Conditional Conservatism and Cost of Capital
Juan M. García Lara
Universidad Carlos III de Madrid - Department of Business Administration
Beatriz Garcia Osma
Universidad Autonoma de Madrid; Universidad Carlos III de Madrid
IESE Business School - University of Navarra
March 23, 2010
Forthcoming in Review of Accounting Studies, Vol. 16, No. 2, June 2011
We empirically test the association between conditional conservatism and cost of equity capital. Conditional conservatism imposes stronger verification requirements for the recognition of economic gains than economic losses, resulting in earnings that reflect losses faster than gains. This asymmetric reporting of gains and losses is predicted to lower firm cost of equity capital by increasing bad news reporting precision, thereby reducing information uncertainty (Guay and Verrecchia 2007) and the volatility of future stock prices (Suijs 2008). Using standard asset-pricing tests, we find a significant negative relation between conditional conservatism and excess average stock returns over the period 1975-2003. This evidence is corroborated by further tests on the association between conditional conservatism and measures of implied cost of capital derived from analysts’ forecasts.
Number of Pages in PDF File: 42
Keywords: Conditional conservatism, asymmetric reporting, cost of capital, information precision, uncertainty
JEL Classification: G10, G38, M41
Date posted: January 29, 2010 ; Last revised: March 24, 2010
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