Conservatism and Pensions: Why Accounting Matters

Pension accounting is anything but conservative since earnings can be protected from actuarial gains and losses. This paper shows that therefore conservatism measures based on models of the asymmetric relationship between earnings and positive versus negative stock returns are biased downwards. This is because unrecognized actuarial gains and losses are reflected in returns and are also asymmetric. The pension effect can be documented and corrected by adjusting earnings or by extending conservatism models. This finding offers a partial explanation of why large firms are less conservative since firm size and having defined benefit plans are positively correlated. Furthermore, extending conservatism models with dummy interaction terms can be used to parsimoniously estimate a firm-year measure of conservatism which takes the pension and possible other effects into account.