Conditional Conservatism and the Cost of Equity Capital: Information Precision and Information Asymmetry Effects

Abstract

Prior studies report negative or insignificant relations between conditional conservatism and the cost of equity capital, arguing that conservatism reduces information risk. Using accounting-based conditional conservatism proxies, however, we find a significantly positive association between conditional conservatism and the cost of equity. This positive relation operates via improving information precision about negative earnings shocks and generally inflating information asymmetry among investors, both of which increase the cost of equity. We further find that the cost of equity effect of conditional conservatism disappears in the period after the enactment of the Sarbanes-Oxley Act (SOX), consistent with the notion that nationwide improvement of information precision about negative news and diminished information asymmetry are engendered by the SOX regulation. This study adds to researches on conditional conservatism, SOX, and the cost of equity, and also has policy implications.

Keywords: conditional conservatism; cost of equity capital; asset pricing test; Sarbanes-Oxley Act (SOX)

JEL Classification: M41; G32; G12; G14