Conservatism and Aggregation: The Effect on Cost of Equity Capital and the Efficiency of Debt Contracts

Abstract

This paper studies the joint effect of conservatism and aggregation on the cost of equity capital and the efficiency of debt contracts. In the model, a firm's two assets are valued at either the lower-of-cost-or-market or fair value and the accounting report aggregates the value of the two assets. While the process of aggregation leads inevitably to a loss of information, what information is lost depends on the accounting regime. In the conservative regime, gains are ignored while in the fair value regime gains are off-set against losses.

The paper studies the joint effect of conservatism and aggregation in two settings. First, it considers an all-equity firm and compares the valuation of equity when investors observe an accounting report under either the conservative or a fair-value regime. The model predicts that cost of equity capital is lower in the conservative regime than in the fair value regime if the firm's production function exhibits sufficiently decreasing marginal returns. Second, the paper takes a contractual perspective and considers the efficiency of debt contracts when debt covenants must be written in terms of the accounting report. The paper shows the maximum capital that can be raised by a debt contract which implements efficient post-contractual decisions is higher in the conservative than in the fair value regime.

Keywords: Financial reporting, Cost of capital, Debt contracts, Conservatism

JEL Classification: M41, N20, D80