Accounting Conservatism and the Relation Between Returns and Accounting Data

Peter Easton The Ohio State University and The University of Melbourne

and

Jinhan PaeQueen’s University

May 2003

We thank Ashiq Ali, Bruce Billings, Keji Chen, Dan Dhaliwal, Jerry Feltham, Rick Morton, Jim Ohlson, Gord Richardson, Greg Sommers, Mark Trombley, Bill Schwartz, Philip Stocken, two anonymous referees, and workshop participants at the University of British Columbia, Florida State University, Nyenrode University, the Ohio State University, the University of Arizona, and the 2001 American Accounting Association annual meetings, for helpful comments on earlier drafts.

Accounting Conservatism and the Relation Between Returns and Accounting Data

Abstract

The study adds change in cash investments and change in lagged operating assets to the regression of returns on earnings levels and earnings changes examined in Easton and Harris (1991). The model in Feltham and Ohlson (1996) suggests that a positive coefficient on change in cash investments captures conservatism associated with investments in positive net present value projects the effects of which will not flow into the accounting statements until the expected future benefits are realized. A positive coefficient on change in lagged operating assets implies accounting conservatism associated with the application of accounting rules (such as expensing rather than capitalizing R&D expenditures) to operating assets in place. Our empirical results are, in general, consistent with the predictions from Feltham and Ohlson (1996). We examine differences in conservatism across samples with different market to book ratios, we compare firms with non-negative returns with firms with negative returns, we compare firms reporting losses with firms reporting profits, and we examine firms in different industries, firms with different levels of research and development expenditure, different amounts of depreciation, different amounts of advertising expense, and firms that adopt LIFO inventory valuation compared with those that adopt an alternative to LIFO.

1. Introduction

The study adds change in cash investments and change in lagged operating assets

to the regression of returns on earnings levels and earnings changes examined in Easton

and Harris (1991).1 We show that change in cash investments and change in lagged

operating assets have incremental explanatory power (over earnings levels and earnings

changes) for returns suggesting that accounting is conservative in the Feltham and Ohlson

(1996) sense.

The model in Feltham and Ohlson (1996) suggests that a positive coefficient on

change in lagged operating assets implies accounting conservatism associated with the

application of accounting rules (such as expensing rather than capitalizing R&D

expenditures) to operating assets in place. A positive coefficient on change in cash

investments captures conservatism associated with investments in positive net present

value projects the effects of which will not flow into the accounting statements until the

expected future benefits are realized. Our empirical results are, in general, consistent

with the predictions from Feltham and Ohlson (1996) providing evidence of accounting

conservatism.

Feltham and Ohlson (1995, 1996) generalize and extend Ohlson (1995) by

introducing the notion of accounting conservatism (defined as market value exceeding

book value in the long run). With few exceptions empirical studies of the relation

between returns and accounting data rely on Ohlson (1995) implicitly ignoring the effects

of conservatism. Easton and Harris (1991) show that deflated (by beginning-of-period

stock price) earnings levels and deflated earnings changes have significant explanatory

power for annual returns. Their regression is implicitly based on Ohlson (1995) in which

accounting is assumed to be unbiased (that is, the market value of equity equals the book

value of equity in the long run). However, the current disparity between market value of

equity and book value of equity suggests that accounting is not likely to be unbiased.

Empirical tests are performed on a sample of 53,554 firm-year observations from

1988 to 2001. The mean of the year-by-year estimates of the coefficients on change in

lagged operating assets is not significantly different from zero while the mean of the

1 We also add lagged dividends in all of our analyses as another explanatory variable for returns. The focus in Easton and Harris (1991) is on earnings changes and earnings levels although they note their model suggests that dividends should be included as an additional explanatory variable. Easton and Harris (1991) observe that inclusion of lagged dividends does not affect their inferences.

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estimate of the coefficient on change in cash investments is 0.266 (t-statistic of 7.56).

The significantly positive estimate of the coefficient on change in cash investments

suggests that accounting is conservative, consistent with the results in Ahmed, Morton,

and Schaefer (2000).

We find that accounting conservatism as defined in Feltham and Ohlson (1996) is

more pronounced for firms where the market value of operating assets is high relative to

their book value (this is consistent with use of the ratio of the market value of common

equity to the book value of common equity as a proxy for accounting conservatism in

Beaver and Ryan (2000)).2 Our empirical analyses demonstrate that the magnitude of the

estimates of the coefficients on change in cash investments and change in lagged

operating assets increase as the price to book ratio increases. Industry-specific analysis

shows evidence of varying degrees of accounting conservatism across industries.

Accounting conservatism is particularly evident in the pharmaceutical industry.

Following Basu (1997) who suggests that accounting will be more (less)

conservative for firms with good (bad) news over the fiscal period, we seek evidence of a

difference in accounting conservatism between firms with non-negative returns (good

news) and firms with negative returns (bad news). Consistent with Basu (1997), the

estimate of the coefficient on change in cash investments is significantly less for firms

with net bad news (negative returns) than the estimate of the coefficient on change in

cash investments for firms with net good news (non-negative returns). The estimate of the

coefficient on change in lagged operating assets is significantly negative for firms with

negative returns while it is not significantly different from zero for firms with non-

negative returns. In the Feltham and Ohlson (1995, 1996) model lagged operating assets

have negative weight if there is under-depreciation of these assets. That is, for these

firms where the market assessed the net change in value as negative, accounting recorded

a smaller decline in value. The negative estimate of this coefficient suggests that the

accruals of firms with net bad news are not sufficient to make accounting earnings fully

reflect the decline of firm value in years of negative returns.

Hayn (1995) focuses on the news in earnings rather than the news in returns to

2 Feltham and Ohlson (1995, 1996) assume that financial assets are marked-to-market and hence conservatism arises in the accounting for operating assets. It follows that the ratio of the market value of net operating assets to the book value of net operating assets (as opposed to the ratio of the market value of common equity to the book value of common equity) may be a more appropriate indicator of conservatism. We show that results are very similar for samples formed on either of these market-to-book ratios.

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motivate an analysis of the returns/earnings relation for firms reporting losses compared

with firms reporting profits. In order to examine the effects of losses on accounting

conservatism, we partition the sample into profit and loss firms. Our empirical analyses

suggest that there is no difference in accounting conservatism associated with the

application of accounting rules between firms reporting losses and firms reporting profits.

The estimates of the coefficients on change in cash investments are positive for both

profit and loss firms consistent with the notion that cash investments are generally in

positive net present value projects.

Several studies have examined whether accounting is on average conservative.

Even though the generally positive difference between market value and book value of

equity suggests that accounting is likely to be conservative, the extant empirical studies

based on Feltham and Ohlson (1995, 1996) do not provide convincing evidence.

Accounting conservatism is usually examined by estimating either the Feltham and

Ohlson (1995) information dynamics or the implied valuation function.3 Contrary to the

general belief that accounting is conservative, empirical studies based on the information

dynamics generally provide evidence that is consistent with aggressive accounting

(Dechow, Hutton, and Sloan 1999; Myers 1999; Ahmed, Morton, and Schaefer 2000).

The results of empirical studies of the valuation relation are mixed. Myers (1999)

provides empirical evidence consistent with unbiased or aggressive accounting while

Ahmed, Morton, and Schaefer (2000) report empirical results consistent with

conservative accounting.4

In this paper, we seek evidence of conservatism using the valuation relation rather

than the information dynamics.5 We provide empirical evidence of accounting 3 Ohlson (1995) and Feltham and Ohlson (1995, 1996) model value relevant information through a set of Markovian processes in which current information is sufficient for prediction of future value relevant information. The information dynamics refer to the sets of Markovian processes assumed in Ohlson (1995) and Feltham and Ohlson (1995, 1996).4 Under conservative accounting, the coefficient on the book value of equity should (in a price-levels regression) be greater than one. Myers (1999) reports that the coefficient on the book value of equity is less than one (see his Table 4 and 5). Ahmed, Morton and Schaefer (2000) regress goodwill (the difference between market value and book value of equity) on residual operating earnings, lagged operating assets, and cash investments. Their significant positive coefficient on lagged operating assets is evidence of conservative accounting. 5The information dynamics in Feltham and Ohlson (1995, 1996) and Ohlson (1995) are a means to the end of understanding the mapping from accounting data to security prices. We focus on this mapping. Of course, the mapping will be affected by the assumed dynamics. Empirical analysis of the information dynamics is, in essence, examination of the descriptive validity of a key assumption akin to testing the capital asset pricing model by determining whether multi-variate normality is descriptive of stock returns. Like the literature on the capital asset pricing model, we focus on the implications of the model rather than

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conservatism using the return specification rather than the levels specification: the

empirical results based on the return specification are less susceptible to scale effects,

omitted variables, and multicollinearity. We show that the degree of accounting

conservatism varies with the ratio of market value to book value and it differs across

industries, we demonstrate the different effects of accounting conservatism associated

with accounting rules and accounting conservatism associated with investment in positive

net present value projects, and we show some consistency between the empirical

implications gleaned from the Feltham and Ohlson (1995, 1996) notion of conservatism

and other notions of conservatism in the extant literature.

The paper proceeds as follows. In section 2, we develop an empirical regression

model that is implied by Feltham and Ohlson (1996). Section 3 describes the data and the

sample selection procedure. Section 4 reports the results of the empirical analysis. We

summarize these results and draw conclusions in section 5.

2. Model

Our empirical regression model is based on Feltham and Ohlson (1996) rather

than Ohlson (1995). In later analyses we consider the empirical implications of Feltham

and Ohlson (1995). Feltham and Ohlson (1996) explicitly model the possibility of

conservative accounting whereas Ohlson (1995) implicitly assumes unbiased accounting.

As in Feltham and Ohlson (1996), accounting is defined as conservative (unbiased) if the

value of a firm is expected to exceed (equal) the firm's book value of equity in the long

run.

The basic ingredients of the Feltham and Ohlson (1996) model are:

(1) the cash flow dynamics: 0

the assumptions. Lack of descriptive validity of the information dynamics suggests that we should only use the model as guidance for our empirical analyses. We will return to this point in the next section of the paper. 0 For the sake of simplicity, the information dynamics in our paper do not include dynamics for other information. In Feltham and Ohlson (1995, 1996), other information is modeled to represent information about future revenues and/or growth opportunities, which may not be reflected in the accounting variables. We argue that the effect of the omission of other information in the return setting used in our empirical analyses will be minimal since, in this setting other information is less likely (compared with the price-levels setting) to be highly correlated with the variables that capture the effect of accounting conservatism. Other studies have introduced other information variables in the Feltham and Ohlson (1995, 1996) setting. For example, Begley and Feltham (2002) demonstrate how to extract other information using one-year and

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~c rt+1=γ cr t+kcit+~ε 1 t+1

~c it +1= ωcit +~ε 2 t+1 (CFD)

(2) the present value of cash flow relation:

V t=∑τ=1

∞

R−τ Et [~c t+ τ ](PVCF)

and (3) the operating asset relation:

(OAR)

where > 0, [0,1), [0, R), crt and cit are cash receipts and cash investments, ct

( crt - cit) is net cash flows, Vt is the market value of operating assets at date t, R is one

plus the riskless rate of return (r), oat is net operating asset at time t, oxt is operating

earnings, and oact is operating accruals for period t.

Assumptions CFD, PVCF, and OAR are sufficient to derive the following

valuation relation:

V t=oat+α1 ox ta+α 2 cit+ΦR [( γ−1)oat−1−oac t ] (1)

whereΦ≡[ R−γ ]−1 , α1=Φγ , α2=[ Φκ−1 ] R

R−ω , and ox ta (≡ox t−( R−1)oat−1 ) is

residual operating income.

Invoking the Feltham and Ohlson (1995) assumption that financial assets are

valued at market, equation (1) may be re-written as:

pt=b t+α1 x ta+α 2 cit+ΦR [(γ−1 )oat−1−oact ] (2)

where pt is the market value of equity at time t, pt is the book value of equity at time t and

xta is residual earnings for period t (that is, xt – (R-1)bt-1).0

two-year-ahead analysts’ forecasts. Liu and Ohlson (2000) show that analysts’ forecasts about one-year-ahead operating earnings and operating assets can be used to infer other information. Myers (1999) uses sales backlogs as a proxy for other information. Of course, as a practical matter there are an infinite array of potential other information variables.0 The assumption that financial assets are valued at market value is also frequently made in the finance literature (see, for example, Brealey and Myers 2002). Of course, there are many financial assets and obligations for which this assumption may not hold. Allowing for this possibility in the Feltham and Ohlson (1996) framework would require introducing an accounting depreciation rate for financial assets that differs from the economic depreciation rate (analogous to (1-) and (1-) for operating assets). Any difference between these rates would be captured via the estimate of the coefficient on an additional variable, change in lagged financial assets. Occasionally estimates of this coefficient are significantly positive when change in lagged financial assets is added to the regressions in the latter part of the paper – the estimates of the coefficients on the remaining variables are not changed significantly. Also, cash

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oa t=oat−1+oxt−ct¿oa t−1+oac t+cit

Feltham and Ohlson (1996) examine the effect of accounting accruals on the

relation between accounting numbers and firm value by focusing on the relation between

operating accruals (the accounting measure of change in value of operating assets –

referred to generically as depreciation) and beginning of period book value of operating

assets. In the interest of parsimony, they invoke the simplifying assumption that operating

accruals are a constant proportion (1-δ ) of beginning of period operating assets.

Although this proportion (1-δ ) may be viewed as an accrual that has the characteristics

of the declining balance depreciation method, it will also capture any change in the

accounting measure of the value of operating assets. For example, research and

development costs that are expensed immediately have a δ of zero. In general, δ may be

viewed as the weighted average of the accounting measures of change in value. Under

this simplifying assumption, Feltham and Ohlson (1996) suggest the following value

relation:

pt=b t+α1 x ta+α2 cit +α 3 oa t−1 (3)

where α 3=ΦR( γ−δ ).

Taking first differences and rearranging yields:

pt+d t−pt−1=(1−rα1 )xt +Rα1 Δx t+rα1 d t−1+α2 Δ cit+α3 Δoat−1 (4)

The coefficient on change in lagged operating assets captures the effect of accounting

value added, and the coefficient on change in cash investments captures the effect of

economic value added. We elaborate on this point.

Recall that α 3=ΦR( γ−δ ). That is, change in lagged operating assets (oat-1)

has positive weight if there is over-depreciation of these assets (that is, the accounting

depreciation rate (1-) is greater than the economic depreciation rate (1-)).0 In other

words, if assets have been over-depreciated in the past, future earnings will be higher

because there will be less depreciation to match against revenues. Since this higher

investments in financial assets may be in positive net present value projects suggesting that a positive estimate of coefficient on change in cash investments may also reflect conservatism in the accounting for these assets. These investments are, however, generally viewed as means of holding reserves for future investments in operations and are thus unlikely to be positive net present value. As a practical matter, Compustat data does not permit us to separate cash investments in operations and cash investments in financial assets. Hence, our estimate of the coefficient on change in cash investments captures positive net present value investments in both of these asset types.0 The term depreciation is used in the general sense of “change in value”.

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earnings is due to the accounting policy (depreciation rate), the consequent positive

residual income reflects only accounting value added – not economic value added. If

δ=γ , operating assets are recorded at market value – and thus goodwill (the present

value of future residual income) associated with depreciation of beginning operating

assets is zero.

Recall that α 2=[Φκ−1 ] R

R−ω . That is, current investments cit have positive

weight if they have positive NPV (that is, > 1). Note that cash investments at the end

of the current period do not affect residual income of the current period (this captures the

reality that new investments do not affect accounting earnings until products are sold or a

service is provided). The effect of current investments is on residual income of future

periods. That is, positive residual income in future periods may reflect economic value

added in past periods but positive residual income in the current period does not reflect

economic value added in the current period.

To summarize, if accounting is conservative as in Feltham and Ohlson (1995,

1996), change in cash investments, change in lagged operating assets, and lagged

dividends should be included as additional variables in the return, earnings levels, and

earnings changes regression as in equation (4). The lack of consideration of accounting

conservatism may affect the estimates of the coefficients on earnings levels and earnings

changes because change in cash investments, change in lagged operating assets and/or

lagged dividends may be correlated with these variables.

Most of our analyses are based on regressions that are the empirical analogue of

equation (4) with all variables scaled by beginning market value of equity: 0

ret jt=β0+ β1

x jt

p jt−1+β2

Δx jt

p jt−1+β3

d jt−1

p jt−1+β 4

Δci jt

p jt−1+β5

Δoa jt−1

p jt−1+ε jt ,

(5)

0 Consistent with all papers that use Ohlson (1995) and/or Feltham and Ohlson (1995, 1996) we estimate the relation between the variables identified in equation (4) for a cross-section of firms. However, we note that these models are based on a single-firm economy and the implications for a multi-firm economy are not addressed. It follows that the conclusions from our empirical tests must be interpreted with this shortcoming in mind.

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where ret jt=( p jt +d jt−p jt−1 )/ p jt−1 .0 The subscript j denotes an observation for firm j.

The cross-sectional regressions are run separately for each year of available data. β4

captures the effect of conservatism due to future positive NPV projects, and β5 captures

the effect of conservatism due to accounting rules. The coefficients on earnings levels,

earnings changes, and lagged dividends are all predicted to be positive.0

3. Data Selection and Sample Description

Initially, we collect all Compustat firm-year observations from fiscal years 1988

through 2001 for which we have complete data for the following items. Return (ret t ) is

obtained from CRSP by compounding monthly returns during the fiscal period. We use

comprehensive income as a measure of earnings (x t ). Comprehensive income is net

income (#172) minus preferred dividends (#19) plus the change in value of marketable

securities (#238) plus the change in cumulative foreign currency translation adjustment

(#230). The change in comprehensive income is denoted by xt. Dividends (d t ) are the

sum of dividends to common shareholders (item #21) and net capital contributions. Net

capital contributions are purchases of common and preferred stock (item#115) minus

sales of common and preferred stock (item#108). Operating assets (oa t ) are book value

0 Equation (4) suggest that restrictions could be placed on the relations among the coefficients β1 , β2 and β 3 . The coefficient estimates sometimes differ significantly when these restrictions are imposed suggesting that the Feltham and Ohlson (1996) model is not descriptively valid and thus our empirical model is mis-specified. It follows that conclusions regarding the significance of the estimates of the coefficients on change in cash investments and change in lagged operating assets must be made with the accompanying caveat that the results may reflect mis-specification of the model that we use to motivate their inclusion in the returns regression. 0Unlike Easton and Harris (1991) we use returns of the fiscal period rather than returns for the twelve months ending three months after fiscal year end. This choice is motivated by the fact that the focus in our analysis is a comparison of the change in value of the assets as captured in the accounting data with the change in the value of these assets as captured by the market in the same period. Lagging returns by three months introduces the possibility that the accounting data conveys information to the market. Although this introduces concepts that go beyond the model in Feltham and Ohlson (1996), we repeated all analyses using returns lagged three months. All conclusions are qualitatively the same. Easton and Harris (1991) also employ abnormal returns as another return metric. In our empirical regression, the use of abnormal

returns (( p jt +d jt−Rp jt−1)/ p jt−1 ) rather than raw returns (( p jt +d jt− p jt−1)/ p jt−1 ) will affect the intercept. If the

regression model is well specified and we use raw returns as a return metric, the intercept (α 0 ) will be zero. If we use abnormal returns instead of raw returns, the intercept will be smaller by the estimate of the “normal return”.

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of equity (b t ) minus financial assets (fat ). Book value of equity (bt) is common equity

(#60) plus preferred treasury stock (#227) minus preferred dividends in arrears (#242).

Financial assets (fat) are cash and short-term investments (#1) plus investments and

advances-others (#32) minus debt in current liabilities (#34) minus long-term debt (#9)

minus preferred stock (#130) plus preferred treasury stock (#227) minus preferred

dividends in arrears (#242) minus minority interest (#38). Cash investments are obtained

from the cash flow statement as the negative of cash flows from investing activities

(#311). 0

The ratio of the market value of operating assets to the book value of operating

assets (V/oa) is the market value of common equity minus financial assets (fat) divided by

the book value of operating assets ((pt - fat)/oat). All variables except the market value of

equity ( pt ), annual stock returns (ret t ), and ratio of the market value of operating assets

to the book value of operating assets (V/oa) are deflated by the beginning market value of

equity (pt−1). Observations with negative book value of equity or negative book value or

market value of operating assets are excluded. We further delete observations in the top

and bottom one percent of the distribution for any one of the following variables: annual

returns, earnings levels, earnings changes, lagged dividends, change in cash investments,

and change in lagged operating assets in order to mitigate the effect of extreme values.

The final sample is 53,554 firm-year observations, which consist of 37,169 firm-

year observations reporting profits (profit firms, hereafter) and 16,385 firm-year

observations reporting losses (loss firms, hereafter) and 28,366 observations with non-

negative returns (good news firms, hereafter) and 25,188 observations with negative

returns (bad news firms, hereafter). The lack of data necessary to measure cash

investments (cit) restricts most of our analysis to the post-1987 period.

Panel A of table 1 reports descriptive statistics for the sample of 53,554 firm-year

observations from 1988 through 2001. The median market value of equity is $128.26

million. Over the 14 years, the mean and median annual raw stock returns are 12.2% and

3.2%, respectively. Median net comprehensive income and the change in net

comprehensive income are 4.3% and 0.4% of the beginning market value of equity.

0 Nissim and Penman (2001) provide detailed justification and explanation of their methods for measuring the accounting related variables. We use their definitions and we use the same data sources.

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Median lagged dividends are zero. The decomposition of book value of equity into

operating assets and financial assets shows that firms have on average net financial

obligations; hence operating assets are greater than book value of equity. The positive

change in operating assets (median of 3.8 percent of price) implies that operating assets

are on average increasing. The ratio of the market value of operating assets to the book

value of operating assets is generally greater than one although, for about 18 percent of

the sample, market value of operating assets is less than their book value.

Panel B of table 1 reports descriptive statistics for profit and loss sub-samples.

Profit firms are, on average, bigger than loss firms. The median market values of equity

for profit and loss firms are $214.68 million and $43.51 million, respectively. Loss firms

have, on average, higher market to book (P/B and V/oa) ratios than profit firms. This is

due to both higher market value of equity for profit firms and lower book value of equity

for loss firms.

Panel C of table 1 reports descriptive statistics for firm-years with non-negative

returns (“good” news) and for the firm-years with negative returns (“bad” news). The

median market values of equity for good and bad news firm-years are $232.84 million

and $66.97 million, respectively. Good news firm-years have, on average, higher market

to book (P/B and V/oa) ratios than bad news firms.

Table 2 reports the Pearson and Spearman correlations among key variables. The

correlations between the returns and each of the independent variables are significant at,

at least the 0.01 level. The correlations between change in lagged operating assets and

both earnings changes and change in cash investments are high (-0.250 and –0.217,

respectively) suggesting that multicollinearity may affect the stability of the estimates of

the coefficients on these variables.

4. Empirical Results

4.1. Conservatism in the entire sample

Table 3 summarizes the output from regression (5) for each of years 1988 to 2001.

Conservatism associated with investment in positive NPV projects (economic value

added) is evident in the data. However, there is no evidence of conservatism due to

accounting rules (accounting value added).

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The estimate of the coefficient on change in cash investments is significantly

positive in every annual regression except year 2001. The mean of these estimates

(0.266) is significantly positive at, at least, the 0.01 level (t-statistic of 7.56). This

evidence is consistent with the notion in Feltham and Ohlson (1996) that conservative

accounting does not reflect the effects of investments in positive net present value

projects until future periods. The estimates of the coefficient on change in cash

investments are significantly positive in 13 of the 14 annual regressions, providing some

comfort that multicollinearity (which may lead to instability of the coefficient estimates)

is not unduly affecting the analyses.

The mean of the estimates of the coefficient on change in lagged operating assets

is not significantly different from zero at conventional levels (t-statistic of –0.59)

suggesting that conservatism associated with over-depreciation of assets in place has no

incremental explanatory power for returns over earnings, earnings changes, and lagged

dividends.

The mean of the adjusted R2 is 11.5%. The estimates of the coefficients on

earnings, earnings changes, and lagged dividends are all positive as predicted. The mean

estimates of the coefficients on earnings and earnings changes are significant at the 0.01

level. However, the mean of the estimates of the coefficients on lagged dividends is not

significantly different from zero.

4.2. A Comparison with Easton and Harris (1991)

We now investigate the effect of the omission of change in cash investments and

change in lagged operating assets from regression (5). The results of this investigation are

reported in table 4. The estimate of the coefficient on earnings levels in the simple

regression of returns on deflated earnings levels (model M1) is significantly positive at

the 0.01 level (t-statistic of 9.25). The estimate of the coefficient on earnings changes in

the simple regression of returns on deflated earnings changes (model M2) is also

significantly positive at the 0.01 level (t-statistic of 15.37). This result is consistent with

Easton and Harris (1991).0 Next, we regress annual stock returns on both earnings levels 0 Easton and Harris (1991) report the estimate of 1.02 (with t-statistic of 10.0) on earnings levels and 0.74 (with t-statistics of 0.74) on earnings changes. The sample period and the measures of returns and earnings of Easton and Harris (1991) are different from this study. Easton and Harris (1991) examined the sample period from 1968 to 1986, and their returns are measured for a year ending three months after fiscal period.

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and earnings changes (model M3). The mean estimates of the coefficients on earnings

levels and earnings changes are 0.655 and 0.533, respectively, with associated t-statistics

of 5.35 and 7.10, respectively.

Consistent with the Ohlson (1995) model, we add lagged dividends to earnings

levels and earnings changes as explanatory variables for returns (model M4). The

addition of lagged dividends does not materially increase the adjusted R2, and the

estimate of the coefficient on lagged dividends is not significantly different from zero at

the 0.05 level.

Addition of change in cash investments and change in lagged operating assets

increases the average adjusted R2 from 10.2% (in model M4) to 11.5% (in model M5).

The estimate of the coefficient on earnings levels decreases from 0.628 to 0.593 (with a t-

statistic for the difference between these coefficient estimates of -2.95) while the estimate

of the coefficient on earnings changes increases from 0.545 to 0.620 (with a t-statistic for

the difference between these coefficient estimates of 1.22).

4.3. The Current Market to Book Ratio as a Proxy for Conservatism

Even though conservatism is defined in Feltham and Ohlson (1995, 1996) as an

asymptotic relation between market value of equity and book value of equity in the long

run, the current price to book ratio may be used as an indication of the degree of

conservatism if it is expected to persist into the future. We note, however, that Feltham

and Ohlson (1995, 1996) assume that financial assets are marked-to-market and hence

conservatism arises in the accounting for operating assets. It follows that the ratio of the

market value of net operating assets to the book value of net operating assets (as opposed

to the ratio of the market value of common equity to the book value of common equity)

may be a more appropriate indicator of conservatism.

We partition the sample each year into deciles based on the ratio of the market

value of net operating assets measured as the market value of equity minus the book

value of financial assets (that is, pt− fat ) to book value of operating assets (that is, oa t )

and we examine whether the current ratio of market value of net operating assets to book

value of net operating assets is related to accounting conservatism as we have defined it

This paper uses comprehensive income as a measure of earnings.

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in our regression (5). We expect that the higher the current ratio of market value of net

operating assets to book value of net operating assets, the more conservative the

accounting. All of the analyses in this section of the paper have been repeated using the

ratio of the market value of common equity to book value of common equity with very

similar results.

Table 5 summarizes the output from regression (5) conducted within deciles of

market value of net operating assets to book value of net operating assets. Decile 1

includes firms with the lowest ratios of market value of net operating assets to book value

of net operating assets, and decile 10 includes firms with the highest ratios.0 If the current

market to book ratio is a good proxy for accounting conservatism, the coefficients on the

change in cash investments and change in lagged operating assets will increase as we

move from decile 1 to decile 10.

Table 5 reports that the median market to book (V/oa) ratio is less than one for

deciles 1 and 2, implying that accounting is more likely to be aggressive.0 For deciles 3

and higher, the median market to book (V/oa) ratios are greater than one, implying that

accounting is more likely to be conservative. The estimate of the coefficient on change in

lagged operating assets is significantly negative for decile 1 consistent with the change in

value represented by the accruals being less than the change in value reflected in returns.

Accounting conservatism in the higher V/oa deciles is seen in significantly positive

estimates of the coefficients on change in lagged operating assets for deciles 4 and higher.

The estimates of the coefficients on change in cash investments increase

monotonically from 0.033 for the decile with lowest V/oa to 1.131 for the decile with

highest V/oa.

To summarize, the higher estimates of the coefficients of change in lagged

operating assets and change in cash investments for higher price-to-book ratio samples

confirm our prediction that the current market to book ratio appears to capture

conservatism as modeled in Feltham and Ohlson (1996).

4.4. Conservatism and Industry

0 In the discussion of the results in table 5, we will refer to the ratio of the market value of net operating assets to book value of net operating assets as the market to book ratio.0 That is, the accounting estimate of change in value is greater than the market’s assessment of change in value for these firms.

13

Table 7 reports medians of key variables by industry. Utilities and firms in the

chemicals and transportation industries have larger market value of equity. The median

annual stock returns are positive in all industries other than the mining and construction,

computers, and services industries. The median net income is positive in all industries

other than the pharmaceutical industry. The median price to book ratio is greater than one

for all industries. The pharmaceutical industry has the highest median price to book ratio

followed by the computer industry. The positive median change in cash investments for

all industries suggests increasing cash investments in operations over this time period.

Consistent with increasing cash investments, the median change in lagged operating

assets is positive for all industries.

Table 8 reports the results from regression (5) conducted at the industry level.

The estimates of the coefficients on change in cash investments (consistent with

investment in positive net present value projects) are significantly positive in all

industries other than agriculture, mining and construction, food, chemicals,

transportation, insurance and real estate, and others. The estimates of the coefficients on

change in lagged operating assets are not significantly different from zero with the

exception of pharmaceuticals (t-statistic of 5.41), extractive industries (t-statistic of 2.53),

and durable manufactures (t-statistic of -2.65). Note that the pharmaceutical industry has

the highest median V/oa (7.268). These results are consistent with those in Table 5.

4.5. Positive Returns vs. Negative Returns and Conservatism

Basu (1997) observes that the explanatory power of earnings for returns differs

according to whether news is on average good (that is, returns of the fiscal period are

positive) or news is on average bad (negative returns). In order to examine this effect,

firms are partitioned according to the sign of their fiscal period returns and regression (5)

is re-estimated for the two partitions of the data.

Panel A of table 9 reports that the estimate of the coefficient on earnings in the

regression of returns on earnings for non-negative returns firms is not significantly

different from zero (0.073) and (also consistent with Basu (1997)) panel B of table 9

reports that the estimate of this coefficient for firms with negative returns is significantly

14

positive (0.418 with a t-statistic of 9.39). The estimate of the coefficient on earnings

changes is significant for both good news and bad news firms.

The results from regression (5) show that for firms with net good news (panel A)

the estimate of the coefficient on change in lagged operating assets is not significantly

different from zero at the 0.05 level. However, the estimate of the coefficient on change

in lagged operating assets is significantly negative (t-statistic of –2.49) for firms with net

bad news (panel B). In the Feltham and Ohlson (1996) model, lagged operating assets

have negative weight if there is under-depreciation of these assets (that is, the accounting

depreciation rate (1-) is less than the economic depreciation rate (1-)). That is, for

these firms where the market has assessed the net change in value as negative, accounting

recorded a smaller decline in value.

The estimate of the coefficient on change in cash investments is significantly

positive for both the non-negative and the negative returns sample suggesting that there is

accounting conservatism associated with firms investing in positive net present projects.

However, the estimate of the coefficient on change in cash investments for firms with net

good news (0.228) is significantly greater (t-statistic of difference (un-tabulated) of 6.13)

than the estimate of this coefficient for firms with net bad news (0.024). This result is

consistent with the notion that firms with net good news have a greater tendency to invest

in positive net present value projects. The result is also consistent with Basu’s (1997)

idea that accounting is less conservative for firms with net bad news than firms with net

good news.

4.6. Profit vs. Loss and Conservatism

Hayn (1995) focuses on the news in earnings rather than the news in returns to

motivate an analysis of the returns/earnings relation for firms reporting losses compared

with firms reporting profits. In order to examine the effects of losses on accounting

conservatism, we partition the sample into profit and loss firms.

Consistent with Hayn (1995), Panel A of table 10 reports that the estimate of the

coefficient on earnings in the simple regression of returns on earnings for profit firms is

significantly positive (3.57) at, at least, the 0.001 level (t-statistic of 19.71). Panel B of

table 9 reports that the estimate of this coefficient for loss firms is not significantly

15

negative (-0.025 with a t-statistic of -0.41). The estimate of the coefficient on earnings

changes is significant for both profit and loss firms.

The results from regression (5) show that the estimate of the coefficient on change

in lagged operating assets is not significantly different from zero for both profit and loss

firms (t-statistics of -0.70 and -0.83, respectively). In other words, there is no difference

in accounting conservatism associated with the application of accounting rules (t-statistic

of difference (un-tabulated) of 0.05) between profit and loss firms.

The estimate of the coefficient on change in cash investments is significantly

positive for both profit and loss firms (t-statistics of 7.19 and 6.73, respectively). The

evidence suggests that cash investments for both profit and loss firms are generally in

positive net present value projects. The estimate of the coefficient on change in cash

investments for profit firms (0.216) is significantly less (t-statistic for difference (un-

tabulated) of -2.63) than the estimate of this coefficient for loss firms (0.294). In other

words, cash investments undertaken by loss firms have a greater tendency to have

positive net present values than those undertaken by profitable firms. At first glance this

may seem strange. We suggest that this reflects the nature of the firms that report losses

during our sample period – it is evident from descriptive statistics reported in table 1 that

loss firms have, on average, higher price to book ratios than profit firms. This is

consistent with loss firms being in an early stage in their life cycle and/or having more

growth potential.

4.7. Accounting Methods and Conservatism

In this subsection, we examine the relation between accounting methods

employed by firms and conservatism as modeled by Feltham and Ohlson (1996). We

consider research and development intensity, depreciation rate, advertising intensity, and

the choice of LIFO inventory accounting method (Beaver and Ryan, 2000 and Ahmed,

Morton, and Schaefer 2000) as indicators of conservatism associated with accounting

methods. We partition our sample into quartiles by research and development intensity

(research and development costs divided by sales), depreciation rate (deprecation and

amortization expenses divided by the sum of beginning property, plant, and equipment,

and intangibles), and advertising intensity (advertising expenses divided by sales). For

16

inventory accounting method, we partition our sample into firms employing LIFO as a

primary inventory accounting method and others.

Table 11 reports the results of annual regressions for quartiles based on each of

the indicators of conservatism. These analyses are based on samples of firm years that

have data for the respective accounting based indicator. The estimate of the coefficient on

change in lagged operating assets is negative (-0.058) for firms that have low research

intensity while the estimate of this coefficient for firms with high research intensity is

positive (0.017); however, nether of them is significant at the 0.05 level. We do not find

significant differences (t-statistic of 0.92) between the estimate of the coefficient on

change in lagged operating assets for the low research intensity portfolio and the high

research intensity portfolio, suggesting that there is no significant difference in

conservatism associated with application of overall accounting rules. Similarly, we do not

find significant differences in accounting conservatism associated with the application of

accounting rules for depreciation rates, advertising intensity, and inventory accounting

method.

The estimate of the coefficient on change in cash investments is significantly

greater (t-statistic of 4.25) for high research intensity firms than for low research intensity

firms suggesting that research expenditures tend to be positive net present value. The

estimate of the coefficient on change in cash investments is significantly greater (t-

statistic of 4.19) for firms with higher depreciation expense than for firms with lower

depreciation expense. A possible explanation for this result may be that higher

depreciation rates suggest that more assets have been acquired recently, consistent with

higher growth via positive net present value investments. The estimate of the coefficient

on change in cash investments is significantly greater (t-statistic of 3.12) for high

advertising intensity firms than for low advertising intensity firms suggesting that

advertising expenditures tend to be positive net present value. The estimate of the

coefficient on change in cash investments is significantly greater (t-statistic of 3.24) for

firms that adopt LIFO than for those that use another inventory valuation methods. In

other words, the degree of accounting conservatism associated with investment in

positive net present value projects tends to be greater for these firms.0

0 The results in section 4.3 suggest that the market to book ratio is a good proxy for accounting conservatism. The median market to book ratio is higher for firms with high research intensity, high depreciation rates, and high advertising intensity than for firms with low research intensity, low

17

4.8 Feltham and Ohlson (1995) and Accounting Conservatism

Both Feltham and Ohlson (1995) and Feltham and Ohlson (1996) incorporate the

possibility of accounting conservatism; however, there are subtle differences in modeling

accounting conservatism. In this sub-section, we examine the implications of Feltham and

Ohlson (1995) for empirical analyses of accounting conservatism. The return regression

model based on Feltham and Ohlson (1995) can be expressed as follows:

ret jt=β0+ β1

x jt

p jt−1+β2

Δx jt

p jt−1+β3

d jt−1

p jt−1+β 4

Δoa jt

p jt−1+ε jt ,

(6)

In regression (6), accounting conservatism is captured by the change in operating

assets (oat), which may be compared with regression (5) based on Feltham and Ohlson

(1996), in which accounting conservatism is captured by change in cash investments and

change in lagged operating assets. Note that, in regression (6), there is no distinction

between conservatism due to accounting rules and conservatism associated with

investment in positive net present value projects. The change in operating assets can be

thought of as the sum of the effects of change in cash investments and change in lagged

operating assets since operating assets can be expressed as the weighted sum of lagged

operating assets and current cash investments by applying the operating asset relation

(OAR) and by representing operating accruals as a multiple of lagged operating asset

(Feltham and Ohlson (1996)):

oa t=oat−1+oac t+cit=oat−1+(δ−1 )oa t−1+cit

=δ oat−1+cit

The return model based on Feltham and Ohlson (1995) can be used to assess the

overall effect of accounting conservatism, and provide a simple framework to control for

accounting conservatism. Since it does not require the decomposition of change in

operating assets into lagged operating assets and cash investments, we can extend our

analysis back to earlier years in which cash flow statements are not available.

Table 12 reports the results of the examination of accounting conservatism based

depreciation rate, and low advertising intensity. However, the median market to book ratio for firms employing LIFO as a primary inventory valuation method (1.49) is lower than that for firms employing other inventory valuation methods (1.71).

18

on the specification of Feltham and Ohlson (1995) for each of years from 1972 through

2001. Consistent with the results in table 5, the estimate of the coefficient on the change

in operating assets (0.05) is significantly positive at the 0.01 level, implying that

accounting is on average conservative. The estimates of the coefficients on earnings

level, earnings changes, and lagged dividends are positive as in table 4.

5. Summary

Based on Feltham and Ohlson (1996), we identify two types of accounting

conservatism: conservatism due to accounting rules and conservatism associated with

investments in positive net present value projects. We add change in lagged operating

assets to the Easton and Harris (1991) regression to capture conservatism due to

accounting rules (accounting value added), and change in cash investments to capture

conservatism associated with investments in positive net present value projects

(economic value added). Consistent with conventional wisdom, we find that accounting is

conservative. This result has implications for the Easton and Harris (1991) regression of

annual stock returns on earnings levels and earnings changes. We show that the estimates

of the coefficients on earnings levels and earnings changes are affected by accounting

conservatism, and that there is an improvement in the explanatory power with the

inclusion of the variables associated with conservatism.

We show that the effect of accounting conservatism is related to the ratio of the

market value of net operating assets to the book value of net operating assets. Industry

analyses show that there is a wide variation in the degree of accounting conservatism

across industries. We find that accounting for pharmaceutical industry is more

conservative than accounting for other industries. We find that accounting tends to be

more conservative for firms reporting losses than for firms reporting profits, and

consistent with Basu (1997) we find that accounting tends to be less conservative for

firms with negative returns than for firms with non-negative returns.

19

References

Ahmed, A. S., R. M. Morton, and T. F. Schaefer 2000. Accounting Conservatism and the Valuation of Accounting Numbers: Evidence of the Feltham-Ohlson (1996) Model. Journal of Accounting, Auditing & Finance 15 (Summer).

Basu, S. 1997. The Conservatism Principle and the Asymmetric Timeliness of Earnings. Journal of Accounting and Economics: 337.

Beaver, W. H. and S. G. Ryan 2000. Biases and Lags in Book Value and Their Effects onthe Ability of the Book-to-Market Ratio to Predict Book Return on Equity. Journal of Accounting Research 38 (Spring): 127148.

Begley, J. and G. A. Feltham 2002. The Relation between Market Values, Earnings Forecasts, and Reported Earnings. Contemporary Accounting Research 19 (Spring): 1-48.

Bernard, V.L. 1987. Cross-sectional Dependence and Problems in Inference in Market-Based Accounting Research. Journal of Accounting Research (Spring): 1-48.

Brealey, R., and S. Myers 2002. Principles of Corporate Finance. McGraw-Hill. Seventh Edition.

Dechow, P. M., A. P. Hutton, and R. G. Sloan 1999. An Empirical Assessment of the Residual Income Valuation Model. Journal of Accounting and Economics 26: 134.

Easton, P. 2001. Discussion of When Capital Follows Profitability: Non-Linear Information Dynamics. Review of Accounting Studies: 267-274.

Easton, P. 1998. Discussion of Revalued Financial, Tangible, and Intangible Assets: Association with Share Prices and Non-market-based Value Estimates. Journal of Accounting Research 36 (Supplement): 235247.

Easton, P. and T. S. Harris 1991. Earnings as an Explanatory Variable for Returns. Journal of Accounting Research 29: 1936.

Easton, P., G. Taylor, P. Shroff, and T. Sougiannis 2002. Simultaneous Estimation of the Cost of Capital and Growth Using Forecasts of Profitability. Journal of Accounting Research: 657-676.

Fama, E. F. and J. D. MacBeth 1973. Risk, Return, and Equilibrium: Empirical Tests. Journal of Political Economy: 607636.

Feltham, G. A. and J. Ohlson 1995. Valuation and Clean Surplus Accounting for Operating and Financial Activities. Contemporary Accounting Research (Spring): 689731.

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Feltham, G. A. and J. Ohlson 1996. Uncertainty Resolution and the Theory of Depreciation Measurement. Journal of Accounting Research 34 (Autumn): 209234.

Feltham, G. A. and J. A. Ohlson 1999. Residual Earnings Valuation With Risk and Stochastic Interest Rates. The Accounting Review 74 (April): 165183.

Hayn, C. 1995. The Information Content of Losses. Journal of Accounting and Economics 20: 125153.

Liu, J. and J. A. Ohlson 2000. The Feltham-Ohlson (1995) Model: Empirical Implications. Journal of Accounting, Auditing & Finance 15 (Summer): 321-331.

Lo, K. and T. Lys 2000. The Ohlson Model: Contribution to Valuation Theory, Limitations, and Empirical Implications. Journal of Accounting, Auditing & Finance 15 (Summer): 337367.

Myers, J. N. 1999. Implementing Residual Income Valuation with Linear Information Dynamics. The Accounting Review 74 (January): 128.

Nissim, D., and S. Penman. 2001. Ratio Analysis and Equity Valuation: From Research to Practice. Review of Accounting Studies 6: 109-154.

Ohlson, J. A. 1995. Earnings, Book Values, and Dividends in Equity Valuation. Contemporary Accounting Research 11: 661687.

Ryan, S. G. 2000. Discussion: "Accounting Conservatism and the Valuation of Accounting Numbers: Evidence of the Feltham-Ohlson (1996) Model". Journal of Accounting, Auditing & Finance 15 (Summer): 293299.

21

Table 1: Descriptive Statistics for Key Variables

Panel A: All Firms (#obs=53,554)Variable Mean Std. Dev. Q1 Median Q2 Min. Max.

pt 1,915.20 10,903.55 30.54 128.26 656.39 0.00 508,329.5rett 0.122 0.621 -0.253 0.032 0.342 -0.955 7.316xt 0.002 0.162 -0.028 0.043 0.081 -2.182 0.535xt -0.001 0.165 -0.037 0.004 0.034 -1.404 2.332dt-1 -0.021 0.104 -0.013 0.000 0.023 -1.087 0.324cit 0.009 0.233 -0.053 0.005 0.066 -2.167 1.822bt 0.664 0.535 0.319 0.550 0.856 0.000 11.638fat -0.348 1.021 -0.520 -0.117 0.082 -47.822 7.142oat 1.012 1.259 0.300 0.692 1.320 0.000 49.343oat 0.076 0.429 -0.022 0.038 0.138 -15.616 29.604oat-1 0.067 0.288 -0.010 0.041 0.136 -3.933 3.134V/oa 15.343 649.810 1.119 1.672 3.281 0.001 86,102.5P/B 4.006 49.247 1.186 1.898 3.315 0.000 6,620.0

Panel B: Profit and Loss Firms

Variable Profit Firms (#obs = 37,169) Loss Firms (#obs = 16,385)Mean Q1 Median Q3 Mean Q1 Median Q3

pt 2,467.37 50.69 214.68 980.87 662.62 13.58 43.51 171.27rett 0.209 -0.130 0.113 0.401 -0.075 -0.487 -0.219 0.124xt 0.076 0.040 0.066 0.097 -0.166 -0.215 -0.100 -0.040xt 0.033 -0.007 0.012 0.041 -0.078 -0.158 -0.060 0.001dt-1 -0.006 -0.006 0.001 0.030 -0.054 -0.073 -0.004 0.000cit 0.020 -0.037 0.009 0.069 -0.016 -0.092 -0.006 0.057bt 0.688 0.370 0.586 0.868 0.608 0.208 0.439 0.814fat -0.318 -0.503 -0.128 0.080 -0.417 -0.577 -0.085 0.086oat 1.006 0.356 0.727 1.311 1.026 0.170 0.581 1.349oat 0.115 0.001 0.056 0.158 -0.012 -0.120 -0.002 0.077oat-1 0.074 -0.004 0.045 0.133 0.051 -0.030 0.030 0.146V/oa 11.596 1.171 1.696 3.040 23.843 0.990 1.585 4.381P/B 3.254 1.258 1.904 3.109 5.709 0.985 1.873 4.122

22

Panel C: Good News and Bad News Firms

Variable Good News Firms (#obs = 28,366) Bad News Firms (#obs = 25,188)Mean Q1 Median Q3 Mean Q1 Median Q3

pt 2,559.38 54.45 232.84 1,035.50 1,189.75 18.15 66.97 313.54rett 0.507 0.144 0.318 0.630 -0.312 -0.465 -0.274 -0.127xt 0.041 0.024 0.066 0.100 -0.042 -0.080 0.012 0.053xt 0.028 -0.009 0.014 0.050 -0.033 -0.069 -0.012 0.015dt-1 -0.009 -0.007 0.000 0.031 -0.034 -0.028 -0.001 0.012cit 0.028 -0.039 0.012 0.084 -0.013 -0.066 -0.001 0.048bt 0.750 0.385 0.629 0.946 0.567 0.259 0.467 0.744fat -0.337 -0.534 -0.118 0.107 -0.361 -0.503 -0.115 0.062oat 1.087 0.348 0.766 1.410 0.928 0.251 0.613 1.213oat 0.105 -0.012 0.049 0.161 0.044 -0.036 0.026 0.115oat-1 0.055 -0.017 0.036 0.123 0.080 -0.004 0.047 0.151V/oa 21.767 1.325 2.028 4.054 8.108 0.957 1.337 2.437P/B 4.430 1.501 2.321 3.970 3.528 0.935 1.495 2.555

pt is the market value of equity (Compustat annual data item #199 x #25). rett is the annual stock return obtained by compounding CRSP monthly returns over the fiscal period. xt is comprehensive income calculated as net income (#172) minus preferred dividends (#19) plus the change in marketable securities adjustment (#238) plus the change in cumulative translation adjustment (#230). xt is the change in comprehensive income. dt-1 is the sum of cash dividends to common shareholders (#21) and net capital contributions. Net capital contributions include purchases of common and preferred stock (#115) minus sales of common and preferred stock (#108). Operating assets (oat) is calculated as book value of equity (bt), minus financial assets (fat). bt is common equity (#60) plus preferred treasury stock (#227), minus preferred dividends in arrears (#242). fat is cash and short-term investments (#1) plus investments and advances-others (#32), minus debt in current liabilities (#34) minus long-term debt (#9), minus preferred stock (#130), plus preferred treasury stock (#227), minus preferred dividends in arrears (#242), minus minority interest (#38.). oat is the change in operating assets. Cash investment (cit) is the negative of cash flows from investing activities (#311). cit is the change in cash investments. V/oa is the ratio of the market value of operating assets to the book value of operating assets. The market value of operating assets is calculated as the market value of equity minus financial assets (pt – fat). P/B is price to book ratio (pt divided by bt). All variables except for pt, rett, V/oa, and P/B are deflated by beginning market value of equity (pt-1).

23

Table 2: Pearson and Spearman Correlations among key variables

pt rett xt xt dt-1 cit oat-1 V/oapt 0.045 0.043 0.005 0.062 0.004 -0.006 0.006

(<0.01) (<0.01) (0.29) (<0.01) (0.35) (0.15) (0.20)rett 0.283 0.214 0.216 0.054 0.107 -0.052 0.018

(<0.01) (<0.01) (<0.01) (<0.01) (<0.01) (<0.01) (<0.01)xt 0.235 0.424 0.469 0.187 0.077 0.079 -0.004

(<0.01) (<0.01) (<0.01) (<0.01) (<0.01) (<0.01) (0.41)xt 0.068 0.349 0.527 0.005 -0.014 -0.250 0.002

(<0.01) (<0.01) (<0.01) (0.27) (<0.01) (<0.01) (0.69)dt-1 0.218 0.148 0.286 -0.010 0.022 -0.093 -0.011

(<0.01) (<0.01) (<0.01) (0.03) (<0.01) (<0.01) (0.01)cit 0.064 0.140 0.116 0.049 -0.005 -0.217 0.003

(<0.01) (<0.01) (<0.01) (<0.01) (0.25) (<0.01) (0.49)oat-1 0.012 -0.068 0.052 -0.163 -0.103 -0.180 -0.005

(0.01) (<0.01) (<0.01) (<0.01) (<0.01) (<0.01) (0.21)V/oa 0.326 0.328 -0.043 0.123 -0.219 0.074 -0.157

(<0.01) (<0.01) (<0.01) (<0.01) (<0.01) (<0.01) (<0.01)

a Pearson correlations above the diagonal, Spearman correlations below the diagonal (two tailed p values in parentheses)

b pt is the market value of equity (Compustat annual data item #199 x #25). rett is the annual stock return obtained by

compounding CRSP monthly returns over the fiscal period. xt is comprehensive income calculated as net income (#172) minus preferred dividends (#19), plus the change in marketable securities adjustment (#238), plus the change in cumulative translation adjustment (#230). xt is the change in comprehensive income. dt-1 is the sum of cash dividends to common shareholders (#21) and net capital contributions. Net capital contributions include purchases of common and preferred stock (#115), minus sales of common and preferred stock (#108). Operating assets (oat) is book value of equity (bt) minus financial assets (fat). bt is common equity (#60) plus preferred treasury stock (#227), minus preferred dividends in arrears (#242). fat is cash and short-term investments (#1) plus investments and advances-others (#32), minus debt in current liabilities (#34), minus long-term debt (#9), minus preferred stock (#130), plus preferred treasury stock (#227), minus preferred dividends in arrears (#242), minus minority interest (#38.). oat is the change in operating assets. Cash investment (cit) is the negative of cash flows from investing activities (#311). cit is the change in cash investments. V/oa is the ratio of the market value of operating assets to the book value of operating assets. The market value of operating assets is the market value of equity minus financial assets (pt – fat). All variables except for pt, rett, and V/oa are deflated by beginning market value of equity (pt-1).

24

Table 3: Accounting Conservatism: Annual OLS Regressions of Returns on the Independent Variables suggested by the Feltham and Ohlson (1996) Model

Coefficient estimates with t-statistics in parenthesesYear #obs Int. xt xt dt-1 cit oat-1 Adj. R2

1988 666 0.126 1.164 0.276 -0.060 0.121 -0.050 0.199(7.62) (9.51) (2.05) (-0.52) (2.16) (-0.80)

1989 3,285 0.125 0.712 0.311 0.103 0.158 -0.032 0.120(15.61) (13.31) (5.74) (1.00) (5.25) (-1.54)

1990 3,440 -0.112 0.783 0.262 -0.084 0.147 -0.028 0.127(-16.42) (15.46) (5.23) (-0.89) (4.66) (-1.13)

1991 3,513 0.377 0.363 0.568 -0.397 0.386 0.069 0.080(30.46) (5.57) (9.32) (-3.05) (7.91) (1.94)

1992 3,648 0.119 0.516 0.507 0.360 0.329 -0.063 0.126(15.05) (9.47) (10.00) (4.12) (7.93) (-2.04)

1993 3,943 0.197 0.676 0.583 -0.094 0.443 -0.001 0.105(21.46) (9.20) (8.32) (-1.12) (9.19) (-0.03)

1994 4,263 -0.035 0.817 0.407 0.319 0.217 -0.061 0.150(-5.68) (14.43) (7.14) (5.90) (6.33) (-1.95)

1995 4,464 0.251 0.317 1.034 -0.087 0.373 -0.064 0.090(25.66) (4.07) (12.51) (-1.05) (8.56) (-1.60)

1996 4,716 0.127 0.738 0.598 0.364 0.423 0.044 0.125(16.41) (11.49) (8.97) (4.33) (12.69) (1.25)

1997 4,869 0.150 1.153 0.409 0.346 0.338 0.101 0.181(20.29) (17.74) (5.80) (5.93) (11.68) (3.07)

1998 4,739 -0.052 0.536 0.603 0.284 0.125 -0.093 0.076(-6.85) (7.88) (8.78) (4.08) (3.73) (-2.65)

1999 4,455 0.295 -0.560 1.210 -0.366 0.387 -0.068 0.041(18.04) (-4.86) (10.82) (-2.50) (6.76) (-1.30)

2000 4,228 0.007 0.746 0.651 0.588 0.232 0.082 0.111(0.65) (8.90) (7.29) (4.67) (5.46) (2.06)

2001 3,325 0.123 0.343 0.443 0.366 0.044 0.023 0.082(11.40) (6.85) (9.08) (4.74) (1.20) (0.74)

Mean 3,825 0.121 0.593 0.562 0.117 0.266 -0.010 0.115t-value (3.33) (5.25) (7.76) (1.46) (7.56) (-0.59)

The dependent variable is annual stock returns obtained by compounding CRSP monthly returns over the fiscal period. xt is comprehensive income calculated as net income (#172) minus preferred dividends (#19), plus the change in marketable securities adjustment (#238), plus the change in cumulative translation adjustment (#230). xt is the change in comprehensive income. dt-1 is the sum of cash dividends to common shareholders (#21) and net capital contributions. Net capital contributions are purchases of common and preferred stock (#115) minus sales of common and preferred stock (#108). Operating assets (oat) is book value of equity (bt) minus financial assets (fat). bt is common equity (#60) plus preferred treasury stock (#227) minus preferred dividends in arrears (#242). fat is cash and short-term investments (#1), plus investments and advances-others (#32), minus debt in current liabilities (#34), minus long-term debt (#9), minus preferred stock (#130), plus preferred treasury stock (#227), minus preferred dividends in arrears (#242), minus minority interest (#38.). oat is the change in operating assets. Cash investment (cit) is the negative of cash flows from investing activities (#311). cit is the change in cash investments. All independent variables are deflated by beginning market value of equity (pt-1).

25

Table 4: Accounting Conservatism: Mean of Annual OLS RegressionsCoefficient estimates with t-statistics in parentheses

Model Int. xt xt dt-1 cit oat-1 Adj. R2

M1 Coef. 0.119 0.911 0.083t-value (3.19) (9.25)

M2 Coef. 0.125 0.871 0.059t-value (3.42) (15.37)

M3 Coef. 0.119 0.655 0.533 0.100t-value (3.23) (5.35) (7.10)

M4 Coef. 0.123 0.628 0.545 0.120 0.102t-value (3.39) (5.46) (7.48) (1.54)

M3 Coef. = M4 Coef.: (-2.04) (1.74)M5 Coef. 0.121 0.593 0.562 0.117 0.266 -0.010 0.115

t-value (3.33) (5.25) (7.76) (1.46) (7.56) (-0.59)M4 Coef. = M5 Coef.: (-2.95) (1.22)

Coefficients are means of annual regressions over the period 1988-2001, and t-values in parentheses are based on the standard error of the mean (Fama and MacBeth 1973, Bernard 1987). The dependent variable is annual stock returns obtained by compounding CRSP monthly returns over the fiscal period. xt is comprehensive income calculated as net income (#172) minus preferred dividends (#19), plus the change in marketable securities adjustment (#238), plus the change in cumulative translation adjustment (#230). xt is the change in comprehensive income. dt-1 is the sum of cash dividends to common shareholders (#21) and net capital contributions. Net capital contributions are purchases of common and preferred stock (#115) minus sales of common and preferred stock (#108). Operating assets (oat) is book value of equity (bt) minus financial assets (fat). bt is common equity (#60) plus preferred treasury stock (#227), minus preferred dividends in arrears (#242). fat is cash and short-term investments (#1) plus investments and advances-others (#32), minus debt in current liabilities (#34), minus long-term debt (#9), minus preferred stock (#130), plus preferred treasury stock (#227), minus preferred dividends in arrears (#242), minus minority interest (#38.). oat is the change in operating assets. Cash investment (cit) is the negative of cash flows from investing activities (#311). cit is the change in cash investments. All independent variables are deflated by beginning market value of equity (pt-1).

26

Table 5: Conservatism and the ratio of the Market Value of Operating Assets to the Book Value of Operating Assets (V/oa): Mean of Annual OLS Regressions

Coefficient estimates with t-statistics in parentheses

V/oa Int. xt xt dt-1 cit oat-1 Adj. R2

Decile Median1 0.67 -0.162 0.483 0.127 0.689 0.033 -0.103 0.204

(-4.19) (6.41) (2.89) (7.91) (2.46) (-5.20)2 0.95 -0.087 0.511 0.329 0.644 0.080 -0.040 0.193

(-2.24) (9.50) (8.55) (8.81) (3.51) (-1.69)3 1.12 -0.034 0.563 0.374 0.625 0.089 0.002 0.199

(-0.83) (6.94) (4.83) (5.57) (2.29) (0.08)4 1.29 0.020 0.718 0.415 0.588 0.182 0.104 0.188

(0.56) (6.20) (3.62) (6.96) (4.77) (2.64)5 1.53 0.056 0.744 0.539 0.532 0.234 0.177 0.180

(1.88) (6.44) (6.35) (7.72) (3.64) (2.77)6 1.87 0.092 0.819 0.674 0.400 0.380 0.331 0.186

(2.95) (5.45) (5.14) (4.41) (6.86) (4.03)7 2.40 0.142 0.902 0.721 0.410 0.370 0.275 0.168

(4.32) (5.92) (6.94) (3.61) (4.23) (2.78)8 3.40 0.173 1.015 1.039 0.277 0.661 0.717 0.198

(4.60) (6.75) (7.28) (2.91) (6.24) (5.25)9 5.60 0.292 0.743 1.008 0.138 0.829 0.650 0.138

(4.79) (3.64) (5.21) (1.14) (6.10) (2.72)10 16.90 0.419 0.553 0.661 -0.310 1.131 0.415 0.103

(4.58) (1.93) (4.13) (-1.30) (7.40) (2.63)

Coefficients are means of annual regressions over the period 1988-2001, and t-values in parentheses are based on the standard error of the mean (Fama and MacBeth 1973, Bernard 1987). The dependent variable is annual stock returns obtained by compounding CRSP monthly returns over the fiscal period. xt is comprehensive income calculated as net income (#172) minus preferred dividends (#19), plus the change in marketable securities adjustment (#238), plus the change in cumulative translation adjustment (#230). xt is the change in comprehensive income. dt-1 is the sum of cash dividends to common shareholders (#21) and net capital contributions. Net capital contributions are purchases of common and preferred stock (#115) minus sales of common and preferred stock (#108). Operating assets (oat) is book value of equity (bt) minus financial assets (fat). bt is common equity (#60) plus preferred treasury stock (#227) minus preferred dividends in arrears (#242). fat is cash and short-term investments (#1) plus investments and advances-others (#32), minus debt in current liabilities (#34), minus long-term debt (#9), minus preferred stock (#130), plus preferred treasury stock (#227), minus preferred dividends in arrears (#242), minus minority interest (#38.). oat is the change in operating assets. Cash investment (cit) is the negative of cash flows from investing activities (#311). cit is the change in cash investments. All independent variables are deflated by beginning market value of equity (pt-1). V/oa is the ratio of the market value of operating assets to the book value of operating assets. The market value of operating assets is the market value of equity minus financial assets (pt – fat).

27

Table 6: Industry Composition

Industry Primary SIC codes # firm-years

% ofObs.

Agriculture 1-999 237 0.44Mining and Construction 1000-1999, excluding 1300-1399 1,401 2.62Food 2000-2111 1,399 2.61Textiles and Printing 2200-2790 3,211 6.00Chemicals 2800-2824, 2840-2899 1,440 2.69Pharmaceuticals 2830-2836 2,364 4.41Extractive Industries 2900-2999, 1300-1399 2,287 4.27Durable Manufacturers 3000-3999, excluding 3570-3579 13,570 25.34

and 3670-3679Computers 7370-7379, 3570-3579, 3670-3679 6,992 13.06Transportation 4000-4899 2,828 5.28Utilities 4900-4999 2,698 5.04Retail 5000-5999 6,308 11.78Financial Institutions 6000-6411 1,438 2.69Insurance and Real Estate 6500-6999 1,948 3.64Services 7000-8999, excluding 7370-7379 5,097 9.52Others 9000 and above 336 0.63

Total 53,554 100.02Mean 3,347 6.25

28

Table 7 Median of Key Variables by Industry

Industry[a] pt rett xt xt dt-1 cit oat-1 V/oaAgriculture 168.67 0.026 0.035 0.002 0.004 0.000 0.044 1.724Mining and Construction 140.72 -0.047 0.037 0.003 0.000 0.003 0.060 1.326Food 167.17 0.054 0.050 0.004 0.012 0.004 0.036 1.845Textiles and Printing 189.66 0.045 0.058 0.004 0.013 0.003 0.045 1.433Chemicals 360.33 0.043 0.053 0.002 0.018 0.001 0.034 1.796Pharmaceuticals 140.29 0.009 -0.038 -0.001 -0.007 0.003 0.012 7.268Extractive Industries 201.19 0.053 0.034 0.004 0.000 0.020 0.049 1.513Durable Manufacturers 88.21 0.025 0.046 0.004 0.000 0.003 0.038 1.596Computers 99.11 -0.031 0.015 0.003 -0.006 0.003 0.027 2.990Transportation 412.65 0.065 0.038 0.002 0.000 0.010 0.061 1.682Utilities 632.75 0.107 0.073 0.004 0.041 0.008 0.062 1.268Retail 105.66 0.007 0.050 0.007 0.000 0.007 0.065 1.421Financial Institutions 171.74 0.123 0.064 0.011 0.001 0.011 0.064 1.738Insurance and Real Estate 128.51 0.093 0.056 0.006 0.007 0.001 0.013 2.067Services 79.67 -0.007 0.034 0.006 -0.001 0.007 0.059 1.702Others 48.81 0.000 0.023 0.001 0.000 0.002 0.038 1.656

a See table 6 for the definition of industry.

pt is the market value of equity (Compustat annual data item #199 x #25). rett is the annual stock return obtained by compounding CRSP monthly returns over the fiscal period. xt is comprehensive income calculated as net income (#172) minus preferred dividends (#19) plus the change in marketable securities adjustment (#238) plus the change in cumulative translation adjustment (#230). xt is the change in comprehensive income. dt-1 is the sum of cash dividends to common shareholders (#21) and net capital contributions. Net capital contributions are purchases of common and preferred stock (#115) minus sales of common and preferred stock (#108). Operating assets (oat) is book value of equity (bt) minus financial assets (fat). bt is common equity (#60) plus preferred treasury stock (#227) minus preferred dividends in arrears (#242). fat is cash and short-term investments (#1) plus investments and advances-others (#32), minus debt in current liabilities (#34), minus long-term debt (#9), minus preferred stock (#130), plus preferred treasury stock (#227), minus preferred dividends in arrears (#242), minus minority interest (#38.). oat is the change in operating assets. Cash investment (cit) is the negative of cash flows from investing activities (#311). cit is the change in cash investments. V/oa is the ratio of the market value of operating assets to the book value of operating assets. The market value of operating assets is the market value of equity minus financial assets (pt – fat). All variables except for pt, rett, and V/oa are deflated by beginning market value of equity (pt-1).

29

Table 8: Conservatism and Industry: Mean of Annual OLS Regressions

Industry[a] Int. xt xt dt-1 cit oat-1 Adj. R2

Agriculture 0.112 0.872 1.037 -0.229 0.096 -0.080 0.275(1.70) (3.40) (1.74) (-0.54) (0.53) (-0.26)

Mining and 0.051 0.828 0.066 0.384 0.060 -0.055 0.141Construction (1.27) (4.52) (0.32) (2.18) (0.77) (-1.27)Food 0.049 1.236 0.932 0.745 0.109 0.110 0.266

(1.28) (4.28) (3.85) (2.69) (1.32) (0.99)Textiles and 0.074 0.775 0.318 -0.050 0.132 -0.046 0.142Printing (1.67) (5.18) (2.76) (-0.27) (2.94) (-1.66)Chemicals 0.082 1.026 0.254 -0.378 0.113 -0.101 0.102

(1.85) (4.37) (1.18) (-0.71) (1.11) (-1.33)Pharmaceuticals 0.175 0.111 0.609 0.183 0.883 0.435 0.122

(2.76) (0.42) (3.38) (0.84) (4.64) (5.41)Extractive Industries 0.087 0.857 0.104 0.122 0.266 0.084 0.147

(1.49) (4.21) (1.18) (0.84) (5.10) (2.53)Durable 0.118 0.712 0.548 0.148 0.191 -0.071 0.129Manufacturers (2.93) (6.30) (6.09) (1.79) (7.22) (-2.65)Computers 0.169 0.666 0.677 0.241 0.444 0.004 0.133

(2.26) (7.81) (8.03) (1.67) (4.42) (0.08)Transportation 0.169 0.274 0.473 0.017 0.296 0.057 0.118

(2.98) (0.92) (3.25) (0.10) (2.80) (1.07)Utilities 0.050 0.939 0.259 0.077 0.187 0.059 0.190

(1.55) (3.00) (1.58) (0.47) (3.37) (1.18)Retail 0.102 0.868 0.529 0.219 0.271 -0.032 0.150

(2.63) (8.92) (4.42) (1.98) (5.09) (-0.85)Financial 0.144 0.954 0.665 0.255 0.159 -0.023 0.136Institutions (2.86) (3.44) (5.29) (1.02) (2.67) (-0.50)Insurance and Real 0.099 0.512 0.102 0.150 0.041 -0.108 0.110Estate (3.12) (2.91) (0.75) (1.09) (0.97) (-1.86)Services 0.110 0.804 0.478 0.014 0.250 -0.014 0.130

(3.21) (5.39) (4.14) (0.10) (4.83) (-0.40)Others 0.045 0.736 -0.077 0.084 0.257 0.057 0.158

(1.19) (2.80) (-0.35) (0.17) (1.37) (0.39)

a See table 6 for the definition of industry.

Coefficients are means of annual regressions over the period 1988-2001, and t-values in parentheses are based on the standard error of the mean (Fama and MacBeth 1973, Bernard 1987). The dependent variable is annual stock returns obtained by compounding CRSP monthly returns over the fiscal period. xt is comprehensive income calculated as net income (#172) minus preferred dividends (#19) plus the change in marketable securities adjustment (#238) plus the change in cumulative translation adjustment (#230). xt is the change in comprehensive income. dt-1 is the sum of cash dividends to common shareholders (#21) and net capital contributions. Net capital contributions are purchases of common and preferred stock (#115) minus sales of common and preferred stock (#108). Operating assets (oat) is book value of equity (bt) minus financial assets (fat). bt is common equity (#60) plus preferred treasury stock (#227) minus preferred dividends in arrears (#242). fat is cash and short-term investments (#1) plus investments and advances-others (#32), minus debt in current liabilities (#34), minus long-term debt (#9), minus preferred stock (#130), plus preferred treasury stock (#227), minus preferred dividends in arrears (#242), minus minority interest (#38.). Cash investment (cit)

30

is the negative of cash flows from investing activities (#311). oat is the change in operating assets. cit is the change in cash investments. All independent variables are deflated by beginning market value of equity (pt-1).

31

Table 9: Conservatism and the Sign of Returns: Means of Annual OLS Regressions

Panel A: Good News Firms (non-negative returns)Model Int. xt xt dt-1 cit oat-1 Adj. R2

M1 Coef. 0.485 0.073 0.007t-value (11.47) (0.73)

M2 Coef. 0.476 0.549 0.028t-value (11.63) (13.97)

M3 Coef. 0.478 -0.194 0.635 0.034t-value (11.57) (-1.64) (10.12)

M4 Coef. 0.472 -0.088 0.583 -0.702 0.049t-value (11.43) (-0.81) (10.31) (-6.29)

M3 Coef. = M4 Coef. (6.64) (-4.65)M5 Coef. 0.466 -0.110 0.619 -0.685 0.228 0.015 0.059

t-value (11.25) (-1.03) (10.91) (-6.14) (7.27) (1.42)M4 Coef. = M5 Coef. (-2.70) (3.64)

Panel B: Bad News Firms (negative returns)Model Int. xt xt dt-1 cit oat-1 Adj. R2

M1 Coef. -0.283 0.418 0.109t-value (-20.58) (9.39)

M2 Coef. -0.293 0.212 0.026t-value (-21.45) (8.11)

M3 Coef. -0.283 0.426 -0.014 0.110t-value (-20.62) (8.99) (-0.76)

M4 Coef. -0.275 0.385 0.009 0.308 0.133t-value (-19.84) (8.87) (0.52) (7.61)

M3 Coef. = M4 Coef. (-4.80) (4.77)M5 Coef. -0.274 0.393 -0.003 0.299 0.024 -0.023 0.135

t-value (-19.78) (9.49) (-0.17) (7.17) (2.82) (-2.49)M4 Coef. = M5 Coef. (1.42) (-1.84)

Coefficients are means of annual regressions over the period 1988-2001, and t-values in parentheses are based on the standard error of the mean (Fama and MacBeth 1973, Bernard 1987). The dependent variable is annual stock returns obtained by compounding CRSP monthly returns over the fiscal period. xt is comprehensive income calculated as net income (#172) minus preferred dividends (#19) plus the change in marketable securities adjustment (#238) plus the change in cumulative translation adjustment (#230). xt is the change in comprehensive income. dt-1 is the sum of cash dividends to common shareholders (#21) and net capital contributions. Net capital contributions are purchases of common and preferred stock (#115) minus sales of common and preferred stock (#108). Operating assets (oat) is book value of equity (bt) minus financial assets (fat). bt is common equity (#60) plus preferred treasury stock (#227) minus preferred dividends in arrears (#242). fat is cash and short-term investments (#1) plus investments and advances-others (#32), minus debt in current liabilities (#34), minus long-term debt (#9), minus preferred stock (#130), plus preferred treasury stock (#227), minus preferred dividends in arrears (#242), minus minority interest (#38). oat is the change in operating assets. Cash investment (cit) is the negative of cash flows from investing activities (#311). cit is the change in cash investments. All independent variables are deflated by beginning market value of equity (pt-1).

32

Table 10: Conservatism and the Sign of Earnings: Means of Annual OLS Regressions

Panel A: Profit firmsModel Int. xt xt dt-1 cit oat-1 Adj. R2

M1 Coef. -0.064 3.570 0.158t-value (-2.86) (19.71)

M2 Coef. 0.173 1.162 0.058t-value (5.32) (11.18)

M3 Coef. -0.052 3.165 0.546 0.169t-value (-2.20) (16.16) (5.07)

M4 Coef. -0.052 3.177 0.540 -0.106 0.171t-value (-2.25) (16.06) (5.07) (-1.55)

M3 Coef. = M4 Coef. (0.94) (-0.98)M5 Coef. -0.051 3.129 0.566 -0.101 0.216 -0.016 0.180

t-value (-2.21) (17.10) (5.34) (-1.60) (7.19) (-0.70)M4 Coef. = M5 Coef. (-2.25) (1.58)

Panel b: Loss firmsModel Int. xt xt dt-1 cit oat-1 Adj. R2

M1 Coef. -0.079 -0.025 0.003t-value (-1.79) (-0.41)

M2 Coef. -0.051 0.302 0.012t-value (-1.01) (8.42)

M3 Coef. -0.078 -0.194 0.366 0.019t-value (-1.77) (-2.34) (5.99)

M4 Coef. -0.071 -0.208 0.376 0.094 0.024t-value (-1.70) (-2.58) (6.14) (0.83)

M3 Coef. = M4 Coef. (-1.73) (1.29)M5 Coef. -0.069 -0.222 0.379 0.077 0.294 -0.017 0.040

t-value (-1.60) (-2.67) (5.73) (0.68) (6.73) (-0.83)M4 Coef. = M5 Coef. (-0.92) (0.16)

Coefficients are means of annual regressions over the period 1988-2001, and t-values in parentheses are based on the standard error of the mean (Fama and MacBeth 1973, Bernard 1987). The dependent variable is annual stock returns obtained by compounding CRSP monthly returns over the fiscal period. xt is comprehensive income calculated as net income (#172) minus preferred dividends (#19) plus the change in marketable securities adjustment (#238) plus the change in cumulative translation adjustment (#230). xt is the change in comprehensive income. dt-1 is the sum of cash dividends to common shareholders (#21) and net capital contributions. Net capital contributions are purchases of common and preferred stock (#115) minus sales of common and preferred stock (#108). Operating assets (oat) is book value of equity (bt) minus financial assets (fat). bt is common equity (#60) plus preferred treasury stock (#227) minus preferred dividends in arrears (#242). fat is cash and short-term investments (#1) plus investments and advances-others (#32), minus debt in current liabilities (#34), minus long-term debt (#9), minus preferred stock (#130), plus preferred treasury stock (#227), minus preferred dividends in arrears (#242), minus minority interest (#38.). oat is the change in operating assets. Cash investment (cit) is the negative of cash flows from investing activities (#311). cit is the change in cash investments. All independent variables are deflated by beginning market value of equity (pt-1).

33

Table 11: Conservatism and Accounting Based Conservatism Proxies: Mean of Annual OLS Regressions

Research Intensity (#obs = 29,257)Portfolio Int. xt xt dt-1 cit oat-1 Adj. R2

P1 0.102 0.821 0.473 0.164 0.152 -0.058 0.137(low) (2.61) (9.35) (6.21) (2.49) (4.91) (-1.73)

P2 0.094 0.820 0.495 0.348 0.172 -0.020 0.139(2.59) (5.23) (3.37) (3.69) (4.02) (-0.70)

P3 0.154 0.796 0.876 0.128 0.397 0.063 0.150(3.11) (7.24) (7.11) (0.95) (6.97) (1.03)

P4 0.137 0.315 0.597 0.007 0.662 0.017 0.086(high) (1.85) (2.92) (5.49) (0.04) (5.33) (0.23)

P1 Coef. = P4 Coef. (4.25) (0.92)Depreciation Rate (#obs = 43,767)

P1 0.082 0.646 0.271 0.251 0.138 0.006 0.106(low) (2.82) (4.31) (3.01) (2.53) (3.25) (0.26)

P2 0.095 0.696 0.457 0.232 0.194 0.002 0.122(3.15) (8.25) (9.03) (3.50) (6.57) (0.09)

P3 0.125 0.694 0.663 0.060 0.324 -0.015 0.137(3.35) (5.54) (5.37) (0.47) (7.44) (-0.58)

P4 0.144 0.559 0.648 0.024 0.440 0.005 0.115(high) (2.41) (4.54) (6.35) (0.19) (6.65) (0.10)

P1 Coef. = P4 Coef. (4.19) (-0.02)Advertising Intensity (#obs = 14,216)

P1 0.150 0.603 0.763 0.340 0.207 -0.063 0.135(low) (3.95) (5.65) (11.03) (1.71) (5.47) (-1.12)

P2 0.110 0.880 0.491 0.212 0.277 -0.025 0.136(3.15) (5.19) (5.05) (1.29) (6.00) (-0.57)

P3 0.118 0.614 0.573 0.169 0.257 -0.095 0.121(2.93) (6.27) (5.75) (1.04) (4.22) (-2.12)

P4 0.113 0.591 0.793 0.165 0.449 0.021 0.141(high) (2.61) (2.73) (3.76) (1.78) (5.35) (0.28)

P1 Coef. = P4. Coef (3.12) (1.13)Inventory Accounting Method (#obs = 53,554)

LIFO 0.076 0.851 0.432 0.234 0.104 -0.054 0.143(2.30) (6.04) (4.30) (2.02) (2.85) (-1.46)

Non 0.125 0.592 0.566 0.125 0.282 -0.008 0.114LIFO (3.28) (5.52) (8.23) (1.58) (7.32) (-0.41)

LIFO Coef. = Non Lifo Coef. (-3.24) (-1.02)

Coefficients are means of annual regressions over the period 1988-2001, and t-values in parentheses are based on the standard error of the mean (Fama and MacBeth 1973, Bernard 1987). Research intensity is measured by research and development expense (#46) divided by sales (#12). Depreciation rate is measured by depreciation and amortization expense (#14) divided by the beginning balance of property, plant, and equipment (#8) plus intangibles (#33). Advertising intensity is measured by advertising expense (#45) dividend by sales (#12). Coefficients are means of annual regressions over the period 1988-2001, and t-values in parentheses are based on the standard error of the mean (Fama and MacBeth 1973, Bernard 1987). The dependent variable is annual stock returns obtained by compounding CRSP monthly returns over the fiscal period. xt is comprehensive income calculated as net income (#172) minus

34

preferred dividends (#19), plus the change in marketable securities adjustment (#238), plus the change in cumulative translation adjustment (#230). xt is the change in comprehensive income. dt-1 is the sum of cash dividends to common shareholders (#21) and net capital contributions. Net capital contributions are purchases of common and preferred stock (#115) minus sales of common and preferred stock (#108). Operating assets (oat) is book value of equity (bt) minus financial assets (fat). bt is common equity (#60) plus preferred treasury stock (#227), minus preferred dividends in arrears (#242). fat is cash and short-term investments (#1) plus investments and advances-others (#32), minus debt in current liabilities (#34), minus long-term debt (#9), minus preferred stock (#130), plus preferred treasury stock (#227), minus preferred dividends in arrears (#242), minus minority interest (#38.). oat is the change in operating assets. Cash investment (cit) is the negative of cash flows from investing activities (#311). cit is the change in cash investments. All independent variables are deflated by beginning market value of equity (pt-1).

35

Table 12: Accounting Conservatism: Mean of Annual OLS Regressions (1972-2001)Coefficient estimates with t-statistics in parentheses

Model Int. xt xt dt-1 oat Adj. R2

M1 Coef. 0.070 1.069 0.125t-value (2.08) (17.80)

M2 Coef. 0.127 0.846 0.071t-value (3.73) (21.57)

M3 Coef. 0.078 0.861 0.409 0.138t-value (2.30) (11.91) (8.75)

M4 Coef. 0.080 0.833 0.420 0.176 0.142t-value (2.38) (12.23) (9.46) (2.32)

M3 Coef. = M4 Coef.: (-3.00) (1.95)M5 Coef. 0.076 0.804 0.426 0.198 0.050 0.145

t-value (2.29) (11.35) (9.33) (2.71) (3.01)M4 Coef. = M5 Coef.: (-2.58) (1.34)

Coefficients are means of annual regressions over the period 1972-2001, and t-values in parentheses are based on the standard error of the mean (Fama and MacBeth 1973, Bernard 1987). The dependent variable is annual stock returns obtained by compounding CRSP monthly returns over the fiscal period. xt is comprehensive income calculated by net income (#172) minus preferred dividends (#19) plus the change in marketable securities adjustment (#238) plus the change in cumulative translation adjustment (#230). xt is the change in comprehensive income. dt-1 is the sum of cash dividends to common shareholders (#21) and net capital contributions. Net capital contributions include purchases of common and preferred stock (#115) minus sales of common and preferred stock (#108). Operating assets (oat) is calculated as book value of equity (bt) minus financial assets (fat). bt is measured by common equity (#60) plus preferred treasury stock (#227) minus preferred dividends in arrears (#242). fat is measured by cash and short-term investments (#1) plus investments and advances-others (#32) minus debt in current liabilities (#34) minus long-term debt (#9) minus preferred stock (#130) plus preferred treasury stock (#227) minus preferred dividends in arrears (#242) minus minority interest (#38.). oat is the change in operating assets. All independent variables are deflated by beginning market value of equity (pt-1).

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