ATJ Asian Tax Journal

Asian Tax Journal

Print ISSN 1738-3323 Online ISSN 2733-9270

The Effects of Conservative Accounting on Cost of Equity Capital －Perspectives from Prospect Theory－

  • Hong-Joon Jun Department of Tax and Accounting, Shingu College

Asian Tax Journal Vol. 19 No. 2 (2018), pp. 257-283

Abstract

The role of accounting conservatism in reporting financial statements is in dispute even though it has been regarded as a fundamental feature for several decades. As a result, accounting conservatism is excluded by the international Accounting Standards Board’s conceptual framework due to concerns causing biases and threatening neutrality in accounting information. However, conservative accounting is still being employed after the adoption of IFRS. At this point, the usefulness of accounting conservatism needs to be reviewed. Accounting conservatism seems to have a close relationship with the phenomenon of avoiding risk. The prospect theory of Kahneman and Tversky(1979) provides a behavioral－based alternative to the rational decision theory. It assumes the investor’s utility for gains exhibits risk－averse behavior while the utility for losses exhibits risk－taking behavior. The purpose of this study is to examine the effect of accounting conservatism on cost of equity capital in terms of prospect theory. For this purpose, a research sample was divided into two groups：gain group (risk－averse) and loss group (risk－seeking). The results show that there exists a significant negative relationship between conditional conservatism and the cost of equity capital. Even in the gain group, conditional conservatism additionally decreases the cost of equity capital. Tests show the cause of the declining cost of equity capital originates from the difference of information asymmetry between the gain and loss group. This study provides a perspective that conservative accounting improves the quality of earnings such as the cost of equity capital and reference point can play an important role in studying accounting conservatism.

Keywords

  • prospect theory
  • accounting conservatism
  • cost of equity capital
  • information asymmetry

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