Conditional Conservatism in Accounting: New Measure and Tests of Determinants
University of Texas at El Paso (UTEP)
Following Basu's (1995, 1997) seminal work, accounting literature adopted the Basu coefficient to measure conditional conservatism (among others, Ball et al. 2003; Ball et al. 2000; Ball et al. 2005; Ball and Shivakumar 2005; Lobo and Zhou 2006; Chandra et al. 2004). However, Basu's choice of proxy for measuring the arrival of good/bad news, stock returns, introduces inaccuracy in the measure of conditional conservatism (Dietrich et al. 2007; Roychowdhury and Watts 2007; Givoly et al. 2007).
To address the problem, I introduce a new measure of conditional conservatism, which results from a Least Absolute Deviation (LAD) piecewise regression and adopts the number of changes in financial analysts' EPS forecasts as a proxy for good/bad news about future earnings and extends the analysis to two-year and three-year time horizons.
I use this new measure to test three determinants that prior literature suggested to explain the presence of accounting conservatism. Results show that companies with high debt-to-assets ratio - closer to default on their debt covenants, with large portion of executives' compensation tied to the firm's performance, and in the year prior to a going concern opinion from their auditors report aggressively, recognizing future good news in annual earnings more quickly than bad news.
Number of Pages in PDF File: 48
Keywords: Conditional conservatism, earnings forecasts, financial analysts, Basu coefficient
JEL Classification: M41, M44, G29
Date posted: March 12, 2008 ; Last revised: May 7, 2008