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'Conservatism is the requirement of a higher degree of verification for gains than for losses. Gains are increases in the value of net assets and losses are decreases in the value of net assets. Differences in the degree of required verification can be determined by first observing actual net asset gains and losses when they occur and then determining whether there is a difference in the speed with which those gains and losses are captured by accounting. Reasonably, Basu (1997) assumes that positive stock returns in a period generally reflect net asset gains and negative stock returns reflect net asset losses. If losses are subject to a lesser degree of verification than gains, Basu argues earnings will reflect net asset losses more quickly than net assets gains. The consequence is that stock returns and earnings will tend to reflect net asset losses in the same period, but stock returns will reflect net asset gains in earlier periods than earnings. In particular, Basu predicts that negative stock returns are more likely than positive stock returns to be fully reflected in earnings of the period in which those returns occur.

Basu illustrates his prediction with the earnings effects of a change in the estimated useful life of a fixed asset. When the estimated life drops, the asset's value drops and the asset is written down to leave the estimated depreciation of future years unchanged.

All of the loss appears in earnings of the year of the loss. Earnings of that year are lower and the expected earnings of future years are unchanged. However, when the estimated life increases (the value of the asset increases), the gain is not taken. Instead, the remaining book value of the asset is spread over the increased number of remaining years of the asset's life, reducing depreciation for those future years. The effect is to increase the earnings of the year of the gain and the earnings of future years by a fraction of the increase in asset value. Only a small fraction of the gain occurs in the earnings of the year of the gain.

To provide estimates of his conservatism measure Basu (1997) regresses annual earnings on stock returns of the same year. The R2 of this regression is predicted to be higher for a sample of firms with negative stock returns than for the sample of firms with positive returns. Likewise the coefficient of stock returns is predicted to be higher for the negative stock return sample. This latter prediction is illustrated by the full loss appearing in earnings in the year of loss in the estimated life example while only a fraction of the gain appears in earnings. If stock returns measured the gain or loss only then the coefficient would be one for the negative return sample and 1/n for the positive return sample (where n is the remaining life of the asset)

Consistent with the conservatism predictions, using US data, Basu (1997) finds that both the R2 and estimated coefficient of stock returns in a regression of a current period's earnings on stock returns are higher for samples of negative returns. Using variations on this methodology, the result has been replicated in other studies including, among others, Ball, Kothari and Robin (2000), Givoly and Hayn (2000), Holthausen and Watts (2001) and Pope and Walker (1999).''

Net asset measures [7]

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