On the Conditional Conservatism Measure: A Robust Estimation Approach

Abstract

Recent research, due to Patatoukas and Thomas (2011) and Ball et al. (2013), focuses on Basu’s (1997) conditional conservatism measure and the existence of a denominator effect — whether the difference between the earnings-return coefficients of bad and good news firms (“the Basu coefficient”) is only due to the beginning-of-year price deflator. We address this issue head-on by applying the Theil-Sen (TS) estimation method, which obtains the same coefficient estimate regardless of the chosen deflator and is robust to outliers. Results show the following: (i) the Basu coefficient remains positive using TS; (ii) the Basu coefficient using TS are similar to those using OLS without scaling but much smaller than what scaled OLS show; (iii) the scaled OLS estimates appear to be influenced by a few outliers; and (iv) OLS estimates are more volatile due to estimation error. In sum, the denominator effect does not overturn Basu’s hypothesis but the magnitude and variation of the Basu coefficient is much smaller than what traditional results show.