Conditional conservatism and cost of capital

Juan Manuel García Lara, Beatriz García Osma, Fernando Penalva

Review of Accounting Studies · 2011 · Volume 16 · Issue 2

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 Verrecchia2007) and the volatility of future stock prices (Suijs2008). 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

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