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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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    2. 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.
    3. Atif Ellahie, 2021. "Earnings beta," Review of Accounting Studies, Springer, vol. 26(1), pages 81-122, March.
    4. 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.
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    6. Ratna Puji Astuti KRISMIAJI, 2021. "Accounting Conservatism and Cost of Equity Capital – Evidence from Indonesia," CECCAR Business Review, Body of Expert and Licensed Accountants of Romania (CECCAR), vol. 2(2), pages 64-72, February.
    7. 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.
    8. 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).
    9. Stephen H. Penman & Xiao-Jun Zhang, 2021. "Connecting book rate of return to risk and return: the information conveyed by conservative accounting," Review of Accounting Studies, Springer, vol. 26(1), pages 391-423, March.
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    12. 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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