In capital markets, the stock market value of a company can sometimes exceed its underlying (fundamental) value. Such overvaluation can materialize over months or even years. Sustained overvaluation is viewed in academic research as a threat to the functioning of capital markets, being at the root of several value-destroying episodes that made the financial system tremble in the last decades. A fundamental concern is that managers of overvalued equity fall into an ‘earnings game’ trap. In this vicious circle, managers face strong incentives to sustain overvalued equity and engage in earnings management practices to meet the unrealistic performance expectations of overvalued prices. To resolve these problems, corporate mechanisms must be identified that prevent managers from engaging in earnings games.
In our recent paper, we examine the role of conditional conservatism, a characteristic of financial reporting, in reducing overvaluation and its related problems. In technical terms, conditional conservatism refers to the differential verifiability requirements in accounting for recognizing bad news in earnings relative to good news. Conditionally conservative firms have earnings that reflect economic losses in a timelier and more complete manner than economic gains. This leads to asymmetric persistence of gains and losses, where difficult-to-verify good news is not recognized in earnings until the associated cash flows are realized. In turn, bad news is recognized in a timely and complete manner, resulting in large losses that reverse quickly. In simpler terms, this means that conditionally conservative firms warn investors about bad news soon, while they are cautious in recognizing good news, being less likely to generate over-optimism that is not rooted in sustainable positive economic events.
Given that overvaluation is often triggered by the release of good news about firm fundamentals and is sustained, at least partly, through strategic disclosure and earnings management, conditional conservatism is expected to discipline and limit both the opportunistic recognition of good news, as well as the opportunistic concealment of bad news. Therefore, we predict that conservatism in accounting limits the incidence of earnings expectation games, reducing overvaluation and breaking the vicious circle of expectations that may trap managers into sustaining overvaluation.
In particular, we expect conditional conservatism to reduce overvaluation through an improved firm information environment, which lowers the opportunities for earnings management and limits the accumulation of undisclosed bad news. In this way, conservatism facilitates monitoring by boards of directors and lenders, attaining several positive economic consequences, such as decreasing the incentives to invest ex-ante in negative NPV projects and accelerating the disinvestment in poorly performing projects. This improved monitoring limits over-investment in risky negative NPV projects, empire-building, and value-destroying mergers and acquisitions typically used to sustain overvaluation.
In our empirical work, we find strong support for our expectations. First, we find that more conditionally conservative reporting is negatively associated with overall and sustained duration (i.e., consecutive periods) of equity overvaluation. Reversals of overvaluation back to underlying value accrue faster to more conditionally conservative firms. Second, we test if conditionally conservative firms can avoid the vicious circle of the earnings management trap. We hypothesize that a fundamental way conservatism breaks the earnings game is that more conservative firms receive lower or no penalties when missing an earnings benchmark. We find support for our expectations. More conditionally conservative firms have lower penalties for missing earnings targets. This result is concentrated in small firms, suggesting that smaller firms benefit more from reporting conservatively. Third, we test whether short sellers are less likely to target conditionally conservative firms. Given that short sellers target firms suspected of having hidden bad news, tracking their accounting accruals to uncover misreporting and take positions in anticipation of stock price decreases (i.e., bad news realizations), we expect a negative association between conditionally conservative firms and short-selling. Our findings support this expectation.
To corroborate our main findings, we use a regulatory change (the passage of SFAS 121) expected to alter the level of conditional conservatism exogenously. Additionally, we analyze the stock performance of high-tech companies during the Dot-Com bubble burst. We find that firms that were more conditionally conservative during the Dot-Com bubble period (from 1995 to 1999) entered the bubble burst with less overvalued stock and, thus, experienced lower stock return drops during the crisis.
Our results may interest accounting regulators in debating whether a conditionally conservative accounting system is desirable compared to a system based on fair value estimates. Both fair value accounting and conditional conservatism impose timely recognition of losses; however, these systems differ substantially in their treatment of difficult-to-verify gains, which we argue are fundamental in creating and sustaining overvaluation and creating incentives to engage in target-beating behavior. In a fair value system, gain and loss recognition are symmetrical, while conditional conservatism limits managers’ discretion in recognizing gains. Our evidence suggests that this disciplining role over the timely recognition of difficult-to-verify gains leads to a lower likelihood of overvaluation. Our results do not support the view that a neutral accounting system is more desirable.
Juan Manuel García Lara is a Professor at Universidad Carlos III de Madrid.
Beatriz García Osma is a Professor at Universidad Carlos III de Madrid.
Akram Khalilov is an Assistant Professor at BI Norwegian Business School.
This post was adapted from their paper, “Accounting Conservatism and the Agency Problems of Overvalued Equity,” available on SSRN.