Does Unconditional Accounting Conservatism Imply Upside or Downside Risk? Evidence from the Options Market

Abstract

SYNOPSIS Conservatism captures an asymmetric reporting practice in response to uncertainty in business operations (earnings). Such uncertainty in business operations implies that investors are exposed to tail risk such that there is a probability of large earnings growth, offset by the probability of a large earnings decline. Existing literature has shown that accounting conservatism relates positively to stock returns. However, the literature is silent on whether this pricing is driven by positive earnings expectation or by the potential negative earnings growth. Using option-implied assets, we find that conservatism is priced by investors’ risk aversion (downside risk) rather than the potential upside. Several robustness tests confirm the findings. We also provide evidence that the returns are not driven by mispricing but as compensation for the risk implied by conservative reporting. We further decompose an alternate conservatism measure and find that our results are driven by the uncertainty in expenses rather than revenues.