Accounting Conservatism and Asset Price

Abstract

This paper presents a static model of a competitive securities market. In the market there are two assets: risk-free asset and risky asset. The payoff of the risk-free asset is one and the payoff of the risky asset is unknown. Rational traders correctly estimate the mean and variance of the risky asset payoff. Earnings fixated traders are functionally fixated on accounting earnings numbers. Due to the conservative accounting practices, earnings fixated traders underestimate the mean and variance of the risky asset payoff. Noise traders' demand for the risky asset is assumed to be random. This paper proves analytically that the presence of accounting conservatism decreases the asset price and the volatility of the asset price and it increases the expected return of the asset. In addition, this paper proves that the presence of accounting conservatism decreases the likelihood of the asset price lying on the right tail of its distribution and depending on the model parameter values, the presence of accounting conservatism may increase or decrease the likelihood of the asset price lying on the left tail of its distribution.