The Confounding Effect of Cost Stickiness in Conservatism Research

Abstract

Sales decreases affect earnings more than sales increases because of cost stickiness. We hypothesize that this correlated omitted variable constitutes a confounding effect in standard asymmetric timeliness models. Adding sales change direction to the Basu (1997) and Ball et al. (2013b) models decreases measured conservatism significantly and has a large impact on the relative ranking of industry-level conservatism estimates and on inferences about drivers of conservatism. Future empirical research on conditional conservatism should control for the potential confounding effect of sticky costs.

Keywords: timely loss recognition, omitted variable bias, over-investment, managerial stock ownership

JEL Classification: D22, D24, M41