Placebo Tests of Conditional Conservatism

Abstract

ABSTRACT Basu (1997) proposes a measure of financial reporting conservatism based on asymmetry in the conditional earnings/returns relation. Patatoukas and Thomas (2011) show upward bias in this measure, because a placebo—lagged earnings—also exhibits similar asymmetry. Ball, Kothari, and Nikolaev (2013a) and Collins, Hribar, and Tian (2014) propose alternative explanations for the bias and offer revised measures to overcome the bias. However, we find that both revised measures remain substantially upward-biased. In particular, a placebo based on lagged share price mimics time-series and cross-sectional variation observed for the revised measures. More generally, we find biases in the asymmetric timeliness specification because earnings, accruals, and other measures of performance are often related to second and higher moments of the distribution of returns. In addition to suggesting that the asymmetric timeliness specification be used with caution, our study illustrates the useful role placebos can play in archival studies. Data Availability: Data are available from the sources identified in the text.