Pricing Conservatism: An Empirical Study on the Value Relevance of Conservative Reserves in Swedish Firms

Abstract: The purpose of this study is to evaluate the financial market's efficiency in respect to conservative accounting. Particularly the study focuses on conservative accounting's influence on the reported return on owners' equity, including the influence of build-ups and realizations of conservative reserves. This is accomplished by proposing a measure of an unbiased return on owner's equity that is unaffected by conservative accounting, and subsequently acts as the basis for establishing stock-picking strategies that are evaluated in a market setting. The unbiased return on owners' equity is obtained by estimating a conservative reserve ratio that reflects unrecorded reserves for long-lived depreciable assets, research and development expenses, inventories and deferred taxes for each individual firm and year. The stock-picking strategies generate annual buy and sell signals on Swedish listed firms in the fiscal years 2003-2014, which are evaluated together as portfolios over 36-month periods. The results of the study imply that the market cannot be assumed to be inefficient in respect to conservative accounting's influence on the reported return on owners' equity. This largely contradicts previous, limited, research on the topic and suggests that considerations regarding conservative accounting have become less value relevant over time.