A Theoretical Analysis Connecting Conservative Accounting to the Cost of Capital

Abstract

We develop an accounting model with three distinctive features: (1) business-cycle-conformity, where the book value of an enterprise equals the fair value of cash at the beginning and the end of a cash-to-cash business 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) expected earnings growth rate is positively correlated with the expected stock return; (b) the earnings-to-cash (i.e. accrual) ratio is negatively correlated with the expected stock return; (c) the expected earnings yield (i.e., forward E/P ratio) is negatively correlated with 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 are more likely to 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.