Accounting Conservatism and the Agency Problems of Overvalued Equity

Abstract

We examine the role of accounting conservatism in alleviating the agency problems of overvalued equity. We predict that by imposing asymmetric timeliness of good versus bad news reporting, conservatism limits the incidence of earnings expectation games. According to Jensen (2005), these games are the main driving force behind overvaluation. Consistent with our prediction, we find that conservatism reduces the extent and duration of equity overvaluation. We document lower penalties for conservative firms when they miss earnings forecasts, and that conservatism reduces short selling. We corroborate our findings exploiting the passage of SFAS 121 as a plausible exogenous shock to conservatism.

Keywords: conditional conservatism, overvalued equity, duration of equity overvaluation, abnormal short interest, short sale constraints, rewards from target beating

JEL Classification: G30, M41