The confounding effect of cost stickiness on conservatism estimates

- Sales change affects earnings and accruals asymmetrically because of sticky costs.
- Sales change is a correlated omitted variable that distorts conservatism estimates.
- Controlling for cost stickiness changes inferences in conservatism models.
- Cost stickiness biases estimates of standard proxies of demand for conservatism.
- How the sticky cost modification should be used depends on the research question.

Sales decreases affect earnings more than sales increases because of cost stickiness. We hypothesize that this correlated omitted variable constitutes a confounding effect in standard asymmetric timeliness models. Controlling for a piecewise linear effect of sales changes in these models decreases the measured asymmetric timeliness significantly and changes inferences about the average level of conservatism and the extent of cross-sectional variation in conservatism. Validation tests confirm that the asymmetry for sales changes is consistent with sticky costs and is distinct from conditional conservatism. Future empirical research on conditional conservatism should recognize the potential confounding effect of sticky costs.