Conservatism and Aggregation: The Effect on Cost of Equity Capital and the Efficiency of Debt Contracts

Accounting

Speaker:Anne Beyer, Stanford University
Date: Wednesday 5 March 2014
Time: 16:00
Location: Bateman Lecture Theatre, Building One

Further details

Anne Beyer is an Associate Professor of Accounting at the Stanford Graduate School of Business and the Michelle R. Clayman Faculty Scholar for 2010-2011. She teaches the introductory class in financial accounting.

Anne’s research focuses on corporate disclosure, information economics and corporate governance. Her recent work examines the properties of financial analysts’ and management’s earnings forecasts, as well as investors’ reaction to earnings forecasts and other forms of corporate disclosures. This work includes studying managers’ and analysts’ incentives to bias forecasts and investors’ inferences about firms’ performance based on earnings forecasts.

 

This paper studies the joint effect of conservatism and aggregation on the cost of equity capital and the efficiency of debt contracts. In the model, a firm's two assets are valued at either the lower-of-cost-or-market or fair value and the accounting report aggregates the value of the two assets.  While the process of aggregation leads inevitably to a loss of information, what information is lost depends on the accounting regime.  In the conservative regime, gains are ignored while in the fair value regime gains are off-set against losses.

The paper studies the joint effect of conservatism and aggregation in two settings.  First, it considers an all-equity firm and compares the valuation of equity when investors observe an accounting report under either the conservative or a fair-value regime. The model predicts that cost of equity capital is lower in the conservative regime than in the fair value regime if the firm's production function exhibits sufficiently decreasing marginal returns. Second, the paper takes a contractual perspective and considers the efficiency of debt contracts when debt covenants must be written in terms of the accounting report. The paper shows the maximum capital that can be raised by a debt contract which implements efficient post-contractual decisions is higher in the conservative than in the fair value regime.