our model by deriving and testing several predictions based on it.
Keywords: Accounting conservatism, asymmetric timeliness, market-to-book ratio, returns-earnings relation
JEL Classification: M41, G10, G30, N20Accepted Paper Series
Date posted: September 11, 2008 ; Last revised: March 5, 2013
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