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On the Conditional Conservatism Measure: A Robust Estimation Approach

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 does not depend on the scaling of variables; the same coefficient estimates are obtained whether or not the regression equation is scaled by beginning-of-year price. Moreover, the TS estimates are intrinsically insensitive 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 outlier firms with negative returns and material losses; and (iv) OLS estimates are more volatile due to estimation error. Also, placebo tests suggested in Patatoukas and Thomas (2011) do not falsify our findings. 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.