A Theoretical Analysis Connecting Conservative Accounting to the Cost of Capital

56 Pages Posted: 26 Nov 2016 Last revised: 3 Mar 2019

See all articles by Stephen H. Penman

Stephen H. Penman

Columbia Business School - Department of Accounting

Xiao-Jun Zhang

University of California, Berkeley - Accounting Group; China Academy of Financial Research (CAFR)

Date Written: February 28, 2019

Abstract

We connect conservative accounting to the cost of capital by developing an accounting model within an asset pricing framework. The model has three distinctive features: (1) transaction-cycle-conformity, where the book value of an investment equals the value of cash at the beginning and the end of a cash-to-cash transaction cycle; (2) a revenue recognition principle, where the level of uncertainty about future cash flows affects the amount of revenues recognized; (3) a matching principle, where expenses are matched with revenue with a conservative bias due to uncertainty. In a single-transaction-cycle model, we identify conditions under which (a) the growth rate of expected earnings is positively related to the expected stock return; (b) the accruals-to-cash ratio is negatively related to the expected stock return; (c) the expected earnings yield (i.e., forward E/P ratio) is negatively related to the expected stock return. In a multi-transaction-cycle setting we analyze how investment growth affects the above results. In particular, we show that accruals and the earnings yield exhibit negative correlation with the expected stock return for firms with high growth in investment. The accounting we model is similar to that under GAAP and IFRS, so the properties that we highlight are features of those regimes.

Keywords: conservative accounting, risk and return, earnings yield, earnings growth, accruals

JEL Classification: M41, G12

Suggested Citation

Penman, Stephen H. and Zhang, Xiao-Jun, A Theoretical Analysis Connecting Conservative Accounting to the Cost of Capital (February 28, 2019). Available at SSRN: https://ssrn.com/abstract=2874641 or http://dx.doi.org/10.2139/ssrn.2874641

Stephen H. Penman

Columbia Business School - Department of Accounting ( email )

3022 Broadway
New York, NY 10027
United States
212-854-9151 (Phone)
212-316-9219 (Fax)

Xiao-Jun Zhang (Contact Author)

University of California, Berkeley - Accounting Group ( email )

545 Student Services Building
SPC 1900
Berkeley, CA 94720
United States
(510) 642-4789 (Phone)
(510) 642-4700 (Fax)

China Academy of Financial Research (CAFR)

1954 Huashan Road
Shanghai P.R.China, 200030
China

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