Exploring the nonlinear effect of conditional conservatism on the cost of equity capital: Evidence from emerging markets

In this study, we investigate the relationship between accounting conservatism and the cost of equity capital. Previous empirical studies examining this association use linear models that collectively resulted in a variety of contradictory outcomes. By combining existing theories in a new non-linear setting, we investigate the presence of a non-monotonic relationship between conservatism and the cost of equity capital for an international sample of public firms in 37 emerging countries during the period 2003-2012. Our findings present robust evidence suggesting a U-shaped, nonlinear relationship between accounting conservatism and the cost of equity capital. The same result holds for disaggregate measures of conservatism and other estimations techniques. The findings of this paper are in line with the theoretical framework of a “too-little-of-a-good-thing” effect, which indicates that the type of the association (negative or positive) depends on the level of conservatism. That is, the relationship is negative to an optimal point after which increasing the level of conservatism will increase the cost of equity capital. This paper sheds more light on the conservatism-cost of equity capital nexus and provides managers, investors, and policymakers with evidence to what extent conservatism is considered as beneficial or harmful.