A Theoretical Analysis Connecting Conservative Accounting to the Cost of Capital

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 of an investment equals the value of cash at the beginning and the end of a cash-to-cash transaction 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) the growth rate of expected earnings is positively related to the expected stock return; (b) the accruals-to-cash ratio is negatively related to the expected stock return; (c) the expected earnings yield (i.e., forward E/P ratio) is negatively related to 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 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