The Link Between Earnings Conservatism and Balance Sheet...
Transcript of The Link Between Earnings Conservatism and Balance Sheet...
The Link Between Earnings Conservatism
and Balance Sheet Conservatism§
Jinhan Pae [email protected]
Phone: (613) 533-3065
Dan Thornton [email protected]: (613) 533-6194
Michael [email protected]
Phone: (613) 533-2317
Queen's University, School of Business Kingston, ON K7L 3N6
Canada
January, 2004
This draft is for presentation at the University of Waterloo by Mike Welker on January 30, 2004.
§ The authors gratefully acknowledge financial support from the Social Sciences and Humanities Research Council of Canada (Grant No. 410-03-1046) and Queen’s School of Business. They also appreciate receiving constructive suggestions and comments on previous versions of the paper from workshop participants at the University of Georgia (J.M. Tull School of Accounting), the University of Calgary, and Queen’s University. Particular thanks go to Linda Bamber, Benjamin Ayres, Steve Baginski, Bill Cannon, Peter Martin (Principal, Canadian Accounting Standards Board), Steve Salterio, Isabel Wang, George Wilson, the referees, and Gordon Richardson.
The Link Between Earnings Conservatism
and Balance Sheet Conservatism
Abstract
Defining earnings conservatism as the degree to which a firm’s earnings are more
timely in reflecting expected losses than gains in a given fiscal year, and balance sheet
conservatism as the firm’s market-to-book ratio at the beginning of the year, we
hypothesize and find: (1) Earnings conservatism is negatively associated with balance
sheet conservatism. (2) The negative link between earnings conservatism and balance
sheet conservatism is primarily due to the accrual component of earnings, not the
operating cash flow component of earnings. Since our hypotheses stem from Watts’
(2003) explanations for accounting conservatism, our results are consistent with his
explanations. Our results imply that incorporating the link between earnings conservatism
and balance sheet conservatism is essential if one uses earnings-returns associations to
investigate cross-sectional or time-series differences in earnings conservatism. To test
this implication, we revisit a prior study that inferred changes in earnings conservatism
over time but did not incorporate the link between earnings conservatism and balance
sheet conservatism in its research design. We find that including the link greatly enhances
the inferences available from that prior study.
Keywords: accounting conservatism; earnings; accruals; returns; market-to-book.
Data availability: The data used in this study are publicly available from the sources
indicated. A list of sample firms is available from the authors.
I. INTRODUCTION
The objectives of this paper are to document and explain the association between
earnings conservatism and balance sheet conservatism in US accounting over three recent
decades. We measure earnings conservatism as the degree to which a firm’s accounting
income reflects expected losses in a more timely fashion than expected gains in a given
fiscal year, and balance sheet conservatism as the firm’s market-to-book ratio at the
beginning of the year. Our measures stem from Watts’ (2003) definition of conservatism
as the differential verifiability required for recognizing profits versus losses.
Conservatism triggers the recognition of losses in earnings when they are probable but
defers the recognition of gains until they are verifiable. It also results in balance sheets
persistently understating the book value of net assets relative to their market values, since
it requires asset write-downs and liability accruals when expected cash flows decline but
generally prohibits upward valuations of assets or downward valuations of liabilities
when expected cash flows increase. Consistent with prior empirical conservatism
literature (Basu, 1997), our proxy for changes in expected gains or losses is realized
market returns to firms’ equity securities.
To provide conceptual support for our hypotheses, we review Watts’ (2003)
explanations for the existence of earnings conservatism. We then extend each explanation
to derive our hypothesized negative association between earnings conservatism and
balance sheet conservatism. Thus, the empirical corroboration we find for our hypotheses
lends support to Watts’ conservatism explanations, enhancing confidence in the
implications of our findings for future accounting research and standard setting.
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Contributions to the literature
In a large sample of US firms over three decades, we find that earnings are
generally conservative in the sense that the sensitivity of earnings to returns is greater for
“bad news firms” (those experiencing negative returns) than for “good news firms” (those
experiencing positive returns). Balance sheets are generally conservative in that both
mean and median market-to-book ratios exceed one. These findings are consistent with
prior studies reporting the existence of earnings conservatism (Basu, 1997) and balance
sheet conservatism (Givoly and Hayn, 2000).
We make two important contributions to the literature. First, we hypothesize and
find that earnings conservatism is negatively associated with balance sheet conservatism:
Firms with low balance sheet conservativism (i.e., low market-to-book ratios) evince
much greater earnings conservatism (i.e., a much greater positive difference between
earnings sensitivity to bad news and earnings sensitivity to good news) than those with
higher balance sheet conservatism. Second, we hypothesize and find that the accrual
component of earnings, but not the operating cash flow component of earnings, is more
conservative for firms with low balance sheet conservatism than for firms with higher
balance sheet conservatism. This is consistent with accruals instigating earnings
conservatism.
Our results imply that allowing for the negative association between earnings
conservatism and balance sheet conservatism in one’s research design can enhance
inferences about variations in earnings conservatism both across firms and over time. We
therefore revisit the results of Givoly and Hayn (2000), who report that both earnings
conservatism and market-to-book ratios generally increased in recent decades but do not
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allow for the negative association between earnings conservatism and balance sheet
conservatism. Estimating pooled earnings-returns regressions for six recent time periods,
we find that earnings conservatism increased much more for low than high market-to-
book firms, offsetting the negative effect of inter-temporal increases in market-to-book
ratios on overall earnings conservatism. However, earnings conservatism also increased
for firms with higher market-to-book ratios. We conjecture that this increase is due to
increases in the earnings conservatism embedded in the wording, application, and SEC
enforcement of accounting standards. These findings enhance the inferences one can
obtain from the Givoly-Hayn’s study.
Our results suggest that the degree of earnings conservatism observed is the
product of two factors. First, at any given time, accounting standards mandate an overall
level of earnings conservatism that accountants implement without regard to a firm’s
market-to-book ratio (e.g., they expense instead of capitalizing research and development
and advertising expenses). A second factor, explained in section III, is novel to this study.
Given an overall level of conservatism, accountants have incentives to be more
conservative—to increase the timeliness with which a given firm’s earnings reflect bad
versus good news—as balance sheet conservatism decreases. That is, earnings
conservatism is negatively associated with balance sheet conservatism across firms.1
1Richardson and Tinaikar (2003) distinguish between ex-ante and ex-post conservatism. Their notion of ex-post conservatism is consistent with our link between earnings conservatism and balance sheet conservatism. McCallig (2003) posits a mechanical link between earnings conservatism and balance sheet conservatism, termed “capitalization conservatism,” that is also consistent with our hypothesized link. According to McCallig, a firm’s financial statements are currently more sensitive to bad news if it previously capitalized a now-impaired asset, which it must now write down, than if it previously expensed an investment in research and development (R&D), because the immediate expensing of R&D already “assumed the worst.” This is also consistent with our hypothesized link. However, McCallig’s “capitalization conservatism” is only a subset of our negative association between earnings and balance sheet conservatism. Besides reflecting asset impairment, bad news can indicate the existence of unbooked
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The paper continues as follows. The next section defines conservatism, reviews
prior research motivating the study, and underscores its contributions to the literature.
Remaining sections develop the hypotheses, describe the research design, outline sample
selection, and present empirical results. We conclude with a summary of the findings and
suggestions for future research.
II. PRIOR RESEARCH AND MOTIVATION
Definition of conservatism
FASB’s Concepts Statement No. 2 defines accounting conservatism as a “prudent
reaction to uncertainty to try to ensure that uncertainty and risks inherent in business
situations are adequately considered” (FASB, 1982). Conservatism in practice generally
means that accountants “anticipate no profit, but anticipate all losses” (Bliss, 1924, cited
in Watts, 2003; Christensen and Demski, 2002). Anticipating profits means recognizing
profits before there is legal claim to the associated future cash flows generating them and
the revenues are verifiable (Watts, 2003). Conservatism does not imply that the firm must
receive cash flows before recognizing the associated revenues: accountants recognize
credit sales once the associated cash flows are verifiable. Rather, as the empirical
literature recognizes, conservatism is “the accountant’s tendency to require a higher
degree of verification to recognize good news as gains than to recognize bad news as
losses” (Basu, 1997, p. 7). Kwon et al. (2001) model conservative financial reporting in
the context of efficient contracting, with a manager subject to limited liability. Their liabilities (e.g., contingent lawsuits) or enhance the value of existing liabilities, leading to negative accruals in response to bad news. Section III of the paper explains that the accounting treatment of contingencies is also likely to foster a negative link between balance sheet conservatism and earnings conservatism. In addition, conservatism depends jointly on accounting rules and the rigor with which auditors and regulators enforce them. Section III shows that existing literature implies that auditors’ and regulators’ incentives to enforce earnings conservatism decrease with balance sheet conservatism.
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definition of conservatism (p. 35) “implies that the accounting system is more likely to
report ‘low’ when the outcome is low than to report ‘high’ when the outcome is high,”
consistent with a higher verification requirement for high outcomes (gains) than for low
outcomes (losses).
Examples of conservatism in generally accepted accounting principles (GAAP)
include the lower of cost or market convention, the expensing of research and
development costs and advertising costs, the recognition of post-retirement obligations
but not their attendant human assets, and write-downs of goodwill following impairment
testing but proscriptions against recognizing internally generated goodwill. Stronger
enforcement of GAAP by the United States Securities and Exchange Commission (SEC)
augments the degree of conservatism observed in practice. For example, Turner (2001)
and Vogt (2001) maintain that the strict revenue recognition criteria contained in SEC
Staff Accounting Bulletin 101 imply an extraordinary level of conservatism. In some
cases, the SAB 101 revenue recognition criteria require delaying recognition even when
revenues are verifiable, so that recognition is less timely than implied by contract law.
Prior studies and motivation
Basu (1997) assumes that current-year equity returns efficiently impound good
and bad news about firms’ expected future cash flows, and that conservative accounting
recognizes bad news in a timelier manner than good news in the income statement. This
implies the hypothesis that the slope coefficient in the regression of earnings on returns is
higher for firms reporting negative returns (“bad news firms”) than for those reporting
positive returns (“good news firms”). Confirming this hypothesis, Basu’s results are
consistent with the existence of earnings conservatism. Ball et al. (2000) extend this
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approach to infer cross-country differences in conservatism from differences in slope
coefficients in regressions of earnings on returns.
Hayn (1995) reports that the slope coefficient in a regression of returns on
earnings is much smaller⎯almost zero⎯for firms reporting losses (“loss firms”) than for
those reporting profits (“profit firms”).2 Since Hayn’s regression of returns on earnings is
the reverse of Basu’s (1997) regression of earnings on returns, her finding of a smaller
coefficient relating earnings to returns for loss firms is consistent with Basu’s finding of a
larger coefficient relating returns to earnings for bad news firms. Hence, the implications
of the results of the two studies are similar: To the extent that gains and losses impound
good and bad news reflected in market returns, the sensitivity of earnings to returns is
greater for bad-news/loss firms than for good-news/profit firms.
Feltham and Ohlson (1995, 1996) use the term “conservative accounting” to mean
that the expected market value of a firm’s equity exceeds the expected book value of its
equity in the long run. Thus, they see conservative accounting as a balance sheet as well
as an income statement phenomenon. Easton and Pae (2003) find that accounting is
conservative on average and suggest controlling for conservatism in valuation models if
market-to-book ratios are extremely low or high. To date, however, research has not
explicitly modeled nor empirically tested the link between earnings conservatism and
balance sheet conservatism. In the next section of the paper, we draw on Watts’
conservatism explanations to develop hypotheses concerning that link.
2 Hayn’s (1995) main interest is the impact of firms’ liquidation option on the relation between returns and earnings, not accounting conservatism.
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III. HYPOTHESIS DEVELOPMENT
Consistent with prior literature, our hypotheses rely on measures of earnings
conservatism inferred from cross sectional regressions of earnings on returns. In the
regression equation , the variable Xititttit RX εββ ++= 10 it represents firm i’s earnings,
accruals or operating cash flows for fiscal year t, deflated by the market value of equity at
the beginning of the fiscal year, i.e., the end of the fiscal year t–1. The variable Rit
represents the market rate of return on firm i’s common stock for the year ending three
months after firm i’s fiscal year ending during year t; and εit is assumed to be random
noise. The cross sectional regression coefficient β1t measures the timeliness with which
earnings, accruals, or cash flows reflect annual returns in a sample of firms whose fiscal
years end during year t. Our general approach is to estimate β1tGN (β1t
BN) in year t for
samples of firms reporting good (bad) news in that year.
Our measure of earnings conservatism is ct ≡ , the excess sensitivity of
earnings to bad versus good news for fiscal year t. Our hypotheses relate to the
association between c
GNt
BNt 11 ββ −
t and balance sheet conservatism, proxied by the market-to-book
ratio, Pt-1/Bt-1, where Pt-1 (Bt-1) represents the market (book) value of equity at the end of
fiscal year t–1. For brevity in the text of the paper, we refer to the latter as the P/B ratio,
suppressing subscripts.
We draw on Watts’ conservatism explanations to support three hypotheses (stated
in alternate form).
H1a: ct > 0 for all t. That is, earnings are conservative in all periods examined.
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H2a: With earnings as the dependent variable, ct is negatively associated with Pt-1/Bt-1. That is, earnings conservatism is negatively associated with balance sheet conservatism. H3a: With accruals as the dependent variable, ct is negatively associated with Pt-1/Bt-1. That is, accrual conservatism is negatively associated with balance sheet conservatism.
We expect our tests to support hypotheses 1 through 3; however, since
accountants implement earnings conservatism through the accrual component of
earnings, we do not expect the cash flow conservatism to be related to P/B. We
therefore state the fourth hypothesis in its null form.
H40: With operating cash flows as the dependent variable, ct is independent of Pt-1/Bt-1. That is, cash flow conservatism is not associated with balance sheet conservatism.
Conceptual support for hypotheses
Watts (1993, 2003) discusses alternative explanations for accounting
conservatism and their implications for accounting regulators. Other papers analytically
examine limited aspects of conservatism.3 However, the breadth of Watts’ less formal
examination suits our purposes because it covers all of the facets of conservatism
germane to our hypotheses. Watts gives four main explanations for conservatism:
contracting, shareholder litigation, regulation, and taxes. We educe support for our
hypotheses from each explanation, summarized below.
3 Kwon, Newman, and Suh (2001) analyze conservatism in a limited liability setting, in which conservative reporting forces accounting numbers into a “good news” region where contracting is not constrained by an assumption of limited liability. Gigler and Hemmer (2001), Gjesdal and Antle (2001), and Scott (1975) also address the demand for conservative accounting.
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Contracting
Accounting and auditing have long provided measures used in contracts
constraining managers from exceeding their decision rights in expending resources and
splitting returns among firm claimants (Holthausen and Leftwich, 1983; Watts and
Zimmerman, 1986). Verifiability of profits is essential to legal contracting because
contracts based on unverifiable accounting numbers are not enforceable. Contracts
relying on earnings numbers include management compensation agreements, debt
contracts, cost-plus contracts, and employment contracts.
Management compensation agreements
Watts (2003) explains that accounting conservatism in contracts efficiently
constrains managers’ tendency to have the firm make opportunistic payments to
themselves and other parties, such as shareholders. Managers with limited tenure have
incentives to inflate earnings to increase their bonus compensation and increase the value
of their stock options. Recovery of excess compensation payments and reparation for
losses due to a manager’s negative-net-present-value investments is difficult if the
manager leaves the firm before it realizes the associated cash flows. Thus, as Barclay et
al. (2000) argue, it is efficient for bonuses based on accounting income to reflect
“delivered performance” in a given period. Earnings conservatism facilitates delivered
performance measurement by deferring the recognition of gains until they are verifiable.
We hypothesize that earnings conservatism is negatively associated with the P/B
ratio in the context of management compensation contracts for the following reason. A
decrease in P/B signals a decline in a firm’s future growth opportunities. The decline in
growth opportunities increases managers’ preference for current versus deferred
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compensation because it reduces the expected present value of deferred compensation
based on future realized earnings. The reduction in the expected present value of deferred
compensation follows from an increase in the probability that either the firm will go
bankrupt or the managers will be fired during the deferral period. A decrease in P/B, then,
motivates managers to overstate current earnings to increase the value of their current
year bonus and stock option compensation. Overstatement of earnings, in turn, is likely to
involve not recording verifiable losses and/or recording unverifiable profits.
Watts (2003, note 3) points out that because verifiability is management
controlled, it is not effective to specify such biases a priori in contracts based on
accounting numbers. Rather, it is efficient for contractors to rely on the expectation that
accounting conservatism—the excess verifiability required to recognize gains versus
losses—will be greater in situations where managers have greater incentives to overstate
earnings. Mechanisms for increasing conservatism in this context include additional
scrutiny by the auditor and independent members of the board of directors.
Debt contracts
Debt covenants aim to restrict the firm from making unrecoverable payments to
shareholders and junior claimants (Leftwich, 1983). Like managers who receive excess
compensation payments, recipients of excessive dividend payments do not generally need
to return them to the firm in the event of future financial trouble. Debt covenants
generally limit dividend payments to “unrestricted” retained earnings calculated using
conservative accounting principles, compelling management to protect debt-holders by
maintaining, within the firm, assets with a given lower bound value. Absent such
restrictions, corporations could not borrow because management could distribute the
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assets to shareholders and, given limited liability, leave the creditors with nothing and no
way of recovering their loans. Debt covenants also restrict additional borrowing by
placing upper limits on firms’ debt/equity ratios. Absent such restrictions, corporations
would either be unable to borrow or need to pay excessive interest. Relying on
conservative book value measures, legislation governing corporations often reinforces the
protection of senior claim holders by mandating that “dividend distributions neither make
a company insolvent nor impair its capital,” (Murphy, 1992, p. 44).
We hypothesize that earnings conservatism is negatively associated with the P/B
ratio in the context of debt covenants for the following reason. As the P/B ratio decreases,
the probability of a firm defaulting on its obligations to senior claim holders increases
because the value of the firm’s expected future cash flows (reflected in the numerator)
decreases in relation to the principal amount of the debt. Following a decrease in P/B,
debt holders wish to tighten constraints on excessive payouts and additional borrowing.
The contractual constraints protecting debt holders against excessive payouts generally
refer to earnings (often before interest and taxes) based on generally accepted accounting
principles, not equity market-based earnings measures. The contractual constraints
protecting them against excessive additional borrowing generally refer to a maximum
allowed value of the debt/equity ratio based on a book value equity measure, not a market
value equity measure.
Earnings conservatism directly constrains dividend and compensation payouts
based on earnings. Earnings conservatism also triggers impaired asset write-offs and
recognition of unrecorded liabilities in the income statement, pushing the debt/equity
ratio closer to its maximum limit and tightening the constraint on additional borrowing. It
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is efficient for debt holders to rely on earnings conservatism increasing as P/B decreases,
offsetting managers’ increasing incentives to overstate earnings, overstate assets, and
understate liabilities.
Shareholder litigation
Watts (1993, 2003), Kothari et al. (1988), and Beaver (1993) maintain that
earnings conservatism reduces the expected present value of shareholder litigation costs
because shareholders are much more likely to litigate when earnings and net assets are
overstated than when they are understated.4 Overstatement facilitates shareholder
litigation in case stock prices later plummet because shareholders can point to the
overstatement of earnings or overvaluation of firms’ net assets as a pretext for suing the
firm, the firm’s auditors, and management to recoup their losses. Thus, managers and
auditors have incentives to report conservative values for earnings and net assets.
We hypothesize that earnings conservatism is negatively associated with P/B
ratios in the context of shareholder litigation for the following reason. As a firm’s P/B
ratio decreases, it becomes more likely that net asset carrying values exceed fair values.
Indeed, Statement of Financial Accounting Standards No. 142 (FASB 2001) mandates
goodwill impairment write-downs when the book value of a reporting unit’s equity
exceeds the market value of equity.5 As P/B declines, the probability of shareholder
litigation increases because it becomes easier for shareholders to substantiate claims that
4 Kellogg (1984) finds that the number of security buyers’ lawsuits against auditors and firms greatly exceeds the number of sellers’ lawsuits. During the period Kellogg examines, the ratio of the number of buyers’ lawsuits to the number of sellers’ lawsuits is 13 to one.
5 Paragraph 23 of Statement of Financial Accounting Standards No. 142 (FASB 2001) states “… the fair value of a reporting unit refers to the amount at which the unit as a whole could be bought or sold in a current transaction between willing parties. Quoted market prices in active markets are the best evidence of fair value and shall be used as the basis for the measurement, if available.”
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assets are misleadingly overvalued. Moreover, the likely magnitude of claimed damages
increases because investors can claim that asset carrying values are farther below fair
values. Hence, to reduce expected litigation costs, it is efficient for both auditors and
managers to increase the degree of earnings conservatism as P/B decreases.
Regulation
Watts (1977) argues that investor losses from overvalued assets and overstated
earnings are more observable and usable in the political process than forgone gains due to
undervalued assets or understated earnings. For example, some commentators blamed
non-conservative accounting for the overvaluation of New York Stock Exchange stocks
in 1929 (Benston 1969). Thus, standard-setters have incentives to set conservative GAAP
and regulators like the SEC have incentives to enforce GAAP in a conservative fashion.
After releasing Staff Accounting Bulletin 101, a response to investor losses relating to
revenue recognition abuses during the dot-com boom, the SEC began enforcing
extremely conservative revenue recognition rules (Vogt, 2001). Following recent
accounting debacles, particularly the bankruptcy of Enron in December 2001, FASB
(2003) proposed more conservative accounting rules for recognizing earnings, assets, and
liabilities related to special-purpose entities.
We hypothesize that earnings conservatism is negatively associated with P/B
ratios in the context of regulation for the following reason. Low P/B ratios imply poor
future prospects for companies and are consistent with recent declines in values having
occurred, making it likely that investors will blame regulators for permitting misleading
accounting practices. Thus, both the wording and required implementation of many
accounting standards imply a negative association between earnings conservatism and the
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P/B ratio. Accounting for inventory is generally at the lower of cost or market. Since P
reflects inventory market values and B reflects inventory costs, the probability of
inventory write-downs is negatively associated with P/B by construction. Similarly, asset
impairment write-downs are likely to occur when asset book values (B) exceed expected
future cash flows (reflected in P). SFAS 142 recently mandated goodwill impairment
write-downs if book value exceeds fair value, replacing an earlier standard requiring
goodwill amortization. Interestingly, Watts (2003) does not view SFAS 142 as a
conservative standard. He states, “…future cash flows are unlikely to be verifiable and
contractible…they, and valuation based on them, are likely to be manipulated.
Conservatism does not allow the use of such measures.” However, because SFAS 142
mandates price/book comparisons as goodwill impairment triggers, we still expect to
observe earnings conservatism being negatively related to P/B in the implementation of
the standard.
SFAS 5 (FASB 1975) mandates contingent loss recognition when the losses are
probable, but generally prohibits contingent gain recognition.6 Thus, the standard
mandates earnings conservatism for any P/B ratio; however, it also results in a negative
association between conservatism and P/B because the market value of equity reflects an
expected loss as a continuous function of the probability of loss. A declining P/B ratio
6 Paragraph 8 of SFAS No. 5 states “An estimated loss from a loss contingency…shall be accrued by a charge to income if both of the following conditions are met: a. Information available prior to issuance of the financial statements indicates that it is probable that an asset had been impaired or a liability had been incurred at the date of the financial statements…b. The amount of loss can be reasonably estimated.” With respect to gains, in contrast, paragraph 17 states “…a. Contingencies that might result in gains usually are not reflected in the accounts since to do so might be to recognize revenue prior to its realization. b. Adequate disclosure shall be made of contingencies that might result in gains, but care shall be exercised to avoid misleading implications as to the likelihood of realization”.
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therefore reflects an increasing probability of loss, eventually triggering recognition in
earnings.7
Taxes
Links between income taxation and financial reporting can enhance earnings
conservatism (Watts, 2003; Smith and Watts, 1982; Watts and Zimmerman, 1979).
Guenther et al. (1997) and Shackelford and Shevlin (2001) suggest that taxes provide
incentives for firms to conform reported accounting income to tax incentives because
court decisions on reporting methods serve as precedents for tax methods and IRS
behavior. Thus, there are incentives for profitable firms with taxable income to defer
income to reduce the present value of taxes.
Links between the P/B ratio and tax-driven earnings conservatism are less clear
than those between the P/B ratio and conservatism relating to contracting, shareholder
litigation, and regulation. For example, managers have incentives to increase reported
income to increase their bonuses but decrease reported income to save corporate taxes;
however, it is unclear how declines in P/B affect the tradeoff.8 Consequently, we limit our
analysis of the implications of Watts’ (2003) conservatism explanations to contracting,
litigation, and regulation. 7 Paragraph 3 of SFAS No. 5 states, “When a loss contingency exists, the likelihood that the future event or events will confirm the loss or impairment of an asset or the incurrence of a liability can range from probable to remote. This Statement uses the terms probable, reasonably possible, and remote to identify three areas within that range…” Accountants would accrue the loss when they judged the probability to change from reasonably possible to probable.
8 On the one hand, as the P/B ratio increases, shareholders can better afford to have the firm sell stock at high earnings multiples to finance the firm’s tax bill, decreasing any pressure on managers to reduce taxable income at the expense of their bonuses. This supports the hypothesized negative association between earnings conservatism and the P/B ratio. On the other hand, if increases in P/B are associated with increases in product prices leading to the adoption of conservative LIFO inventory accounting, tax-driven earnings conservatism is positively associated with the P/B ratio. We would need to collect and analyze firm-specific tax and compensation parameters to make directional predictions. This investigation is beyond the scope of the present study.
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Summary of conceptual support for hypotheses
In summary, Watts’ (2003) contracting explanation for conservatism implies that
earnings conservatism is negatively associated with P/B because a decline in P/B
enhances junior claim holder incentives to overstate earnings in order to garner excessive
earnings-linked payouts. Thus, senior claim holders demand more earnings
conservatism—i.e., a greater amount of differential verification for the recognition of
gains versus losses—as P/B declines. Watts’ shareholder litigation explanation implies
that earnings conservatism is negatively associated with P/B because expected
shareholder litigation costs increase as P/B decreases, making it efficient for both auditors
and managers to increase earnings conservatism. Finally, Watts’ regulation explanation
implies that earnings conservatism is negatively associated with P/B because lower P/B
ratios imply poorer future prospects for companies and are consistent with recent declines
in values having occurred, making it more likely that investors will blame regulators for
allowing companies to record inflated earnings and net asset values. Thus, both the
wording and implementation of many accounting standards imply a negative association
between earnings conservatism and the P/B ratio, and SEC enforcement incentives
enhance this association.
IV. DATA AND DESCRIPTIVE STATISTICS
We compute annual stock returns (R) for years ending three months after firms’
fiscal yearends by compounding CRSP monthly stock returns. Earnings, components of
earnings, and other variables come from COMPUSTAT. Earnings (NI) are the bottom
line number in the income statement (COMPUSTAT #172). Accruals (ACC) are the
change in non-cash and non-debt working capital (∆#4 - ∆#1 - ∆#5 + ∆#34) plus
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depreciation (#14). Operating cash flows (OCF) are the difference between earnings and
accruals. If cash flow statements are available, we obtain operating cash flows directly
from them (#308), and compute accruals as the difference between earnings and
operating cash flows.9 We deflate earnings, operating cash flows, and accruals by the
beginning-of-year equity market value. To mitigate the effect of extreme observations,
we delete observations in the top and bottom percentiles of earnings, operating cash
flows, accruals, and stock returns. We also delete observations with negative equity book
value. The resulting sample contains 119,983 firm-year observations from 1970 through
2001.
Insert Table 1
Panel A of Table 1 gives descriptive statistics for the full sample. The median
annual stock return is 4 percent; median earnings are 6 percent of beginning-of-year
equity market value. Median accruals are negative; median operating cash flows are
positive. The median P/B ratio, 1.61, indicates that most balance sheets are conservative.
We partition the sample into a group of 65,044 firms with non-negative annual
stock returns (“good news” firms) and a group of 54,939 firms with negative annual stock
returns (“bad news” firms). Panels B and C give descriptive statistics for the good and
bad news sub-samples, respectively. Median annual stock returns are 31 percent (minus
26 percent) for the good (bad) news firms. On average, compared with bad news firms,
good news firms have greater market capitalization, annual sales, earnings, and operating
cash flows. Good and bad news firms exhibit no difference in accruals, however. Thus,
9 As described later, we repeat all our testing using only post-1987 data, so that cash flow data are directly available from cash flow statements. Results are qualitatively similar.
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the absolute values of accruals are greater in proportion to earnings and operating cash
flows for bad news firms than for good news firms.
Insert Table 2
Table 2 gives Pearson and Spearman correlations among selected variables. In
Panel A, annual stock returns are positively associated with earnings and operating cash
flows but unassociated with accruals. Consistent with prior studies, operating cash flows
are negatively correlated with accruals. Panels B and C show that the correlations
between the variable R and the variables NI, ACC, and OCF are significant but very
small for good news firms, but are significant and much larger for bad news firms. This
pattern suggests that the high correlations between returns and earnings or operating cash
flows for the bad news firms are largely responsible for similarly high correlations in
Panel A for the full sample. Correlations between returns and accruals are positive for
bad news firms (0.077) but negative for good news firms (–0.028). This finding is
consistent with the idea that accruals enhance the recognition bad news in earnings but
tend to smooth earnings when there is good news. The stronger negative Pearson
correlation coefficient between operating cash flows and accruals in the good news
sample (–0.741) than in the bad news sample (–0.535) is also consistent with this idea.
Good (bad) news firms’ earnings are more highly correlated with operating cash flows
(accruals) than with accruals (operating cash flows).
V. RESEARCH DESIGN
As section III outlined, our measure of the timeliness with which earnings,
accruals, or cash flows reflect annual returns in a sample of firms in year t is the
coefficient β1t in the cross sectional regression . In this regression ititttit RX εββ ++= 10
19
model, Xit represents firm i’s earnings, accruals, or operating cash flows for the fiscal
year ending at time t, deflated by the market value of equity at the end of fiscal year t–1;
Rit represents firm i’s annual stock returns for the year ending three months after t. Our
conservatism measure is ct ≡ , where βGNt
BNt 11 ββ − 1t
BN (β1tGN) is the slope coefficient in the
regression of earnings, accruals, or operating cash flows on returns for bad (good) news
firms. That is, we measure earnings conservatism as the difference between the slope
coefficients for bad and good news firms. Prior studies use other conservatism measures:
Givoly and Hayn (2000) use the ratio of bad news slopes to good news slopes to measure
conservatism; Basu (1997) compares regression R2 for bad and good news firms to infer
conservatism.
We do not use R2 because both timeliness and dependent variable measurement
error affect R2. Absorbed in the regression disturbance term ( ), dependent variable
measurement error decreases R
itε
2 but does not affect slope coefficient estimation (Greene,
1990). We expect that earnings contain more measurement error for bad news firms
because, by definition, conservative accounting recognizes bad news to a greater degree
than good news. In cross section, if the same contingent liability affected a group of bad
news firms, the liability accrued would differ across firms because accountants would
differ in their judgment of whether the occurrence of the contingency was probable or
reasonably possible.10 However, if the same contingent asset affected a group of good
news firms, all firms would accrue nothing. In a reverse regression context, these two
effects counteract each other in R2: Increased timeliness increases the slope but the
10 See footnote 7.
20
measurement error associated with making timely accruals decreases R2. We therefore
focus on slope coefficients rather than R2.
We examine the difference between slope coefficients in sub-samples of bad and
good news firms rather than their ratio for three reasons:
1) Differences in sensitivities to good and bad news relate to the structure of accounting
standards, auditor behavior, and SEC enforcement. Under conservative accounting,
accountants write off more absolute dollars in response to bad news than good news.
They do not accrue “ten times more dollars” in response to bad news than good news.
That is, if an asset is impaired and worth zero dollars, accountants write off the whole
carrying value; if it is worth half its carrying value, they write off half the carrying
value, but they still write off the dollar amount of the impairment without referring to
how much good news they are recognizing in earnings.
2) Because we must partition the sample in many different ways to test our hypotheses,
ratios pose practical difficulties that did not affect prior studies: In some sub-samples,
slope coefficients are negative, so ratio measures are not meaningful. In other sub-
samples, slope coefficients are insignificantly different from zero. Any ratio measure
involving such measures would then be noise, but the difference between a significant
coefficient in one subsample and a coefficient that is insignificantly different from
zero in another subsample is still a significant difference.
3) Small, insignificant coefficients dramatically influence ratios of coefficients but not
differences between coefficients.
Insert Table 3
21
VI. HYPOTHESIS TESTS
H1a: Earnings are conservative in all periods examined.
Table 3 contains the results of annually regressing earnings on returns from 1970
to 2001 for good and bad news firms. It also reports mean coefficient estimates and mean
adjusted R2s. Consistent with Basu (1997), the sensitivity coefficient estimates are greater
for bad than good news firms (i.e., ) in all 32 periods. The mean of the 32
coefficient estimates is much higher for bad news firms than for good news firms. The
mean difference between the bad and good news coefficients is 0.279, with a highly
significant t-statistic of 12.5. These results strongly support H1
GNBN11 ββ >
a: Earnings are
conservative in all periods examined, i.e., earnings recognize bad news in a timelier
fashion than good news.
Insert Tables 4 and 5
H2a: Earnings conservatism is negatively associated with balance sheet conservatism
Table 4 gives descriptive statistics for key variables after allocating firm-year
observations to five portfolios based on the beginning-of-year P/B ratio. We allocate
firms with P/B ratios less than one to Portfolio I (16,226 observations) and Portfolio II
(16,227 observations). Similarly, we allocate to Portfolios III through V the remaining
firms with P/B ratios greater than or equal to one. Each of Portfolios III through V
contains about 29,200 firm-year observations. Because of this allocation procedure, each
portfolio contains good and bad news observations in different proportions: the
proportion of bad news firm-years tends to increase with the P/B ratio as one goes from
22
Portfolio I to V. However, within each portfolio, the average P/B ratios of good and bad
news observations are about the same.
Table 2 showed that good news firms are generally larger (as measured by total
market capitalization) than bad news firms; Table 4 shows that this is so for all five P/B
portfolios. Firm size also increases with the P/B ratio as one goes from Portfolio I to
Portfolio V. This implies that increases in P/B ratios are not due merely to low equity
book values.
In Table 5, for each of the five P/B portfolios, we estimate the sensitivities of
earnings, accruals, and cash flows to good and bad news. The regression coefficients
β1GN (β BN
1 ) reflect dependent variable sensitivities to good (bad) news in each of the five
portfolios. We measure earnings conservatism in each portfolio as the difference between
the sensitivities to bad and good news, , i = I, II…V. GN(i)1
BN(i)1 ββ −≡ic
Panel A estimates overall earnings conservatism in the five portfolios. As
hypothesized, earnings conservatism increases monotonically as the P/B ratio declines
through portfolios V (high P/B) to I (low P/B). Each increase is individually significant
except the increase occurring between portfolios II and I, both of which contain
observations with P/B less than one. For the portfolio I (V), the lowest (highest) P/B
portfolio, the earnings conservatism measure is 0.542 (0.152). The difference between the
conservatism measures in these extreme portfolios is 0.390 with a t-statistic of 7.92.
These results strongly support H2a: earnings conservatism is negatively associated with
P/B.
23
H3a: Accrual conservatism is negatively associated with balance sheet conservatism.
The dependent variables in Panels B and C are the accrual and cash flow
components of earnings. By construction, for a given sub-sample of firm-years, the slope
coefficient relating earnings to returns is the sum of the corresponding coefficient relating
operating cash flows to returns plus that relating accruals to returns. This breakdown
affords an assessment of the relative contribution of accruals and operating cash flows to
the overall relation between earnings and returns.
Reflecting the fact that conservatism is primarily an accrual accounting
phenomenon, H3a is that accrual conservatism is negatively associated with P/B.
Consistent with H3a, accrual conservatism increases monotonically as the P/B ratio
declines in P/B portfolios V through I. Each increase is individually significant except the
increase that occurs between portfolios III and II, the break point between observations
with P/B greater than or equal to one and P/B less than one. For portfolio I (V), the
lowest (highest) P/B portfolio, the accrual conservatism measure is 0.361 (0.020). The
difference between these measures is 0.341, with a t-statistic of 5.47. In portfolio V, the
highest P/B portfolio, the conservatism measure is insignificantly positive. Moreover, for
the good news firms, three of the five sensitivity coefficients β1GN(i), i = I, II,…V are
negative and none of the five is statistically significant. For the bad news firms, all of the
five sensitivity coefficients β1BN(i), i = I, II,…V are positive and all but the coefficient in
the highest P/B portfolio are statistically significant. This pattern accounts for the fact
that all of the conservatism measures, which are differences between the sensitivity
coefficients for bad and good news portfolios, are significant except the one in portfolio
24
V, the highest P/B portfolio. These results strongly support H3a: accrual conservatism is
negatively associated with P/B.
H40: Cash flow conservatism is not associated with balance sheet conservatism.
Panel C contains the regression results with operating cash flows as the dependent
variable. The conservatism measures, , i = I, II…V, are positive and
significant in all five portfolios. However, c
GN(i)1
BN(i)1 ββ −≡ic
is unrelated to P/B. None of the changes in cii
is statistically significant as one goes from portfolio V (highest P/B) through I (lowest
P/B). Indeed, the changes are not even consistently positive: cash flow conservatism
decreases along with a decrease in P/B as one goes from portfolio II to portfolio I. For
portfolio I (V), the lowest (highest) P/B portfolio, the cash flow conservatism measure is
0.180 (0.132). The difference between these measures is 0.048 with an insignificant t-
statistic of 1.04. These results do not reject H4o: cash flow conservatism is unrelated to
balance sheet conservatism.
The result that cash flow conservatism is positive (though unrelated to P/B)
simply means that operating cash flows are more sensitive to bad news than good news.
Inverting this result, one can argue that negative returns are less persistent with respect to
cash flows than positive returns are with respect to cash flows. Although this is not the
focus of the paper, we conjecture that the result is due to firms’ real option to abandon
operations when the projected net present value of staying in a particular line of business
is negative (Hayn 1995).
Insert Figure 1
25
Summary of hypothesis test results
Figure 1 summarizes the results of our hypothesis tests, plotting the conservatism
coefficients , i = I, II…V, in each P/B group, for overall earnings
(H2
GN(i)1
BN(i)1 ββ −≡ic
a), accruals (H3a), and operating cash flows (H40). The figure shows graphically why
the results fail to reject H40, but suggest that both overall earnings conservatism and
accrual conservatism are negatively associated with balance sheet conservatism. The
accrual component of earnings accounts for 87 percent (0.341/0.390 × 100) of the
difference in earnings conservatism between the low and high P/B portfolio; the cash
flow component of earnings accounts for only 13 percent of this difference.
Insert Table 6
Additional support for hypotheses
Table 6 contains 2 × 2 partitions of sample observations. Aiming to enhance the
interpretation of the hypothesis tests above, we allocate observations to the groups that
are most and least likely to display earnings conservatism, partitioning along two
dimensions—the level of accruals and the size of the P/B ratio. We expect that low-
accruals, low-P/B firms exhibit the most earnings conservatism and high-accruals high-
P/B firms the least, if any, earnings conservatism.
Results summarized in panels A (earnings), B (accruals), and C (cash flows)
largely confirm these expectations. Panel A reveals that c, the difference between the bad
news and good news slope coefficients with earnings as the dependent variable is greatest
(0.630 – 0.050 = 0. 580) when both P/B and accruals are low and is the least when both
are high (0.146 – 0.015 = 0.131). The difference between earnings conservatism in the
26
low P/B, low accrual portfolio and earnings conservatism in the high P/B, high accrual
portfolio is 0.449 (i.e., 0.580 – 0.131); this difference is highly significant, with a t-
statistic of 10.83.
Panels B and C reinforce the results from Table 5, that earnings conservatism
stems chiefly from the accrual component of earnings, not the cash flow component. In
Panel B, with accruals as the dependent variable, accrual conservatism for the low P/B,
low accrual firms is 0.331 (i.e., 0.278 – [–0.053]) versus – 0.048 (i.e., –0.024 –0.024) for
the high P/B, high accrual firms. The difference between accrual conservatism for the
low P/B, low accrual firms and accrual conservatism for the high P/B, high accrual firms
is 0.379 (i.e., 0.331 – [–00.048]); again this difference is highly significant, with a t-
statistic of 9.70.
In Panel C, with operating cash flows as the dependent variable, the conservatism
measure is more similar for the low P/B, low accrual firms (0.352 – 0.103 = 0.249) and
the high P/B, high accrual firms (.171 – [–0.008])=0.179) than it was in Panels A and B.
The difference in cash flow conservatism between the low P/B, low accrual firms and the
high P/B, high accrual firms is only 0.070 (i.e., 0.249 – 0.179). Although this difference
in conservatism between the low P/B, low accrual portfolio and the high P/B, high
accrual portfolio is small compared with the corresponding differences in Panels A and
B, the t-statistic of 2.47 is significant at conventional levels. Accruals account for 84
percent (i.e., 0.379/0.449 × 100) of the overall earnings conservatism difference between
these two extreme portfolios; cash flow conservatism accounts for only 16 percent (i.e.,
0.070/0.449 × 100) of the conservatism difference.
27
Summary of contribution
In summary, our results are consistent with Basu’s (1997) finding that earnings
are conservative, i.e., earnings are more strongly associated with returns for bad news
firms than for good news firms. However, we make two new contributions to the
literature. First, earnings conservatism is negatively associated with balance sheet
conservatism. Second, earnings conservatism’s negative association with P/B is primarily
an accrual phenomenon, not a cash flow phenomenon. These results are intuitively
appealing because accruals are the mechanism for implementing earnings conservatism.
We conjecture that the results have important implications for any time-series or cross-
sectional (across firms, industries or countries) examination of conservatism. In the next
section, we present some preliminary evidence confirming this conjecture.
VII. ASSESSING CHANGES IN EARNINGS CONSERVATISM OVER TIME:
GIVOLY AND HAYN REVISITED
Our main results imply that one must control for changes in balance sheet
conservatism in order to infer changes in earnings conservatism over time. To test this
conjecture, we extend Givoly and Hayn (2000) by estimating equation (1) below, which
has the same form as theirs, and equation (2) below, which incorporates P/B to capture
the effect of P/B on earnings conservatism:
(1) itititititit RDRDX εββββ +×+++= 3210
ititit
itititititit
RPBDRPB
PBDPBRDRDX
εββ
ββββββ
+××+×+
×++×+++=
)()(
)()(
76
543210 (2)
28
In these equations, Xit represents net income deflated by the beginning-of-year equity
market value; Rit is annual stock returns for the year ending three months after fiscal
period end; Dit is an indicator variable taking the value 1 (0) when annual stock returns
are negative (non-negative). PB is a dummy variable taking the value 1 (0) when P/B is
less than (greater than or equal to) one. Thus, the coefficient β3 is a measure of
conservatism for firms with P/B greater than or equal to one; β7 is a measure of the extra
conservatism exhibited by firms with P/B less than one.
Givoly and Hayn estimate equation (1) over five-year intervals from 1950-1988,
concluding that earnings conservatism increased over that period. They also report (in
their Figure 4) an initial decline in P/B, then an increase, which they attribute to
increasing earnings conservatism that accumulates to manifest itself in balance sheet
conservatism. However, they do not explore the link between the two results. Given
rising P/B ratios, all else being equal, we expect earnings conservatism to fall, not rise. Of
course, other factors influencing conservatism also changed over the period. For example,
an increase in litigiousness or an increase in the conservatism built into GAAP could also
account for an observed increase in overall earnings conservatism. The examination of
such factors is beyond the scope of both their paper and ours. Still, in not controlling for
P/B, we conjecture that Givoly and Hayn underestimate the full extent of the increase in
earnings conservatism over time. Since the proportion of firms with low P/B must have
declined over Givoly and Hayn’s sample period, there are two explanations for the
overall increase in earnings conservatism.
1) Timeliness of the recognition of bad news for the firms that did have low P/B ratios
increased dramatically.
29
2) Earnings conservatism for all firms, whatever the level of P/B, increased
dramatically.
The explanations are not mutually exclusive.
Insert Table 7 and Figure 2
Table 7 and Figure 2 present the results of estimating pooled regressions using the
constant sample of 788 firms that existed throughout our 1970-2001 test period.11 To
determine how earnings conservatism evolved for low and high P/B firms, we estimate
the two equations above for six sub-periods, each of which contains five years except the
first and last sub-periods, 1970-75 and 1996-2001, which contain six years. The main
results of this analysis are:
1) In equation (1), like Givoly and Hayn, we find that β3, representing the overall level
of earnings conservatism, generally increases until 1990. However, consistent with
Ryan and Zarowin (2003), we find that the overall level of earnings conservatism is
less in the 1996-2001 period than it is in the prior periods; it does not continue to
increase as the Givoly and Hayn pattern might suggest.12
2) In equation (2), β3, the coefficient on D × R representing conservatism for firms with
P/B greater than or equal to one, also increases until 1990 then declines. This pattern
is similar to the general pattern observed in equation (1).
3) In equation (2), for the full sample period and across each sub-period, β7, the
coefficient on D × PB × R representing the extra conservatism for firms with P/B less
11 We impose this restriction for comparability with the analysis in Givoly and Hayn. However, relaxing this constraint and estimating equations 1 and 2 using the full sample do not affect our inferences.
12 Ryan and Zarowin (2003) speculate that the recent decline in conservatism may be due to the passage of the Private Securities Litigation Reform Act of 1995.
30
than one, is highly significant and is generally two to three times larger than β3 in
either equation (1) or equation (2).
4) In equation (2) the coefficient β7 increases monotonically from the 1970-1975 to the
1991-1995 period; β7 increases more consistently with time than β3 in either equation
(1) or (2), which declines in one or two of the sub-periods.
In sum, the negative association between earnings conservatism and P/B accounts for a
very significant proportion of any changes in overall earnings conservatism observed in
the past three decades. The increase in the negative association between earnings
conservatism and P/B is also largely responsible for Givoly and Hayn’s finding that
earnings conservatism increased up to 1988 despite the fact that P/B ratios generally
increased.
VIII. TESTS FOR ROBUSTNESS AND EXAMINATION OF ALTERNATE EXPLANATIONS FOR RESULTS
We compute annual stock returns for the year ending three months after the fiscal
yearend in order to ensure that all accounting information is available before the
beginning of the return period. As an additional check, we repeat the tests using annual
stock returns calculated for the fiscal period. The results (not reported) are robust to the
choice of the return period.
Hribar and Collins (2002) note that using balance sheet data to calculate accruals
and cash flows introduces measurement error for firms involved in acquisitions or
divestitures. To ensure that our results are not sensitive to the use of balance sheet data to
calculate accruals, we repeat our tests using only post-1987 data obtained directly from
cash flow statements. The results are qualitatively similar.
31
Because we rely on market returns incorporating good and bad news, market
efficiency is a maintained assumption in this study. Fama and French (1992) report a
strong negative cross-sectional association between P/B and security returns, concluding
that it is unclear whether this association reflects rational pricing of risk related to P/B or
market mis-pricing.13 Even if the P/B effect of Fama and French represented mis-pricing,
however, it is likely that this would bias our tests against, not in favor of, finding the
hypothesized effects. Suppose that low P/B firms are systematically under-priced. When
the market later corrects this mis-pricing, triggering higher returns in subsequent periods,
security returns measure the news of the period with error for low P/B firms. This
measurement error would attenuate, not increase, the observed sensitivity of earnings to
returns for low P/B firms. Thus, we maintain that market inefficiency is not a viable
alternate explanation for our results.
IX. CONCLUSIONS, LIMITATIONS, AND FUTURE RESEARCH
Defining earnings conservatism as the degree to which a firm’s accounting
income reflects expected losses in a timelier fashion than expected gains in a given fiscal
year, and balance sheet conservatism as the firm’s market-to-book ratio at the beginning
of the year, we hypothesize and find: (1) Earnings conservatism is negatively related to
balance sheet conservatism. (2) The link between earnings and balance sheet
conservatism is primarily due to the accrual component of earnings, not the operating
cash flow component of earnings. Besides being consistent with the hypotheses, this
13 Fama and French (1993) express their findings in terms of a positive association between B/P (the book-to-market ratio) and later returns. This of course implies a negative association between P/B and later returns.
32
second finding confirms the intuition that accruals are the mechanism for instigating
earnings conservatism.
Since our hypotheses stem from Watts’ (2003) conservatism explanations, our
results are consistent with his explanations. Our results are also consistent with Watts’
contention that, because verifiability is management controlled, it is not effective to
attempt to specify conservative accounting biases a priori in contracts based on
accounting numbers. Rather, it is efficient for contractors to rely on the expectation that
accounting conservatism—the excess verifiability required to recognize gains versus
losses—will be greater in situations where managers have greater incentives to overstate
earnings. Since managers’ incentives to overstate earnings increase as the price-to-book
ratio decreases, our finding that earnings conservatism is negatively associated with the
price-to-book ratio is consistent with Watts’ contention. Mechanisms for increasing
conservatism in this context include additional scrutiny by the auditor and independent
members of the board of directors.
Both Watts’ contention and our findings are consistent with FASB Concepts
Statement No. 2’s description of conservatism as “a prudent reaction to uncertainty, to try
to ensure that uncertainties and risks inherent in business situations are adequately
considered” (FASB 1980, paragraph 95, emphasis added). Since a decline in the price-to-
book ratio is a change in a firm’s business situation that is likely to motivate
overstatements of earnings and net assets under uncertainty, increased conservatism is a
prudent reaction to such a change that enhances the usefulness of accounting information.
Consistency with Watts’ conceptual perspective and the FASB’s description of
33
conservatism in its Concepts Statement greatly enhances confidence in the interpretation
of our findings and their implications.
Our results indicate that incorporating the link between earnings conservatism and
balance sheet conservatism is essential if one uses earnings-returns associations to
investigate cross-sectional (e.g., across industries or across countries) or time-series
differences in earnings conservatism. To perform a preliminary test of this important
implication of our findings, we revisit a previous study that inferred changes in earnings
conservatism over time but did not incorporate our newly reported link in the research
design. We find that incorporating the market-to-book in the research design greatly
enhances the inferences from that prior study.
Future research could fruitfully build on our results by examining the effects of
recent accounting pronouncements that purport to enhance the degree of conservatism
embedded in generally accepted accounting principles. For example, the SEC recently
enforced more conservative revenue recognition rules. The FASB recently proposed more
conservative accounting for special purpose entities in both the income statement and the
balance sheet, and mandated impairment testing for goodwill triggered by market/book
comparisons. Because these institutional changes respond to demands for increased
earnings conservatism to counteract managerial opportunism, we expect that they not
only increased earnings conservatism generally, but also increased the negative
association between earnings conservatism (especially accrual conservatism) and balance
sheet conservatism.
Another potentially fertile extension of our results lies in incorporating the
market-to-book ratio in research testing the impact of changes in the degree of
34
litigiousness on earnings conservatism, and its negative association with balance sheet
conservatism, at decisive points such as the institution of class action suits in the U.S.
Future research could also compare earnings conservatism across countries with tests that
allow for cross-country variation in the relation between earnings conservatism and
balance sheet conservatism. We conjecture that variation across countries in the
institutional features that give rise to conservatism (such as legal systems, insider trading
regulations, and accounting standard setting mechanisms) also results in cross-country
variation in the association between earnings conservatism and balance sheet
conservatism.
35
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Watts, R.L. 1977. Corporate financial statements, a product of the market and political processes. Australian Journal of Management 2 (April): 53-75.
________. 1993. “A Proposal for Research on Conservatism.” Working Paper, University of Rochester, presented at the American Accounting Association convention, August.
________ . 2003. “Conservatism in Accounting: Explanations and Implications” Bradley Policy Research Center Financial Research and Policy Working Paper No. FR 02-21, University of Rochester, May. Forthcoming, Accounting Horizons.
________. and J.L. Zimmerman. 1979. The demand for and supply of accounting theories: The market for excuses. The Accounting Review 54 (April): 273-305.
________. 1986. Positive Accounting Theory, Prentice-Hall, Englewood Cliffs, NJ.
38
Table 1: Descriptive Statistics of Key Variables
Panel A: Full Sample – 119,983 observations
Variable Mean Standard Deviation
First Quartile Median Third
Quartile Min Max
R 0.12 0.58 -0.23 0.04 0.34 -0.97 8.39 NI 0.03 0.20 -0.01 0.06 0.11 -2.46 0.98
ACC -0.09 0.23 -0.14 -0.04 0.01 -3.61 1.17 OCF 0.11 0.23 0.00 0.09 0.20 -1.25 3.34 MV 1,114.29 7,322.57 16.92 69.47 358.05 0.06 467,096
Sales 1,045.27 4,917.51 25.35 104.07 447.47 -203.75 217,799 P/B 3.82 60.65 0.96 1.61 2.90 0.03 10,474
Panel B: Good News (non-negative returns) – 65,044 observations
Variable Mean Standard Deviation
First Quartile Median Third
Quartile Min Max
R 0.47 0.56 0.14 0.31 0.61 0.00 8.39 NI 0.07 0.17 0.04 0.08 0.14 -2.36 0.98
ACC -0.09 0.23 -0.14 -0.05 0.01 -3.22 1.17 OCF 0.16 0.24 0.04 0.13 0.24 -1.11 3.34 MV 1,417.60 8,338.03 25.68 108.49 542.50 0.06 467,096
Sales 1,265.43 5,440.95 36.05 139.89 595.05 -4.39 217,799 P/B 3.26 66.71 0.89 1.45 2.53 0.03 10,474
Panel C: Bad News (negative returns) – 54,939 observations
Variable Mean Standard Deviation
First Quartile Median Third
Quartile Min Max
R -0.30 0.22 -0.44 -0.26 -0.12 -0.97 0.00 NI -0.03 0.21 -0.07 0.03 0.07 -2.46 0.90
ACC -0.09 0.24 -0.13 -0.04 0.01 -3.61 1.07 OCF 0.06 0.20 -0.03 0.05 0.14 -1.25 2.83 MV 755.17 5,878.21 11.38 42.03 196.37 0.07 422,640
Sales 784.61 4,199.74 17.19 72.28 303.65 -203.75 195,805 P/B 4.49 52.58 1.06 1.83 3.39 0.03 6,620
R is annual stock returns for the year ending three months after fiscal period-end. NI is net income. ACC is accruals measured by the change in working capital (excluding cash) plus depreciation. OCF is cash flow from operation measured by net income minus ACC. If cash flow statement is available, OCF is obtained from cash flow statement and accruals are calculated as net income minus OCF. NI, ACC and OCF are deflated by the beginning market value of equity. MV is the market value of equity at fiscal year end. P/B is the ratio of the market value of equity to the book value of equity measured at the beginning of fiscal period. Sales are annual sales. Good (bad) news is represented by non-negative (negative) stock returns.
39
Table 2: Correlation Coefficients among Key Variables
Pearson (Spearman) correlation coefficients are above (below) the diagonal; p-values are in parentheses. Panel A: Full Sample (119,983 observations)
Variable R NI OCF ACC MV Sales P/B R 0.220 0.189 0.002 0.029 0.009 -0.008
(<0.01) (<0.01) (0.54) (<0.01) (<0.01) (<0.01)
NI 0.398 0.411 0.447 0.019 0.040 -0.010 (<0.01) (<0.01) (<0.01) (<0.01) (<0.01) (<0.01)
OCF 0.298 0.523 -0.632 -0.001 0.045 -0.021 (<0.01) (<0.01) (<0.01) (0.68) (<0.01) (<0.01)
ACC -0.021 0.176 -0.616 0.018 -0.010 0.012 (<0.01) (<0.01) (<0.01) (<0.01) (<0.01) (<0.01)
MV 0.208 0.141 0.137 0.036 0.624 0.005 (<0.01) (<0.01) (<0.01) (<0.01) (<0.01) (0.06)
Sales 0.148 0.288 0.326 -0.086 0.796 -0.003 (<0.01) (<0.01) (<0.01) (<0.01) (<0.01) (0.27)
P/B -0.160 -0.294 -0.395 0.293 0.298 -0.055 (<0.01) (<0.01) (<0.01) (<0.01) (<0.01) (<0.01)
Panel B: Good News (non-negative returns, 65,044 observations)
Variable R NI OCF ACC MV Sales P/B R -0.024 0.010 -0.028 -0.012 -0.060 0.004
(<0.01) (0.01) (<0.01) (<0.01) (<0.01) (0.29)
NI 0.089 0.426 0.292 -0.014 0.006 -0.011 (<0.01) (<0.01) (<0.01) (<0.01) (0.15) (<0.01)
OCF 0.033 0.503 -0.741 -0.025 0.021 -0.017 (<0.01) (<0.01) (<0.01) (<0.01) (<0.01) (<0.01)
ACC -0.011 0.074 -0.720 0.016 -0.018 0.010 (0.01) (<0.01) (<0.01) (<0.01) (<0.01) (0.01)
MV -0.054 -0.092 -0.009 0.013 0.642 0.005 (<0.01) (<0.01) (0.03) (<0.01) (<0.01) (0.25)
Sales -0.126 0.138 0.227 -0.111 0.813 -0.002 (<0.01) (<0.01) (<0.01) (<0.01) (<0.01) (0.55)
P/B 0.006 -0.384 -0.441 0.303 0.390 0.034 (0.12) (<0.01) (<0.01) (<0.01) (<0.01) (<0.01)
40
Panel C: Bad News (negative returns, 54,939 observations) Variable R NI OCF ACC MV Sales P/B
R 0.312 0.244 0.077 0.049 0.079 -0.027 (<0.01) (<0.01) (<0.01) (<0.01) (<0.01) (<0.01)
NI 0.399 0.333 0.618 0.038 0.058 -0.004 (<0.01) (<0.01) (<0.01) (<0.01) (<0.01) (0.33)
OCF 0.307 0.462 -0.535 0.016 0.062 -0.022 (<0.01) (<0.01) (<0.01) (<0.01) (<0.01) (<0.01)
ACC 0.031 0.349 -0.523 0.020 0.000 0.015 (<0.01) (<0.01) (<0.01) (<0.01) (1.00) (<0.01)
MV 0.231 0.262 0.191 0.082 0.584 0.009 (<0.01) (<0.01) (<0.01) (<0.01) (<0.01) (0.04)
Sales 0.237 0.359 0.368 -0.045 0.760 -0.003 (<0.01) (<0.01) (<0.01) (<0.01) (<0.01) (0.43)
P/B -0.215 -0.128 -0.302 0.279 0.274 -0.115 (<0.01) (<0.01) (<0.01) (<0.01) (<0.01) (<0.01)
R is annual stock returns for the year ending three months after fiscal period-end. NI is net income. ACC is accruals measured by the change in working capital (excluding cash) plus depreciation. OCF is cash flow from operation measured by net income minus ACC. If cash flow statement is available, OCF is obtained from cash flow statement and accruals are calculated as net income minus OCF. NI, ACC and OCF are deflated by the beginning market value of equity. MV is the market value of equity at fiscal year end. P/B is the ratio of the market value of equity to the book value of equity measured at the beginning of fiscal period. Sales are annual sales. Good (bad) news is represented by non-negative (negative) stock returns.
41
Table 3: The Relation between Earnings and Annual Stock Returns: Good News versus Bad News
Good News (GN) Bad News (BN)
Year Number
of obser-vations
β0 β1Adusted
R2
Number of
obser-vations
β0 β1Adusted
R2
GNBN11 ββ −
1970 825 0.055 0.023 0.015 594 0.043 0.116 0.059 0.093 1971 940 0.067 0.030 0.014 707 0.057 0.236 0.083 0.206 1972 527 0.081 -0.009 -0.001 1,221 0.093 0.130 0.081 0.139 1973 609 0.120 0.053 0.015 1,874 0.129 0.175 0.155 0.122 1974 1,020 0.163 0.099 0.023 1,909 0.170 0.255 0.082 0.156 1975 2,458 0.123 0.147 0.076 417 0.049 0.260 0.007 0.113 1976 1,791 0.168 0.115 0.074 866 0.159 0.385 0.093 0.270 1977 1,981 0.139 0.092 0.074 818 0.137 0.441 0.103 0.349 1978 2,149 0.156 0.066 0.035 634 0.138 0.264 0.034 0.198 1979 1,590 0.175 0.021 0.003 1,280 0.207 0.482 0.162 0.461 1980 2,552 0.118 0.033 0.017 479 0.036 0.227 0.016 0.194 1981 1,017 0.142 0.102 0.034 2,062 0.136 0.272 0.140 0.170 1982 2,581 0.058 0.021 0.009 733 -0.013 0.144 0.021 0.123 1983 1,939 0.078 0.003 0.000 1,434 0.058 0.296 0.072 0.293 1984 1,795 0.074 0.049 0.017 1,825 0.060 0.281 0.159 0.232 1985 2,279 0.043 0.035 0.008 1,374 0.025 0.439 0.120 0.404 1986 2,088 0.041 -0.001 0.000 1,532 0.011 0.350 0.090 0.351 1987 1,235 0.060 -0.020 0.001 2,621 0.075 0.309 0.146 0.329 1988 2,372 0.052 0.040 0.007 1,900 0.043 0.400 0.134 0.360 1989 2,099 0.051 0.021 0.002 2,057 0.055 0.441 0.141 0.420 1990 1,763 0.045 -0.012 0.000 2,429 0.064 0.408 0.125 0.420 1991 2,641 0.022 -0.004 0.000 1,556 0.027 0.694 0.110 0.698 1992 2,421 0.020 0.024 0.003 1,883 0.013 0.316 0.068 0.292 1993 2,542 0.027 0.009 0.000 2,064 0.025 0.277 0.071 0.268 1994 2,472 0.044 0.008 0.000 2,612 0.052 0.273 0.144 0.265 1995 3,598 0.050 -0.025 0.010 1,747 0.014 0.260 0.078 0.285 1996 2,956 0.051 0.004 0.000 2,606 0.036 0.268 0.128 0.264 1997 3,811 0.034 0.005 0.000 2,016 0.014 0.271 0.118 0.266 1998 1,499 0.034 -0.051 0.033 4,172 0.059 0.208 0.112 0.259 1999 2,954 0.024 -0.023 0.038 2,368 0.049 0.224 0.068 0.247 2000 1,977 0.058 0.007 0.000 3,132 0.055 0.233 0.123 0.226 2001 2,563 -0.003 -0.020 0.001 2,017 -0.036 0.417 0.079 0.437
Mean 0.074 0.026 0.016 0.064 0.305 0.098 0.279 (t-value) (8.50) (3.31) (6.49) (14.58) (12.50) Xit is net income deflated by the beginning market value of equity. Rit is annual stock returns for the year ending three months after fiscal period end. The sample is partitioned into the good and bad news sub samples depending on whether annual stock returns are positive or negative. and denote the coefficient estimates on annual stock returns on the good news (GN) and bad news (BN) sub samples, respectively.
GN1β
BN1β
42
Table 4: Descriptive Statistics of Key Variables: Portfolios Partitioned by the Beginning-of-Year Market-to-Book Ratio
Good News (Number of observations 65,044 ) Bad News (Number of observations 54,939)
Variable Mean First Quartile Median Third
Quartile Mean First Quartile Median Third
Quartile Portfolio I (low P/B): Number of observations 10,270 Number of observations 5,956
P/B 0.51 0.41 0.53 0.62 0.52 0.43 0.54 0.63 R 0.50 0.17 0.36 0.65 -0.24 -0.35 -0.20 -0.09 NI 0.11 0.04 0.16 0.26 -0.12 -0.26 0.01 0.13
ACC -0.23 -0.40 -0.17 -0.01 -0.27 -0.45 -0.20 -0.01 OCF 0.34 0.11 0.30 0.52 0.15 -0.04 0.14 0.33 MV 141.75 7.32 19.46 62.84 68.25 3.69 10.16 30.77
Portfolio II: Number of observations 9,765 Number of observations 6,462 P/B 0.85 0.78 0.85 0.93 0.85 0.78 0.86 0.93 R 0.44 0.14 0.30 0.57 -0.25 -0.36 -0.20 -0.10 NI 0.11 0.06 0.13 0.19 -0.03 -0.10 0.04 0.12
ACC -0.11 -0.21 -0.10 0.00 -0.14 -0.24 -0.10 0.01 OCF 0.22 0.09 0.21 0.33 0.10 -0.01 0.11 0.23 MV 454.49 17.92 55.45 214.38 218.25 7.57 22.97 78.07
Portfolio III: Number of observations 16,917 Number of observations 12,259 P/B 1.30 1.14 1.29 1.46 1.31 1.15 1.30 1.47 R 0.43 0.13 0.28 0.54 -0.26 -0.38 -0.22 -0.10 NI 0.09 0.06 0.10 0.14 -0.01 -0.06 0.04 0.09
ACC -0.07 -0.14 -0.07 0.00 -0.09 -0.16 -0.07 0.01 OCF 0.16 0.08 0.16 0.24 0.08 -0.01 0.09 0.17 MV 890.58 34.41 130.91 534.44 417.74 12.06 41.86 173.49
Portfolio IV: Number of observations 15,189 Number of observations 13,988 P/B 2.19 1.87 2.14 2.49 2.21 1.88 2.16 2.51 R 0.46 0.14 0.30 0.60 -0.29 -0.43 -0.25 -0.12 NI 0.06 0.05 0.08 0.10 0.00 -0.03 0.04 0.07
ACC -0.04 -0.09 -0.04 0.01 -0.05 -0.10 -0.04 0.01 OCF 0.10 0.05 0.10 0.16 0.05 -0.02 0.06 0.12 MV 1,686.24 57.11 226.92 926.16 717.20 16.52 65.44 293.96
Portfolio V (high P/B): Number of observations 12,909 Number of observations 16,274 P/B 11.11 3.55 4.57 6.81 11.75 3.71 5.00 8.09 R 0.55 0.15 0.35 0.71 -0.37 -0.55 -0.34 -0.17 NI 0.02 0.01 0.05 0.07 -0.03 -0.06 0.01 0.04
ACC -0.02 -0.05 -0.01 0.01 -0.03 -0.05 -0.01 0.01 OCF 0.05 0.00 0.05 0.10 0.00 -0.05 0.01 0.06 MV 3,537.63 59.93 280.38 1,308.91 1,507.00 18.04 70.57 346.05
R is annual stock returns for the year ending three months after fiscal period-end. NI is net income. ACC is accruals measured by the change in working capital (excluding cash) plus depreciation. OCF is cash flow from operation measured by net income minus ACC. If cash flow statement is available, OCF is obtained from cash flow statement and accruals are calculated as net income minus OCF. NI, ACC and OCF are deflated by the beginning market value of equity. MV is the market value of equity at fiscal year end. P/B is the ratio of the market value of equity to the book value of equity measured at the beginning of fiscal period. Good (bad) news is represented by non-negative (negative) stock returns. The sample is partitioned into five portfolios by the beginning market-to-book ratio (P/B). First, we partition the full sample into firms with P/B ratios less than one and others. Second, we partition the firms with P/B ratios less than one into two portfolios. Finally, we partition the remaining firms into three portfolios. Portfolio I includes firms with the lowest P/B ratios, and portfolio V includes firms with the highest P/B ratios.
43
Table 5: Market-to-Book Ratios and the Relation between Earnings, Components of Earnings and Returns
it itttit RX εββ ++= 10
Xit is net income, accruals or operating cash flows deflated by the beginning market value of equity. Rit is annual stock returns for the year ending three months after fiscal period end. The sample is partitioned into the good and bad news sub samples depending on whether annual stock returns are positive or negative. The sample is partitioned into five portfolios by the market-to-book ratio (P/B), which is the ratio of the market value of equity to the book value of equity measured at the beginning of fiscal period. First, we partition the full sample into firms with P/B ratios less than one and others. Second, we partition the firms with P/B ratios less than one into two portfolios. Finally, we partition the remaining firms into three portfolios. Portfolio I includes firms with the lowest P/B ratios, and portfolio V includes firms with the highest P/B ratios. and denote the coefficient estimates on annual stock returns on the good news (GN) and bad news (BN) sub samples, respectively.
GN1β
BN1β
Panel A: Earnings as Dependent Variable
Good News (GN) Bad News (BN) P/B
β0 β1 Adj. R2 β0 β1 Adj. R2
GNBN11 ββ −
Increase over next highest P/B portfolio
I 0.029 0.062 0.023 0.009 0.604 0.127 0.542 0.060 (low) (1.50) (4.56) (0.44) (10.82) (9.87) (1.67)
II 0.081 0.042 0.034 0.086 0.524 0.171 0.482 0.135 (7.80) (3.80) (6.77) (13.11) (11.69) (4.85)
III 0.085 0.024 0.016 0.090 0.371 0.152 0.347 0.114 (11.88) (4.82) (11.89) (12.59) (11.45) (6.50)
IV 0.068 0.019 0.029 0.079 0.252 0.132 0.233 0.081 (18.19) (2.55) (14.87) (15.98) (11.82) (5.12)
V 0.038 0.006 0.015 0.041 0.158 0.077 0.152
Mean of Annual
regressions (t-value)
(high) (9.58) (1.04) (9.23) (14.12) (10.83) 0.056 0.446 0.390 P/B(V)
1P/B(I)
1 ββ − (4.66) (8.67) (7.92)
Panel B: Accruals as Dependent Variable
Good News (GN) Bad News (BN) P/B
β0 β1 Adj. R2 β0 β1 Adj. R2
GNBN11 ββ −
Increase over next highest P/B portfolio
I -0.196 -0.013 0.000 -0.187 0.348 0.033 0.361 0.113 (low) (-12.62) (-1.06) (-10.21) (5.52) (5.53) (2.16)
II -0.103 -0.015 0.004 -0.085 0.233 0.034 0.248 0.084 (-13.00) (-1.63) (-8.72) (5.46) (5.64) (1.80)
III -0.071 0.003 0.002 -0.046 0.167 0.029 0.164 0.083 (-11.73) (0.56) (-8.36) (4.32) (4.39) (2.96)
IV -0.033 -0.004 0.006 -0.022 0.077 0.013 0.081 0.061 (-7.67) (-0.57) (-4.90) (4.83) (4.45) (3.01)
V -0.018 0.005 0.004 -0.009 0.025 0.007 0.020
Mean of Annual
regressions (t-value)
(high) (-5.83) (1.00) (-2.82) (1.86) (1.31) -0.018 0.323 0.341 P/B(V)
1P/B(I)
1 ββ − (-1.53) (5.35) (5.47)
44
Panel C: Operating Cash Flows as Dependent Variable Good News (GN) Bad News (BN)
P/B β0 β1 Adj. R2 β0 β1 Adj. R2
GNBN11 ββ −
Increase over next highest P/B portfolio
I 0.224 0.075 0.018 0.196 0.255 0.024 0.180 -0.055 (low) (16.23) (3.68) (13.75) (5.20) (3.74) (-1.20)
II 0.184 0.057 0.011 0.171 0.292 0.047 0.235 0.052 (24.36) (4.96) (22.69) (12.52) (8.99) (1.29)
III 0.155 0.021 0.005 0.136 0.204 0.054 0.183 0.031 (27.92) (3.06) (21.64) (6.14) (5.38) (1.17)
IV 0.101 0.023 0.019 0.101 0.175 0.062 0.152 0.020 (28.18) (1.92) (26.60) (13.68) (8.31) (0.81)
V 0.056 0.001 0.012 0.050 0.133 0.050 0.132
Mean of Annual
regressions (t-value)
(high) (13.05) (0.13) (10.58) (10.14) (7.50) 0.074 0.122 0.048 P/B(V)
1P/B(I)
1 ββ − (3.98) (2.66) (1.04)
45
Table 6: The Relation between Earnings, Components of Earnings and Returns: Market-to-Book Ratios and Levels of Accruals
it itttit RX εββ ++= 10
Xit is net income, accruals or operating cash flows deflated by the beginning market value of equity. Rit is annual stock returns for the year ending three months after fiscal yearend. The sample is partitioned into the good and bad news sub samples depending on whether annual stock returns are positive or negative. Next, the sample is partitioned into five portfolios by the market-to-book ratio (P/B), which is the ratio of the market value of equity to the book value of equity measured at the beginning of fiscal period. First, we partition the full sample into firms with P/B ratios less than one and others. Second, we partition the firms with P/B ratios less than one into two portfolios. Finally, we partition the remaining firms into three portfolios. Portfolio I includes firms with the lowest P/B ratios, and portfolio V includes firms with the highest P/B ratios. The sample is further partitioned into quintiles each year by the levels of (signed) accruals. Portfolios I and II are grouped together, and portfolios III, IV, and IV are grouped together. We estimate the above regression for these four P/B ratios and levels of accruals portfolios, each year separately for the good and bad news samples, and report the means of the coefficient estimates on annual stock returns. T-values are reported in parentheses. and denote the coefficient estimates on annual stock returns for the good news (GN) and bad news (BN) sub-samples, respectively.
GN1β
BN1β
Panel A: Earnings as Dependent Variable
Good News ( ) GN1β Bad News ( ) BN
1β ACC ACC
P/B [I, II] [III,IV,V] P/B (I, II) (III,IV,V)
[I, II] 0.050 (3.71)
0.059 (6.23)
[I, II] 0.630 (13.50)
0.293 (11.11)
[III,IV,V] 0.008 (0.86)
0.015 (3.15)
[III,IV,V] 0.395 (17.31)
0.146 (17.99)
Difference (c = ) GNBN
11 ββ −
ACC
P/B [I, II] [III,IV,V]
[I, II] 0.580 (12.58)
0.234 (8.49)
[III,IV,V] 0.387 (15.56)
0.131 (12.55)
Difference in c between P/B & ACC [I, II] and P/B & ACC [III, IV, V] is 0.449 (t = 10.83)
46
Panel B: Accruals as Dependent Variable
Good News( ) GN1β Bad News ( ) BN
1β ACC ACC
P/B [I, II] [III,IV,V] P/B [I, II] [III,IV,V]
[I, II] -0.053 (-5.64)
0.048 (6.19)
[I, II] 0.278 (7.42)
-0.064 (-3.18)
[III,IV,V] -0.025 (-4.44)
0.024 (7.47)
[III,IV,V] 0.166 (4.67)
-0.024 (-2.93)
Difference (c = ) GNBN
11 ββ −
ACC
P/B [I, II] [III,IV,V]
[I, II] 0.331 (8.58)
-0.112 (-5.40)
[III,IV,V] 0.191 (5.23)
-0.048 (-5.10)
Difference in c between P/B & ACC [I, II] and P/B & ACC [III, IV, V]is 0.379 (t = 9.70)
Panel C: Operating Cash Flows as Dependent Variable
Good News ( ) GN1β Bad News ( ) BN
1β ACC ACC
P/B [I, II] [III,IV,V] P/B [I, II] [III,IV,V]
[I, II] 0.103 (5.61)
0.011 (1.07)
[I, II] 0.352 (11.82)
0.357 (11.80)
[III,IV,V] 0.033 (3.00)
-0.008 (-1.79)
[III,IV,V] 0.229 (6.46)
0.171 (18.46)
Difference (c = ) GNBN
11 ββ −
ACC
P/B [I, II] [III,IV,V]
[I, II] 0.249 (8.76)
0.346 (11.57)
[III,IV,V] 0.196 (4.61)
0.179 (17.19)
Difference in c between P/B & ACC [I, II] and P/B & ACC [III, IV, V] is 0.070 (t = 2.47)
47
Table 7: Market-to-Book Ratios and the Relation between Earnings and Returns: Pooled Estimation Within Sub-periods: Constant Sample of 788 Firms
itititititit RDRDX εββββ +×+++= 3210 (1)
ititit
itititititit
RPBDRPB
PBDPBRDRDX
εββ
ββββββ
+××+×+
×++×+++=
)()(
)()(
76
543210 (2)
Xit is net income deflated by the beginning market value of equity. Rit is annual stock returns for the year ending three months after fiscal period end. Dit is a dummy variable taking on 1 (0) when annual stock returns are negative (positive). PB is a dummy variable taking on 1 (0) when the market-to-book ratio, which is the ratio of the market value of equity to the book value of equity measured at the beginning of fiscal period, is less (greater) than 1. The analysis is restricted to a sample of 788 firms that exist over the sample period 1970 to 2001. T-value is reported in parentheses.
Time Period (number of
observations)
Equation β0 β1 β2 β3 β4 β5 β6 β7
Adjusted R2
All Years 1 0.086 0.008 0.049 0.221 0.093 (20,758) (51.86) (2.63) (14.49) (21.92)
2 0.077 0.006 0.026 0.149 0.039 0.012 0.040 0.395 0.134 (39.07) (1.61) (6.10) (13.12) (11.23) (1.87) (5.86) (17.05)
1970 – 1975 1 0.093 0.016 0.122 0.026 0.123 (3,108) (20.75) (2.27) (13.10) (1.26)
2 0.076 0.010 0.035 0.050 0.053 0.016 0.122 0.107 0.214 (13.17) (1.22) (2.57) (2.02) (6.23) (1.15) (6.82) (2.40)
1976 – 1980 1 0.153 0.000 0.051 0.260 0.094 (3,368) (44.87) (-0.01) (7.75) (7.50)
2 0.129 -0.011 0.021 0.138 0.045 0.032 0.057 0.286 0.161 (26.65) (-1.15) (2.30) (3.11) (6.76) (2.30) (4.56) (4.24)
1981 – 1985 1 0.101 -0.006 0.030 0.232 0.081 (3,388) (23.65) (-0.72) (3.93) (8.15)
2 0.095 -0.007 0.020 0.142 0.017 0.008 0.018 0.373 0.104 (16.49) (-0.69) (1.81) (4.16) (1.97) (0.47) (1.21) (6.07)
1986 – 1990 1 0.073 0.028 0.040 0.414 0.165 (3,359) (17.49) (4.04) (3.44) (16.31)
2 0.078 0.021 0.032 0.304 -0.037 0.017 0.047 0.409 0.223 (17.74) (2.86) (2.49) (10.93) (-3.34) (0.97) (1.78) (6.93)
1991 – 1995 1 0.043 0.023 0.049 0.404 0.102 (3,404) (10.65) (2.96) (5.21) (12.33)
2 0.055 0.008 0.032 0.230 -0.070 0.050 0.082 0.656 0.183 (12.79) (1.04) (3.04) (6.48) (-6.81) (2.59) (4.04) (8.66)
1996 – 2001 1 0.060 0.014 0.006 0.225 0.078 (4,126) (17.88) (2.31) (0.89) (13.35)
2 0.063 0.014 0.008 0.167 -0.028 -0.018 0.001 0.325 0.140 (17.58) (2.26) (1.12) (9.35) (-3.11) (-1.05) (0.08) (7.19)
48
Figure 1: Conservatism Measures for Earnings, Accruals, and Operating
Cash Flows for Firms Grouped in Order of Increasing Market-to-Book
0.000
0.100
0.200
0.300
0.400
0.500
0.600
I II III IV VMarket to Book Group
Con
serv
atis
m
Market to book less than 1
OperatingCash Flows
Accruals
Earnings
Market to book greater than 1
Mean and median market to book ratios (see Table 4) increase in groups I through V.
49
Figure 2 - Conservatism Measures with and without P/B Controls
0.000
0.100
0.200
0.300
0.400
0.500
0.600
0.700
70-75 76-80 81-85 86-90 91-95 96-2001
Time Period
Bet
a Va
lues
GHβ3
β3
β7
GH β3 is Givoly and Hayn’s (2000) conservatism measure. In Table 7, this is the
coefficient β3 in equation (1). β3: From Table 7, this is the coefficient β3 in equation (2). β7: From Table 7, this is the coefficient β7 in equation (2).