Accounting conservatism and earnings expectations

Conservatism is a long-standing convention in accounting. Previous literature finds that conservative accounting is desirable because it can reduce agency costs and litigation risk. The users of financial statements, however, desire unbiased information in evaluating firm performance. Prior literature finds that accounting conservatism complicates the mapping of current financial information to future earnings and firm valuation. Financial Accounting Standard Board (FASB) states that accounting conservatism conflicts with neutrality and that undue conservatism may mislead investors. This study empirically examines whether the concerns expressed by FASB are valid.; Specifically, this study investigates whether: (1) financial analysts and stock market investors use accounting conservatism information in one-year-ahead earnings expectations, (2) financial analysts' and stock market investors' use of accounting conservatism information is consistent with the economic implications of accounting conservatism for one-year-ahead earnings, (3) financial analysts' use of accounting conservatism information influences the stock market's pricing or mispricing of accounting conservatism. The inquiry of this study is important because conservatism is deeply rooted in accounting practice and the economic impact of mispricing in accounting conservatism can be significant.; This study constructs two distinct accounting conservatism measures, one arising from mandatory accounting policy and the other from management's discretionary choices. The results suggest that financial analysts tend to overreact to mandatory accounting conservatism for firms with growth. In addition, financial analysts' forecasts contain systematic errors in accounting conservatism regardless of growth. The results also show that the stock market underprices the two accounting conservatism measures for both the positive and negative growth firms, and sizeable excess returns can be earned based on a hedging strategy utilizing the mispricing information. Lastly, the results indicate that analysts forecast error is not likely responsible for the stock market's mispricing of accounting conservatism. The findings of this study help assess whether accounting conservatism impedes financial statement users' earnings expectations and the findings have implications for investors, financial analysts, accounting standard setters and academic researchers.