Abstract:
We show, analytically and empirically, that there is a positive correlation between
default risk and the Basu measure of conservatism: the higher the default risk, the higher
the bias in the Basu measure. We use the insight provided by our analysis to construct
an improved version of the Basu measure, the Default-Adjusted-Basu (DAB) measure.
The DAB measure adjusts for the effects of default risk on the Basu measure. Using
Distance-to-Default as a measure of default risk, we contend that the DAB measure
can substantially reduce the bias caused by default risk, and hence is a more robust
measure of accounting conservatism than the standard Basu measure. We demonstrate
that once one adjusts for the distance-to-default, the Basu conservatism coefficient is
no longer positively correlated with leverage.
