Re-examining Accounting Conservatism: The Importance of Adjusting for Firm Heterogeneity

Prior studies have documented the extent of accounting conservatism (in the form of the asymmetric response of accountings earnings to news) and its increase over time. However, many of these studies implicitly assume that unobserved firm-specific characteristics (known as firm heterogeneity or firm-specific fixed effects) are homogenous and, thus, unimportant to earnings determination. In this paper, we show that this assumption is over-restrictive, and there are significant cross-sectional differences (firm heterogeneity) in earnings. We find that, after accounting for firm-specific fixed effects in the earnings determination, [i] the level of accounting conservatism is smaller in magnitude than previously documented, and [ii] there is no clear pattern of increasing conservatism over time. Our results stand in stark contrast to much of the findings in the literature and raise the awareness among researchers of the importance of accounting for firm-specific heterogeneity in examining earnings-returns relations.