ERASMUS UNIVERSITY ROTTERDAM
Erasmus School of Economics
Department of Business Economics
Section: Accounting, Auditing and Control
The Persistence, Conservatism and Value Relevance
of Earnings throughout the Business Cycle
Master Thesis
2011/2012
MASTER THESIS ACCOUNTING, AUDITING & CONTROL
Date
19-07-2012
Student
Bebi Merinda 326348
Supervisor
Drs. Rob van der Wal RA
Co-reader
Dr. Lil Dai
69
Abstract
This thesis explores the behavior of earnings persistence, earnings conservatism and value
relevance of earnings throughout the business cycle. The main thought of this thesis is that the
fluctuations in macroeconomic situations have influences on the accounting information
particularly earnings and on the response of the investors as the users of financial statements.
The findings demonstrate that earnings persistence is higher in expansions relative to
contractions whereas earnings conservatism is lower during expansion periods than during
contraction periods. Due to higher earnings persistence and lower conservatism, earnings appear
to be more useful for the investors in expansion periods than in contraction periods. This can be
indicated from higher value relevance of current and future earnings during expansion periods
than contraction periods. Further this thesis reconciles the mixed results between Johnson (1999)
and Jenkins et al. (2009) concerning the value relevance of earnings. Value relevance of current
and future earnings is higher in expansion periods when earnings are more persistent and less
conservative.
Key words: persistence, conservatism, value relevance, business cycle
2
Acknowledgements
This thesis is written as a final paper to conclude the master’s program Accounting, Auditing and
Control at the Erasmus University Rotterdam. I have done an empirical research in the field of
market-based accounting research. Before starting with the introduction, I would like to express
my gratitude to certain people.
First, I would like to thank my thesis supervisor at the faculty Erasmus School of Economics,
Drs. Rob van der Wal for his suggestions, critical comments and ingenious ideas. His
professional knowledge and guidance has been very useful for the completion of this thesis. I
also thank the data-team at the Erasmus University’s library. Their assistance was very helpful
for me in order to attain the appropriate data from many sources available at the library.
Finally I wish to thank my parents, my fiancé Leroy, and my friends for their support and
encouragement during my studies. During the year, they have motivated me in the
accomplishment of my master’s degree.
Thank you!
Rotterdam, July 2012
Bebi Merinda
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Table of Contents
1.
2.
3.
4.
Introduction ........................................................................................................................................... 6
1.1.
Chapter Introduction ..................................................................................................................... 6
1.2.
Motivation ..................................................................................................................................... 6
1.3.
Relevance and Contribution .......................................................................................................... 8
1.4.
Problem Definition and Methodology .......................................................................................... 9
1.5.
Structure, Boundary and Limitation............................................................................................ 11
1.6.
Chapter Conclusion ..................................................................................................................... 11
Financial Accounting Theory.............................................................................................................. 13
2.1.
Chapter Introduction ................................................................................................................... 13
2.2.
Efficient market theory ............................................................................................................... 13
2.3.
Agency theory ............................................................................................................................. 14
2.4.
Positive accounting theory .......................................................................................................... 14
2.5.
Chapter Conclusion ..................................................................................................................... 15
Value Relevance, Earnings Persistence and Conservatism ................................................................. 17
3.1.
Chapter Introduction ................................................................................................................... 17
3.2.
Value relevance of earnings ........................................................................................................ 17
3.3.
Earnings Persistence ................................................................................................................... 21
3.4.
Conservatism............................................................................................................................... 25
3.5.
Business cycle ............................................................................................................................. 28
3.6.
Chapter Conclusion ..................................................................................................................... 30
Literature Review................................................................................................................................ 31
4.1.
Chapter Introduction ................................................................................................................... 31
4.2.
Earnings persistence and Conservatism ...................................................................................... 31
4.3.
Conservatism and Value relevance ............................................................................................. 33
4
4.4.
Earnings persistence and Value relevance .................................................................................. 37
4.5.
Conservatism, earnings persistence and value relevance throughout business cycle ................. 38
4.6.
Chapter Conclusion ..................................................................................................................... 41
5.
Hypothesis Development and Methodology ....................................................................................... 43
5.1.
Chapter Introduction ................................................................................................................... 43
5.2.
Hypotheses Development ........................................................................................................... 43
5.3.
Methodology ............................................................................................................................... 45
5.3.1.
Measurement ....................................................................................................................... 45
5.3.2.
Data sample ......................................................................................................................... 47
5.3.3.
Descriptive Statistics ........................................................................................................... 49
5.3.4.
Findings............................................................................................................................... 52
5.4.
Analysis....................................................................................................................................... 55
5.5.
Chapter Conclusion ..................................................................................................................... 58
6.
Conclusion .......................................................................................................................................... 59
6.1.
Thesis Conclusion ....................................................................................................................... 59
6.2.
Limitations and Suggestions ....................................................................................................... 60
References ................................................................................................................................................... 62
Appendix ..................................................................................................................................................... 66
1.
Summary of literature reviews .................................................................................................... 66
2.
Sample distribution ..................................................................................................................... 69
5
1. Introduction
1.1.
Chapter Introduction
Accounting information is a formal way for the management to communicate the firm’s financial
performance. Financial statements have an important role for investors’ decision-making process. Prior
studies document that the usefulness of accounting information particularly accounting earnings vary
according to the fluctuations in macroeconomic situations namely the business cycle (Johnson 1999;
Jenkins et al. 2009). This thesis investigates the usefulness of financial statements including earnings
persistence and earnings conservatism throughout the business cycle. This chapter elaborates on the
background, problem definition and structure of this thesis.
1.2.
Motivation
Every single entity aims for a steady growth in order to maintain its competitive position. In fact the
accounting principle of going concern assumes that every firm involves in strategic investments and
business operations in an attempt of longer term existence. The positive outcome of these strategic
decisions is a sustained level of current earnings and an expected increase of future earnings.
Nevertheless, another flip of the coin is a possibility of lower level of earnings in which the competitive
position of the corresponding firm is degraded.
Financial analysts and investors investigate any observable features such as earnings persistence to assess
the performance of firms’ strategic decisions. Earnings persistence is the autocorrelation between current
earnings and future earnings. Earnings persistence reflects ‘the effect of a current earnings innovation
upon the whole stream of future realizations of the earnings series’ (Baginski et al. 1999, pp. 109). Prior
accounting research documents evidences of firm-specific characteristics that drive a persistence level of
earnings such as barriers to entry, capital intensity, firm size and product type (Lev, 1983). For instance a
larger firm usually has higher capital intensity and quick access to financial resources than a smaller firm
which leads to a stable growth and a more persistent earnings stream. Nevertheless most accounting
studies relate earnings persistence only to the internal characteristics of the firms (Baginski et al. 1999),
leave the macroeconomic situations outside the scope of research.
Prior research shows that the relation between stock returns and earnings varies with respect to macroeconomic condition. Johnson (1999) finds that earnings persistence and value relevance of earnings are
higher during economic expansions than during contractions. Johnson (1999) reasons that the aggregate
investing and financing opportunity set varies across different stages of business cycle i.e. expansion and
6
recession which leads to variations in the response of stock market to accounting earnings. Value
relevance of earnings is the usefulness1 of earnings information to the equity market. Johnson (1999)
suggests that positive growth and high economic activity during an expansion imply a higher level of
earnings persistence and value relevance of earnings in an expansion than in a contraction.
The usefulness of earnings information is not only affected by economic growth and earnings persistence
but also on the way of the financial statement has been prepared. The most common way of
communicating a firm’s business performance is by disclosing its financial information in a formal form
called a financial statement. Publishing financial statements is mandatory for public listed firms while for
smaller firms financial statements are mainly used for limited purpose for example to obtain a loan from a
bank. For larger firms, financial statements cover various purposes such as tax and legal purposes. The
information provided in a financial statement is also useful for the analysts and investors in assessing the
firm’s level of performance. Due to the series of accounting scandals in 2001, the Sarbanes-Oxley (SOX)
Act has been introduced to enhance the quality of firm’s internal control and constrain managerial
discretion over financial reporting. Lobo and Zhou (2006) find an increase in conservatism in financial
reporting following the implementation of SOX.
Contrary to the Johnson (1999) line of reasoning, Jenkins et al. (2009) argue that a greater demand for
conservative accounting numbers during a contraction resulted in a higher value relevance of earnings
during a contraction period than during an expansion period. Jenkins et al. (2009) state as follows: “To
the extent that reporting firms respond to the increased demand for conservative earnings during
contractions by reporting more conservatively, there should be a positive effect on the value relevance of
current earnings” (p. 1042). While Johnson (1999) finds higher earnings persistence and value relevance
during expansions than recessions, Jenkins et al. (2009) find that conservatism and value relevance of
earnings are higher in a recession than in an expansion. Jenkins et al. (2009) comment on the proxy of
value relevance used by Johnson (1999) which does not take into account the expectation of future
earnings. These mixed results in the earnings-returns relation throughout the business cycle draws my
attention and therefore I find it interesting to carry on this subject as a research topic for my master thesis.
This paper is also motivated by the lack of empirical research which related value relevance of earnings
and economic situation that is the business cycle stages. Instead, a great body of study has mainly focused
on the influence of firm-specific characteristics rather than macroeconomic situations (Clinch and Wei
2011). To my knowledge, there are only two empirical literatures i.e. Johnson (1999) and Jenkins et al.
(2009) that study the relation between earnings and returns with respect to business cycle. Johnson (1999)
1
Later on these words value relevance and usefulness are used randomly in this thesis.
7
relates the fluctuation during business cycle with earnings persistence and value relevance of earnings
while Jenkins et al. (2009) associate the business cycle with conservatism and value relevance of
earnings. In this paper, I investigate the earnings persistence, conservatism and value relevance of
earnings throughout business cycle in one research setting.
1.3.
Relevance and Contribution
This research is relevant for those who are interested at the development of accounting practices in the
United States. Since this research investigates three important topics in accounting i.e. value relevance,
earnings conservatism and earnings persistence therefore this paper may serve the wide interest of future
researchers who are going to investigate the usefulness of accounting information across business cycle.
This thesis is related to value relevance literatures. Value relevance falls into the category of marketbased accounting study that is branch of accounting which “investigates the relation between accounting
data and firm valuation” (Bernard, 1989, p. 72). This is done by associating the change in accounting
measures with the level or change in the stock market.
This research contributes in three ways; first it reveals whether the investors use the accounting numbers
differently depending on the economic situation. This gives an insight on how the investors approach the
earnings number for their decision making throughout different stages of business cycle. Earlier studies
raise a concern on the decrease in the usefulness of financial statements to investors (Francis and
Schipper, 1999; Lev and Zarowin, 1999). Several reasons have been claimed as a possible cause of the
decrease in the usefulness of accounting numbers such as increasing rate of business change and
inadequate accounting standards in facilitating the high pact of business change (Lev and Zarowin, 1999).
This paper provides evidence whether value relevance of accounting information differs throughout the
business cycle and how the persistence of earnings and conservative accounting relates to the value
relevance of financial statements.
Second it reminds the standard-setters that different economic situations may alter the behavior of
investors and firms. For example fair-value accounting evaluates asset values based on market price and
therefore using fair value accounting for firm evaluation will result in different asset values during
economic contractions than economic expansions. The market price during a contraction will be lower
than during an expansion. It implies that during an extreme economic situation some exceptional rule
perhaps should be made in order to facilitate a better financial reporting practice. Knowing that investors
react differently towards accounting information throughout different stages of business cycle suggests
that another measurement method is perhaps more appropriate than a daily best practice.
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Third, for future research it is important to take into account the economic fluctuation in making inference
from available sample. Macroeconomic variation such as a deep recession may have different
characteristics such as (lower earnings persistence and higher conservatism: depend on the outcome of
this paper, rewrite again). For example previous research suggests that implementation of SOX in 2002
increase the level of conservatism (Lobo and Zhou, 2006). However, this result might be partly caused by
the aftermath of economic downturn in 2001. Therefore understanding the role of macroeconomic
situation on the earnings-return relation supports a right inference for the future research.
1.4.
Problem Definition and Methodology
As mentioned before, this research is motivated by the mixed results between the influence of earnings
persistence and conservatism to the value relevance of earnings across the business cycle fluctuation.
Johnson (1999) argues that higher earning persistence during expansion leads to higher value relevance
during expansion periods relative to contraction. However Jenkins et al. (2009) claim that higher demand
of conservative earnings during contraction leads to higher value relevance during contraction than during
expansion period. Therefore to investigate this mixed result, I formulate the research question as follows:
‘How do earnings persistence, conservatism and value relevance of earnings vary throughout the
business cycle?’ The sub-questions below assist this research in order to arrive on the right conclusion.
1. What are relevant financial accounting theories for this research? (Chapter 2)
2. What are value relevance, earnings persistence, conservatism and business cycle? (Chapter 3)
3. Based on prior studies, what is the relation among value relevance of earnings, earnings
persistence and conservatism; and how does it vary across business cycle? (Chapter 4)
4. Based on empirical data, how do earnings persistence, conservatism and value relevance change
throughout the business cycle? (Chapter 5 and 6)
The methodology of this paper is base on both qualitative and quantitative research. To study the effect of
earnings persistence and earnings conservatism on the value relevance of earnings an adequate
understanding of these three concepts is necessary. Therefore a qualitative research is done before
employing quantitative data. A qualitative research is done by selecting financial accounting theories and
prior empirical literatures which are relevant in solving the research question. A large amount of study
has been done in this area and to discuss all relevant literatures will be redundant. Therefore only the most
relevant literatures will be discussed. The relevant literatures are literatures which focused on earnings
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attributes such as persistence, conservatism and value relevance and how it relates with the fluctuation in
business cycle.
Accounting information is useful for the decision-making process for rational investors. Based on Scott
(2006) there are two versions of decision usefulness approach: information perspective and measurement
perspective. Information perspective assumes that reporting information is useful in predicting future firm
performance disregard the form of disclosures. The form of disclosures is not important because in an
efficient market, informed investors quickly react to available information from any source and
incorporate it directly in stock prices. Empirical researches under this perspective assess the usefulness of
accounting measures in terms of its association with equity market measures. Measurement perspective
implies greater incorporation of fair values in financial statements to enhance the usefulness of reporting
information in assisting investors to predict firm value. Measurement perspective questions the
assumption of efficient security market and the capability of historical cost accounting to provide reliable
information for the investors.
In this paper the information perspective is applied and therefore efficient security market is an important
assumption. To study the information content of earnings, the empirical part of this paper examines the
association between accounting measures e.g. earnings and equity market measures such as stock returns.
This methodology assumes that earnings is more value relevant if it has more decision useful inputs to
equity valuation model (Dechow et al. 2010). Based on the theories and the findings of prior research
some hypotheses are developed. These hypotheses are tested using a sample of listed firms in the U.S.
The data is obtained from the Compustat databank. Using statistical analysis software Eviews, these data
are tested according to the applicable models. The applied models are auto-regression model, asymmetrictimeliness model and earnings model. The proxies in these models indicate the behavior of earnings
persistence, earnings conservatism and value relevance of earnings respectively throughout business
cycle. Ultimately in this paper I do not use a short window time period (i.e. days) because it is unlikely
that business cycle changes in just a couple of days. Therefore it is necessary to take a longer period such
as several years in order to observe the effect of business cycle.
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1.5.
Structure, Boundary and Limitation
This paper has a similar research approach as two prior empirical literatures; they are Johnson (1999) and
Jenkins et al. (2009). To my knowledge, these are the only empirical studies that document the difference
in the level of value relevance of earnings throughout the business cycles. Johnson (1999) distinguishes
four stages of business cycle namely expansion, credit crunch, recession and reliquification whereas
Jenkins et al. (2009) define business cycle merely to two stages of expansion and contraction. To improve
comparison, I divide business cycle only to two stages of expansion and contraction. The reason is related
to the purpose of this research in examining the mixed result of value relevance during expansion and
contraction. However restricting only to expansion and contraction constrains the comparison purely on
these two stages of business cycle. Another limitation is in the sample selection which is merely based on
the U.S. public firms. To investigate the mixed results between Johnson (1999) and Jenkins et al. (2009),
I determine to use sample from similar country that is the United States. Nevertheless, including other
countries will add more value to the research. I leave this for future research.
This thesis is structured as follows. The first chapter gives short introduction of the topic, research
motivation and structure of this thesis. The second chapter provides theoretical background relevant for
this thesis as well as answering the first sub-question. The third chapter elaborates on the definition of the
main concepts used in this research; they are value relevance, earnings persistence, earnings conservatism
and business cycle. The third chapter answers the second sub-question. The fourth chapter reviews
empirical literature of the main concepts described beforehand including the answer of the third subquestion. The fifth chapter is devoted for hypotheses development, methodology to test these hypotheses
which consists of descriptive statistics of the sample, the applied models to test the hypotheses and
findings, and analysis of the statistical results. Finally the sixth chapter concludes by answering the main
research question. Limitation and suggestions for future research are also provided in chapter six. The
flow chart of this thesis depicts in figure 1 on the next page.
1.6.
Chapter Conclusion
Mixed results between Johnson (1999) and Jenkins et al. (2009) on the value relevance of earning
throughout the business cycle have drawn my interest to carry on this research topic. This thesis is
interested for investors, standard-setters and future researcher who want to know whether macroeconomic situations affect the usefulness of accounting earnings, the persistence of earnings and
conservatism throughout the business cycle. The main research question is defined and additional subquestions are useful as a guidance to answer the research question. Restricted sample only to the US firms
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limits the generalization of the research findings. The subsequent chapter explains the financial
accounting theory relevant for this thesis.
Chapter 1
Motivation
Chapter 2
Chapter 3
Chapter 4
Theoretical background
Main concepts
Literature review
Chapter 5
Hypotheses, methodology,
findings, & analysis
Chapter 6
Conclusion
Figure 1: The thesis flowchart
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2. Financial Accounting Theory
2.1.
Chapter Introduction
In order to gain some understanding on the usefulness of accounting information for the capital market,
this chapter provides the underlying theories behind financial reporting. This chapter aims to answer the
first sub-question. There are three financial accounting theories applicable here: efficient market theory,
agency theory and positive accounting theory. Efficient market theory assumes that stock price reflects all
publicly available information included information provided in the financial statements. Agency theory
implies that financial statements are prepared in order to reconcile the asymmetrical information between
investors as the principals and managements as the agents. Positive accounting theory reveals why the
applied accounting methods are of interests for both parties.
2.2.
Efficient market theory
Efficient market theory assumes that the price of a security reflects all available information and will
adjust quickly to the newly released information. The information of many investors is accumulated in the
capital market and this information is reflected in security prices. A security price is determined based on
the net present value of future cash flows expected from that security. If there is information indicated a
positive net present value, investors with that information will choose to buy that stock. Their attempts
increase the demand of that stock and escalate the stock’s price. Correspondingly investors with
information that selling a stock had a positive net present value will sell the stock and result in a drop on
the stock’s price (Berk and DeMarzo, 2007). Thus the competition among investors eliminates all positive
trading opportunities and leads to a fairly stock’s price is referred as the efficient market hypothesis.
To form an expectation of future cash flows, investors and financial analysts obtain information about the
specific firm from many sources outside the accounting information. If there is new information
becoming available which changes the beliefs of investors on future expected cash flows, the security
price is expected to change (Deegan, 2009, p. 261). There are three versions of efficient market: strong,
semi-strong and weak. Under perfect conditions, the security price fully reflects all information including
the insider information and therefore the market value of that security is equal to the fundamental value.
This is known as the strong form of efficient market. Under imperfect condition, market stock prices only
reflect publicly available information. The weak form assumes that stock prices reflect the historical
publicly available information whereas the semi-strong form predicts that stock prices reflect all publicly
available information and future expectations about those stocks (Scott, 2006). The difference exists
13
because of insider information and insider trading (Scott, 2006, p. 104). The definition that I shall use
here is the semi-strong form.
In practice, a perfect efficient market does not seem to hold because of information asymmetry.
Information asymmetry between agencies involved in the stock markets may lead to a failure in the stock
market, for example the collapse of Enron and WorldCom after large accounting scandals in 2001.
Information asymmetry is costly and difficult to avoid. The cost which results from information
asymmetry is entitled as agency costs. The next section elaborates more on the agency theory.
2.3.
Agency theory
As mentioned before, information asymmetry may have an adverse effect on the functioning of capital
market. The agency theory highlights the contract relation between principal and agent in which the agent
(the manager) agree to render its service on behalf of the principal (the owners). In order to perform this
service, it is necessary for the principle to assign some decision making authority to the agent over the
principal’s resources. However, this discretion provides an opportunity to the agent to pursue its own
interest instead of the principal’s interest. Hereby some agency problems may emerge because of three
reasons below (Clegg et. al., 1996, p125).
1. The agent has typically different interest than the principal (conflict of interests).
2. The principle is unable to monitor the actions of the agent perfectly and costless.
3. The principle is unable to obtain the information available to or attained by the agent perfectly and
costless.
The costs related to the reduction of these agency problems are called the agency costs. A common way
to mitigate or eliminate the agency costs is through a profit-share bearing in which both the principal and
agents benefits from the alleviation of the agency costs. The positive accounting theory explains further
the implication of principal-agent relation on the financial reporting practice.
2.4.
Positive accounting theory
Positive accounting theory gives an explanation on manager’s preference of particular accounting
methods as opposed to others. This theory was formulated by Watts and Zimmerman (1978) who seeks to
explain and predict manager’s choices of accounting methods to present the performance of a firm in the
favorable way. This theory examines the relationship among individuals within and outside the firm and
explains how accounting methods can be used to decrease the costly implications of each contracting
party pursuing their own interest (Deegan & Unerman, 2011). The contractual agreements of the
14
corresponding parties are based on the output of applied accounting method and therefore the accounting
method is of the interest for both parties. The assumptions behind this theory are efficient market and selfinterest individual. There are three central hypotheses in positive accounting theory:
1.
The bonus hypothesis
This hypothesis predicts that managers will manipulate the performance indicators such as
earnings in order to generate a higher bonus. One way to reduce agency costs is by tying the
manager’s bonus schemes with the firm’s performance. This way self-interested manager is
motivated to perform in the bests interests of the owners as it will also increase his/her bonus. The
firm’s performance is mostly measured based on accounting numbers. Therefore the manager
prefers accounting method which has a positive impact on the bonus payout.
2.
The debt hypothesis
This hypothesis predicts that managers will apply accounting methods that minimize the effect of
debt covenant. If the debt/equity ratio is too high, the cost of attaining new debt capital is higher.
This hypothesis predicts that the manager is motivated to attain higher earnings in order to change
the investors’ perception on the creditworthiness level of the firm.
3.
The political cost hypothesis
This hypothesis predicts that managers will apply accounting methods that minimize earnings in
order to reduce the level of political scrutiny. If a firm earns higher profit than expected, it will
adversely attract the attention from media and community. For example the same high level of
profit in time of recession will attract more media attention than during an economic expansion.
Hence managers will adopt accounting methods that leads to lower level of reported profit.
2.5.
Chapter Conclusion
This chapter aims to answer the first sub-question related to the financial theories relevant for this thesis.
The semi-strong form of efficient market theory assumes that the security price reflects all publicly
available information in the market. The agency theory predicts the inevitable effect of information
asymmetry which leads to agency costs. Positive accounting theory explains three hypotheses predict the
behavior of management towards available discretion inside the applicable accounting standards. In
practice, a perfect efficient market does not exist due to asymmetrical information between the principal
and the agency. The principal that is the investor cannot fully monitor the agent which leads to the
existence of agency costs. The agency which is the management benefits from the asymmetrical
15
information by opportunistically applying accounting methods in the management’s best interests. Their
action may distort the usefulness or value relevance of accounting information for the investors. Next
chapter explains further the value relevance of earnings including two important properties of earnings;
they are earnings persistence and earnings conservatism.
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3. Value Relevance, Earnings Persistence and Conservatism
3.1.
Chapter Introduction
Previous chapter elaborates on theories which explain the importance of accounting information for both
managers and owners. The owners are indeed the investors, the one who provides fund for firm’s
operation. This chapter focus on the usefulness of accounting number particularly earnings for the
investors and how it has been investigated empirically. The definition of value relevance and the
applicable model are discussed here. Earnings persistence and conservatism are two concepts which have
influence on the usefulness of accounting numbers for the investors. The relationships between these two
accounting phenomena with value relevance of earnings also are also explained below. Most of the
studies employed in this chapter are from the earlier research. The recent literatures will be discussed in
the next chapter.
3.2.
Value relevance of earnings
As mentioned in the previous chapter, the importance of earnings is crucial for both managers and owners
(investors) of a firm. The investors evaluate a firm’s performance by looking at the earnings figure and
the manager’s bonus scheme is tied to the accounting earnings. That is why management sometimes
manages the earnings number in order to impress the investors. The usefulness of accounting earnings for
the investor’s decision-making is called the value relevance of earnings. ‘Value relevance research
measures the usefulness of accounting information from the perspective of equity investors’ (Beisland,
2009, p.8).
There are different ways to measure the usefulness of accounting information for the equity market
values. One way to do this is by examining the association between accounting measures and equity
measures. If a change in the accounting measures is also incorporated in the equity measures then it can
be proved that accounting information are value relevant for the capital market. Holthausen and Watts
(2001) identify three valuation models that are commonly used in value relevance research.
Table 1: Value Relevance models
Earnings model
Balance sheet model
Ohlson(1995) model
Associated earnings with equity Associated book value (BV) with Associated BV + Earnings with
returns
equity value
equity value
Rit = β0 + β1Eit + β2∆Eit + εit
Pit = γ0 + γ1BVit + εit
Pit = α0 + α1Eit + α2BVit + εit
17
Three models mentioned above are the basic model. These models can be adapted according to the
research purpose by changing or adding additional proxy into the equation. As an example Kouesenidis et
al. (2009) employ the Ohlson (1995) model by using stock return instead of stock price as a proxy for
equity value. For my research purpose, earnings model is the relevant model because this thesis focuses
on the value relevance of earnings.
Prior literatures suggest several factors that have influence on the value relevance of earnings. A short
overview of these factors is provided below:
1. Business change
In the past two decades, business enterprises have experienced increased rate of changes. Innovation in
technology is basically the major initiator of change. In financial reporting, these innovative activities are
recorded mostly as a form of investment in intangible assets such as research and development (R&D),
information technology (IT), brands and human resources. However the current reporting system is still
using the old-fashioned tangible assets and inadequate to facilitate the accounting treatment of these
innovative activities, causing mismatch between costs and revenues. This is an example to describe the
inconsistencies in current accounting rules. When a firm develops equipment internally, it is not allowed
to capitalize the development costs on the balance sheet. In contrast if the firm purchases a similar
instrument, the value of the equipment are allowed to be capitalized as an asset. Accordingly the
investments in intangible assets such as R&D costs should be immediately expensed while the benefits
(e.g. improvement in efficiency or a new product) are gradually recognized later which does not match
with the earlier investment expenses.
Lev and Zarowin (1999) find a positive association between the rate of business change and intangible
investment in R&D. Investment in R&D is important to survive in today high competitive business
environment. Lev and Zarowin (1999) also find a positive association between the increase in R&D
spending and the decline of value relevance of earnings. To improve the value relevance of financial
information, Lev and Zarowin (1999) propose a fundamental change in current accounting treatment of
intangible assets. They claim that current accounting approach on capitalization of intangibles assets is
partly accountable for the decline in the value relevance of accounting information. Current financial
accounting information perhaps is not relevant in reflecting the firm values with high amounts of
unwritten intangible assets.
2. Mismatch costs and revenues
Current reporting practices restraint the timeliness of periodically matching costs and revenues. The
prudence concept of accounting applies a higher degree of verification on the recognition of assets and
gains in order to avoid the overstatement of assets and income as well as the understatement of liabilities
18
and expenses. Current accounting standards accentuate more on objectivity and verifiability than
timeliness (Francis and Schipper, 1999). Consequently the contemporaneous costs and revenues are not
match which seriously deteriorate the value relevance of earnings. Mismatch between costs and revenues
have two consequences: 1) a lag on how earnings reflecting information related to stock prices; and 2) an
asymmetric timeliness on how earnings reflecting good news versus bad news (Ryan and Zarowin, 2003).
The first factor is induced by the recognition of income which is based on historical cost valuation. The
historical cost valuation does not consider future cash flows causing lags in the capability of earnings to
capture stock prices. Ryan and Zarowin (2003) suggest the application of fair value accounting in order to
take into account the future elements. The second factor is related to conservative accounting. According
to Watts (2003), conservatism is defined as early recognition of losses (bad news) than gains (good news)
in financial statements. This asymmetry in gains and losses recognition brings systematic differences
between the period of bad news and good news in the timeliness and persistence of earnings (Basu, 1997).
Ryan and Zarowin (2003) claim the conservative nature of accounting principles and increasing legal
liability as the reasons of increased conservatism.
3. Less persistence components and reported losses
Investors put less weight on earnings which include a large amount of non-recurring items because less
persistence components such as non-recurring items2 are interpreted as more transitory than ‘core’
earnings3 (Eliott and Hanna, 1996). Emphasizing on special items, Eliott and Hanna (1996) find an
increase in the frequency of a firm reporting special items in its financial statement. An increase in the
occurrence of non-recurring items indicates that these items have become more persistent. Hence the
regularity in the occurrence of non recurring items suggests that these items are also value relevant for a
firm valuation. Nevertheless investors fail to distinguish the relevance between the permanent and
transitory components of the reported earnings (Eliott and Hanna, 1996). Because investors place less
weight on this ‘regular’ non-recurring item, the relevance of reported earnings for investor’s valuation is
also decreasing as indicated by the lower value relevance of earnings. Collins et al. (1997) who examine
the effect of non-recurring items on the value relevance of earnings report that the non-recurring items are
partly responsible for the observable decline in the value relevance of earnings across time.
Reported losses are less persistent than profits because no firm is willing to stay in a business with
negative earnings. The transitory nature of losses is less informative for the investors because investors
have a choice to drop a stock with negative earnings. Hence firms with losses are likely to be less value
2
Non-recurring items are categorized into three elements: extraordinary items, discontinued operations and special
items (Eliott and Hanna, 1996).
3
Core earnings capture the income from a firm’s core business while non-recurring items are infrequent and not part
of ongoing business and therefore will be less persistent (Nichols and Wahlen 2004).
19
relevance because of lower earnings persistence (Dechow et al., 2010). Hereby the persistence of earnings
plays a great role to increase the usefulness of accounting earnings for the firm valuation.
4. Firm size
The earnings of larger firms tend to be more stable than smaller firms because smaller firms have more
uncertainty on its ongoing position and higher chance of liquidation. Because smaller firms are likely to
have lower earnings persistence, investors perceived the earnings of smaller firm as less relevant for their
decision making process. For a smaller firm in which earnings are less persistent, investors consider the
book value as more value relevant for their decision making than the earnings number (Collins et al.,
1997). Hayn (1995) found that smaller firms report losses more frequent than larger firms. A plausible
explanation is a more diversified operation protects the larger firms from reporting losses in an economy
downturn (Collins et al. 1997). As mentioned before reported losses are proven to be less persistent and
therefore less value relevant.
5. Earnings management
The remuneration of managers is often measured based on the earnings number. Managers manipulate the
earnings number as an attempt to impress shareholders. This has a severe consequence since the reported
earnings are not reliable indicators of the firm’s performance anymore. If investors realize that the
reported earnings are not reliable, the earnings will be less relevant for their investment decisions.
Marquardt and Wiedman (2004) presume that the book values are less useful for the investors when
earnings management is expected to take place. Their findings demonstrate a decline in the value
relevance of net income in a setting of secondary offering4 in which investors expect earnings
management to emerge.
6. External information
As indicated before, in the midst of fast innovative changes current accounting information fails to
support the investors in their investment decisions. Therefore investors inquire supplementary and
timelier update from external sources such as non-financial information (Amir and Lev, 1996). Another
information sources such as the forecasts of financial analysts are usually available before the issuance of
financial reporting. Non-informational trading activities also indirectly affect the payoffs of the trading
securities (Grossman, 1995). Dontoh et al. (2004) demonstrate that the decline of value relevance of
accounting information could be driven by the increase in non-information based trading activity. Noninformation based trading weakens the ability of stock prices to capture reported earnings, hence affects
the value relevance of earnings.
4
Secondary offering is the issuance of new security from a company whose security has been previously issued at
initial public offering (IPO).
20
7. Accounting standard setters
The development of accounting standards and differences in the standard setting bodies influence the
value relevance of accounting information. The change in business environment - which is outside the
control of standard setters - enforces the amendment of existing accounting standards by the standard
setting bodies in order to suit current business development. Accordingly Ely and Waymire (1999) claim
that accounting standard setters may affect the value relevant of accounting information by the way
accounting standards have been developed across time.
As mentioned in the second chapter the market price of a stock is determined by the present value of
future cash flow expected from that particular stock. Therefore a high level of earnings persistence is
important for the decision making of investors whether to buy/sell a stock. A high level of earnings
persistence provides a better indication for investors in forecasting future cash flows from the stock
(Dechow et al., 2010). Incorrect judgment on future cash flow of a stock may induce a significant security
mispricing, leading to overvaluation or undervaluation of the stock (Sloan, 1996).
The untimely recognition of gains and losses may also reduce the relevance of earnings for investors
because market price of the stock fails to reflect the economic value of the firm accurately. This might be
caused by conservatism in earnings. According to Watts (2003), conservatism is defined as early
recognition of losses (bad news) than gains (good news) in financial statements. The asymmetry in gains
and losses recognition brings systematic differences between the period of bad news and good news in the
timeliness and persistence of earnings (Basu, 1997). Prior research also documents that the usefulness of
earnings has been decline over time due to the conservatism in earnings (Lev and Zarowin, 1999; Francis
and Schipper, 1999; Core et al. 2003). Next Section provides definition of two important properties of
earnings: earnings persistence and earnings conservatism.
3.3.
Earnings Persistence
Earnings persistence captures the effect of current earnings innovation on the future realization of
earnings series. Firms entangle in business investments and innovations in order to have a persistent
stream of earnings. Excluding any exogenous shocks, the earnings level is expected to persist into the
foreseeable future. Because earnings are often used for equity analysis and firms valuation therefore
earnings persistence is an important key for an effective financial analysis (Subramanyam and Wild,
2009). Earnings persistence has been used as a proxy to measure earnings quality with underlying
assumption that high persistence earnings are more useful for equity valuation (Dechow et al., 2010).
More persistent earnings provide better information to equity valuation model and therefore it has higher
quality than less persistent earnings.
21
Based on efficient market theory, capital market price adjusts quickly to the publicly available
information. The capital market reacts to useful information available from any source including financial
statements. Beaver (1998) develops a theoretical framework that relates earnings with stock prices. There
are three theoretical links:
1. Current earnings contain information to predict future earnings.
2. Future earnings provide information to form expectation of future dividends.
3. Expected future dividends provide information to judge the stock value, assuming that stock
prices reflect the present value of all expected future dividends.
Current earnings
Expected future earnings
Current stock price
Expected future dividends
Figure 2: The theoretical links between earnings and stock prices (Beaver, 1998)
The theoretical links above depict the importance of earnings as predictive information for future stock
price. The first link predicts that earnings (provided in the firm’s financial statement) gives information
about current and expected future performance to form expectation of the future earnings. The second link
predicts that current and expected future earnings provide investors with information about current and
expected future dividends. Based on the capital pricing theory, stock price equals to the present value of
future dividends expected to flow out from owning the stock. Therefore the third link predicts that stock
price equals to the present value of expected future dividends. These theoretical links imply that
accounting information particularly earnings induces an expectation change of future dividends for the
investors which account to a change in the market value of the firm. This theoretical framework provides
a line of reasoning for understanding the connection between earnings and stock value. Current reported
earnings provide the investors information to develop expectation of future earnings which eventually
used as the basis for valuing the stock (market price). The next question is whether this theoretical
framework holds in practice.
This has been worked out by prior researchers such as Ball and Brown (1968), Kormendi and Lipe (1987)
and Nichols and Wahlen (2004). Ball and Brown (1968) is the first empirical study that document
evidences of the usefulness of accounting information to the stock market (value relevance). They study
the association between accounting income numbers and changes in stock returns. Ball and Brown (1968)
find that on average firms with good news (i.e. firm’s reported earnings are larger than market
22
expectation) enjoyed positive abnormal returns and bad news had negative abnormal returns. Abnormal
return is the difference between actual return of a share with the expected return. Kormendi and Lipe
(1987) found that the persistence of past and current earnings is positively related to the unexpected
earnings on stock return. Kormendi and Lipe (1987) conclude that earnings persistence positively affect
the value relevance of earnings to the investor. Nichols and Wahlen (2004) who replicate Kormendi and
Lipe (1987) also reported that earnings persistence is important for the evaluation of firm’s value.
Dechow et al. (2010) quote three model specifications to estimate earnings persistence. The first model is
simply the first autocorrelation of earnings which assume that current earnings are useful to estimate the
next period earnings. The second model comes from Sloan (1996) who decomposes total earnings into
cash flow and accruals components. This model is commonly used to compare the persistence between
these two components of earnings. The third model is the extension of second model which further
specify the components of total accruals and cash flows. Table below provides summary of each model.
Other empirical studies on the relation between earnings persistence and value relevance are discussed in
the next chapter.
Table 2: Earnings Persistence models
Persistence models
The lag model
Model specification
Earnings t+1 = b0 + b1Earnings t + t
The persistence of earnings Earnings t+1 = b0 + b1Cashflow t + b2Accruals t + t
components (Sloan 1996)
The persistence of accruals Earnings t+1 = b0+ b1Earnings t + b2 financial statements components t +
and cash flow components
b3 other information t + t
Subramanyam and Wild (2009) mentioned four determinants of earnings persistence such as:

Earnings trends
The trend in a firm’s earnings stream is highly dependent on the characteristics of the firm. Commonly
there are two essential characteristics: the size of firm and firm’s growth. Firm size affects the persistence
of earnings because the size of a firm is closely related to the competitive position of a company. Capital
requirements, scale economies, barriers-to-entry and industry concentration are closely related to
industry-level profitability (Schmalensee, 1989). Baginski et al. (1999) find that capital intensity, barriersto-entry and product-type are significantly related to earnings persistence. Growth affects earnings
persistence because a stable growth corresponds to a persistent stream of earnings and firm’s profitability.
Future profitability and firm value are related to the growth of net operating assets and current
profitability (Ohlson, 1995; Feltham and Ohlson, 1995). Shroff (1995) finds that earnings of firms with a
23
high price-to-earnings (P/E) ratio together with a high return on equity (ROE) provides ex ante indication
of earnings growth. The earnings of firms with these features demonstrate a positive correlation with
future earnings and also a higher explanatory power for returns than earnings of firms with a high P/E and
a low ROE.

Variability
Variability in earnings is determined by the volatility of earnings flows. Persistent and transitory items in
earnings by large determine the variability of earnings. Large earnings changes and losses are transitory
and unlikely to persist in the future. Earnings tend to return to the previous level before the large earnings
changes (Brooks and Buckmaster, 1976). Large earnings changes may result from positive economic
shock such as technological changes. Because of the nature of this positive shock which is one-time
event, the effect of larger earnings changes is unlikely to stay in the future. Losses are another source of
less persistent earnings. Losses are less persistent than gains for two reasons; first, due to conservatism in
accounting practice, expected losses are recognized more timely than expected gains (Basu, 1997);
second, losses caused by negative shocks (e.g. natural disaster, strike) and asset liquidations are likely to
be immediately recognized while positive gains are realized gradually over time (Hayn, 1995).

Management incentives
As explained in the prior chapter management as an agent has different interests than the principal. As a
person in charge of the firm’s resources management has incentives to regulate earnings to attain results
according to his/her best interest. These incentives may relate to personal objectives, distress firms,
preserving hard-earned reputations in the case of prosperous firms, bonus schemes, and accounting-based
incentives and constraints. An example of how management can influence earnings persistence is by
deciding to postpone a certain investment undertaking in order to constrain current costs yet in expense of
long term earnings sustainability. There is no future return can be earned without any new investment.

Earnings management
Earnings management is an act to manipulate a firm’s financial earnings either directly through
accounting methods such as changing accounting assumptions, offsetting extraordinary gains and losses
or indirectly such as big baths, write-downs, timing revenue and expense recognition. Earnings
management has consequences on earnings persistence because it affects particularly the accrual
component of earnings. Accrual component of earnings is less persistent than the cash flow component.
Sloan (1996) finds that the persistence of earnings performance depends on the relative magnitudes of the
cash and accrual components. He concludes that investors seems only focusing on aggregate earnings and
fail to discern information contained in both earnings components (accruals and cash flows) until that
information impacts future earnings. Richardson et al. (2005) who extend Sloan’s (1996) work also
24
confirm that less persistent accruals lead to lower earnings persistence which mislead investors who do
not fully aware of the lower earnings persistence, leading to security mispricing. In the long term when
accruals eventually due, there will be no difference between accrual and cash flow in explaining earnings
persistence.
3.4.
Conservatism
Conservatism is not a new concept in accounting. The influence of conservatism in accounting practice
and theory has been existed for centuries (Basu, 1997). Traditionally, conservatism was expressed as the
rule “anticipate no profits but anticipate all losses” (Bliss, 1924). This means that conservative reporting
recognizes events with an expected unfavorable outcome immediately while the recognition of expected
favorable outcome is delayed. In the beginning of the 20th century, this view is common for accountants.
The least favorable valuation is adopted in order to anticipate too optimistic or even fraudulent
management which may mislead the users of financial statements.
Nowadays, conservatism is less favorable because it does not lead to a true and fair view of the firm’s
financial performance. Indeed the Financial Accounting Standards Board (FASB) attempts to mitigate
conservatism from accounting practice. They state as follows: “conservatism … introduces a bias into
financial reporting, it tends to conflict with significant qualitative characteristics, such as
representational faithfulness, neutrality, and comparability (including consistency)” (FASB, 1980,
paragraph 92). Prior empirical study mentions conservatism as one reason of the declining earnings
usefulness for investors (Francis and Schipper, 1999).
Regardless of its popularity there is no authoritative definition of conservatism. Conservatism is defined
distinctly based on the research purpose. The Statement of Concepts No. 2 of the FASB defines
conservatism as “a prudent reaction to uncertainty to try to ensure that uncertainty and risks inherent in
business situations are adequately considered.” Basu (1997) interpreted conservatism as "the
accountant's tendency to require a higher degree of verification to recognize good news as gains than to
recognize bad news as losses" (p. 7). Conservatism can be seen as asymmetric treatment of gains and
losses in the financial reporting. Despite of various definitions of conservatism, there is one common
accord that a consequence of conservative reporting is the systematic understatement of net asset values
relative to their economic values (Watts, 2003a).
According to Givoly et al. (2006), there are different features of reporting which may result in
understatement of net asset values. The first feature is the ‘conservative’ selection of accounting methods.
For example immediate expense of investment in certain asset such as internally generated intangible
asset (e.g. R&D) and accelerated depreciation lead to net asset understatement on the balance sheet
(known as “balance sheet conservatism”). Asset understatement on the balance sheet is also related to a
25
reduction in income (“earnings conservatism”). For example the capitalization of costs protects current
earnings from certain expense - although in the future this capitalized cost will need to be amortized
reducing future earnings - and higher depreciation costs in current earnings because of accelerated
depreciation will followed by lower depreciation charges in the next accounting period. The second
reporting feature that leads to assets understatement is the asymmetric timeliness in losses recognition
relative to gains. An eminent example is the implementation of the lower-of-cost-or-market (LCM)5
approach in valuing the impaired value of assets when they are reasonably foreseen while the recognition
gains and appreciation has to wait until they are realized.
Above mentioned reporting features originate from the tendency of accountants to attain a substantial
degree of verification for the recognition of asset than liabilities (Basu, 1997; Watts, 2003a). Balance
sheet conservatism is sometimes referred to “unconditional conservatism”. Unconditional conservatism is
ex ante and independent of any underlying economic events. A common example of unconditional
conservatism is an immediate expense of R&D costs (as mentioned above). Earnings conservatism
sometimes referred as “conditional conservatism” because it is triggered by a contemporaneous economic
event (see the example mentioned before). The unconditional conservatism emphasizes on the difficulty
of valuing certain economic assets/liabilities while the focus of unconditional conservatism is on
improving contracting efficiency by written down book values under adverse situation but not upwardbiased under favorable events (Ball and Shivakumar, 2005). Ball and Shivakumar (2005) who introduce
these terms mention that conditional conservatism can increase the contracting efficiency because it
protects lenders by triggers debt covenant violation earlier after economic losses emerged and provides
less incentive for managers to undertake negative present value investment projects whereas
unconditional conservatism appears inefficient or neutral in contracting.
In this paper, the concern is on the conditional conservatism and/or earnings conservatism. As mentioned
in the first chapter, the purpose of this paper is to examine earnings persistence, conservatism and value
relevance throughout business cycle. Business cycle fluctuates based on the macroeconomic situations i.e.
expansion and recession. Hence unconditional conservatism will not be affected by the economic
situation since this type of conservatism is independent of the underlying economic events. Therefore
conditional conservatism is more relevant for my research purpose than unconditional conservatism. This
will have implication on the measurement method applied in the empirical part of this thesis. Based on
Wang et al. (2008), there are five measures of conservatism which are widely used in accounting
5
Lower of cost or market (LCM) is a rule to write down inventory based on market value when its carrying value is
above market price. The decline in the inventory value is reported as loss. However there is no written-up of
inventory when the historical costs fall below market price.
26
research. The Basu (1997) measure is the most popular model of conservatism in the empirical literatures
(Ryan, 2006; Wang et al., 2008).
Table 3: Conservatism models
Conservatism
Authors
Model specification
Market-to-Book
Feltham and
MTB = Market ValueBook Value
(MTB) ratio
Ohlson (1995)
A higher MTB indicate a higher degree of conservatism
Asymmetric
Basu (1997)
Eit = β0+ β1Rit + β2DRit + β3Rit * DRit + εit
model
timeliness measure
E = earnings, R = equity return,
(AT)
DR = 1 if Rit < 0 otherwise 0, it = firm i year t
Coefficient β3 indicates asymmetric timeliness and hence higher
β3 suggest a higher degree of conservatism
Negative-accruals
Givoly and
Increase
in
accumulated
negative
accruals
indicates
(NA) measure
Hayn (2000)
conservatism in the firm’s book value
Hidden-reserves
Penman and
Index of conservatism : C-score= ERit / NOAit
measure (HR)
Zhang (2002)
ER =Estimated hidden reserve due to conservative accounting
NOA = Net operating assets
Asymmetric-cash-
Ball and
ACCt = β0 + β1DCFOt + β2CFOt + β3DCFOt *CFOt + εt
flow-to-accruals
Shivakumar
ACCt: Accruals6, CFOt: Cash-flow for period t,
measure
(2005)
DCFOt = 1 if CFOt < 1 otherwise 0
Higher β3 indicates a higher degree of conservatism.
Despite of some controversy in the application of conservatism, conservatism still exists in accounting
practice because of its considerable role in financial reporting. Watts (2003a) identifies four reasons on
why conservatism continues to exist in financial reporting. These four reasons are as follows:
1. Contracting explanation
Conservative accounting improves contracting efficiency in the organization of the firm and its
various contracting parties because it reduces the agency costs by addressing moral hazard caused by
asymmetric information, asymmetric payoffs, limited horizons, and limited liability among
contracting parties. Conservative accounting is used as instrument to improve contracting efficiency.
Accruals calculated from Δ inventory + Δ Debtors + Δ other current assets – Δ Creditors – Δ other current
liabilities – Depreciation.
6
27
Watts (2003a) discerns three important contracts: debt contract, manager compensation contract and
firm governance. Debt contract addresses the ability of debt-holder to repay its creditor; manager
compensation addresses the conflict of interest between management and shareholders in choosing a
project to be undertaken; and firm governance addresses the appropriate action of dealing with losses
timely when losses occur.
2. Shareholder litigation
For firms with high liquidation probability, understating net assets is more likely to reduce the
litigation costs than overstating the firm’s net assets. Conservative accounting undervalues net assets
and current earnings which accordingly reduce the firm’s expected litigation costs. By understating
net assets and earnings, managers and other parties such as auditor lower the risk of being prosecuted
by the shareholders.
3. Taxation
Conservative accounting accelerates the recognition of expense and postpones the recognition gain to
defer tax payments. Deference of tax payments allowed profitable firms to lower the present value of
taxes charges and ultimately increase the current value of the firm. An empirical study by Desai et al.
(2009) shows that the amount of firms reduces their earnings aiming to lower their tax burdens is
substantially increased.
4. Accounting regulation
Standard setters and regulators have a political responsibility with regard to the consequences of the
accounting standards they developed. The regulators are likely to be less criticized when firms
understate net assets than when firms overstate net assets. Hence for the regulators to encourage
conservative accounting is more beneficial because it reduces the political costs impose on them.
3.5.
Business cycle
The distribution of macro-economic activity varies over time, following an irregular pattern of economic
expansions and contractions. Expansion and contraction occur around a trend growth path in the
economy. Business cycle refers to the fluctuations around the trend (Johnson, 1999). Based on the
impulse-propagation approach7, these fluctuations occur because of an impulse which drives the cycle and
the propagation mechanism determines how the impulse is transmitted (Burda and Wyplosz, 2005).
A business cycle can be divided into four stages: expansion, peak, contraction, and trough. Expansion is
indicated with a positive economic growth rate and a high level of GDP. Peak is the highest point in an
expansion period. A failure to expand further leads the economy to a recession or a contraction which
7
Macroeconomist approaches business cycle in two ways; first is business cycle as self-renewing phenomena which
is largely predictable and the second as an impulse-propagation mechanism.
28
marked by a low even negative growth rate and a substantially low level of GDP. The lowest point in a
contraction is trough (see figure 4). In a contraction the government and the central bank commonly
intervene through the fiscal and monetary policy to save the economy from declining even further.
Eventually the economy starts to climb up from trough and start expanding again. The graph of U.S.
business cycle based on the U.S. GDP (obtained from the U.S. Bureau of Economic Analysis (BEA)) is
provided below.
Business Cycle in the United States
8
6
GDP
4
2
0
-2
-4
-6
60 61 62 63 64 65 66 67 68 69 70 71 72 73 74 75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11
United States 0 2 6 4 6 6 7 2 5 3 0 3 6 6 -1 0 5 5 6 3 0 3 -2 5 7 4 3 3 4 4 2 0 3 3 4 3 4 5 4 5 4 1 2 3 4 3 3 2 0 -4 3 3
Figure 3: Business cycles in the U.S. for years 1960-2011
Despite of well-known existence of business cycle, the effects of business cycle is difficult to define and
measure accurately. One way to measure business cycle is by using the definition from a well known
research institution. In this paper I use the business cycle definition from the National Bureau of
Economic Research (NBER)8. To define business cycle in the United States, NBER designs a
measurement method that applies multiple variables to define the monthly business cycle. These multiple
variables include employment, personal income, industrial and manufacturing production, and trade sales.
Although NBER also provided data about the peak and trough during a business cycle, for the sake of
simplicity and comparison with the findings of other empirical study this paper will only classified the
business cycle into two stages of expansion and contraction. Figure 4 depicts the NBER business cycle.
8
NBER is a leading nonprofit research organization specialized in the area of Economics and Business in the United
States.
29
Figure 4: Business cycle based on NBER
Financing and investment opportunity sets change throughout expansion and recession. As we see in the
practice nowadays, in a recession internal financing is limited and therefore firms are relied more on
external financings. To negotiate a debt covenant, the external funds ask for a higher degree of reliability
of the information provided in the financial statement. Hence, this might increase the level of
conservatism in the earnings. With regard to earnings persistence, because of an economy contraction
sustaining former level of earnings becomes really difficult. In the glorious period of expansion firms are
able to finance their project internally because excessive internal funds are likely available. However
during a contraction, the availability of both external and internal funding is very limited. Therefore it is
expected that the level of earnings persistence will decrease during a contraction.
3.6.
Chapter Conclusion
This chapter has elaborated on theory and important concepts which are necessary for grounded
understanding of this research. Based on the agency theory, asymmetric information motivates the
manager and other contracting parties to keep the practice of conservative accounting. Earnings
persistence is the capability of current earnings to predict future earnings. High earnings persistence is
necessary for security valuation. Conservatism is a prudent action for requiring a higher verification in
gains recognition than losses recognition. The asymmetric treatment between gains and losses recognition
may lead to cumulative net assets understatement in the financial statement which reduce the usefulness
of financial report. Both conservatism and earnings persistence may affect the value relevance of
earnings. Value relevance of earnings can be defined as the usefulness of earnings for investors in the
firm’s valuation. Prior research suggests that earnings persistence, conservatism and value relevance vary
throughout the business cycle (Johnson 1999; Jenkins et al. 2009). In the next chapter, some empirical
literatures provide evidences on how these accounting phenomena relate to each other based on previous
empirical studies.
30
4. Literature Review
4.1.
Chapter Introduction
The definition of value relevance, earnings persistence and conservatism has been explained in the
previous chapter. This chapter elaborates on the empirical studies which relates to value relevance of
earnings, earnings persistence and conservatism. The aim of this chapter is to answer the third subquestion which is to find out from prior empirical studies the relation among value relevance of earnings,
earnings persistence and conservatism; and whether it varies across business cycle.
4.2.
Earnings persistence and Conservatism
The existence of conservatism in the accounting practice has been well known. Prior studies have
documented evidences on the existence of conservative accounting (Basu, 1997; Givoly and Hayn, 2000).
Basu (1997) examines the influence of conservatism on the properties of earnings. He made four
hypotheses to investigate whether conservatism has asymmetric impact in good news period relative to
bad news period. A good news period is indicated by positive returns while bad news period as period
with negative returns. One of his hypotheses predicts that negative earnings changes tend to be reversed
in the next period than positive earning changes. In other word, negative earning changes are less
persistent than positive earnings changes. The sample consists of the US public listed firms in total
36,394 firm-year observations during the period of 1964-1990. Basu (1997) uses a regression analysis
with independent variables consist of the changes in earnings and a dummy which equal to one for good
news firms otherwise zero and the dependent variable is the stock return. This regression analysis is well
known as Basu (1997) asymmetric timeliness (see table 3) which is the most adopted conservatism
measures (Wang et al., 2008). Lower adjusted R2 from negative earning changes than positive earnings
changes indicates that bad news earnings changes tend to reverse in the next period than good news
earnings changes. Basu (1997) argues that a higher persistence of earnings changes in good news period
is affected by conservatism. Under conservative accounting losses (bad news) should be immediately
recognized whereas gain recognition is recognized gradually which implies that gains tend to persist into
the next period.
Paek et al. (2007) examine the effect of conservative accounting on earnings persistence and the stock
market’s valuation of earnings. They hypothesize that more conservative earnings are less persistent than
less conservative earnings. The argument behind this hypothesis is the mismatching between currentperiod revenues and future-period revenues due to conservative accounting adds noise into earnings.
Hereby an important assumption is a match between contemporaneous revenues and expenses is
31
necessary to give a true and fair view of the firm’s performance (Dechow, 1994). The sample was
obtained from the US Compustat database which consists of 431,194 firm-year observations during year
1984-2003. The firms with non-December fiscal year were excluded in order to avoid the effects of
different economic conditions related to different fiscal year. Further financial service and utility
companies were also excluded from the sample because these firms have different institutional and
regulatory natures.
Paek et al. (2007) use four different conservatism measures. These are the asymmetric timeliness of Basu
(1997), the cumulative non-operating accruals (Givoly and Hayn, 2000) over the past five years, the
negative of response coefficient of change in operating income on change in lagged operating income and
the response coefficient of accruals on cash flow (Ball and Shivakumar, 2005; Ruddock et al. (2006). The
earnings persistence is measured by the first autocorrelation between earnings of two consecutive years.
The magnitude of these measures indicates the level of conservatism in the earnings. The larger the
magnitude is the more conservative earnings are. To test the hypothesis, Paek et al. (2007) regress
current-period earnings included a dummy variable as independent variable with the next-period earnings
as dependent variable. A dummy variable represents conservatism in current period and equals to one if
the conservatism measure is greater than the yearly median and otherwise zero. Each conservatism
measure is tested separately. The findings show that less conservative earnings are likely to persist into
the next period than more conservative earnings regardless which conservatism measure being applied.
This means that more conservative earnings are less persistent compared to less persistent earnings.
Sloan (1996) investigates whether the relative magnitudes of earnings components affect the persistence
of current earnings. The autocorrelation of current and future earnings can be expressed as:
Earnings t+1 = b0 + b1Earnings t + et
Recall that earnings constitute accruals and cash flow, this equation can be specified as:
Earnings t+1 = b0 + b1Cashflow t + b2Accruals t + et
Sloan (1996) hypothesizes that the persistent of current earnings is decreasing in the magnitude of the
accrual and increasing in the magnitude of the cash flow. His sample was obtained from the U.S.
Compustat database which contained 40,679 firm years during the period of 1962-1991. The findings
show a smaller coefficient on accruals (b1) relative to cash flows (b2) which means that accrual and cash
flow components of current earnings have different implications in explaining future earnings. The
accrual component of earnings demonstrates lower persistence for the assessment of future earnings than
the cash flow component of earnings. The finding of Sloan (1996) is important to interpret the findings of
the next paper on how accruals relates to earnings persistence and conservatism.
32
Wakil and Alam (2012) investigate the effect of conservatism on accruals persistence in predicting future
earnings. They hypothesize that higher degree of conservatism will positively affect the accruals
persistence in high accrual firms relatively more than low accrual firms. A firm with high accrual has
more uncertainty in the future earnings compared to low accruals firm. Accruals have higher subjectivity
and transitory nature than cash flow (Sloan, 1996) and therefore higher verifiability is required in
determining accruals than cash flows. Hereby conservatism plays a role. A firm with high accrual is
expected to have a higher degree of conservatism in order to reduce information asymmetry between
shareholders and management.
Wakil and Alam (2012) employ three different metrics to measure a firm’s conservatism. They are Basu
(1997) asymmetric timeliness, C-score (Penman and Zhang (2002) which is estimated from three
reserves: LIFO inventory, R&D, and advertising, and market-to-book (MTB) ratio (Giovaly and Hayn,
2000). The level of conservatism from these metrics is included in the regression analysis in which
operated cash flow, operating accruals, level of conservatism and a dummy variable as independent
variable and future earnings as dependent variable. A dummy variable is equal to one for firms belong to
the high accrual deciles, otherwise zero.
The sample was obtained from the US Compustat and CRSP (Center for Research on Security Prices)
databases and comprises of 30,944 firm year observations during the period of 1987-2008. Similar to the
reasoning of Paek et al. (2007), Wakil and Alam (2012) also exclude non-December fiscal year-end
observation and firms in financial and utility industries. Likewise Sloan (1996) findings, they find a
higher magnitude of persistence coefficients for cash flows than accruals. Further they find evidence
confirming their hypothesis that conservatism increases accrual persistence of firms belong to high
accruals deciles more than firms belong to low accruals deciles. In other words, the effect of conservatism
is higher for firms with high accruals than firms with low accruals. How does this relate to earnings
persistence? Following from Sloan (1996) current earnings persistence is decreasing in the magnitude of
accrual component. Hence the higher the accruals, the stronger effect conservatism has on earnings, the
lower the persistent of earnings are.
4.3.
Conservatism and Value relevance
Brown et al. (2006) examine the relationship between conditional conservatism and the value relevance of
accounting earnings across 20 countries. Brown et al. (2006) hypothesize the association between value
relevance and conditional conservatism is positively related to the accrual intensity. He argue that in the
country with high accrual intensity the effect of conditional conservatism on value relevance of earnings
will be higher due to more accounting choices available through the accruals accounting. Accrual
33
accounting supports for better matching of revenues and expenses than cash accounting and hence is
expected to yield more value-relevant earnings. (Dechow, 1994). However accrual accounting introduces
more noise in the earnings because of the higher degree of subjectivity in estimating the amount of
accruals (Dechow and Dichev, 2002). Accordingly accruals allow managers to opportunistically benefit
from their choices in estimating and presenting accruals for their private gains. Hung (2001) finds that
low shareholder protection allows managers to use accruals which increase opportunistic behavior of
managers and as a result reduces the value relevance of earnings. Watts (2003a) argues that conditional
conservatism constrains manager behavior to manage earnings upward. Guay and Verrechia (2006) find
that conservatism introduces higher costs on managers who are likely to manipulate earnings upward.
Thus conditional conservatism is expected to increase value relevance of earnings when accruals intensity
is high because higher accrual intensity allows opportunistic behavior of managers.
Using a sample of firms from 20 countries9 during the period of 1993-2004, Brown et al. (2006) find
support for their hypothesis. The sample comprises of 47,802 firm-year observations obtained from the
Compustat Global database. Only the industrial firms include in the sample in order to enhance the
comparability of the outcomes across countries. The value relevance of earnings is calculated as the mean
returns of the earnings-based portfolio scaled by the mean return of the return-based hedge portfolio.
Brown et al. (2006) do not use the earnings-return regression approach but rather the portfolio approach
since the portfolio approach controls for the different volatility of market returns across countries.
Conditional conservatism is calculated using the asymmetric timeliness of Basu (1997) model and
association between accruals and cash flows (Ball and Shivakumar, 2005). Brown et al. (2006) also
calculate the market-to-book ratio (Givoly and Hayn, 2000) to capture the unconditional conservatism.
MTB ratio reflects the cumulative effect of net asset understatement. To estimate the relation between
conditional conservatism, value relevance of earnings and the accrual intensity, Brown et al. (2006) use
regression equation which consists of accrual index, tax-book conformity, conditional conservatism, and
unconditional conservatism as dependent variable, and value relevance of earnings as independent
variable. Accrual index exhibits the degree that the accounting system departs from a cash measure. Taxbook conformity expresses the convergence between tax reporting and financial accounting. Both accrual
index and tax-book conformity are attained from Hung (2001).
The coefficients of accrual index and conditional conservatism show a negative value means that higher
accrual intensity and high conditional conservatism negatively related to the value relevance of earnings.
However the coefficient of the interaction between accrual intensity and conditional conservatism shows
9
These are Australia, Belgium, Canada, Denmark, Finland, France, Germany, Hong Kong, Italy, Japan, The
Netherlands, New Zealand, Norway, Singapore, South Africa, Spain, Sweden, Switzerland, UK, and USA.
34
a positive association with the value relevance of earnings both including and excluding unconditional
conservatism. This supports the hypothesis that the accrual intensity positively increases the association
between conditional conservatism and the value relevance of earnings. Conditional conservatism
increases the value relevance of earnings only for countries with high accrual intensity.
Kousenidis et al. (2009) investigate the association between conservatism and value relevance of earnings
in Greece. They made three hypotheses; the first hypothesis is the presence of conservatism in the
accounting practice of Greek firms, the second hypothesis is that conservatism increase the value
relevance of accounting earnings and the third hypothesis is that the conservatism level of post-crisis
period of 2000-2003 is relatively higher than the period of 1989-1999. The traditional Greek accounting
system addresses mainly the firm’s tax liability and hence is considered to be conservative by nature
(Ballas, 1994). Moreover after the implementation of the Fourth EU Directive put forth, the valuation
should be made at the lower price between the historical cost and the market price which even increase
conservative accounting. Therefore Kousenidis et al. (2009) argue that conservatism presents in the data.
The implementation of IFRS (International Financial Reporting Standards) in 2005 could also have an
impact on the level of conservatism and for that reason Kousenidis et al. (2009) constraint their sample
period only until year 2003.
The data was obtained from the Profile database for the accounting data and the Athens Stock Exchange
for the stock price data. The total sample consists of 1,035 firm year observations from the period of
1989-2003. Due to different reporting requirements, financial industry has been excluded from the
sample. Basu (1997) model was used to measure the level of conservatism in the data. The significant
value of Basu (1997) measure indicates the presence of conservatism in the data. To investigate the
effects of conservatism on value relevance, the sample are separated into three groups according to the
level of conservatism. The lower and upper thirty percent are classified as the low conservatism group
and the high conservatism group whereas the remainder forty percent as the medium conservatism group.
The value relevance of accounting earnings is estimated based on the Easton and Harris (1991) model.
This model regressed earnings and changes in earnings as independent variable with stock returns as
dependent variable. To deal with heterogeneity the fixed/random effects estimator is included in the
equation.
With regard to the second hypothesis, the findings show that the value relevance of medium-conservatism
group is higher than the low-conservatism group suggesting that conservative accounting enhances the
value relevance of earnings. However the high-conservatism group exhibits lower value relevance of
earnings although it is slightly higher than the low conservatism group. Kousenidis et al. (2009) suggests
that “the excessive exercise of conservatism appears to distort the explanatory power of accounting
35
information” (p. 231). They conclude that the effect of conservatism on value relevance of earnings is
non-linear. Value relevance of earnings improves only in the medium-conservatism group and declines in
the low- and high-conservatism group. To test the third hypothesis, Kousenidis et al. (2009) divide their
sample period into two sub-samples that is the period of 1989-1999 and the period of 2000-2003. The
results show a higher and significant level of conservatism in the post-crisis period of 2000-2003 than
before the crisis i.e. the period of 1989-1999. This finding supports the view of Watts (2003a) that the
concern of litigation and increased accounting regulation during a market downturn may lead to more
conservative accounting. Furthermore the results also show that in the time of recession the value
relevance for low and high conservatism group is relatively lower than the medium conservatism group.
This demonstrates that investors value both high and low conservative earnings to be equally irrelevant in
the market downturn.
Despite of these two literatures that document evidence of conservatism’s effect on earnings,
Balachandran and Mohanram (2010) found no evidence that conservative accounting reduce the value
relevance of accounting information. They examine the association between value relevance of
accounting information and conservatism. The sample consists of 100,894 firm-year observations of the
U.S. firms during the period of 1975-2004, which obtained from the Compustat and CRSP databases. The
sample constitutes all industries except for firms with negative book value. The value relevance of
accounting information is measured by using three approaches: 1) price value relevance is the regression
of earnings and book values per share with stock price per share; 2) returns value relevance is the
regression of earnings and changes in earnings with the annual stock return; 3) perfect measures foresight
is the regression earnings, change in earnings and book value with the market-adjusted return.
Conservatism is measured by using two proxies: 1) Beaver and Ryan (2000) approach by regressing the
lags of stock returns10 with book-to-market ratio; 2) C-score (Penman and Zhang 2002). Please note that
these proxies measure unconditional conservatism.
Balachandran and Mohanram (2010) found that conservatism has substantially increased over the 30
years sample period using either proxy. They argue that increase in conservatism is driven by significant
growth of intangible assets and reporting standards which become more conservative. As mentioned in
the previous chapter, valuation of intangible assets allows certain level of subjectivity which is greatly
influenced by conservatism. With regard to the trend in value relevance, all three approaches demonstrate
a declining trend. Consistent with the findings of previous empirical literatures (Francis and Schipper
1999; Lev and Zarowin 1999), the value relevance of accounting information has declined over time. To
10
The coefficient of lagged stock returns captures the delayed recognition due to conservative accounting.
36
investigate whether the decline in value relevance related to the increase in conservatism, Balachandran
and Mohanram (2010) separate the sample of each year into two groups (high and low) based on the level
of conservatism and independently two groups (steady and increasing) based on conservatism growth.
They find that the decline in price and returns value relevance is more pronounced for groups with steady
conservatism growth than those with increasing conservatism. However for the value relevance for
perfect measures foresight, there is no difference between steady and increasing groups. They conclude
that the decline in value relevance is not related with increasing level of conservatism.
4.4.
Earnings persistence and Value relevance
Earlier studies such as Kormendi and Lipe (1987), Easton and Zmijewski (1989) and Collins and Kothari
(1989) have proved that persistent earnings impose a higher response of stock price. It has been well
established by prior researches that more persistent earnings are more relevant for stock valuation than
less persistent earnings. Kormendi and Lipe (1987) and Easton and Zmijewski (1988) record a positive
relationship between earnings persistence and the earnings response coefficients (ERC) of the earningsreturn relation. Earnings response coefficient is a proxy for the usefulness of earnings information for the
equity market in other words a proxy for value relevance. Kormendi and Lipe (1987) analyze whether the
magnitude of the relationship between unexpected earnings on stock return (measured by an ERC) is
(positively) correlated with the present value of revisions in expected future earnings. Revision coefficient
is a proxy of earnings persistence which relates current earnings to future earnings. It measures the extent
to which earnings changes in the former years continued in the current year. The greater the influence of
the former year’s earnings changes on current year’s earnings change, the greater the persistence of these
former earnings. Their sample consists of US listed firms during the period of 1947-1980 which obtained
from Compustat and CRSP databases. Using a univariate time-series model, the results show a positive
relation between persistence and ERC.
Easton and Zmijewski (1989) use revision coefficients to examine ERC relation with earnings
persistence. They hypothesize that ERC is positively correlated with revision coefficients and negatively
associated with systematic risk. Firm size is included as control variable. They use the quarterly earnings
of US listed firms during the period of 1975-1980. They find evidence supporting their hypothesis that
earnings persistence estimated by revision coefficients is positively associated with ERC. ERC is
negatively related to systematic risk and positively related to firm size however the results are not
statistically significant.
Collins and Kothari (1989) investigate the inter-temporal and cross-sectional determinants of ERC. They
included earnings persistence as one of independent variables in their multivariate models (growth, riskfree interest rate, systematic risk and return) and find a statistically significant of earnings persistence
37
coefficient. Their sample consists of firms listed on the New York Stock Exchange (NYSE) over the
period 1968-1982 which obtained from the Compustat database. Although Collins and Kothari (1989)
unable to discern between the effect of growth and earnings persistence on ERC, they suggest that
earnings persistence is an important determinant of the value relevance of earnings.
Nichols and Wahlen (2004) who replicate Kormendi and Lipe (1987) show the importance of earnings
persistence for stock valuation. They hypothesize that firms with high persistent earnings will have higher
abnormal returns for earnings increases than firms with low persistent earnings. Contrary to Kormendi
and Lipe (1987), for earnings decrease Nichols and Wahlen (2004) predict relatively small differences in
abnormal returns between high-and low-persistence firms because earnings decreases or losses are not
likely to persist in the future. Firms with earnings decreases will improve their operations to avoid losses
in the next period.
Nichols and Wahlen (2004) examine on how the accounting information specifically earnings numbers
related to the stock returns. They use data of annual earnings and stock returns of publicly traded U.S.
firms. The sample comprises of 31,923 firm-year observations obtained from Compustat and CRSP
databases during the period of 1988-2001. They divide the sample firms into two portfolios: firms with
earnings increases and earnings decreases. Based on the magnitude of earnings changes, each portfolio is
sorted into ten deciles. The earnings persistence of each firm is ranked into ten deciles based on the
magnitude of earnings changes. The results show that during years with earnings increases, firms with
high earnings persistence earn on average higher abnormal returns than low-persistence firms. However
during years with earnings decreases there is only small difference in abnormal returns between high and
low persistence firms. This result supports the hypothesis of Nichols and Wahlen (2004).
4.5.
Conservatism, earnings persistence and value relevance throughout
business cycle
Johnson (1999) investigates the impact of business cycle on the association between reported earnings
and stock returns. She argues that fluctuations in macroeconomic performances influence both the
investment and financing opportunity sets which will be reflected by the variation in earnings persistence
throughout the business cycle. Johnson (1999) divides the variation in business cycle into four stages;
expansion, credit crunch, recession and reliquification. Credit crunch is defined as a period during the
peak leading to recession. On the demand side, firms have insufficient internal-generated funds to finance
desired investment projects and therefore depend highly on external financing. On the supply side the
Federal Reserve is tightening supply funds and reduces the availability of external funds. Reliquification
occurs during the trough, mainly at late recession and early recovery periods. The periods of expansion
38
and recessions are defined based on the National Bureau of Economic Research (NBER) while periods of
credit crunch and reliquification are define based on the US largest forecasting firm called Data
Resources, Inc (DRI). Johnson (1999) made four hypotheses; the first two hypotheses are related to
earnings persistence and the rest related to value relevance of earnings. The first hypothesis predicts that
‘earnings are more persistent in expansions than in recessions’ (p.98) because of higher aggregate
availability of investment opportunities leads to more stable earnings during expansions and more
transitory during recessions. The second hypothesis predicts that ‘earnings are more persistent in credit
crunch periods than in reliquification periods’ (p.100). During a credit crunch period, the difference
between the capital costs from external fund is higher than internal fund compare to reliquification period.
Therefore firms rely as much as possible on internal fund. This implies a higher positive relation between
internal funds and earnings persistence during credit crunch periods. Using a sample of 53.324 quarterly
earnings during 1970-1987, the results support both earnings persistence hypotheses and indicate that
earnings persistence varies throughout business cycle.
Next to earnings persistence Johnson (1999) also investigates the value relevance of earnings estimated
by ERC throughout business cycle. She hypothesizes that ERCs are ‘larger in expansions than in
recessions’. As likely to persistence hypotheses she also predicts that ERCs are ‘larger in credit crunch
periods than in reliquification periods’. Johnson (1999) uses cumulative abnormal returns11 as dependent
variable and unexpected earnings per share12 as independent variable. To capture variations across
business cycle, three dummy variables for expansion, credit crunch and reliquification are included in the
regression model. Her results support both hypotheses, indicating that value relevance of earnings varies
throughout business cycle. Johnson (1999) demonstrates that value relevance of earnings is higher during
expansion periods relative to recessions and also higher during credit crunch periods relative to
reliquification periods.
Jenkins et al. (2009) relate business cycle variations with changes in earnings conservatism and value
relevance. Unlike Johnson (1999) who distinguishes business cycles into four stages, Jenkins et al. (2009)
divide the fluctuations in a business cycle only into two stages, namely expansions and contractions.
Further on, in their hypotheses they apprehend the value relevance of current earnings from the expected
future earnings. They formulate three hypotheses. The first hypothesis relates to earnings conservatism.
The second and third hypotheses are related to value relevance. The first hypothesis predicts that earnings
are more conservative during contractions relative to expansion periods. Jenkins et al. (2009) argue that
during contractions, the debt suppliers will demand more conservative earnings because it better reflects
11
12
Abnormal return is the difference between actual return and expected return of capital asset pricing model.
Unexpected earning is the difference between actual EPS and Value Line forecasts of EPS.
39
the risk of default. In the second hypothesis, they predict that value relevance of current earnings,
controlling for future earnings expectations, is higher in contractions than in expansions. They criticize
the model used by Johnson (1999) which does not distinguish between current and expected future
earnings. Consequently the effect of expected future earnings is captured by the proxy of current earnings
and ‘mask the true contemporaneous return earnings relation’ (Jenkins et al., 1999, p. 1045). They argue
that more conservative earnings during contractions benefit investors for prediction of future earnings
using current earnings. Higher uncertainty during contractions and more conservative earnings imply that
earnings information is more reliable for the investors to form expectations compared to other informal
sources. The timely reporting of bad news due to conservative accounting helps investors to evaluate the
increased default risk. Therefore investors perceive earnings as more value relevant during contractions.
Hence this leads to higher association between returns and current earnings. Accordingly the ERC of
current earnings will be larger in contractions than in expansions.
Additionally, the third hypothesis predicts a higher value relevance of expected future earnings in
expansions than contractions. Jenkins et al. (2009) predict that during expansions investors will focus
more on the future cash flow and growth opportunity instead of the downside risk and conservative
earnings likewise in case of contractions. Further during expansions investors are likely to rely more on
expected future earnings to determine firm’s value instead of on historical earnings. Therefore expected
future earnings are more value relevant during expansions than contractions.
Jenkins et al. (2009) regress between annual stock return as dependent variable with annual earnings and
change of annual earnings as independent variable. They applied Basu (1997) asymmetric timeliness to
estimate earnings conservatism. They further specify the realized earnings as having expected and
unexpected components. Therefore, to examine the second and third hypotheses, they include future
returns as a proxy for future unexpected earnings and actual future earnings as a proxy for future expected
earnings. Their sample consists of 120,070 firm-year observations of U.S. firms during the period of
1980-2003 from the Compustat database. During that period, there were in total five contractions and
nineteen expansions as determined by NBER. They find evidence supporting all their hypotheses.
Earnings are more conservative during expansions relative to contractions. They submit that their findings
are somewhat contradictive from the findings of Johnson (1999), however this might be caused by the
difference in the return-earnings model being applied and the explanatory variables included in the model.
Jenkins et al. (2009) argue that current earnings are more value relevant in expansion than in contraction
if the expected future earnings (as a proxy for growth prospects) are omitted from the return-earnings
model. By controlling for the effects of future earnings expectation, their results indicate that value
relevance of current earnings may actually be lower in expansion than in contraction. The confirmation of
40
the third hypothesis demonstrates that the value relevance of expected future earnings is larger during
expansions relative to contractions, when the relation between past earnings information and future
growth prospects is likely to weaken.
Clinch and Wei (2011) apply a simple approach to examine the earnings-returns relation by regressing
abnormal returns and earnings. Instead of using definition from certain research bureau, Clinch and Wei
(2011) use macroeconomic indicators to define business cycle. These macroeconomic indicators are GDP
growth rate and market index return of each country. The year of sample periods are divided based on
negative, small positive and large positive of macroeconomic performance, depending on which indicator
being applied. They use sample firms from three countries – Australia (during years 1987-2008), the U.S.
(1971-2008) and China (1991-2008). Although the sample periods include years of the current crisis, they
do not investigate the current crisis extensively. The recent global financial crisis is viewed as motivating
interest of doing the research and not the purpose of their research.
For the US sample, they document evidence of a stronger earnings and returns relation in times of large
positive performance measured by GDP growth rate. However, if market index returns are used as the
macroeconomic performance indicator, the difference between positive and negative market return years
are not as significant as the results obtained from the test using GDP growth rate as the indicator.
Contrarily, Australian and Chinese firms demonstrate no evidence that ERCs are significantly different
across the three periods. However, these results differ when market index is used as macroeconomic
performance indicator. For US firms, the ERCs for negative market return years are not different from
small positive market return years while Chinese firms show smaller ERCs for negative market return
years than positive market return years. None of these countries show increased ERCs in years of
negative market returns. Australian firms show no difference in the earnings-returns relation across the
three periods. They conclude that only when GDP growth is used as an indicator for macroeconomic
performance, and only for the US firms, there is evidence of a stronger association between returns and
earnings in times of high macroeconomic performance. A stronger association between returns and
earnings indicate that earnings are perceived as more value relevant for the investors.
4.6.
Chapter Conclusion
This chapter has elaborated on the findings of several empirical literatures regarding earnings persistence,
conservatism and value relevance. Earlier studies demonstrate that earnings persistence is negatively
related to conservatism. Paek et al. (2007) find that more conservative earnings are less persistent than
less conservative earnings. Related to accruals components of earnings, Sloan (1996) finds that accruals
have lower persistence than cash flows. Conservatism increases accruals persistence however this is only
valid for firms with high accruals (Wakil and Alam, 2012). Basu (1997) finds that due to conservatism
41
earnings changes during good news period are more persistent than during bad news period. Herewith
conservatism is expected to be higher during bad news period that is contraction than during good news
period or expansion.
Brown et al. (2006) find a negative correlation between conditional conservatism and value relevance of
earnings. Kousenidis et al. (2009) also demonstrate that high conservatism reduce the value relevance of
earnings. However firm with low conservatism is also perceived to be less value relevant for the
investors. Balachandran and Mohanram (2010) find a significant increase in conservatism along with a
declining trend of value relevance. Contrary to prior literatures that suspect conservatism as a reason of
declining value relevance (Francis and Schipper, 1999; Lev and Zarowin, 1999), Balachandran and
Mohanram (2010) demonstrate that firms with high conservatism do not necessarily less value relevant
for investors.
Earlier researches demonstrate that earning persistent is positively associated with the value relevance of
earnings (Kormendi and Lipe, 1987; Easton and Zmijewski, 1989; Collins and Kothari, 1989). Recent
study from Nichols and Wahlen (2004) confirm the findings of Kormendi and Lipe (1987) that firms with
higher persistence earnings are more value relevant for investors as indicated by higher abnormal returns
earned by these firms.
Related to fluctuations in business cycle, Clinch and Wei (2011) find that US firms show higher value
relevance in time of large positive GDP. Nevertheless there is no significant difference between positive
and negative GDP periods for Australian and China firms. Periods with positive GDP can be seen as the
expansion stage of business cycle. Indeed based on NBER business cycle, GDP is one of the indicators
which used to determine different stage of business cycle. Johnson (1999) finds that earnings persistence
and value relevance are higher during expansions than during recessions. Contrarily Jenkins et al. (2009)
find that value relevance of current earnings is higher during contractions than expansions. Jenkins et al.
(2009) argue that higher conservatism during contractions leads to higher value relevance during
contractions than expansions. Value relevance of future expected earnings is found to be higher during
expansions than contractions (Jenkins et al. 2009). These mixed results are investigated further in the next
chapter. Based on conclusions of prior literatures, some hypotheses are developed and tested using
empirical data from the U.S. listed firms.
42
5. Hypothesis Development and Methodology
5.1.
Chapter Introduction
This chapter is the quantitative part of this thesis in order to find evidences on value relevance, earning
persistent and earnings conservatism throughout business cycle. To test the relation among value
relevance, earnings persistent and earnings conservatism, several hypotheses are developed and tested
with the help of Eviews statistical software. The hypotheses are developed based on prior empirical
studies provided in chapter four. Likewise the methodology on testing these hypotheses is provided here.
Further the findings and the analysis are presented at the end of this chapter.
5.2.
Hypotheses Development
During market downturn, firms rely more on external financing because the internally generated funds are
likely to be lower than during an expansion. Firms face more difficulty to cover their fixed costs because
fewer goods are being sold and due to lower demand, the market price of inventories will be lower.
Consequently reporting losses occur more frequent during a market downturn. Based on Basu (1997)
conservatism is the tendency of accountants to acquire higher verification regarding gains compared to
losses. Because losses are likely to appear during a contraction, therefore the level of conservatism
appears to be higher during a contraction. Realized that the litigation risk is higher during a recession,
debt suppliers require firms to present their results conservatively because conservative accounting better
informs about the risk of default (Jenkins et al. 2009). Accordingly firms apply conservative accounting
in order to get access to new loan and to conform to the expectation of debt suppliers. High conservatism
in a market downturn can be noticed in the more conservative earnings during contractions relative to
expansions. Jenkins et al. (2009) show that earnings are more conservative during contractions than
expansion. Therefore I predict that:
H1: Earnings conservatism is relatively higher during contraction periods than during expansion periods.
During an expansion, business activity is higher and there is less uncertainty in the market. An expansion
is indicated by higher economic growth and positive GDP. This steady growth during an expansion offers
firms more persistent income than during a contraction. Nichols and Wahlen (2004) find that earnings
persistence is higher during years of earnings increases. Johnson (1999) demonstrates that earnings are
more persistent during expansions period than during contractions period. Therefore I predict that:
H2: The persistence of earnings is relatively higher during expansion periods than during contraction
periods.
43
Prior research has documented positive association between earnings persistence and value relevance
(Collins and Kothari, 1989; Nichols and Wahlen, 2004). Because earning persistence is predicted to be
higher during expansions periods, it seems logical to predict that value relevance is higher during
expansions compared to contractions. However whether conservatism has an effect on value relevance
prior literatures found mixed evidence. Brown et al. (2006) suggest that conditional conservatism is
negatively related to value relevance of earnings. However Kousenidis et al. (2009) argue that both
absence and excessive conservatism lead to less value relevance earnings. Balachandran and Mohanram
(2010) show that conservatism has no effect on value relevance. If the proposition of Balachandran and
Mohanram (2010) is correct then it can be expected that value relevance of earnings will be higher during
expansions and recessions which is consistent with the findings of Johnson (1999). The value relevance
of earnings with or without controlling future earnings expectations should be higher during expansions
than contractions. Nevertheless, Jenkins et al (2009) - who control for future earnings expectation demonstrate that value relevance of earnings is lower during contraction periods than during expansions.
However Jenkins et al. (2009) do not consider earnings persistence which is likely to be lower during
contraction and likewise lowering the value relevance of earnings. To reconcile these mixed results
between Johnson (1999) and Jenkins et al (2009), I develop two hypotheses as follows:
H3: Controlling for future earnings expectations, current earnings are relatively more value relevant
during expansion periods than during contraction periods.
H4: The expected future earnings are relatively more value relevant during expansion periods than during
contraction periods.
Summary of the four hypotheses and their relations with the research question is provided in table 4.
Expansion periods
H1
H2
Conservatism exp
Persistence exp
H3
Value relevance
Expected sign
exp
<
>
Conservatism cont
Persistence cont
>
Value relevance cont of
current earnings
>
Value relevance cont of
future earnings
of current earnings
H4
Value relevance
exp
of future earnings
Contraction periods
Research Question
Higher earnings
persistence and lower
conservatism during
expansion leads to higher
value relevance of current
and future earnings in
expansions than
contractions
Table 4: Hypotheses summary
44
5.3.
Methodology
This section elaborates on the applied methods for testing the four hypotheses above. Measurement
explains the models used to estimate earnings persistence, conservatism and value relevance of earnings
throughout the periods. Data sample provides information on the data which is employed to test these
hypotheses. Descriptive statistics test the suitability of the data available to be used for statistical analysis.
Last but not least findings show the statistical result and analysis of the tested hypotheses using the
available data.
5.3.1. Measurement
Starting from the first hypothesis, there are five methods to estimate conservatism as have been
mentioned in the third chapter. The method to be used is depending on the purpose of the research.
Asymmetric timeliness of Basu (1997) is the most applied method in empirical research (Wang et al.,
2008). For the purpose of this thesis, the asymmetric timeliness of Basu (1997) is the most appropriate for
three reasons: 1) this model measures conservatism in earnings which is the subject of this thesis; 2) this
model includes capital market measure i.e. stock returns which is also affected by the business cycle; and
3) this model is similar to the conservatism proxy applied by Jenkins et al. (2009). Perhaps it is not a very
strong argument to apply the same proxy because another literature applies similar model as well.
Nevertheless in this case it is favorable to apply similar model with Jenkins et al. (2009) in order to
enhance the comparability of this outcome with the one from Jenkins et al. (2009). Recall the aim of this
thesis is to investigate the mixed results between Johnson (1999) and Jenkins et al. (2009). The
asymmetric timeliness of Basu (1997) is based on the semi-strong form of efficient market hypothesis that
stock returns symmetrically and quickly reflect information from all publicly available information.
Returns are used to measures the available ‘news’. The greater timeliness of earnings for bad ‘news’
indicates that earnings is more sensitive to bad news (negative returns) than good news (positive returns)
which is measured by the slope coefficient and R2 from a reverse regression of earnings on returns (Basu,
1997).
Coefficient β1 reflects the earnings response to return if returns are positive while coefficient (β1 + β3)
reflects the earnings response to returns if returns are negative. If coefficient (β1 + β3) is greater than β1, it
indicates asymmetric timeliness of earnings for bad news versus good news. Rewrite again (β1 + β3) > β1
is equal to β3 > 0. Hence if β3 is significantly greater than zero then it can be concluded that earnings are
conservative. To investigate whether earnings conservatism differs throughout business cycles, the
original Basu (1997) model is modified as follows:
45
Eit = β0 + β1Rit + β2DRit + β3Rit*DRit + β4Expt + β5Expt*Rit + β6Expt*DRit + β7Exp*Rit* DRit + it + εit
In this modified version, a dummy variable representing business cycle is included. Exp is a dummy
variable which equals to one during an expansion and zero for contraction. As mentioned in the first
chapter, this thesis defines business cycle only to two stages of expansion and contraction. Coefficient β5
captures the impact of business cycle on the earnings timeliness of good news recognition while (β5 + β7)
captures the effect of business cycle on the earnings timeliness of bad news recognition. Likewise if (β5 +
β7) > β5 (or β7 > 0), it indicates that earnings are more conservative during expansion. Contrariwise if
coefficient β7 is significantly negative, this provides support for the first hypothesis that earnings are less
conservative during expansions relative to contraction.
For the second hypothesis, earnings persistence is estimated using the lag model of earnings. The
persistence of earnings is measured by the first auto-correlation coefficient between current earnings and
future earnings. This model does not take into account the different persistence between earnings
components which are accruals and cash flow. The second hypothesis does not particularly focus on
earnings components but on the aggregate earnings therefore the lag model is applied. Moreover to
enhance comparability with the findings of Johnson (1999), I apply the lag model which is similar to the
model applied in Johnson (1999). To include the business cycle effect, the model is modified as follows:
E t+1 = 0 + 1Et + 2Expt + 3Expt *Etit + t
A dummy variable representing business cycle is included. Exp is a dummy variable which equals to one
during an expansion and zero for contraction. Coefficient β3 reflects the effect of expansion on the
persistence of current earnings. If coefficient β3 > 0, it demonstrates that earnings persistence is higher
during the expansion periods than during the recession periods. Therefore a positive β3 coefficient
provides support for the second hypothesis that the persistence of earnings is higher during expansions
relatively to contractions.
The third and fourth hypotheses are related to value relevance of earnings. As mentioned in the third
chapter, there are three models which are commonly used in value relevance research. To measure the
value relevance of accounting information for the capital market, it can be done by associating stock
returns with earnings and/or book value. The last two hypotheses are focusing on earnings and not on
book value. For this reason, earnings model is the suitable model to apply. Following Jenkins et al. (2009)
I utilize the next period earnings and returns as proxies for future earnings expectation. Future earnings
has both expected and unexpected components which are not directly observable. The expected part of
future earnings is captured by the next period earnings while the unexpected shock to future earnings i.e.
46
earnings surprise is captured by future stock returns (Jenkins et al., 2009). Therefore to control for future
earnings expectations, the earnings model is modified as follows:
Rit = β0 + β1Eit + β2∆Eit + β3Eit+1 + β4Rit+1 + β5Expt + β6Expt*Eit + β7Expt*∆Eit + β8Exp*Eit+1 + β9Exp*Rit+1
+ it + εit
The next period earnings and stock returns are included as control for future earnings expectations. If
coefficients β6 > 0, it shows that value relevance of current earnings – controlling for future earnings
expectations - are higher during expansions than during contractions. The value relevance of expected
future earnings is captured by coefficient β8. If coefficient β8 > 0, then it can be concluded that the value
relevance of expected future earnings is higher during expansions than contractions.
Please note here that the regression formula have two dimensions: firm (i) and year (t) namely for panel
data. Data with only one dimension for example only firms is called cross-section data and if only for
year period is called time-series data. Whereas the inclusion of both dimensions firms and year periods
called panel data analysis. Not all statistic packages contain features for panel data analysis. For this
thesis I use Eviews statistic software which is commonly used for financial analysis. In the formula, the
symbol it stands for fixed effect estimator. The fixed effect model is a suitable specification for the
analysis which inference is restricted to the specific sets of items, in this case a set of firms (Baltagi,
2008). Including fixed effect estimator remove the effect of different characteristics between the
individual so allowing the regression coefficient to estimate only the independent variables’ net effect.
Various firm-specific characteristics among firms may bias the dependent and independent variables.
Therefore fixed effect parameter is applied to control for this bias.
5.3.2. Data sample
The sample contains of 364 companies listed in Standard & Poor 500 (S&P 500) list in the United States.
The S&P 500 concentrates on the listed company in the United States that has a large capitalization of the
market. The S&P 500 includes approximately 75% coverage of U.S. equities and it is therefore an ideal
proxy of the total US capital market. Additionally using listed company with large market capitalization
reduces size differences between companies, excluding size effect from the sample. The data are taken
from Compustat database. The data of earnings per share (eps) and stock prices are numbers drawn from
firm’s consolidated annual statement. During the sample period 1988-2011, there are in total 582
companies which have and ever been listed in the S&P 500. There are more than 50 companies because
throughout the years there are new firms enter the market and become listed while some lose their
competitiveness and went bankrupt or become a private company.
47
To enhance the comparability of business cycle effects between firms, firms with fiscal year ending other
than December are excluded from the sample. There are 437 firms remained after excluding 145 firms
which have fiscal year ending other than December. Moreover firms with SIC code higher than 6000 which are firms in sectors: financial, insurance and public administration - are also excluded from the
sample. Financial and insurance sectors often have different accounting regulations while public
administration sector is less likely to be affected by fluctuations in the business cycle. After excluding 63
companies with SIC code higher than 6000, there are 374 companies that meet these criteria. Companies
which do not have complete earnings and returns data of at least two consecutive years are removed from
the sample. The remaining sample contains of 364 companies. Stock return is calculated by subtracting
prior year stock price from current stock price and divided by prior year stock price. To calculate the
stock return of year 1988, the stock price of year 1987 is therefore required.
The sample period is between years 1988-2011 which contains in total 18 years of expansions and 6 years
of contractions. Summing from prior expansion to the next expansion, there are in total three business
cycles during the sample period of 1988-2011.
Year
NBER Business Cycle Classification
Duration
1988-1989
Expansion
1990-1991
Contraction
1992 – 2000
Expansion
2001
Contraction
2002 – 2006
Expansion
2007 – 2009
Contraction
2010 – 2011
Expansion
1988-2011
Three business cycles
Table 5: Business cycles in US for periods 1988-2011
2years
2 years
9 years
1 year
5years
3 years
2 years
24 years
US Business Cycle
6
5
4
GDP
3
2
1
0
-1
-2
-3
-4
-5
88
89
90
91
92
93
94
95
96
97
98
99
00
01
02
03
04
05
06
07
08
09
10
11
US GDP
4
4
2
0
3
3
4
3
4
5
4
5
4
1
2
3
4
3
3
2
0
-4
3
3
dummy
1
1
0
0
1
1
1
1
1
1
1
1
1
0
1
1
1
1
1
0
0
0
1
1
Figure 5: The business cycles during sample periods 1988-2011 (adapted from www.BEA.gov)
48
The business cycle stages i.e. expansion or contraction are represented by the dummy, one equal to
expansion and zero for contraction. The dash line is the second-moving average trend line around the U.S.
GDP line. The graph clearly demonstrates the ups and downs of the U.S economics. In line with the
NBER definition of business cycle a contraction period is indicated by a low level of GDP. The graph of
US business cycle is provided in figure 5.
5.3.3. Descriptive Statistics
i.
Sample distribution
There are in total 7000 observations obtained from 364 companies between years 1988-2011. It is an
unbalanced panel data because not every company has full observations for sample period 1988-2011.
From the frequency graph below it can be seen that the availability of the data increasing throughout the
time however start to decline again before the financial crisis in year 2008-2009. It seems that there are
fewer companies who are able to survive the current crisis resulting in the declining of data.
Unbalanced panel data
350
300
250
200
150
frequency
100
50
0
88
89
90
91
92
93
94
95
96
97
98
99
00
01
02
03
04
05
06
07
08
09
10
11
frequency 229 238 241 245 258 262 273 280 292 300 305 315 323 330 332 333 332 322 313 304 301 300 290 282
Figure 6: Data frequency
Table 6 depicts the descriptive statistics of the sample. EPS1 represents epst+1 and RET1 represents rett+1.
There are less eps1 and ret1 because for year 2011 there is no sample of year 2012 are included and also
some firms does not have full sample which also reduces the availability sample for EPS1 and RET1.
Jarque-Bera (JB) tests for the normality of the sample which is calculated from the skewness and
kurtosis13. The null hypothesis of JB test is a normal distribution sample. None of the variables has a
normal distribution as the null hypothesis of JB test is rejected for all variables (see the probability which
is lower than 5%). One way to normalize a skewed distribution is by taking logarithm function of the
13
Skewness refers to the asymmetry of a sample distribution in which the length of the tail is important and kurtosis
refers to the variation in the frequencies of the distribution sample for example extreme outliers and highly
concentrated data values which increases the distribution peak.
49
variables. However this cannot be done here since the sample is also included negative numbers. Based
on Brooks (2008), skewed distribution has little consequences for a large sample size. Therefore there is
no special treatment for this non-normal distribution sample. Looking at the graph of earnings per share
(eps) and return distribution (see appendix 2), non-normal distribution is particularly caused by long tail
of some eps and returns observation. Deleting these outliers will reduce the valuable information
contained in these data from the total sample. Graph 1 and 2 in the appendix demonstrate the nonnormality distribution of the eps and returns sample.
Mean
Median
Max.
Value
Min.
Std.dev
value
.
Full sample
EPS
RET
EPS1
RET1
DR
Exp
1.941
0.124
1.922
0.122
0.422
0.754
1.91
0.056
1.91
0.051
0
1
68.85
29.833
68.85
29.833
1
1
-76.52
-0.991
-76.52
-0.991
0
0
EPS
RET
2.012
0.136
1.9
0.075
41.27
26.492
-44.08
-0.991
30.31
29.833
-76.52
-0.983
3.699
0.924
3.713
0.937
0.494
0.431
Skewness
Kurtosis
JB
p.val
Total
Obs.
-2.318
89.679
-2.536
18.879
0.317
-1.180
18.791
499.911
92.104
497.237
1.1
2.393
0.000
0.000
0.000
0.000
0.000
0.000
7000
7000
6636
6636
7000
7000
-0.057
19.516
47.309
568.994
0.000
0.000
5279
5279
-6.475
17.042
555180.3
7023100.
0.000
0.000
1721
1721
Expansion
3.17
0.797
Contraction
1.689
1.95
EPS
0.038
-0.069
RET
Table 6: Descriptive statistics
4.457
1.3017
Looking at the correlation between variable, there is no multicollinearity between the variables.
Multicollineariy implies a high correlation between independent and dependent variables which is
troublesome to disentangle the effects of different independent variables on dependent variable.
Multicollinearity can be identified from correlation matrix between variables which is provided below.
Because there is no variable which is highly correlated with each other, hereby there is no concern of
multicollinearity.
DEPS
EPS1
Correlation
0.521662
0.492518
EPS
0.15522
DEPS
EPS1
RET
Table 7: Correlation matrix between variables
RET
RET1
0.041543
0.190929
0.001881
-0.132176
0.004319
0.001881
0.017482
ii. Validity framework
50
The effectiveness of an experiment in financial accounting is depending on the internal and external
validity. Internal validity refers to the degree to which variation in the independent variables attribute to
the variation of the dependent variable while external validity deals with the generalization of the
experimental findings beyond the specific procedures, measures and samples applied in the study (Libby
et al., 2002). Lack of internal validity produces a misleading evidence of the relation between independent
and dependent variables whereas lack of external validity brings on results that are not in line with the
purpose of the study (Libby et al., 2002).
With regard to this study, the internal validity of this study is determined by the relation between earnings
and stock market returns. In order to measures the effect of accounting information on the capital market,
earnings per share is employed as an independent variable and regresses with stock return as the
dependent variable. The effect of earnings information to the equity market is measured by the earnings
response coefficient that is the slope coefficient of a linear equation between earnings and stock returns.
The external validity is accomplished by controlling for different stages of business cycle. As mentioned
in the first chapter the purpose of this study is to find the relation between value relevance, earnings
persistence and earnings conservatism throughout the business cycle. Therefore the state of earnings
persistence and earnings conservatism throughout the business cycle stages are being monitored as well.
Moreover the sample selection which consists of firms with large market capitalization controlled for the
firm size effect. Validity framework of this study depicts in figure 7.
Independent variables
Conceptual
Operational
Dependent variables
Accounting
Capital market
information
response
Earnings per
Stock
share
Return
Control variables
 Conservatism
 Persistence
 Business
cycle stages
 Firm size
Figure 7: Predictive validity framework
51
5.3.4. Findings
The regression coefficient and p-value of all hypotheses are summarized in this subsection. The first
regression analysis is done by applying the panel least squares method. However looking at the
conservatism and the value relevance models, both earnings per share and stock returns may be
endogenous variables (Jenkins et al. 2009). It means that earnings and stock returns are influencing each
other simultaneously. This can be problematic because when for example eps is used as dependent
variable and stock return as explanatory variable the error term of the regression test is correlated with the
dependent variable. This is because the dependent variable has a simultaneous effect on one of the
explanatory variable. Earnings per share and return may affect each other in both directions; high earnings
induce high return and high return may increase future earnings. The regression coefficient is therefore
biased because the error term is correlated with the dependent variable.
Therefore I employ the two-stages least squares (TSLS) method as robustness check. Basically TSLS
method is done by running least squares regression in two stages. In the first stage of regression, earnings
are regressed with returns. The estimated values of earnings and returns (Ehat or Rhat) from the first stage
regressions are substituted for Eit in model 1a and for Rit in model 3b. There is no the two-stages least
squares performed for the earnings persistence test (model 2). The theoretical reason behind it is because
there is no return included in model 2. It is also unlikely that future earnings (Et+1) as dependent variable
affects the predictor variable current earnings (Et). Future earnings cannot influence back the past
earnings. Therefore endogeneity problem in the persistence test is very unlikely.
i.
Hypothesis 1: Earnings conservatism test
The result from earnings conservatism tests (model 1 and 1a) are shown in table below. Model 1 is
provided to compare the sample with the findings of Basu (1997). All coefficients from Model 1 are
significant and have positive sign which are similar to the findings of Basu (1997). From Model 1 the
interaction term between return and the dummy of negative returns (Rit*DRit) is positive and significant at
1% level. This implies that earnings are about 12 times (11.90 = [0.34 + 3.718]/0.34) more sensitive to
negative return as it is to positive returns. With regard to the first hypothesis, the negative and significant
result of coefficient β7 on 1% significant level provides support for the first hypothesis. This implies that
earnings are less conservative during expansions than during recessions. In other words earnings are more
conservative during the market downturn relatively to the expansion periods. Moreover the robustness
check of TSLS method also confirms this result. Coefficient of interaction term DR*Exp*Ret is negative
and still significant at 5% level.
52
Model 1: Eit = β0 + β1Rit + β2DRit + β3Rit*DRit + it + εit
Model 1a: Eit = β0 + β1Rit + β2DRit + β3Rit*DRit + β4Expt + β5Expt*Rit + β6Expt*DRit + β7Exp*Rit* DRit +
it + εit
Coefficient
Least squares
Robustness check: TSLS*
(p-value)
Model 1
Model 1a
Model 1a
Intercept
Rit
DRit
Rit*DRit
Expt
Expt*Rit
Expt*DRit
Expt *Rit*DRit
R-squared
2.184 (0.000)
0.088 (0.06)
0.34 (0.002)
3.718 (0.000)
0.299
1.947 (0.000)
0.013 (0.848)
0.867 (0.000)
5.312 (0.000)
0.282 (0.031)
0.154 (0.096)
-0.734 (0.004)
-2.631 (0.000)
0.302
1.807 (0.000)
0.071 (0.141)
-1.096 (0.000)
0.34 (0.379)
0.164 (0.198)
0.071 (0.139)
0.357 (0.045)
-0.159 (0.045)
0.289
*Note: Concerning the robustness test, the return (Rit ) variable is substituted with the fitted value of return (i.e.
Rhatit) which is estimated value from the earnings and returns regression.
Table 8: The results of earnings conservatism test
ii. Hypothesis 2: Earnings persistence test
The results of earnings persistence test is provided in table 9. Model 2 is provided as a benchmark model
that excludes business cycle effects. The positive and highly significant coefficient of current earnings in
Model 2 shows that current earnings are useful in predicting future earnings. Moreover when including
the expansion dummy, model 2a shows that during expansions current earnings has more power in
predicting future earnings than in contraction periods. The intercept of dummy expansion (Expt) and the
interaction term of current earnings and expansion (Expt * Et) are positive and significant at 5% level.
This implies that earnings persistence is higher in expansion than contractions. The positive and
significant coefficient of 3 on 5% significant level provides support for the second hypothesis that
earnings persistence is higher during expansion periods than during recessions.
Model 2: E t+1 = 0 + 1Et it + t
Model 2a: E t+1 = 0 + 1Et + 2Expt + 3Expt * Etit + t
Coefficient
Least squares
(p-value)
Model 2
Model 2a
1.321 (0.000)
0.749 (0.000)
Intercept
0.314 (0.000)
0.481 (0.000)
Et or Epshatit
0.226 (0.023)
Expt
Expt * Et
0.057 (0.012)
0.342
0.245
R-squared
Table 9: The results of earnings persistence test
53
iii. Hypothesis 3 and 4: Value relevance tests
The results of value relevance tests are demonstrated in table 10. Model 3 is provided as basic model
which preclude business cycle effects. One particular note here, the variable earnings has a negative and
significant value. This implies that capital market response negatively to earnings increase. This seems
awkward and different from prior research (Jenkins et al. 2009) which finds positive coefficient of
earnings. What is the explanation behind this negative coefficient? This is perhaps has something to do
with the sample year included in my sample. One third of my sample consists of years 2001-2011. Due to
major accounting scandal in 2001 the accounting information has been accused not to give a true and fair
view of a firm’s performance. It seems that the capital market has learned to gather information from
other sources instead of a simple earnings number. This does not mean that earnings have no explanation
power on return because the earnings change (∆Eit) coefficient still has a positive and significant value. A
positive and significant value of earnings change coefficient implies that higher earnings change
positively affects the firm’s stock return. Model 3a expands model 3 by including future earnings (Eit+1)
as a proxy for expected future earnings on year t stock return and future returns as a proxy for unexpected
earnings. Consistent with the result of Jenkins et al. (2009), model 3a shows a positive and significant
coefficient on actual year-ahead earnings (at 10% level) and a negative and significant coefficient on
actual year-ahead returns (at 1% level).
A positive coefficient β6 demonstrates that value relevant of current earnings – controlling for future
earnings – is higher in expansion periods than contraction periods. This finding provides support for the
third hypothesis (H3). However this coefficient is not significant, so based on least squares method it
cannot be concluded that the value relevance of current earnings is significantly different between
expansions and contractions. Looking further on the robustness check, the interaction coefficient between
dummy expansion and Ehatit is positive and significant on 1% significant level. Therefore it can be
concluded that value relevance of current earnings is higher during expansions than contractions. This is
in line with the result of Johnson (1999) and the prediction from prior literature that value relevance of
current earnings will be higher during expansions than contractions.
With regards to the fourth hypothesis, a positive and significant coefficient β8 shows that value relevance
of expected future earnings is higher during the expansion than contractions. The interaction term
between dummy expansion and future earnings (Exp*Eit+1) is significant at 5% level. This implies that the
expected future earnings are more value relevant during expansions than during contractions. The
robustness check shows the same conclusion however the coefficient β8 is significant at 10% level. The
next section provides the analysis of all hypotheses tests and their relations with the research question.
54
Model 3: Rit = β0 + β1Eit + β2∆Eit + it + εit
Model 3a: Rit = β0 + β1Eit + β2∆Eit + β3Eit+1 + β4Rit+1 + it + εit
Model 3b: Rit = β0 + β1Eit + β2∆Eit + β3Eit+1 + β4Rit+1 + β5Expt + β6Expt*Eit + β7Expt*∆Eit + β8Exp*Eit+1 +
β9Exp*Rit+1 + it + εit
Coefficient
Least squares
Robustness check: TSLS*
(p-value)
Model 3
Model 3a
Model 3b
Model 3b
0.142 (0.000)
0.154 (0.000)
0.159 (0.000)
0.265 (0.000)
Intercept
-0.01
(0.023)
-0.016
(0.002)
-0.02
(0.011)
-1.127
(0.000)
Eit
0.05 (0.000)
0.06 (0.000)
0.048 (0.000)
0.053 (0.000)
∆Eit
0.007 (0.054)
-0.001 (0.823)
0.002 (0.795)
Eit+1
-0.054 (0.000)
0.071 (0.000)
0.068 (0.001)
Rit+1
-0.019 (0.54)
-0.102 (0.009)
Expt
Expt*Eit
0.005 (0.561)
0.757 (0.000)
0.024 (0.005)
0.017 (0.024)
Expt * ∆Eit
Exp*Eit+1
0.017 (0.025)
0.0129 (0.069)
-0.21 (0.000)
-0.208 (0.000)
Exp*Rit+1
0.087
0.102
0.115
0.117
R-squared
*Note: Concerning the robustness test, the earnings (Eit ) variable is substituted with the fitted value of earnings (i.e.
Ehatit) which is the estimated value of earnings from the earnings and returns regression.
Table 10: The results of value relevance test
Summary of the findings from these hypotheses tests is provided in table 11.
Expected sign
H1
H2
Expansion periods
Conservatism exp
Persistence exp
H3
Value relevance
<
>
Conservatism cont
Persistence cont
exp
of
>
Value relevance
current earnings
exp
of
>
Value relevance
future earnings
current earnings
Value relevance
H4
Contraction periods
future earnings
Findings
Supported
Supported
cont
of
Supported
cont
of
Supported
Table 11: Summary of the findings
5.4.
Analysis
Prior section demonstrates results from all hypotheses tests. There are four key findings from these
hypotheses tests. First, it shows that business cycle has an impact on the earnings and the earnings-returns
relation. Earnings conservatism, earnings persistence and value relevance of earnings vary throughout
different stages of business cycle. Earnings conservatism is lower in expansions than in contractions
whereas earnings persistence is higher in expansions than in contractions. Current earnings and future
earnings are more value relevant in expansion periods than in contractions periods. Business cycle
55
therefore has a significant effect on the accounting information in this case thus earnings and on the
association between accounting information particularly earnings and the response of capital market
measured by stock returns.
Second, more conservative earnings during contractions do not result in higher value relevance of current
earnings in contractions which is contrary to the result of Jenkins et al. (2009). Jenkins et al. (2009) argue
that more conservative earnings have higher predictive value which should result in higher value
relevance of earnings. In contrast to Jenkins et al. (2009) prediction, the value relevance test shows that
less conservative earnings during expansion periods are more value relevant than more conservative
earnings in contraction periods. This is in line with Brown et al. (2006) who suggest that conditional
conservatism is negatively related to the value relevance of earnings.
Third, the higher earnings persistence in expansions results in higher value relevance for both current
earnings and future earnings in expansions relative to contractions. As suggested by Dechow et al. (2010)
high persistent earnings are more useful for firm’s valuation because of its higher predictive value. In line
with the result from Johnson (1999) and Nichols and Wahlen (2004) earnings persistence is higher in the
years of earnings increase for example during periods with steady economic growth namely an expansion.
Fourth, current earnings and expected future earnings behave in the same way throughout the business
cycle. This is in contrast to the proposition of Jenkins et al. (2009) who find that value relevance of
current earnings is actually lower in expansions if the future earnings are included as a proxy of future
earnings expectation. The capital market commonly employs current earnings in forecasting a firm’s
future earnings. Based on this forecast, investors assess the firm’s value and decide on the most profitable
investment choice. As mentioned before, earnings with higher persistent are more useful and provide
better estimation for earnings forecast. Therefore the relevance of current earnings and future earnings for
the equity market valuation should demonstrate a similar pattern throughout different stages of business
cycle. Consequently, both current and future earnings appear to be more value relevant in expansions than
in contractions.
Comparing the findings with prior research, the results are similar to previous studies (Johnson, 1999;
Jenkins et al. 2009) except for the value relevance of current earnings. The outcome of earnings
conservatism test that conservatism is higher in contractions than in expansions is in line with Jenkins et
al. (2009). The outcome of earnings persistence test that earnings persistence is higher in expansions than
in contractions is similar to the findings of Johnson (1999). With regard to the value relevance test,
current earnings and future earnings are more value relevant in expansions relative to contractions. This is
in line with the results of Johnson (1999) who finds higher value relevance of current earnings in
56
expansions than in contractions. However Jenkins et al. (2009) find that current earnings to be more value
relevant in contractions than in expansions. Jenkins et al. (2009) argue that a higher demand of
conservative accounting during contraction periods enhances the value relevance of earnings in
contraction periods. Yet Brown et al. (2006) and Kousenidis et al. (2009) demonstrate that high
conservatism reduces the value relevance of earnings. This means that Jenkins et al (2009) argument does
not seem to hold although they found evidence supporting their arguments. Lower conservatism also
implies that earnings capture the true firm’s performance more accurately. Moreover Jenkins et al. (2009)
did not consider the positive effect of higher earnings persistence on the value relevance of earnings.
Higher persistence of earnings improves the predictive power of current earnings to forecast the future
earnings. Investors establish their evaluations on this forecast. All together, less conservative and higher
persistent earnings contribute to the higher value relevance of earnings during expansion periods than
during contraction periods.
One important question still remains: why do Jenkins et al. (2009) find evidences supporting their
proposition that value relevance of current earnings is higher in contractions than in expansions? With
regard to the value relevance model, I employ exactly similar model to the model applied in Jenkins et al.
(2009). Therefore the source of differences does not cause by the applied model. The possible explanation
lies in the different sample firms and sample periods. Firstly, Jenkins et al. (2009) use all firm-years listed
on the Compustat database whereas my sample constrains to the firms with large market capitalization.
As explained in chapter three, larger firms have more persistent earnings and are less likely to report
losses than smaller firms. Jenkins et al. (2009) do not take into account the size-effect in their sample
selection. Including all firms (from the small to the large ones) might lower the persistence of earnings
during expansion which leads to lower value relevance of current earnings in expansions than in
contractions. Because Jenkins et al. (2009) do not measure earnings persistence of their sample; it is
difficult to conclude whether including all firms might be the reason of different results between my
findings and Jenkins et al. (2009). Furthermore Jenkins et al. (2009) also include financial, insurance and
public administration sectors, which assemble the effect of various firm-specific characteristics in their
research findings. Jenkins et al. (2009) also do not distinguish firms with different fiscal-year periods. All
together the findings of Jenkins et al. (2009) are entangled with various other factors i.e. firm-size and
firm-specific characteristics which make the interpretation of their findings problematic.
Secondly, the sample periods of Jenkins et al. (2009) include years 1980-2003 while my sample periods
are years 1988-2011. Although there is overlapping in my sample periods with the sample periods of
Jenkins et al. (2009), yet it is unknown whether the business cycles in these periods are comparable.
Jenkins et al (2009) - who also use the NBER business cycle classifications - categorize years 1980-1982
57
as contractions. Nevertheless, three years of consecutive contractions 1980-1982 might not be comparable
to the consecutive contractions of years 2007-2009 in my sample, resulting in different outcomes between
the findings of my current earnings value relevance test and of Jenkins et al. (2009).
5.5.
Chapter Conclusion
This chapter elaborates on the empirical part of this thesis. This chapter aims to answer the fourth subquestion on how earnings persistence, conservatism and value relevance change throughout the business
cycle. In order to answer this question, four hypotheses are developed and tested using the US firms
sample listed on S&P500. Based on the earnings conservatism test (H1) earnings are less conservative
during the expansion periods relative to the contractions. Due to the higher chance of reporting losses in a
contraction, therefore the level of conservatism in earnings appears to be higher in a contraction relative
to an expansion. From the earnings persistence test (H2) earnings are more persistent in expansions than
in contractions. In an expansion when the economics are growing, a persistent flow of income is more
feasible than in a contraction when external and internal financing sources are hardly available. Based on
the value relevance test (H3 and H4) current earnings and future earnings are higher in expansion periods
than contraction periods. Value relevance of earnings is higher during expansions when earnings
conservatism is lower and earnings persistence is higher. This result is different from Jenkins et al. (2009)
who find higher value relevance of current earnings in contractions than in expansions. This might be
caused by different sample periods and sample firms employed in Jenkins et al. (2009).
58
6. Conclusion
6.1.
Thesis Conclusion
Recall the research question of this thesis: ‘How do earnings persistence, conservatism and value
relevance of earnings vary throughout the business cycle?’ The answer to this question is that earnings
persistence and value relevance of earnings are higher during the expansion periods than the contraction
periods while earnings conservatism is lower during the expansion periods than the contraction periods.
The value relevance of current and future earnings appears to be higher in expansion that is when
conservatism is lower and persistence is higher in earnings.
This thesis investigates whether earnings persistence, conservatism and value relevance of earnings vary
throughout business cycle. In this thesis, the business cycle is distinguished into two stages of expansion
and contraction. During an expansion when the economy is growing, internal and external financing
sources are more feasible to obtain than during a contraction. Four hypotheses related to the variations of
earnings persistence, earnings conservatism and value relevance of earnings throughout business cycle are
developed. The underlying thought of the hypotheses development is that the fluctuations in
macroeconomic situation should have influence on the information provided in the financial statements
particularly earnings and on the response of the investors as the users of financial statements which
measured by stock returns.
Hereby the asymmetric timeliness of Basu (1997), the lag model and the earnings model are employed in
order to test earnings conservatism, earnings persistence and value relevance of earnings respectively.
The hypotheses tests have indicated that earnings persistence, earnings conservatism and value relevance
of earnings vary throughout the business cycle. In line with the findings of Johnson (1999), earnings
persistence appears to be significantly higher during expansion periods than during contraction periods.
From the conservatism test, earnings are less conservative in expansions relative to the contractions. This
is in line with Jenkins et al. (2009) who find that earnings conservatism is higher during contraction
periods than expansion periods.
With regards to the value relevance test, current earnings and future earnings are more value relevant in
expansions relative to contractions. This is in line with the result of Johnson (1999) and somewhat
contrary to Jenkins et al. (2009). Jenkins et al. (2009) find current earnings to be less value relevant in
expansions compared to contractions while future earnings are vice versa. As mentioned in the first
chapter, the motivation of this thesis is to reconcile the mixed results between Johnson (1999) and Jenkins
et al. (2009). Less conservative earnings and higher persistent earnings in expansion periods enhance the
59
usefulness and hence the value relevance of both current and future earnings for the equity market
valuations. My findings are consistent with Jenkins et al. (2009) except for the value relevance of current
earnings. Different sample periods and sample firms are the sources of these different outcomes. Jenkins
et al (2009) do not control for other factors in their sample such as different firm-size and firm-specific
characteristics which might distort their findings. Jenkins et al. (2009) do not take into account that large
firms have more persistent earnings than smaller firms. Further, Jenkins et al. (2009) did not measure the
earnings persistence level of their sample which makes it more difficult to establish whether earnings
persistence is the cause of different outcome. Earnings persistence has a positive effect on value relevance
of earnings (Collins and Kothari, 1989; Nichols and Wahlen, 2004). Higher earnings persistence improves
the predictive power of current earnings in forecasting future earnings. Investors base their investments
decisions on this forecast when assessing the performance of a firm’s stock. Further lower conservatism
implies that earnings capture the true firm’s performance more accurately in expansions than in
contraction periods when earnings are more conservative. Collectively, less conservative and higher
persistent earnings contribute to the higher value relevance of current and future earnings in expansion
periods than in contraction periods.
At last this thesis contributes to the existence literatures in three ways; first it provides evidences of the
business cycle impacts on earnings. Fluctuations in the macroeconomic conditions lead to variations in
earnings persistence, earnings conservatism and value relevance of earnings. Investors, standard-setters
and future researchers should take the effect of business cycle into account in their decision-making
process. Second the findings reconcile the mixed results of value relevance tests between Johnson (1999)
and Jenkins et al. (2009). Value relevance of both future and current earnings are higher during the
expansion periods that are when earnings are less conservative and more persistence. Third, this thesis
enriches value relevance literatures particularly related to the influence of macroeconomic situations on
value relevance. As suggested by Clinch and Wei (2011), a large part of study has mainly focused on the
impact of firm-specific characteristics rather than macroeconomic variations.
6.2.
Limitations and Suggestions
As indicated in the first chapter, this thesis has some limitations. The first limitation comes from the
relationships among earnings conservatism, earnings persistence and value relevance of earnings. This
thesis expects direct connections of earnings conservatism and earning persistence with value relevance
of earnings. Less conservative earnings and high persistent earnings are expected to increase the value
relevance of earnings. However other factors may also have influence on value relevance of earnings as
listed in chapter three, to mention a few: different standard setters affect the development of accounting
standards (Ely and Waymire, 1999), earnings management reduces the usefulness of earnings for the
60
investors (Marquardt and Wiedman, 2004) and external information decreases the value relevance of
accounting information (Dontoh et al., 2004).
The second limitation lies in the sample. The sample is only limited to the firms with large market
capitalization from the United States. Including merely large firms restricts the generalization of the
research outcome only to large-size firms. Further the research findings may not hold in another country
since the sample includes only the U.S. firms. Other countries have different accounting standards than
the U.S. which may have an impact on the research outcomes.
The third limitation is related to the statistical test. Because of the non-normality in the sample, the
coefficient in the regression equation is no longer the best prediction. Using a large sample reduces the
severe consequences of running a regression analysis on non-normal distribution. Nevertheless any
conclusion deriving from the tests should be done cautiously.
Suggestion for the future research is to focus on the causal relationships among earnings conservatism,
earnings persistence and value relevance of earnings. Enlarge the sample by including other countries is
also interesting for example to investigate whether variations in institutional factors between countries
have an impact on the fluctuation in the value relevance of earnings throughout the business cycle.
However this might be complicated due to different accounting standards between countries.
61
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Appendix
1. Summary of literature reviews
Earnings persistence and conservatism
Authors
Objective
Basu (1997)
Re-examine the
conservatism principle
Paek et al.
(2007)
The effect of
conservative
accounting on earnings
persistence
Sloan (1996)
The effect of earnings
components on
earnings persistence
Wakil and Alam
(2012)
the effect of
conservatism on
accruals persistence in
predicting future
earnings
Methodology
Asymmetric timeliness which regress
earnings changes and a dummy represents
good news versus bad news with stock
returns
Conservatism:
1. Asymmetric timeliness of good news
and bad news
2. Cumulative accruals
3. Change in lagged operating income
4. Response coefficients of accruals
Earnings persistence:
The first autocorrelation between earnings of
two consecutive years
The first autocorrelation of current earnings
components i.e. accruals and cash flows in
predicting next year earnings.
Sample
US sample during the
period 1964-1990
Conservatism:
1. Asymmetric timeliness
2. C-score
3. Market-to-Book ratio
Regression analysis which includes cash
flow, accruals and dummy of conservatism
US sample during the
period of 1987-2008
US sample during the
period of 1984-2003
US sample during the
period of 1962-1991
Result
Earnings changes during bad
news period are less
persistent than during good
news period.
Less conservative earnings
are likely to persist into the
next period than more
conservative earnings
accruals have lower
persistence for the assessment
of future earnings than cash
flow
conservatism increases
accrual persistence of firms
with high accruals deciles
more than firms with low
accruals
Conservatism and Value Relevance
69
Brown et al.
(2006)
Kousenidis et al.
(2009)
Balachandram
and Mohanram
(2010)
the relationship
between conditional
conservatism and the
value relevance
earnings
the association between
conservatism and value
relevance of earnings
Conservatism:
1. Asymmetric timeliness
2. Market-to-Book ratio
Value relevance is measured by the mean
returns of the earnings-based portfolio
Conservatism: Basu (1997) asymmetric
timeliness;
Value relevance: Easton and Harris (1991)
model which regressed stock returns with
earnings and changes in earnings
Sample from 20
countries during the
period of 1993-2004
conditional conservatism and
accrual intensity are
negatively related to the value
relevance of earnings
Greek firms over
period 1989-2003
The relation between
value relevance and
conservatism
Conservatism:
1. Regression of lagged of returns with
the book-to-market ratio
2. C-Score
Value Relevance
1. Price and earnings regression
2. Returns regressed with earnings and
book value
3. earnings, change in earnings and
book value regressed with marketadjusted return
The US listed firms
over period 1975-2004
Non-linear association
between conservatism and
value relevance which means
that high and low
conservatism is perceived as
less value relevant relative to
medium conservatism.
- significant increase of
conservatism across the
time
- declining trend of value
relevance
- The decline in value
relevance is not related to
the increase in
conservatism
Earnings Persistence and Value Relevance
Kormendi and
The effect of Earnings
Lipe (1987)
persistence on the
earnings-return relation
Easton and
Zmijewski
(1989)
Stock market response
to earnings
announcements
Regression analysis between changes in
earnings and stock return
Univariate time-series model of
persistence and earnings response
coefficient
Multiple regression models included
abnormal returns, unexpected earnings,
systematic risk and firm size.
US listed firm
during 1947-1980
ERC is positively related to
earnings persistence
US listed firm
during 1975-1980
ERC is positively related to
earnings persistence and negatively
related to systematic risk
67
Collins and
Kothari (1989)
Nichols and
Wahlen (2004)
inter-temporal and
cross-sectional
determinants of
earnings response
coefficient (ERC)
The relation between
earnings and stock
returns
Multivariate model consists of growth,
risk-free interest, systematic risk, earnings
persistence and stock return
US listed firm
during 1968-1982
ERC is positively related to growth
and/or earnings persistence and
negatively related with the risk-free
interest and systematic risk
Firms are divided into two portfolios of
earnings increases and decreases. Each
portfolio is divided into ten deciles based
on the magnitude of earnings changes.
US listed firms
over the period
1988-2001
During years of earnings increases,
high persistence firms earn higher
abnormal return than low
persistence firms but only small
difference during years of earnings
decreases
US listed firm over
period 1970-1987
Earnings are more persistent and
more value relevant during
expansions (credit crunch) than
during recessions (reliquification
period)
US listed firm over
period 1980-2003
During contractions, current
earnings are more conservative and
more value relevant than during
expansions. Future expected
earnings are more value relevant
during expansions than during
contractions
Stronger associations between
returns and earnings during large
positive GDP periods only for the
US firms and only when GDP
growth is used to macro-economic
indicator.
Conservatism, earnings persistence and value relevance throughout business cycle
Johnson (1999) the impact of business
Persistence: Regression analysis of first
cycle on the association autocorrelation quarterly earnings per
between accounting
share
earnings and stock
Value relevance: regression analysis of
returns
unexpected earnings and cumulative
abnormal return
Jenkins et al.
business cycle variation Conservatism: asymmetric timeliness
(2009)
with changes in
Value relevance: Earnings model which
earnings conservatism
includes change in earnings, next period
and value relevance
return and a dummy represents business
cycle
Clinch and Wei
(2011)
Investigate the relation
between accounting
earnings and stock
returns
Business cycle is defined based on GDP
growth and market returns
Regression analysis between abnormal
returns and earnings
Australia (19872008), the US
(1971-2008) and
China (1991-2008)
68
2. Sample distribution
i. Earnings per share distribution
EPS
.16
.14
.12
Density
.10
.08
.06
.04
.02
.00
-80
-60
-40
-20
0
20
40
60
80
ii. Returns distribution
RET
4,000
3,500
Frequency
3,000
2,500
2,000
1,500
1,000
500
0
-4
0
4
8
12
16
20
24
28
32
69