Conditional Conservatism and Cost of Capital
Forthcoming in Review of Accounting Studies, Vol. 16, No. 2, June 2011
42 Pages Posted: 29 Jan 2010 Last revised: 24 Mar 2010
Date Written: March 23, 2010
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.
Keywords: Conditional conservatism, asymmetric reporting, cost of capital, information precision, uncertainty
JEL Classification: G10, G38, M41
Suggested Citation: Suggested Citation