Articlegreen2010

Conditional conservatism and cost of capital

Juan Manuel García Lara · Beatriz García Osma · Fernando Peñalva

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Auditing, Earnings Management, Governance Financial Markets and Investment Strategies Accounting Theory and Financial Reporting

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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References

1993Common risk factors in the returns on stocks and bonds 1997On Persistence in Mutual Fund Performance 1992The Cross-Section of Expected Stock Returns 1973Risk, Return, and Equilibrium: Empirical Tests 2008Estimating Standard Errors in Finance Panel Data Sets: Comparing Approaches 2005The economic implications of corporate financial reporting 2003Corporate Governance and Equity Prices 1987A Simple Model of Capital Market Equilibrium with Incomplete Information

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