Conservatism and stock price informativeness

• Published date: 01 April 2023
• Author: Joohyung Ha
• Date: 01 April 2023
• DOI: http://doi.org/10.1002/jcaf.22608

Received: 19 September 2022 Accepted: 10 December 2022

DOI: 10.1002/jcaf.22608

RESEARCH ARTICLE

Conservatism and stock price informativeness

Joohyung Ha

Department of Accounting, University of

San Francisco, San Francisco, California,

USA

Correspondence

Joohyung Ha, Department of Accounting,

University of San Francisco, 2130 Fulton

Street, San Francisco, CA 94117,USA.

Email: jha6@usfca.edu

Abstract

This paper examines how conservative financial reporting influences stock price

informativeness, which is defined as the extent to which the current market

price reflects future earnings information. Using the accuracy of the future

earnings expectations embedded in the current equity price as a measure of

stock price informativeness, I find that conservative reporting is positively

associated with price informativeness. The results are robust to an alternative

stock price informativeness measure, namely, specific return variation or price

non-synchronicity. Furthermore, I also find that a greater positive association

between conservatism and stock price informativeness is associated with (1)

lower analyst coverage and decreased forecast dispersion, (2) greater bid–ask

spreads and greater R&D, and (3) lower financial disclosure quality, supporting

the argument that main channel by which conservatism improves stock price

informativeness is its impact on the information environment. Overall, the evi-

dence suggests that (1) conservatism improves stock price informativeness by

improving the firm’s information environment, and (2) the marginal benefit

of improvement in stock price informativeness via conservatism is more pro-

nounced in firms with poorer information environments. The results further

confirm that conservatism substitutes for information environments in ensuring

more accurate equity pricing.

KEYWORDS

accounting, conservatism, financial reporting, stock price informativeness

1 INTRODUCTION

Stock prices are shaped by information disclosed by

firms as well the information independently produced by

investors. This means higher quality financial reporting

and better disclosure improves stock price informativeness

(SPI) by improving the information environment (Dia-

mond & Verrecchia, 1991; Jin & Myers, 2006; Zuo, 2016).

Information about future earnings and cash flows is dis-

closed by a firm well before these are realized in earnings.

This information, in conjunction with other sources of

public signals or news independently generated by ana-

lysts, is reflected in the stock price. Price informativeness

is defined as the extent to which the current market price

reflects future earnings information. Price informativeness

is thus a function of at least three elements: the firm’s infor-

mation environment, its earnings informativeness, and

analysts’ price discovery efforts and ability. Accounting

conservatism affects all three elements. Although conser-

vatism has been widely documented for decades, little is

known for its effect on price informativeness. To fill this

gap, this study explores the impact of conservatism on a

firm’s SPI.

There are two differenttypes of accounting conservatism

recognized in the literature: conditional and uncondi-

tional. Conditional accounting conservatism (hereafter

J Corp Account Finance. 2023;34:273–295. © 2022 Wiley PeriodicalsLLC. 273wileyonlinelibrary.com/journal/jcaf

274 HA

simply conservatism) refers to the asymmetric timelier

recognition of losses versus gains (Basu, 1997), and is often

considered news-dependent conservatism. Unconditional

conservatism arises when firms simply adopt account-

ing rules that tend to systematically understate the book

value of net assets, therefore, it is often considered news-

independent conservatism. I focus on conditional conser-

vatism because the informational benefits associated with

conservatism are more applicable to the news-dependent

application of conservatism.i

Prior research provides supporting evidence that con-

servatism improves a firm’s information environment by

reducing information asymmetry between managers and

external parties such as debtholders (i.e., Ahmed et al.,

2002; Francis & Martin, 2010;Nikolaev,2010;Zhang,2008)

and equity holders (García Lara et al., 2011;Khan&Watts,

2009;LaFond&Watts,2008, García Lara et al., 2014;Kim

&Zhang,2016; Kim et al., 2013).ii More specifically, firms

with conservative reporting will have less information

asymmetry because bad news is recognized in the income

statement, while good news is disclosed through chan-

nels other than the income statement, such as the notes

to financial statements, conference calls, management

guidance, press releases, and so forth.

Prior research also provides mixed evidence regarding

the impact of conservatism on earnings informativeness.

Some researchers argue that conservatism results in more

accurate earnings information and improves the pre-

dictability of earnings by counteracting managers’ desire

to overstate earnings (Ball, 2001; LaFond & Watts, 2008;

Watt s, 2003). Lower information asymmetry and less

earnings management under conservatism could make

firms’ prices more informative about future earnings and

cash flows, which suggests that conservatism might be

positively associated with SPI.

Alternatively, others have argued that conservatism

intentionally creates biases in earnings, reducing the qual-

ity of earnings. For example, because conservatism intro-

duces transitory negative earnings shocks while delaying

recognizing good news in earnings, conservative reporters

have lower earnings smoothness and persistence. Accord-

ing to Tucker and Zarowin (2006), earnings smoothness

increases price informativeness by revealing managers’

private information. In this case, conservative firms’ lower

earnings smoothness and persistence would suggest lower

SPI. Accounting conservatism results in greaterdifferences

between good and bad news and thus delays the price

discovery at earnings announcements (Barth et al., 2020).

There are also conflicting views on how conservatism

affects analysts’ information environment. Prior research

documents that earnings management reduces analysts’

forecast accuracy and increases information asymmetries

between managers and information users (Burgstahler &

Eames, 2003; Givoly et al., 2011). As conservatism con-

strains earnings management, it could be argued that

financial analysts may produce more accurate forecasts

for conservative firms, implying a positive association

between conservatism and SPI. In line with this argu-

ment, García Lara et al. (2014) find that conservatism

helps to improve an information environment for financial

analysts, leading to greater analyst coverage, greater fore-

cast accuracy, and less forecastdispersion. However, some

studies report conflicting results, namely, that analysts do

not completely understand the downward bias in a firm’s

earnings due to conservatism and, in turn, they set target

price too high for conservative firms (Kim et al., 2019; Louis

et al., 2014; Mensah et al., 2004). These studies find that

analysts’ forecast errors and dispersion are higher for firms

with greater degrees of both unconditional and conditional

conservatism. On this view, a negative relation between

conservatism and price informativeness can be assumed.

The above arguments suggest that the links between

conditional conservatism and SPI are far from being set-

tled. Thus, whether conservative reporting policies are in

fact associated with SPI is an interesting research question.

This paper uses two measures of SPI. The first mea-

sure, developed by Fan et al. (2021), is the accuracy of the

future earnings forecasts embedded in the current equity

price. This measure is superior to the returns-based SPI

measure that has commonly been employed by prior stud-

ies, such as future earnings response coefficients (FERCs)

or stock return synchronicity measures. This is because

the returns-based measure primarily reflects changes in

expectations regardless of whether the underlying levels of

expectations are actually accurate. Fan et al.’s price-based

measure overcomes this shortfall because it distinguishes

between the level of expected future earnings and the level

of realized earnings. To develop their SPI measure, Fan

et al. first calculate a variable DIFF, which is the differ-

ence between a firm’s equity market value at the end of

period 𝑡and the firm’s capitalized realized aggregate earn-

ings for the subsequent T(set to 28) quarters and then

calculate ERR, which is the component of DIFF that is

unexplainable by a large set of variables that capture risk

and investors’ expectations for the future value created by

the firm after quarter t+T. This measure is a modified ver-

sion of Bai et al. (2016) informativeness measure, which

captures how well market prices predict future earnings.

Bai et al. (2016) measure can only measure the informa-

tiveness of a portfolio of firms for a specific year, while Fan

et al. (2021) measure can be estimated for a specific firm.

The latter measure is also more appropriate for the present

study because one of the main variables of this study, C-

Score, is based on stock returns, and using a return-based

informativeness measure would potentially confound the

results. For robustness, I use an additional measure,