Conditional Conservatism and the Cost of Equity Capital: Informational, Fundamental, and Behavioral Effects

Abstract

Prior studies report negative or insignificant relations between conditional conservatism and the cost of equity capital, arguing that conservatism reduces information risk. Using equity cost measures that control for cash flow news and accounting-based conditional conservatism proxies, we document a significantly positive association between conditional conservatism and cost of equity, and detect three channels for the equity premium to conditional conservatism: information precision and information asymmetry effects, behavioral effect, and effect of earnings downside risk. Using the Sarbanes-Oxley Act (SOX) as a natural experiment, we confirm that the positive relation disappears in the post-SOX period, consistent with diminished informational, behavioral, and operational risks engendered by SOX regulations.