Conservatism and stock return skewness

In this paper, we study the association between conservatism and stock return skewness. Existing literature has studied how conservatism is associated with stock return distribution in terms of mean returns as well as return volatility. The literature is relatively silent on how conservatism influences stock return skewness. Conservatism implies higher verification threshold for gains versus losses, thereby creating an asymmetry or skewness in reported earnings. Given that earnings and prices are highly correlated, we expect to find an association between conservatism and stock return skewness. Following recent literature, we use returns on skewness assets, which are designed to be long skewness, as a measure of stock return skewness. Every month, we sort our sample into quintiles, based on the conservatism score, and find that the returns on the skewness assets increase monotonically across conservatism quintiles, consistent with our expectation. In additional tests, we find that a dollar-neutral trading strategy with a long position in quintile 5 firms (highest conservatism) and a short position in quintile 1 firms (lowest conservatism) yields significant returns, after adjusting for priced risk factors. Section 1: Introduction In this paper, we study the association between conservatism and stock return skewness. Empirical evidence documents the association of conservatism with contemporaneous and future average stock returns as well as stock return volatility (Penman & Zhang [2002], Khan & Watts [2009], Penman & Zhang [2014]). However, the literature is relatively silent on whether and how, conservatism influences stock return skewness. Conservatism implies a higher degree of verification to recognize good news as gains than to recognize bad news as losses (Basu 1997). It therefore implies that expected losses are immediately recognized in earnings, whereas expected gains are recognized into earnings only after detailed verification and a fair amount of certainty that the gains will materialize. Conservatism thus, creates an asymmetry or skewness in earnings. Given that stock prices are discounted values of expected earnings, stock returns can be impacted by the skewness in expected earnings. Consequently, we expect to see an association between conservatism and the skewness of stock returns. To conduct our tests, instead of using the 3 moment formula, we use skewness assets constructed using a combination of stocks and options following Bali & Murray (2013). These assets are long skewness, implying that any increase in the skewness of the underlying stock return distribution, should be associated with an increase in the returns on these skewness assets. As a result, we test our hypothesis using the returns on these skewness assets, as a measure of stock return skewness. Using these assets has two advantages. Firstly, these assets are constructed as delta and vega neutral. As a result, any changes in the mean returns or volatility of the underlying stock return 1 Basu (1995) also provides evidence of an association between conservatism and stock return skewness 2 We explain more about the skewness assets and other aspects of the research design later in the paper 3 Please see Appendix E to understand how these assets are delta and vega neutral distribution do not impact the returns on these assets. This allows us to isolate the impact of skewness of stock returns. Secondly, the traditional skewness formula (3 moment formula) is not tradable. The skewness assets are a combination of options and stocks, which makes these assets tradable, allowing us to test our hypothesis in the capital markets setting. We use the three skewness assets from Bali & Murray (2013). Every month, we sort our sample into quintiles based on the conservatism score, and find that the returns on the two skewness assets increase monotonically across quintiles. This result is consistent with our expectation. This result is robust to several robustness tests, thereby providing support to our results. In additional tests, we show that a trading strategy which involves a long position in quintile 5 firms (highest conservatism firms) and a short position in quintile 1 firms (lowest conservatism firms), generates statistically and economically significant excess returns, which are not explained by well-known risk factors. A related paper to our study is Kim & Zhang (2016), where the authors use the negative conditional skewness of weekly stock returns over the next year, as a measure of crash risk. They show that conservatism is negatively associated with crash. Our results are consistent with theirs, which further lends credibility to our results. However, our study differs from theirs in a few aspects. Firstly, the authors in their paper use the 3 moment formula, whereas we use skewness assets, and analyze our results in a trading strategy as well. Secondly, they look at annual data, whereas our paper focuses on more frequent, monthly data. Thirdly, by using the skewness assets, we are able to control for the impact of contemporaneous stock return changes as well as changes in the volatility of the underlying stock return distribution, which can be correlated with stock return skewness. Our paper contributes to the literature in several ways. Firstly, we contribute to the literature on conservatism by providing evidence on how conservatism can influence stock return skewness. In addition, our results can be tested in the capital market by means of a trading strategy. We also contribute to the capital markets literature by documenting conservatism as a determinant of stock return skewness. To the best of our knowledge, this is the first paper to conduct a detailed test of association between conservatism and stock return skewness as well as the first paper to use skewness assets as a measure of skewness as associated with an accounting variable. The rest of the paper is organized as follows: Section 2 discusses the background and hypothesis development; section 3 discusses research design, sample selection and descriptive statistics; section 4 discusses main results, robustness tests and additional analyses; section 5 concludes. Section 2: Background and Hypotheses development The conservatism principle has been widely studied in the accounting literature. Basu (1997) noted conservatism as accountants’ tendency to require a higher verification for gains vs losses. Extant literature has studied determinants as well as consequences of conservatism from the perspective of multiple stakeholders, including company’s board, managers, debtholders, suppliers, analysts, shareholders as well as stock market participants. Ahmed & Duellman (2007) show that conservatism is associated with board characteristics; LaFond & Roychowdhury (2008) document the effect of managerial ownership on financial reporting conservatism. They state that separation of ownership and management gives rise to agency problems, and financial reporting conservatism is one potential mechanism to address this issue. In addition, Hui et al. (2012) show how a firm’s suppliers and customers can influence accounting reporting practices, in terms of accounting conservatism. Hui et al. (2009) document a negative association between accounting conservatism and the frequency, specificity and timeliness of management forecasts. Zhang (2008) finds that more conservative borrowers are more likely to violate debt covenants following a negative price shock, and that lenders offer lower interest rates to more conservative borrowers. Mensah et al. (2004) find accounting conservatism to be associated with higher analyst forecast errors and forecast dispersion. These studies document the impact of conservatism on stakeholders, both within and outside the firm. Another area of research in the conservatism literature is its association with and impact on the stock market. Existing studies have proven the association of conservatism with stock returns as well as stock return volatility. Penman & Zhang (2002) find a positive association between conservatism and future raw and size-adjusted stock returns. They suggest this is due to investors’ inability to understand conservatism in the financial statements. In addition, Khan & Watts (2009) show a positive association between conservatism and stock return volatility. They suggest that firms with high uncertainty tend to have higher agency costs, higher potential shareholder losses thereby increasing the likelihood of shareholder litigations, as well as higher unverifiable future gains. All these factors generate a higher demand for conservatism. Penman & Zhang (2014) also document a similar intuition. They suggest that conservative accounting considers the uncertainty in future gains before recognizing those in the financial statements. As a result, the higher the uncertainty of the future cash flows, the more conservative the financial statements would be. The authors document a positive association between conservatism and future stock returns (which they term as the required return, due to the uncertainty of the cash flows). Consequently, they suggest a positive conservatism and future volatility. The literature, though, is relatively silent on whether and how conservatism influences skewness in stock return distribution. Conservatism implies a higher degree of verification to recognize good news as gains than to recognize bad news as losses (Basu 1997). What this means is expected losses are recognized into earnings much faster (without extensive verification) than expected gains (after extensive verification). This asymmetric verification threshold or asymmetric recognition of expected cash flows into earnings, creates an asymmetry or skewness in earnings. Given that prices are highly correlated with earnings, this skewness in earnings should impact skewness in stock returns as well. As a result, we hypothesize that conservatism would influence s