Accounting conservatism and the cost of equity capital: UK evidence

Abstract

The purpose of this paper is to investigate the economic consequences of different dimensions of accounting conservatism: ex ante (balance sheet or unconditional) conservatism and ex post (earnings or conditional) conservatism. It is argued that the two dimensions of conservatism convey different information to the market about the quality of accounting numbers and have different associations with equity investors` required rates of return. The cost of equity capital estimates are based on the Ohlson and Juettner-Nauroth model. The paper applies a regression model to examine the relationship between the cost of equity capital and accounting conservatism controlling for other risk factors. The findings indicate that ex ante conservatism is associated with higher quality of accounting information and lower costs of equity capital and that ex post conservatism is associated with lower quality of accounting information and higher costs of equity capital. The firm-level conservatism measures may suffer from measurement error. Future studies can be more specific in determining proxies for ex ante and ex post conservatism. The results imply that conservative accounting signals information to investors about the quality of a firm`s current and future earnings. Investors` required rates of returns may be higher for conservative reporting firms that are more susceptible to opportunistic management discretion. The paper provides the first UK evidence on the effect of different dimensions of conservatism on equity investors` required rates of return.