An Analytical and Empirical Measure of the Degree of Conditional Conservatism, Working Paper

The Vuolteenaho (2002) return decomposition is linear because it assumes that the market’s return expectations are obtained solely from accounting infor-mation. By restricting accounting recognition rules to specific (and primarily) negative future cash flow shocks, conservative accounting drives a wedge between the market’s return expectations that are based upon all positive and negative cash flow shocks and return expectations that are based solely on accounting numbers. This insight allow us to derive analytically a nonlinear relation be-tween revisions to returns and earnings news for conservative firms, of which the Basu relation is a special case. This nonlinear relation is shown to be math-ematically equivalent to two linear relations conditioned on the firm’s degree of conservatism. From these relations, we derive a model-based measure of the de-gree of conservatism at the firm-year level which is a function of the determinant