The Pricing of Conservative Accounting and the Measurement of Conservatism at the Firm-Year Level

Posted: 22 Oct 2008

See all articles by Jeffrey L. Callen

Jeffrey L. Callen

University of Toronto - Rotman School of Management

Dan Segal

Interdisciplinary Center (IDC) Herzliyah

Ole-Kristian Hope

University of Toronto - Rotman School of Management

Date Written: October 22, 2008

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 conceptual 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: Conditional Conservatism, Special Items, Return Decomposition, Ratio

JEL Classification: M41, M44, G14, G32, G33

Suggested Citation

Callen, Jeffrey L. and Segal, Dan and Hope, Ole-Kristian, The Pricing of Conservative Accounting and the Measurement of Conservatism at the Firm-Year Level (October 22, 2008). Review of Accounting Studies, Forthcoming, Available at SSRN: https://ssrn.com/abstract=1287963

Jeffrey L. Callen (Contact Author)

University of Toronto - Rotman School of Management ( email )

105 St. George Street
Toronto, Ontario M5S 3E6 M5S1S4
Canada
416-946-5641 (Phone)
416-971-3048 (Fax)

Dan Segal

Interdisciplinary Center (IDC) Herzliyah ( email )

P.O. Box 167
Herzliya, 46150
Israel

Ole-Kristian Hope

University of Toronto - Rotman School of Management ( email )

105 St. George Street
Toronto, Ontario M5S 3E6 M5S1S4
Canada

HOME PAGE: http://www.rotman.utoronto.ca/FacultyAndResearch/Faculty/FacultyBios/Hope.aspx

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