The Link Between
Earnings Conservatism
and
Balance Sheet Conservatism
Jinhan Pae
Dan Thornton
Mike Welker
Queen’s University
1
The Punch Line:
Basu documents that earnings are much more highly
correlated with bad news (negative stock returns) than with
good news (positive stock returns)
We argue that earnings conservatism is related to the
conservatism in the balance sheet at the beginning of the
period (most straight forward way to see – lower of cost or
market rules - suggest that recognition of bad news is a
function of the relation between book and market,
recognition of good news is not)
We use market to book to measure balance sheet
conservatism and document a very strong negative relation
between market to book and earnings conservatism
We further document that this relation is principally driven by
2
the accrual component of earnings
Earnings Conservatism
Inherent in accounting standards
– Expense R&D and advertising
– Recognize post-retirement obligations but not
human assets
– Write down impaired goodwill but don’t recognize
internally generated goodwill.
SEC enforcement augments or diminishes it
– e.g., SAB 101’s strict revenue recognition criteria.
3
Empirical literature to date operationalizes
conservatism and explains its “existence”
Watts’ (2003) –:
“Differential verifiability required for
recognizing profits versus losses.”
Earnings conservatism measure:
Degree to which a firm’s accounting income
reflects expected losses in a more timely
fashion than expected gains (Basu 1997).
4
Simple empirical measure of the timeliness of
accounting numbers
X it   0t  1t Rit   it
Cross sectional regression coefficient 1t measures the
timeliness with which accounting numbers reflect returns
Xit : firm i’s earnings, accruals, or operating cash flows for
fiscal year t, deflated by the market value of equity at the
end of year t–1.
Rit : the market rate of return on firm i’s common stock for
the year ending 3 months after fiscal year t
it : assumed to be noise.
5
X it   0t  1t Rit   it
Good news firms (R  0):
Estimate 1tGN
Bad news firms (R < 0):
Estimate 1tBN
General approach – Estimate 1tGN (1tBN) in year t for
samples of firms reporting good (bad) news
– Cross sectional regression at t or pooled.
We define conservatism as ct ≡ 1tBN - 1tGN
– Excess sensitivity of earnings to bad versus good news for
fiscal year t.
6
We are interested in “responsiveness”
Unaddressed so far in empirical literature
Does earnings conservatism increase with managers’
incentive to overstate earnings/net assets?
We hypothesize that this incentive, and hence earnings
conservatism is negatively associated with balance
sheet conservatism.
– Balance sheet conservatism measure:
lagged market-to-book ratio Pt-1/Bt-1
– Proxy for changes in expected gains or losses:
stock returns (Basu, 1997).
• Assumes market efficiently reflects investor perceptions
7
Summary of Approach
X it   0t  1t Rit   it
Conservatism ct ≡ 1tBN - 1tGN
Good news firms (R  0):
Estimate 1tGN
Bad news firms (R < 0):
Estimate 1tBN
– Earnings Conservatism at t is the excess sensitivity of
earnings to bad versus good news for fiscal year t.
We hypothesize ct is negatively associated
with balance sheet conservatism, Pt-1/Bt-1
– Pt-1 (Bt-1) represents the market (book) value of equity at the
end of fiscal year t–1.
– (For brevity we call this “the P/B ratio”).
8
Three hypotheses in alternate form
H1a: Existence: ct > 0 for all t. That is, earnings
are conservative in all periods examined.
H2a: Responsiveness: With earnings as the
dependent variable, ct is negatively
associated with Pt-1/Bt-1.
H3a: Responsiveness: With accruals as the
dependent variable, ct is negatively
associated with Pt-1/Bt-1.
9
Fourth hypothesis in null form
H40: With operating cash flows as the
dependent variable, ct is independent of
Pt-1/Bt-1.
That is, cash flow conservatism is not
associated with balance sheet conservatism.
– Accountants don’t control this (except, maybe, to
urge selling off assets for cash).
10
Hypotheses development
•
Review Watts’ (2003) four explanations for
existence of conservatism
1. Contracting
2. Shareholder litigation
3. Regulation
4. Taxes
•
Extend each explanation to derive our
hypothesized negative association between
earnings conservatism and balance sheet
conservatism.
11
Contracting Explanation for
Conservatism
Accounting measures are common in
contracts constraining managers in
expending resources and splitting returns
among firm claimants (Holthausen and
Leftwich, 1983; Watts and Zimmerman, 1986).
12
Contracting I:
Management compensation agreements
Existence of Conservatism
– Managers with limited tenure have incentives to
inflate earnings to increase their bonus
compensation and increase the value of their
stock options.
– Earnings conservatism facilitates delivered
performance measurement (Barclay et al. 2000) by
deferring the recognition of gains until they are
verifiable.
13
Contracting I:
Management compensation agreements
Negative P/B Association
– Decrease in P/B signals a decline in a firm’s future
growth opportunities, increasing managers’
preference for current vs. deferred compensation.
– Motivates managers to overstate current earnings
to increase bonus, stock option compensation.
14
Contracting II: Debt contracts
Existence of Conservatism
– Debt covenants restrict firm from making unrecoverable
payments to shareholders and junior claimants (Leftwich,
1983).
• Recipients of excessive dividend payments do not generally
need to return them to the firm in the event of financial trouble.
– Limit dividend payments to “unrestricted” retained earnings.
– Restrict additional borrowing by placing upper limits on firms’
debt/equity ratios.
– Corporations laws say “dividend distributions neither make a
company insolvent nor impair its capital.”
15
Contracting II: Debt contracts
Negative P/B Association – Earnings Constraints
– As P/B decreases, the probability of default increases
because the value of the firm’s expected future cash flows
(numerator) decreases vis a vis principal amount of debt.
– Following a decrease in P/B, debt holders wish to tighten
constraints on excessive payouts and additional borrowing.
– The contractual constraints protecting debt holders against
excessive payouts generally refer to earnings (often before
interest and taxes) based on GAAP, not market-based
earnings measures.
– Earnings conservatism directly constrains dividend and
compensation payouts based on earnings.
16
Contracting II: Debt contracts
Negative P/B Association – Debt/Equity Constraints
– Constraints protecting debt holders against excessive
additional borrowing generally refer to a maximum D/E
based on book value equity measure.
– Earnings conservatism triggers impaired asset write-offs
and recognition of unrecorded liabilities in the income
statement, pushing the D/E closer to its maximum limit and
tightening the constraint on additional borrowing.
– Debt holders to rely on earnings conservatism increasing as
P/B decreases, more than offsetting managers’ increasing
incentives to overstate earnings, overstate assets, and
understate liabilities.
17
Hypotheses development
•
Review Watts’ (2003) four explanations for
existence of conservatism
1. Contracting
2. Shareholder litigation
3. Regulation
4. Taxes
•
Extend each explanation to derive our
hypothesized negative association between
earnings conservatism and balance sheet
conservatism.
18
Shareholder litigation
Existence of Conservatism
– Earnings conservatism reduces the expected
present value of shareholder litigation costs
– Shareholders are much more likely to litigate
when earnings and net assets are overstated than
when they are understated Watts (1993, 2003),
Kothari et al. (1988), and Beaver (1993).
19
Shareholder litigation
Negative P/B Association
– As P/B decreases
• It becomes more likely that net asset carrying values exceed
fair values.
• Probability of shareholder litigation increases because
shareholders can more readily substantiate claims that
assets are misleadingly overvalued.
• Likely magnitude of claimed damages increases as investors
can claim that asset carrying values are farther below fair
values.
– Hence, to reduce expected litigation costs, it is efficient for
both auditors and managers to increase the degree of
earnings conservatism as P/B decreases.
20
Hypotheses development
•
Review Watts’ (2003) four explanations for
existence of conservatism
1. Contracting
2. Shareholder litigation
3. Regulation
4. Taxes
•
Extend each explanation to derive our
hypothesized negative association between
earnings conservatism and balance sheet
conservatism.
21
Regulation
Existence of Conservatism
– Investor losses from overvalued assets and
overstated earnings are more observable and
usable in the political process than forgone gains
due to undervalued assets or understated
earnings (Watts 1977, Benston 1969).
– Thus, standard-setters have incentives to set
conservatively worded GAAP; regulators like the
SEC have incentives to enforce GAAP in a
conservative fashion.
22
Regulation
Negative P/B Association
– Low P/B ratios imply poor future prospects for companies
and are consistent with recent declines in values having
occurred, making it likely that investors will blame
regulators for permitting misleading accounting practices.
– Thus, both the wording and required implementation of
many accounting standards imply a negative association
between earnings conservatism and the P/B ratio.
Examples:
• Inventory at the lower of cost or market.
• SFAS 142 mandated goodwill impairment write-downs
• SFAS 5 contingent loss recognition
23
Hypotheses development
•
Review Watts’ (2003) four explanations for
existence of conservatism
1. Contracting
2. Shareholder litigation
3. Regulation
4. Taxes
•
Extend each explanation to derive our
hypothesized negative association between
earnings conservatism and balance sheet
conservatism.
24
Taxes
Existence of Conservatism
– Incentives for profitable firms with taxable income
to defer income (be conservative) to reduce the
present value of taxes (Watts, 2003; Smith and
Watts, 1982; Watts and Zimmerman, 1979;
Guenther et al. 1997; Shackelford and Shevlin
2001)
25
Taxes
Negative P/B Association??
Managers’ incentives
– Increase reported income to increase bonuses
– Decrease reported income to save corporate taxes
It is unclear (to us) how declines in P/B affect the
tradeoff.
So, we limit our analysis of the implications of Watts’
(2003) conservatism explanations to contracting,
litigation, and regulation.
26
Results
27
Mean
Standard
Deviation
First
Quartile
Median
Third
Quartile
Min
Max
R
0.12
0.58
-0.23
0.04
0.34
-0.97
8.39
NI
0.03
0.20
-0.01
0.06
0.11
-2.46
0.98
ACC
-0.09
0.23
-0.14
-0.04
0.01
-3.61
1.17
OCF
0.11
0.23
0.00
0.09
0.20
-1.25
3.34
MV
1,114.29
7,322.57
16.92
69.47
358.05
0.06
467,096
Sales
1,045.27
4,917.51
25.35
104.07
447.47
-203.75
217,799
P/B
3.82
60.65
0.96
1.61
2.90
0.03
10,474
Mean
Standard
Deviation
First
Quartile
Median
Third
Quartile
Min
Max
R
0.47
0.56
0.14
0.31
0.61
0.00
8.39
NI
0.07
0.17
0.04
0.08
0.14
-2.36
0.98
ACC
-0.09
0.23
-0.14
-0.05
0.01
-3.22
1.17
OCF
0.16
0.24
0.04
0.13
0.24
-1.11
3.34
MV
1,417.60
8,338.03
25.68
108.49
542.50
0.06
467,096
Sales
1,265.43
5,440.95
36.05
139.89
595.05
-4.39
217,799
P/B
3.26
66.71
0.89
1.45
2.53
0.03
10,474
Mean
Standard
Deviation
First
Quartile
Median
Third
Quartile
Min
Max
R
-0.30
0.22
-0.44
-0.26
-0.12
-0.97
0.00
NI
-0.03
0.21
-0.07
0.03
0.07
-2.46
0.90
ACC
-0.09
0.24
-0.13
-0.04
0.01
-3.61
1.07
OCF
0.06
0.20
-0.03
0.05
0.14
-1.25
2.83
MV
755.17
5,878.21
11.38
42.03
196.37
0.07
422,640
Sales
784.61
4,199.74
17.19
72.28
303.65
-203.75
195,805
P/B
4.49
52.58
1.06
1.83
3.39
0.03
28
6,620
Variable
DATA – TABLE 1
Panel A: Full Sample
– 119,983 observations
Variable
Panel B: Good News (non-negative returns)
– 65,044 observations
Variable
Panel C: Bad News (negative returns)
– 54,939 observations
Panel A: Full Sample (119,983 observations)
Variable
R
NI
OCF
R
0.220
0.189
(<0.01)
(<0.01)
0.411
(<0.01)
ACC
0.002
(0.54)
MV
0.029
(<0.01)
Sales
0.009
(<0.01)
P/B
-0.008
(<0.01)
0.447
(<0.01)
0.019
(<0.01)
0.040
(<0.01)
-0.010
(<0.01)
-0.632
(<0.01)
-0.001
(0.68)
0.045
(<0.01)
-0.021
(<0.01)
0.018
(<0.01)
-0.010
(<0.01)
0.012
(<0.01)
0.624
(<0.01)
0.005
(0.06)
NI
0.398
(<0.01)
OCF
0.298
(<0.01)
0.523
(<0.01)
ACC
-0.021
(<0.01)
0.176
(<0.01)
-0.616
(<0.01)
MV
0.208
(<0.01)
0.141
(<0.01)
0.137
(<0.01)
0.036
(<0.01)
Sales
0.148
(<0.01)
0.288
(<0.01)
0.326
(<0.01)
-0.086
(<0.01)
0.796
(<0.01)
P/B
-0.160
(<0.01)
-0.294
(<0.01)
-0.395
(<0.01)
0.293
(<0.01)
0.298
(<0.01)
-0.003
(0.27)
-0.055
(<0.01)
29
Panel B: Good News (non-negative returns, 65,044 observations)
Variable
R
NI
OCF
ACC
MV
R
-0.024
0.010
-0.028
-0.012
(<0.01)
(0.01)
(<0.01)
(<0.01)
NI
0.089
(<0.01)
0.426
(<0.01)
OCF
0.033
(<0.01)
0.503
(<0.01)
ACC
-0.011
(0.01)
0.074
(<0.01)
-0.720
(<0.01)
MV
-0.054
(<0.01)
-0.092
(<0.01)
-0.009
(0.03)
0.013
(<0.01)
Sales
-0.126
(<0.01)
0.138
(<0.01)
0.227
(<0.01)
-0.111
(<0.01)
0.813
(<0.01)
P/B
0.006
(0.12)
-0.384
(<0.01)
-0.441
(<0.01)
0.303
(<0.01)
0.390
(<0.01)
Sales
-0.060
(<0.01)
P/B
0.004
(0.29)
0.292
(<0.01)
-0.014
(<0.01)
0.006
(0.15)
-0.011
(<0.01)
-0.741
(<0.01)
-0.025
(<0.01)
0.021
(<0.01)
-0.017
(<0.01)
0.016
(<0.01)
-0.018
(<0.01)
0.010
(0.01)
0.642
(<0.01)
0.005
(0.25)
-0.002
(0.55)
0.034
(<0.01)
30
Panel C: Bad News (negative returns, 54,939 observations)
Variable
R
NI
OCF
ACC
R
0.312
0.244
0.077
(<0.01)
(<0.01)
(<0.01)
0.333
(<0.01)
MV
0.049
(<0.01)
Sales
0.079
(<0.01)
P/B
-0.027
(<0.01)
0.618
(<0.01)
0.038
(<0.01)
0.058
(<0.01)
-0.004
(0.33)
-0.535
(<0.01)
0.016
(<0.01)
0.062
(<0.01)
-0.022
(<0.01)
0.020
(<0.01)
0.000
(1.00)
0.015
(<0.01)
0.584
(<0.01)
0.009
(0.04)
NI
0.399
(<0.01)
OCF
0.307
(<0.01)
0.462
(<0.01)
ACC
0.031
(<0.01)
0.349
(<0.01)
-0.523
(<0.01)
MV
0.231
(<0.01)
0.262
(<0.01)
0.191
(<0.01)
0.082
(<0.01)
Sales
0.237
(<0.01)
0.359
(<0.01)
0.368
(<0.01)
-0.045
(<0.01)
0.760
(<0.01)
P/B
-0.215
(<0.01)
-0.128
(<0.01)
-0.302
(<0.01)
0.279
(<0.01)
0.274
(<0.01)
-0.003
(0.43)
-0.115
(<0.01)
31
Replication of Previous Results
Consistent with H1a
32
H1a: Earnings are conservative in all
periods examined (Table 3)


BN
1

GN
1
BN
1

GN
1
Reliably, in all 32 periods
from 1970 to 2001
Mean = 0.279 (t = 12.5).
Coefficient relating earnings to returns when returns are
negative is on average around 10 times larger than
coefficient relating earnings to returns when returns are
non-negative over this period
33
Table 5
Form 5 portfolios based on the beginning-ofyear P/B.
P/B < 1  Portfolio I (16,226 firm-years) and II
(16,227).
P/B  1  Portfolios III through V ( 29,000
firm-years each).
34
H2a: With earnings as the dependent variable,
ct is negatively associated with Pt-1/Bt-1.
Panel A: Earnings as Dependent Variable
Good News (GN)
P/B
Adj. R2
0
1
I
(low)
II
Mean of
Annual
regressions
(t-value)
0.029
(1.50)
0.081
(7.80)
III
0.085
(11.88)
IV
0.068
(18.19)
V
0.038
(high) (9.58)
1P/B(I)  1P/B(V)
0.062
(4.56)
0.042
(3.80)
0.024
(4.82)
0.019
(2.55)
0.006
(1.04)
0.056
(4.66)
0.023
0.034
0.016
0.029
0.015
Bad News (BN)
0
1
Adj. R2
0.009
(0.44)
0.086
(6.77)
0.090
(11.89)
0.079
(14.87)
0.041
(9.23)
0.604
(10.82)
0.524
(13.11)
0.371
(12.59)
0.252
(15.98)
0.158
(14.12)
0.446
(8.67)
0.127
0.171
0.152
0.132
0.077
1BN   1GN
0.542
(9.87)
0.482
(11.69)
0.347
(11.45)
0.233
(11.82)
0.152
(10.83)
0.390
(7.92)
Increase over
next highest
P/B portfolio
0.060
(1.67)
0.135
(4.85)
0.114
(6.50)
0.081
(5.12)
35
H3a: With accruals as the dependent variable,
ct is negatively associated with Pt-1/Bt-1.
Table 5 (Panel B)
Panel B: Accruals as Dependent Variable
Good News (GN)
P/B
Adj. R2
0
1
I
(low)
II
Mean of
Annual
regressions
(t-value)
III
IV
V
(high)
 1P/B(I)   1P/B(V)
-0.196
(-12.62)
-0.103
(-13.00)
-0.071
(-11.73)
-0.033
(-7.67)
-0.018
(-5.83)
-0.013
(-1.06)
-0.015
(-1.63)
0.003
(0.56)
-0.004
(-0.57)
0.005
(1.00)
-0.018
(-1.53)
0.000
0.004
0.002
0.006
0.004
Bad News (BN)
0
1
Adj. R2
-0.187
(-10.21)
-0.085
(-8.72)
-0.046
(-8.36)
-0.022
(-4.90)
-0.009
(-2.82)
0.348
(5.52)
0.233
(5.46)
0.167
(4.32)
0.077
(4.83)
0.025
(1.86)
0.323
(5.35)
0.033
0.034
0.029
0.013
0.007
 1BN   1GN
0.361
(5.53)
0.248
(5.64)
0.164
(4.39)
0.081
(4.45)
0.020
(1.31)
0.341
(5.47)
Increase over
next highest
P/B portfolio
0.113
(2.16)
0.084
(1.80)
0.083
(2.96)
0.061
(3.01)
36
H40: With operating cash flows as the dependent
variable, ct is independent of Pt-1/Bt-1.
Table 5 (Panel C)
Panel C: Operating Cash Flows as Dependent Variable
Good News (GN)
P/B
Adj. R2
0
1
I
(low)
II
Mean of
Annual
regressions
(t-value)
III
IV
V
(high)
1P/B(I)  1P/B(V)
0.224
(16.23)
0.184
(24.36)
0.155
(27.92)
0.101
(28.18)
0.056
(13.05)
0.075
(3.68)
0.057
(4.96)
0.021
(3.06)
0.023
(1.92)
0.001
(0.13)
0.074
(3.98)
0.018
0.011
0.005
0.019
0.012
Bad News (BN)
0
1
0.196 0.255
(13.75) (5.20)
0.171 0.292
(22.69) (12.52)
0.136 0.204
(21.64) (6.14)
0.101 0.175
(26.60) (13.68)
0.050 0.133
(10.58) (10.14)
0.122
(2.66)
Adj. R2
0.024
0.047
0.054
0.062
0.050
 1BN   1GN
0.180
(3.74)
0.235
(8.99)
0.183
(5.38)
0.152
(8.31)
0.132
(7.50)
0.048
(1.04)
Increase over
next highest
P/B portfolio
-0.055
(-1.20)
0.052
(1.29)
0.031
(1.17)
0.020
(0.81)
37
Cash Flow vs.
Accruals
Cash flows:
No declines significant
Individually or in total
0.600
Earnings
Earnings: All declines individually
Significant except this one
0.500
Figure 1
Table 5
Accrual component
of earnings
accounts for 87% of
difference in
earnings
conservatism
between the low and
high P/B portfolio
Conservatism
0.400
Accruals
0.300
0.200
Accruals: All declines
individually significant
except this one
Operating
Cash Flows
0.100
Cash flow
component of
earnings accounts
for only 13% of this
difference.
Market to book
less than 1
Market to book
greater than 1
0.000
I
II
III
IV
V
Market to Book Group
38
Conjecture
That cash flow conservatism is positive
(though unrelated to P/B) is due to firms’ real
option to
– Adapt assets to next best use (Restructuring
charges less persistent than core operating cash
flows – Collins et al. 1999)
– Liquidate unprofitable operations (Hayn 1995)
39
Table 6
Partitions along two dimensions—the level of
accruals and the size of the P/B ratio.
Confirms that low-accruals, low-P/B firms
exhibit the most earnings conservatism and
high-accruals high-P/B firms the least, if any,
earnings conservatism.
40
c
BN
1
Table 6
Earnings
Accruals
ACC
P/B

GN
1
Cash Flows
ACC
ACC
[I, II]
[III,IV,V]
I, II
0.580
(12.58)
0.234
(8.49)
III,IV,V
0.387
(15.56)
0.131
(12.55)
P/B
I, II
III,IV,V
P/B
I, II
III,IV,V
I, II
0.331
(8.58)
-0.112
(-5.40)
I, II
0.249
(8.76)
0.346
(11.57)
III,IV,V
0.191
(5.23)
-0.048
(-5.10)
III,IV,V
0.196
(4.61)
0.179
(17.19)
41
CHANGES IN EARNINGS
CONSERVATISM OVER TIME
Givoly and Hayn (2000)
X it   0  1 Dit   2 Rit   3 Dit  Rit   it
Dit = dummy taking the value 1 (0) when annual stock
returns are negative (non-negative).
β3 measures EXISTENCE of earnings conservatism.
G&H find it has increased over time
42
Our modification
X it   0  1 Dit   2 Rit   3 ( D  R ) it   4 PBit   5 ( D  PB ) it
  6 ( PB  R ) it   7 ( D  PB  R ) it   it
PB = dummy taking the value 1 (0) when P/B is
less than (greater than or equal to) one.
Thus,
– Our 3 is an EXISTENCE measure of conservatism
for firms with P/B greater than or equal to one
– Our 7 is a measure of RESPONSIVENESS – the
extra conservatism exhibited by firms with P/B
less than one.
43
Our Results
• Table 7 and Figure 2 present the results of
estimating pooled regressions using the
constant sample of 788 firms that existed
throughout our 1970-2001 test period.
• β7 increases monotonically from the
1970-75 to the 1991-95 period.
• β7 increases more consistently with time
than β3 in either G&H or our model.
44
0.700
0.600
Beta Values
0.500
Our

0.400
0.300
GH
3
0.200
Our

0.100
0.000
70-75
76-80
81-85
86-90
Time Period
91-95
962001
45
CHANGES IN EARNINGS
CONSERVATISM OVER TIME:
Summary
• The increase in the negative association
between earnings conservatism and P/B is
also largely responsible for G&H’s finding
that earnings conservatism increased up to
1988 even though P/B generally increased.
• Accountants generally increased reactive
conservatism until the dot-com boom.
46
Robustness/Alternate Explanations
• Choice of the return period – fiscal year
same
• Hribar and Collins (2002) direct cash flow –
similar results post-87
• Market inefficiency – Fama and French (1992)
negative cross-sectional association
between P/B and security returns – we don’t
see how this can explain results
47
Conclusions, Limitations, Future
Research
(1) Earnings conservatism is negatively
associated with P/B
– Given an overall level of conservatism embedded
in accounting standards, accountants and
managers wax more conservative when we need
them to – here, proxied by P/B decreases
– Both overall conservatism and reactive
conservatism vary over time
• Enrons, new governments
• Litigiousness
48
Conclusions, Limitations, Future
Research
(2) The link between earnings and balance
sheet conservatism is mainly due to the
accrual component of earnings, not the
operating cash flow component of earnings.
(3) Accruals implement reactive earnings
conservatism: Cash flow conservatism
exists, but is unrelated to P/B.
49
Future Research
• Compare earnings conservatism across countries
– Allow for cross-country variation in the relation between
earnings conservatism and P/B.
• We conjecture that variation in the institutional
features that give rise to conservatism also results
in cross-country variation in responsiveness the
association between earnings conservatism and
balance sheet conservatism.
– legal systems
– insider trading regulations
– accounting standard setting mechanisms
50
Future Research
• Possibly, one could revisit Dechow/Dichev
(2002) and see if conservatism increases or
decreases the mapping of accruals into past,
present, and future cash flows. The research
tension:
– Conservatism delays earnings recognition until
cash receipts are more verifiable; ignores
“irrational exuberance”
– Conservatism biases earnings recognition away
from timely and neutral reflection of market
perceptions.
51