Estimation and Empirical Properties of a Firm-Year Measure of Accounting Conservatism

Abstract

We estimate a firm-year measure of accounting conservatism, examine its empirical properties as a metric, and illustrate applications by testing new hypotheses that shed further light on the nature and effects of conservatism. The results are consistent with the measure, C_Score, capturing variation in conservatism and also predicting asymmetric earnings timeliness at horizons of up to three years ahead. Cross-sectional hypothesis tests suggest firms with longer investment cycles, higher idiosyncratic uncertainty and higher information asymmetry have higher accounting conservatism. Event studies suggest increased conservatism is a response to increases in information asymmetry and idiosyncratic uncertainty.Both authors are at the Sloan School of Management,

Conditional conservatism and the yield spread of corporate bond issues

“…We use Khan and Watts's (2009) firm-year measure of conservatism as the proxy for conditional conservatism. 12 Firms with more conditionally conservative reporting have a higher C_Score.…”

“…12 Firms with more conditionally conservative reporting have a higher C_Score. According to Khan and Watts (2009), C_Score captures variation in conservatism and predicts asymmetric earnings timeliness at horizons of up to 3 years into the future. This measure follows Basu's (1997) notion of timely loss recognition; however, it overcomes Basu's (1997) limitation of single-period, cross-sectional regression or single-firm time series regression as indicated by Givoly et al (2007).…”

“…This measure follows Basu's (1997) notion of timely loss recognition; however, it overcomes Basu's (1997) limitation of single-period, cross-sectional regression or single-firm time series regression as indicated by Givoly et al (2007). To allow coefficients to vary across firms and time, Khan and Watts (2009) modify the original Basu (1997) regression as follows:…”

Business Ethics and Financial Reporting Quality: Evidence from Korea

“…In this study, we use a variation of Basu's measure of accounting conservatism as proposed by Khan and Watts (2009). Unlike the original Basu's measure of conservatism that measures the average level of accounting conservatism over the whole sample, Khan and Watts' (2009) variation makes measuring the level of accounting conservatism of individual companies possible.…”

“…As in Khan and Watts (2009), we measure the degree of accounting conservatism using a two-step procedure. In the first step, we estimate the following cross-sectional regression in each year.…”