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

Juan M. García Lara

Universidad Carlos III de Madrid - Department of Business Administration

Beatriz Garcia Osma

Universidad Carlos III de Madrid - Department of Business Administration

Fernando Penalva

IESE Business School - University of Navarra

Date Written: March 23, 2010

Abstract

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

García Lara, Juan M. and Garcia Osma, Beatriz and Penalva, Fernando, Conditional Conservatism and Cost of Capital (March 23, 2010). Forthcoming in Review of Accounting Studies, Vol. 16, No. 2, June 2011. Available at SSRN: https://ssrn.com/abstract=1544307

Juan Manuel García Lara (Contact Author)

Universidad Carlos III de Madrid - Department of Business Administration ( email )

Calle Madrid 126
Getafe, Madrid, Madrid 28903
Spain

Beatriz Garcia Osma

Universidad Carlos III de Madrid - Department of Business Administration ( email )

Calle Madrid 126
Getafe, Madrid, Madrid 28903
Spain

Fernando Penalva

IESE Business School - University of Navarra ( email )

Ave. Pearson 21
Barcelona, Barcelona 08034
Spain
932534200 (Phone)
932534343 (Fax)

HOME PAGE: http://www.iese.edu

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