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A theoretical analysis connecting conservative accounting to the cost of capital

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  • Penman, Stephen
  • Zhang, Xiao-Jun

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 equals the value of cash at the beginning and the end of a cash-to-cash transaction cycle; (2) a revenue recognition principle, where uncertainty affects the amount of revenues recognized; (3) a matching principle, where expenses are matched with revenue with a conservative bias due to uncertainty. We demonstrate how the growth rate of expected earnings, the accruals-to-cash ratio, and the expected earnings yield relate to the expected stock return.

Suggested Citation

  • Penman, Stephen & Zhang, Xiao-Jun, 2020. "A theoretical analysis connecting conservative accounting to the cost of capital," Journal of Accounting and Economics, Elsevier, vol. 69(1).
    • Handle: RePEc:eee:jaecon:v:69:y:2020:i:1:s016541011930031x
    DOI: 10.1016/j.jacceco.2019.101236
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    References listed on IDEAS

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    Cited by:

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    3. Dr. Asad Abbas & Dr. Asif Saeed & Asad Abbas, 2023. "Does Ownership Structure and Financial Health Affect Firm’s Earnings Quality? Evidence from Emerging Economy," Bulletin of Business and Economics (BBE), Research Foundation for Humanity (RFH), vol. 12(4), pages 665-671.
    4. Ray Ball & Gil Sadka & Ayung Tseng, 2022. "Using accounting earnings and aggregate economic indicators to estimate firm-level systematic risk," Review of Accounting Studies, Springer, vol. 27(2), pages 607-646, June.
    5. Stephen Penman, 2023. "Accounting for Intangible Assets: Thinking It Through," Australian Accounting Review, CPA Australia, vol. 33(1), pages 5-13, March.
    6. Atif Ellahie, 2021. "Earnings beta," Review of Accounting Studies, Springer, vol. 26(1), pages 81-122, March.
    7. Zihang Peng, 2023. "Do risk exposures explain accounting anomalies? A new testing method," Accounting and Finance, Accounting and Finance Association of Australia and New Zealand, vol. 63(3), pages 2965-2983, September.
    8. Stephen Penman & Julie Zhu & Haofei Wang, 2023. "The implied cost of capital: accounting for growth," Review of Quantitative Finance and Accounting, Springer, vol. 61(3), pages 1029-1056, October.
    9. Cao, Viet Nga & Pham, Anh Viet, 2021. "Behavioral spillover between firms with shared auditors: The monitoring role of capital market investors," Journal of Corporate Finance, Elsevier, vol. 68(C).
    10. Beyer, Anne & Smith, Kevin C., 2021. "Learning about risk-factor exposures from earnings: Implications for asset pricing and manipulation," Journal of Accounting and Economics, Elsevier, vol. 72(1).
    11. Glover, Jonathan & Xue, Hao, 2023. "Accounting conservatism and relational contracting," Journal of Accounting and Economics, Elsevier, vol. 76(1).
    12. Jakub Horak & Petr Suler & Jaroslav Kollmann & Jan Marecek, 2020. "Credit Absorption Capacity of Businesses in the Construction Sector of the Czech Republic—Analysis Based on the Difference in Values of EVA Entity and EVA Equity," Sustainability, MDPI, vol. 12(21), pages 1-16, October.
    13. Penman, Stephen & Zhu, Julie, 2022. "An accounting-based asset pricing model and a fundamental factor," Journal of Accounting and Economics, Elsevier, vol. 73(2).

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    More about this item

    Keywords

    Conservative accounting; Risk and return; Earnings growth; Accruals; Earnings yield;
    All these keywords.

    JEL classification:

    • M41 - Business Administration and Business Economics; Marketing; Accounting; Personnel Economics - - Accounting - - - Accounting
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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