Identifying Conditional Conservatism

Abstract

This paper provides guidance for empiricists interested in measuring conditional conservatism and in interpreting associations of those measures with variables of interest. I begin by discussing the nature and importance of conditional conservatism and surveying the literature identifying conditional conservatism. I then describe and comment on the various limitations of asymmetric timeliness identified in the literature. Despite these limitations, I argue that asymmetric timeliness is the most direct implication of conditional conservatism, and that alternative measures that have been proposed need not capture any type of conservatism. Finally, I provide four specific suggestions for estimating asymmetric timeliness and for interpreting it as a measure of conditional conservatism.

Acknowledgement

I thank Laurence van Lent, Thorsten Sellhorn and Valeri Nikolaev for useful comments.

Notes

1. The intuition underlying this view is that, in order to be useful for contracting purposes, accounting measures must be informative and timely, which conditional conservatism can facilitate but unconditional conservatism cannot. While I generally agree with this view, which is consistent with certain branches of contracting theory (e.g. agency theory examining managerial effort), I also note that contracting involves many complex problems (e.g. project selection), and for some of these problems conditional conservatism could have adverse consequences (e.g. induce managerial risk aversion) and/or unconditional conservatism could have favorable consequences (e.g. alleviate material risk aversion). Such consequences are probably even likely once behavioral considerations are taken into account. Moreover, conditional and unconditional conservatism are interrelated – in particular, unconditional conservatism creates accounting slack that preempts conditional conservatism, as discussed in Section 2 – and so it is inherently limiting to consider conditional conservatism separately from unconditional conservatism. For these reasons, in my view claims made in the literature about the usefulness of conditional conservatism and the lack thereof of unconditional conservatism are more sweeping than is justified. Quite the contrary, I think there are many open empirical questions about the circumstances and ways in which greater conditional conservatism is desirable in isolation or instead of greater unconditional conservatism. In the interest of maintaining the focus of this paper on the identification of conditional conservatism, however, with one exception I do not discuss these issues further. The exception is the preemption of conditional conservatism by unconditional conservatism, which has direct implications for the identification of conditional conservatism and so is discussed in Section 2.

2. In my view, two well-known empirical results together imply the biases identified by Dietrich et al. are likely to be fairly small and so biases in returns-based measures of asymmetric timeliness are likely to be correspondingly small. First, the low values of R 2 observed in contemporaneous returns–earnings regressions suggest that the extent to which earnings causes returns is tiny compared to the extent to which both variables are determined by other, more primitive information. Second, a large literature, only some of which employs the reverse regressions of earnings on returns used to estimate asymmetric timeliness, exists that shows returns typically reflect information on a timelier basis than earnings.

3. The use of energy prices as measures of news for samples of energy-related firms was suggested to me several years ago by Sudipta Basu.