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Published in: Review of Accounting Studies 2/2011

01-06-2011

Conditional conservatism and cost of capital

Authors: Juan Manuel García Lara, Beatriz García Osma, Fernando Penalva

Published in: Review of Accounting Studies | Issue 2/2011

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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.

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Footnotes
1
For brevity, we sometimes refer to conditional conservatism simply as conservatism. Similarly, we use the terms cost of capital and cost of equity capital interchangeably.
 
2
See Botosan (1997), Botosan and Plumlee (2002), Battacharya et al. (2003), Francis et al. (2004, 2005), Hribar and Jenkins (2004), Aboody et al. (2005), Barth et al. (2010), Kravet and Shevlin (2007), McInnis (2010), Francis et al. (2008), Core et al. (2008), Daske et al. (2008). The evidence presented by this literature is somewhat mixed, which is partly attributable to the different empirical methods used, as well as the use of accounting quality proxies, such as disclosure, transparency or income smoothing, with a tenuous link with information precision about future cash flows.
 
3
Consistent with this view, Beekes et al. (2004), Ahmed and Duellman (2007), and García Lara et al. (2009a) show that better governed firms report more conditionally conservative numbers, while the work of Ball et al. (2008) confirms that both debt and equity markets demand conservative accounting.
 
4
See pages 448 and 458 in LaFond and Watts (2008).
 
5
Guay and Verrecchia (2007) page 3.
 
7
In additional robustness tests, we also use 25 size-conservatism portfolios and 100 conservatism portfolios.
 
8
There is an alternative firm-year specific measure of conservatism (c-score) developed by Khan and Watts (2009). Although it is a perfectly valid measure, we choose not to use c-score in our tests because it is a linear combination of size, market-to-book, and leverage. These three variables are proxies for risk and the results could be attributed to c-score being a proxy for these three risk factors.
 
9
The precise estimation details are available in Callen and Segal (2009). We also appreciate the technical assistance provided by Dan Segal.
 
10
All our inferences remain unchanged if we set the value of Conservatism equal to the firm-year specific CR. For the single-year CR, our descriptive statistics are virtually identical to those reported in Callen et al. (2010).
 
11
We obtain similar inferences using the Fama and MacBeth (1973) procedure. The results are also robust to the inclusion of industry indicator variables.
 
12
Notice that special items are on average negative. Higher special items are associated with higher conservatism. Therefore, the coefficient on special items is expected to be negative.
 
13
In additional tests to validate Conservatism, we create four portfolios of firms ranked according to Conservatism. For each portfolio, we estimate the cross-sectional models of (a) asymmetric persistence in income changes (Basu 1997; Ball and Shivakumar 2005) and (b) asymmetric earnings timeliness to good and bad news (Basu 1997). Unreported results show that conservatism measures drawn from these models increase as we move from the least to the most conservative portfolio according to our Conservatism measure, confirming that our measure of conditional conservatism correctly classifies firms according to their level of conservative accounting.
 
14
The first year is 1976 because we start measuring Conservatism in the previous year.
 
15
In model (13) we consider the following risk proxies: (a) the CAPM beta, (b) market capitalization (size), (c) the book-to-market ratio, and (d) prior price momentum. These risk proxies are measured as previously described in Section 3. To isolate the discretionary component of the earnings attribute of interest, Conservatism, in model (13) we control for the same determinants used by Francis et al. (2004): (a) log of total assets, (b) cash flow variability, (c) sales variability, (d) length of the operating cycle, (e) incidence of negative earnings realizations, (f) intangibles intensity, (g) absence of intangibles, (h) capital intensity, and (i) dividend yield.
 
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Metadata
Title
Conditional conservatism and cost of capital
Authors
Juan Manuel García Lara
Beatriz García Osma
Fernando Penalva
Publication date
01-06-2011
Publisher
Springer US
Published in
Review of Accounting Studies / Issue 2/2011
Print ISSN: 1380-6653
Electronic ISSN: 1573-7136
DOI
https://doi.org/10.1007/s11142-010-9133-4

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