Aggregation Bias in Estimates of Conditional Conservatism: Theory and Evidence

This paper documents a study about the influence of the aggregation effect on the estimates of models based on the original Basu model – specifically the Ball, Kothari and Nikolaev model (Ball et al., 2013b). We provide an analytical study of the effect, showing that it can produce two biases: an omitted‐variable bias and a truncated‐sample bias. Using separate proxies for good and bad news for each company and year, we estimate the empirical sign and magnitude of those biases. Our results show that the estimates of conditional conservatism based on regressions of (unexpected) earnings on (unexpected) returns, as in the paper by Ball et al., are contaminated by substantial aggregation bias. More specifically, the aggregation effect causes these models to underestimate good‐news timeliness and overestimate bad‐news timeliness, thereby overestimating differential timeliness. Moreover, when we use proxies that provide better control for the aggregation effect, the differential timeliness coefficient tends to 0, showing that the influence of conditional conservatism on the returns–earnings relationship is, at best, marginal.     

The effect of differential accounting conservatism on the “over-valuation” of high-tech firms relative to low-tech firms

This paper examines systematic differences in the level of accounting conservatism between high-tech and low-tech firms. Relying on the recent development in theoretical models and empirical measures of conservatism, we investigate conservative accounting practices and earnings management behavior in high-tech and low-tech firms. The results based on comparisons of cumulative nonoperating accruals, regression coefficients from the income timeliness models in Basu (1997), the distribution of earnings, and discretionary accruals between the two groups are consistent with a higher level of accounting conservatism in high-tech firms vis-à-vis low-tech firms. Additional analyses show that the effect of conservatism cannot be used as a defense for the over-valuation of high-tech firms.     

Conservatism and Cross-Sectional Variation in the Post–Earnings Announcement Drift

Accounting conservatism allows me to identify a previously undocumented source of predictable cross‐sectional variation in Standardized Unexpected Earnings' autocorrelations viz. the sign of the most recent earnings realization and present evidence that the market ignores this variation (“loss effect”). It is possible to earn returns higher than from the Bernard and Thomas (1990) strategy by incorporating this feature. Additionally, the paper shows that the “loss effect” is different from the “cross quarter” effect shown by Rangan and Sloan (1998) and it is possible to combine the two effects to earn returns higher than either strategy alone. Thus, the paper corroborates the Bernard and Thomas finding that stock prices fail to reflect the extent to which quarterly earnings series differ from a seasonal random walk and extends it by showing that the market systematically underestimates time‐series properties resulting from accounting conservatism.     

Do analysts who understand accounting conservatism exhibit better forecasting performance?

This study investigates the performance of analysts when they match the asymmetric timeliness of their earnings forecast revisions (i.e., asymmetric forecast timeliness) with the asymmetric timeliness of firms’ reported earnings (i.e., asymmetric earnings timeliness). We find that better timeliness‐matching analysts produce more accurate earnings forecasts and elicit stronger market reactions to their forecast revisions. Further, better timeliness‐matching analysts issue less biased earnings forecasts, more profitable stock recommendations and have more favorable career outcomes. Overall, our results indicate that analysts’ ability to incorporate conditional conservatism into their earnings forecasts is an important reflection of analyst expertise and professional success.     

Conditional and Unconditional Conservatism:Concepts and Modeling

We develop a model that captures the distinct natures of and interactions between conditional and unconditional conservatism. Under unconditional conservatism, the book value of net assets is understated due to predetermined aspects of the accounting process. Under conditional conservatism, book value is written down under sufficiently adverse circumstances, but not up under favorable circumstances. The specification of earnings provided by the model yields hypotheses about how unconditional conservatism and other factors preempt conditional conservatism and so affect the asymmetric response of earnings to positive and negative share returns, both current and lagged, documented by Basu (1995, “Conservatism and the Asymmetric Timeliness of Earnings.” Ph.D. dissertation, University of Rochester’ 1997, “The Conservatism Principle and the Asymmetric Timeliness of Earnings.” Journal of Accounting and Economics 24, 3–37).This revised version was published online in August 2005 with a corrected cover date.     

Asymmetry in earnings timeliness and persistence: a simultaneous equations approach

This study addresses simultaneity bias in piecewise linear forms of the earnings-return relation. We specify an overidentified system of simultaneous equations that incorporates both asymmetric earnings timeliness and asymmetric earnings persistence specifications and implement two-stage least squares for this piecewise linear system. Estimation of a system that is piecewise linear in endogenous variables presents several issues that are unprecedented in the accounting literature. Findings provide evidence that the asymmetric timeliness specification is particularly affected by simultaneity and that failing to correct for simultaneity results in coefficient estimates that potentially understate the degree of asymmetric earnings timeliness. Moreover, inferences regarding how conditional conservatism has evolved over time are sensitive to whether OLS or 2SLS coefficients are used as the basis of comparison.     

Market Reactions to Tangible and Intangible Information

The book‐to‐market effect is often interpreted as evidence of high expected returns on stocks of “distressed” firms with poor past performance. We dispute this interpretation. We find that while a stock's future return is unrelated to the firm's past accounting‐based performance, it is strongly negatively related to the “intangible” return, the component of its past return that is orthogonal to the firm's past performance. Indeed, the book‐to‐market ratio forecasts returns because it is a good proxy for the intangible return. Also, a composite equity issuance measure, which is related to intangible returns, independently forecasts returns.     

Financial Distress and the Earnings‐Sensitivity‐Difference Measure of Conservatism

Following Basu (1997 ), the difference between the sensitivity of accounting earnings to negative equity return (proxy for bad news) and its sensitivity to positive equity return (proxy for good news) is interpreted as an indicator of conditional accounting conservatism. However, there is concern that the earnings‐sensitivity difference (ESD) may be affected by factors other than conditional conservatism, and that this may impair its reliability as an indicator of conditional conservatism. Motivated by such concerns and by recognition that financial distress could contribute to an ESD through a conditional‐conservatism route and/or through a non‐conditional‐conservatism route, we examine the association between financial distress and the ESD for U.S. non‐financial firms. By decomposing the association into an element arising from accruals, which can reflect conditional conservatism, and an element arising from cash flow from operating activities (CFO), which cannot directly reflect conditional conservatism, we seek evidence as to whether such association arises through a conditional‐conservatism route or through a non‐conditional‐conservatism route. We find that positive association between financial distress and the ESD arises predominantly through the accruals component of earnings rather than the CFO component, consistent with it arising primarily because of a higher degree of conditional conservatism in relatively financially distressed firms. The inference that there is a positive association between financial distress and conditional conservatism is supported by other non‐equity‐return‐based measures of conditional conservatism. The evidence in this paper suggests that the effect of financial distress does not significantly impair the reliability of the ESD as an indicator of conditional conservatism.     

Time Variation in the Covariance between Stock Returns and Consumption Growth

The conditional covariance between aggregate stock returns and aggregate consumption growth varies substantially over time. When stock market wealth is high relative to consumption, both the conditional covariance and correlation are high. This pattern is consistent with the “composition effect,” where agents' consumption growth is more closely tied to stock returns when stock wealth is a larger share of total wealth. This variation can be used to test asset‐pricing models in which the price of consumption risk varies. After accounting for variations in this price, the relation between expected excess stock returns and the conditional covariance is negative.     

Beyond accounting and back: An empirical examination of the relative relevance of earnings and “other” information

Ohlson (1995) models firm value as a function of book value, earnings, and analysts' earnings forecasts which capture “other” information not yet reflected in the financial statements. Within this framework, stock returns reflect information from earnings and forecasts, each of which is different in terms of reliability and timeliness. For the period 1984–2012, this paper examines time trends and the influence of aggregate market conditions on the relative relevance of earnings and forecasts. In this context, relative relevance is defined as the incremental explanatory power of earnings or forecasts, relative to their combined explanatory power with respect to the cross-section of stock returns. This inquiry is motivated by anecdotal evidence and recent research, which suggests that aggregate market conditions influence the usefulness of accounting information for investors. The findings show that while the relative relevance of earnings has remained stable, the relative relevance of forecasts has increased over time. I also find that the relative relevance of earnings is higher in bad years, i.e. years with low market returns or elevated market uncertainty. Overall, the results reported in this study suggest that despite the increase in the relevance of timely “other” information, investors tend to rely more on reliable accounting information during bad years.     

Publicly traded versus privately held: implications for conditional conservatism in bank accounting

Compared with privately held banks, publicly traded banks face greater agency costs because of greater separation of ownership and control but enjoy greater benefits from access to the equity capital market. Differences in control and capital market access influence public versus private banks’ accounting. We predict and find that public banks exhibit greater degrees of conditional conservatism (asymmetric timeliness of the recognition of losses versus gains in accounting income) than private banks. We predict and find that public banks recognize more timely earnings declines, less timely earnings increases, and larger and more timely loan losses. Although public ownership gives managers greater ability and incentive to exercise income-increasing accounting, our findings show that the demand for conservatism dominates within public banks and that the demand for conservatism is greater among public banks than private banks. Our results provide insights for accounting and finance academics, bank managers, auditors, and regulators concerning the effects of ownership structure on conditional conservatism in banks’ financial reporting.

Has Australian financial reporting become more conservative over time?

This study examines whether Australian financial reporting became more conservative over the period of 1993–2009. Unlike the United States and European evidence in Givoly and Hayn (2000) and Grambovas et al. (2006) , the Australian evidence is not consistent with the notion that conservatism has increased over time. The degree of conservatism fluctuates without any obvious trend over the 17‐year period, especially for the constant sample of firms appearing throughout the period. We also examine the impact of mandatory International Financial Reporting Standards (IFRS) adoption on accounting conservatism in Australia. Our evidence suggests the adoption of IFRS has led to a decrease in conditional conservatism (i.e. asymmetric timeliness).     

The pricing of conservative accounting and the measurement of conservatism at the firm-year level

This paper analyzes the relation between equity prices and conditional conservatism and introduces a new measure of conservatism at the firm-year level. We show that the asymmetric properties of conservative accounting, the existence of non-accounting sources of information, and the properties of GAAP related to special items combine to generate a nonlinear relation between unexpected equity returns and earnings news (the shock to expected current and future earnings). Based on this model, we construct a conservatism ratio (CR) defined as the ratio of the current earnings shock to earnings news. CR measures the proportion of the total shock to expected current and future earnings recognized in current year earnings. Ranking firms according to CR, we show empirically that higher CR firms have more leverage, increased volatility of returns, more incidence of losses, more negative accruals, and increased volatility of earnings and accruals, consistent with the literature on conservative accounting.     

Conservatism measures that control for the effects of economic rents on stock returns

Recent studies show that regression-based estimates of accounting conservatism reflect both differences in the asymmetric recognition of bad news and differences in asset composition. In particular, a firm’s market value and returns reflect both assets-in-place and expected future rents, while book values tend to reflect only assets-in-place. We propose two tests that remove the effect of asset composition on cross-sectional comparisons of accounting conservatism. First, a test based on a ratio of regression coefficients allows for valid cross-sectional comparisons of conservatism relative to overall news recognition. Second, in some cases, researchers can separately identify and make cross-sectional comparisons of the fraction of good news recognized and the fraction of bad news recognized. The estimates in this second scenario use a regression of earnings on returns interacted with a book-to-market ratio. We validate our model by deriving and testing several predictions based on it.     

Accounting Conservatism and the Relation Between Returns and Accounting Data

This study adds change in cash investments and change in lagged operating assets to the regression of returns on earnings levels and earnings changes examined in Easton and Harris (1991). We argue that a positive coefficient on change in cash investments captures conservatism associated with investments in positive net present value projects the effects of which will not flow into the accounting statements until the expected future benefits are realized. A positive coefficient on change in lagged operating assets implies accounting conservatism associated with the application of accounting rules to operating assets in place. Our empirical results are, in general, consistent with these arguments. We examine differences in conservatism across samples with different market to book ratios, we compare firms with non-negative returns with firms with negative returns, we compare firms reporting losses with firms reporting profits, and we examine firms in different industries, firms with different levels of research and development expenditure, different amounts of depreciation, different amounts of advertising expense, and firms that adopt LIFO inventory valuation compared with those that adopt an alternative to LIFO.JEL Classification: M41     

Accounting conservatism of cross-listing firms in the pre- and post-Sarbanes Oxley periods

This study investigates the level of accounting conservatism of a sample of cross-listed firms, American Depository Receipts (ADRs), during the pre- and post-Sarbanes Oxley (SOX) periods. After examining two proxies for accounting conservatism, Basu's [Basu, S. (1997). The conservatism principle and the asymmetric timeliness of earnings. Journal of Accounting and Economics 24(1), 3-37.] conservatism measure and abnormal accruals, we find that the SOX-exposed Levels II and III ADRs become more conservative during the post-SOX period while the SOX-unexposed Level I ADRs have no increase in the level of accounting conservatism. Further, we investigate whether such an increase in accounting conservatism is associated with different levels of shareholder protection in ADRs' home countries, and find that only Levels II and III ADRs from code law (weak shareholder protection) countries become more conservative and Levels II and III ADRs from common law (strong shareholder protection) countries have no change in accounting conservatism. These results suggest that SOX-exposed cross-listing firms from weak shareholder protection countries are most greatly influenced by the stringent requirements in SOX, and hence respond by increasing conservatism in their financial reporting.     

Asymmetric timeliness tests of accounting conservatism

Recent accounting research employs an asymmetric timeliness measure to test the hypothesis that reported accounting earnings are “conservative.” This research design regresses earnings on stock returns to examine whether “bad” news is incorporated into earnings on a more timely basis than “good” news. We identify properties of the asymmetric timeliness estimation procedure that will result in biases in the test statistics except under very restrictive conditions that are rarely met in typical empirical settings. Using data series that are devoid of asymmetric timeliness in reported earnings, we show how these biases result in evidence consistent with conservatism. We conclude that the biased test statistics inherent in the asymmetric timeliness research design preclude using this method to measure conservatism; that these biases are irresolvable as they originate in the test’s specification; and that studies employing asymmetric timeliness tests cannot be interpreted as providing evidence of conservatism.

An Investment Management Methodology for Publicly Held Property/Casualty Insurers

Investment officers of publicly held property/casualty companies wrestle with the question of how best to contribute to shareholder value. Should they view themselves as managers of a closed‐end investment company that happens to be funded by insurance underwriting? Or should they instead be investing funds primarily to defease the firm's liabilities and thus support the operations of a company whose principal value derives from its insurance activities? The authors of this article suggest that the investment policy of most insurance companies should have two primary objectives: (1) immunizing insurance reserves with a fixed‐income portfolio and (2) earning “abnormal returns” on surplus in “a responsible and disciplined” way. The latter means adhering to an asset allocation approach that takes account of the risk‐reward tradeoffs presented by a broad variety of investment types as well as the accounting treatment of investment income. Both accounting and economic considerations lead the authors to suggest that after‐tax net investment income (“NII”), as defined by U.S. GAAP, is the best benchmark of performance. While focusing mainly on the fixed income part of the portfolio, the authors suggest active management and portfolio approaches that aim to produce a growing, but relatively stable NII. Consistent with GAAP's treatment of NII (which includes interest income but excludes most capital gains) as “recurring income,” the authors argue that the market appears to assign significantly higher multiples to NII than to other sources of reported income.     

Accounting conservatism and voluntary corporate governance mechanisms by Australian firms

This study examines the relationship between voluntary adoption of selected corporate governance mechanisms and accounting conservatism for a sample of firms listed on the Australian Securities Exchange (ASX) over the 11‐year period prior to the promulgation of the ASX Corporate Governance Council Good Governance Principles and Best Practice Recommendations in 2003. Using four accounting and market‐based accounting conservatism measures, our results provide evidence of both conditional and unconditional conservatism in accounting reporting for Australian firms. We find that voluntary audit committee formation, increasing board independence and decreasing board size are positively associated with unconditional accounting conservatism and negatively related to the degree of conditional conservatism. Our results support the contention that firms voluntarily adopting perceived best practice corporate governance mechanisms employ unconditional accounting conservatism as a complimentary agency control device and are consistent with the observed negative association between the unconditional and conditional forms of accounting conservatism practice.     

Accounting conservatism and the profitability of corporate insiders

We predict that accounting conservatism influences insiders' opportunities to speculate on good and bad news, and thus, insider trading profitability. We find that greater conditional (unconditional) conservatism is associated with lower (higher) insiders' profitability from sales. We find limited evidence that conservatism influences profitability from purchases. These findings are consistent with our hypotheses on the different informational roles of conditional and unconditional conservatism, and on the asymmetric influence of conservatism over the opportunities to speculate on good versus bad news. Our research design takes into consideration the endogenous nature of insiders' trading and conservatism. The results are robust to different measures of conservatism and a number of additional analyses.