The Link Between Earnings Conservatism

and Balance Sheet Conservatism§

Jinhan Pae jpae@business.queensu.ca

Phone: (613) 533-3065

Dan Thornton dbt@qsilver.queensu.caPhone: (613) 533-6194

Michael Welkermw18@qsilver.queensu.ca

Phone: (613) 533-2317

Queen's University, School of Business Kingston, ON K7L 3N6

Canada

January, 2004

This draft is for presentation at the University of Waterloo by Mike Welker on January 30, 2004.

§ The authors gratefully acknowledge financial support from the Social Sciences and Humanities Research Council of Canada (Grant No. 410-03-1046) and Queen’s School of Business. They also appreciate receiving constructive suggestions and comments on previous versions of the paper from workshop participants at the University of Georgia (J.M. Tull School of Accounting), the University of Calgary, and Queen’s University. Particular thanks go to Linda Bamber, Benjamin Ayres, Steve Baginski, Bill Cannon, Peter Martin (Principal, Canadian Accounting Standards Board), Steve Salterio, Isabel Wang, George Wilson, the referees, and Gordon Richardson.

The Link Between Earnings Conservatism

and Balance Sheet Conservatism

Abstract

Defining earnings conservatism as the degree to which a firm’s earnings are more

timely in reflecting expected losses than gains in a given fiscal year, and balance sheet

conservatism as the firm’s market-to-book ratio at the beginning of the year, we

hypothesize and find: (1) Earnings conservatism is negatively associated with balance

sheet conservatism. (2) The negative link between earnings conservatism and balance

sheet conservatism is primarily due to the accrual component of earnings, not the

operating cash flow component of earnings. Since our hypotheses stem from Watts’

(2003) explanations for accounting conservatism, our results are consistent with his

explanations. Our results imply that incorporating the link between earnings conservatism

and balance sheet conservatism is essential if one uses earnings-returns associations to

investigate cross-sectional or time-series differences in earnings conservatism. To test

this implication, we revisit a prior study that inferred changes in earnings conservatism

over time but did not incorporate the link between earnings conservatism and balance

sheet conservatism in its research design. We find that including the link greatly enhances

the inferences available from that prior study.

Keywords: accounting conservatism; earnings; accruals; returns; market-to-book.

Data availability: The data used in this study are publicly available from the sources

indicated. A list of sample firms is available from the authors.

I. INTRODUCTION

The objectives of this paper are to document and explain the association between

earnings conservatism and balance sheet conservatism in US accounting over three recent

decades. We measure earnings conservatism as the degree to which a firm’s accounting

income reflects expected losses in a more timely fashion than expected gains in a given

fiscal year, and balance sheet conservatism as the firm’s market-to-book ratio at the

beginning of the year. Our measures stem from Watts’ (2003) definition of conservatism

as the differential verifiability required for recognizing profits versus losses.

Conservatism triggers the recognition of losses in earnings when they are probable but

defers the recognition of gains until they are verifiable. It also results in balance sheets

persistently understating the book value of net assets relative to their market values, since

it requires asset write-downs and liability accruals when expected cash flows decline but

generally prohibits upward valuations of assets or downward valuations of liabilities

when expected cash flows increase. Consistent with prior empirical conservatism

literature (Basu, 1997), our proxy for changes in expected gains or losses is realized

market returns to firms’ equity securities.

To provide conceptual support for our hypotheses, we review Watts’ (2003)

explanations for the existence of earnings conservatism. We then extend each explanation

to derive our hypothesized negative association between earnings conservatism and

balance sheet conservatism. Thus, the empirical corroboration we find for our hypotheses

lends support to Watts’ conservatism explanations, enhancing confidence in the

implications of our findings for future accounting research and standard setting.

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Contributions to the literature

In a large sample of US firms over three decades, we find that earnings are

generally conservative in the sense that the sensitivity of earnings to returns is greater for

“bad news firms” (those experiencing negative returns) than for “good news firms” (those

experiencing positive returns). Balance sheets are generally conservative in that both

mean and median market-to-book ratios exceed one. These findings are consistent with

prior studies reporting the existence of earnings conservatism (Basu, 1997) and balance

sheet conservatism (Givoly and Hayn, 2000).

We make two important contributions to the literature. First, we hypothesize and

find that earnings conservatism is negatively associated with balance sheet conservatism:

Firms with low balance sheet conservativism (i.e., low market-to-book ratios) evince

much greater earnings conservatism (i.e., a much greater positive difference between

earnings sensitivity to bad news and earnings sensitivity to good news) than those with

higher balance sheet conservatism. Second, we hypothesize and find that the accrual

component of earnings, but not the operating cash flow component of earnings, is more

conservative for firms with low balance sheet conservatism than for firms with higher

balance sheet conservatism. This is consistent with accruals instigating earnings

conservatism.

Our results imply that allowing for the negative association between earnings

conservatism and balance sheet conservatism in one’s research design can enhance

inferences about variations in earnings conservatism both across firms and over time. We

therefore revisit the results of Givoly and Hayn (2000), who report that both earnings

conservatism and market-to-book ratios generally increased in recent decades but do not

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allow for the negative association between earnings conservatism and balance sheet

conservatism. Estimating pooled earnings-returns regressions for six recent time periods,

we find that earnings conservatism increased much more for low than high market-to-

book firms, offsetting the negative effect of inter-temporal increases in market-to-book

ratios on overall earnings conservatism. However, earnings conservatism also increased

for firms with higher market-to-book ratios. We conjecture that this increase is due to

increases in the earnings conservatism embedded in the wording, application, and SEC

enforcement of accounting standards. These findings enhance the inferences one can

obtain from the Givoly-Hayn’s study.

Our results suggest that the degree of earnings conservatism observed is the

product of two factors. First, at any given time, accounting standards mandate an overall

level of earnings conservatism that accountants implement without regard to a firm’s

market-to-book ratio (e.g., they expense instead of capitalizing research and development

and advertising expenses). A second factor, explained in section III, is novel to this study.

Given an overall level of conservatism, accountants have incentives to be more

conservative—to increase the timeliness with which a given firm’s earnings reflect bad

versus good news—as balance sheet conservatism decreases. That is, earnings

conservatism is negatively associated with balance sheet conservatism across firms.1

1Richardson and Tinaikar (2003) distinguish between ex-ante and ex-post conservatism. Their notion of ex-post conservatism is consistent with our link between earnings conservatism and balance sheet conservatism. McCallig (2003) posits a mechanical link between earnings conservatism and balance sheet conservatism, termed “capitalization conservatism,” that is also consistent with our hypothesized link. According to McCallig, a firm’s financial statements are currently more sensitive to bad news if it previously capitalized a now-impaired asset, which it must now write down, than if it previously expensed an investment in research and development (R&D), because the immediate expensing of R&D already “assumed the worst.” This is also consistent with our hypothesized link. However, McCallig’s “capitalization conservatism” is only a subset of our negative association between earnings and balance sheet conservatism. Besides reflecting asset impairment, bad news can indicate the existence of unbooked

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The paper continues as follows. The next section defines conservatism, reviews

prior research motivating the study, and underscores its contributions to the literature.

Remaining sections develop the hypotheses, describe the research design, outline sample

selection, and present empirical results. We conclude with a summary of the findings and

suggestions for future research.

II. PRIOR RESEARCH AND MOTIVATION

Definition of conservatism

FASB’s Concepts Statement No. 2 defines accounting conservatism as a “prudent

reaction to uncertainty to try to ensure that uncertainty and risks inherent in business

situations are adequately considered” (FASB, 1982). Conservatism in practice generally

means that accountants “anticipate no profit, but anticipate all losses” (Bliss, 1924, cited

in Watts, 2003; Christensen and Demski, 2002). Anticipating profits means recognizing

profits before there is legal claim to the associated future cash flows generating them and

the revenues are verifiable (Watts, 2003). Conservatism does not imply that the firm must

receive cash flows before recognizing the associated revenues: accountants recognize

credit sales once the associated cash flows are verifiable. Rather, as the empirical

literature recognizes, conservatism is “the accountant’s tendency to require a higher

degree of verification to recognize good news as gains than to recognize bad news as

losses” (Basu, 1997, p. 7). Kwon et al. (2001) model conservative financial reporting in

the context of efficient contracting, with a manager subject to limited liability. Their liabilities (e.g., contingent lawsuits) or enhance the value of existing liabilities, leading to negative accruals in response to bad news. Section III of the paper explains that the accounting treatment of contingencies is also likely to foster a negative link between balance sheet conservatism and earnings conservatism. In addition, conservatism depends jointly on accounting rules and the rigor with which auditors and regulators enforce them. Section III shows that existing literature implies that auditors’ and regulators’ incentives to enforce earnings conservatism decrease with balance sheet conservatism.

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definition of conservatism (p. 35) “implies that the accounting system is more likely to

report ‘low’ when the outcome is low than to report ‘high’ when the outcome is high,”

consistent with a higher verification requirement for high outcomes (gains) than for low

outcomes (losses).

Examples of conservatism in generally accepted accounting principles (GAAP)

include the lower of cost or market convention, the expensing of research and

development costs and advertising costs, the recognition of post-retirement obligations

but not their attendant human assets, and write-downs of goodwill following impairment

testing but proscriptions against recognizing internally generated goodwill. Stronger

enforcement of GAAP by the United States Securities and Exchange Commission (SEC)

augments the degree of conservatism observed in practice. For example, Turner (2001)

and Vogt (2001) maintain that the strict revenue recognition criteria contained in SEC

Staff Accounting Bulletin 101 imply an extraordinary level of conservatism. In some

cases, the SAB 101 revenue recognition criteria require delaying recognition even when

revenues are verifiable, so that recognition is less timely than implied by contract law.

Prior studies and motivation

Basu (1997) assumes that current-year equity returns efficiently impound good

and bad news about firms’ expected future cash flows, and that conservative accounting

recognizes bad news in a timelier manner than good news in the income statement. This

implies the hypothesis that the slope coefficient in the regression of earnings on returns is

higher for firms reporting negative returns (“bad news firms”) than for those reporting

positive returns (“good news firms”). Confirming this hypothesis, Basu’s results are

consistent with the existence of earnings conservatism. Ball et al. (2000) extend this

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approach to infer cross-country differences in conservatism from differences in slope

coefficients in regressions of earnings on returns.

Hayn (1995) reports that the slope coefficient in a regression of returns on

earnings is much smaller⎯almost zero⎯for firms reporting losses (“loss firms”) than for

those reporting profits (“profit firms”).2 Since Hayn’s regression of returns on earnings is

the reverse of Basu’s (1997) regression of earnings on returns, her finding of a smaller

coefficient relating earnings to returns for loss firms is consistent with Basu’s finding of a

larger coefficient relating returns to earnings for bad news firms. Hence, the implications

of the results of the two studies are similar: To the extent that gains and losses impound

good and bad news reflected in market returns, the sensitivity of earnings to returns is

greater for bad-news/loss firms than for good-news/profit firms.

Feltham and Ohlson (1995, 1996) use the term “conservative accounting” to mean

that the expected market value of a firm’s equity exceeds the expected book value of its

equity in the long run. Thus, they see conservative accounting as a balance sheet as well

as an income statement phenomenon. Easton and Pae (2003) find that accounting is

conservative on average and suggest controlling for conservatism in valuation models if

market-to-book ratios are extremely low or high. To date, however, research has not

explicitly modeled nor empirically tested the link between earnings conservatism and

balance sheet conservatism. In the next section of the paper, we draw on Watts’

conservatism explanations to develop hypotheses concerning that link.

2 Hayn’s (1995) main interest is the impact of firms’ liquidation option on the relation between returns and earnings, not accounting conservatism.

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III. HYPOTHESIS DEVELOPMENT

Consistent with prior literature, our hypotheses rely on measures of earnings

conservatism inferred from cross sectional regressions of earnings on returns. In the

regression equation , the variable Xititttit RX εββ ++= 10 it represents firm i’s earnings,

accruals or operating cash flows for fiscal year t, deflated by the market value of equity at

the beginning of the fiscal year, i.e., the end of the fiscal year t–1. The variable Rit

represents the market rate of return on firm i’s common stock for the year ending three

months after firm i’s fiscal year ending during year t; and εit is assumed to be random

noise. The cross sectional regression coefficient β1t measures the timeliness with which

earnings, accruals, or cash flows reflect annual returns in a sample of firms whose fiscal

years end during year t. Our general approach is to estimate β1tGN (β1t

BN) in year t for

samples of firms reporting good (bad) news in that year.

Our measure of earnings conservatism is ct ≡ , the excess sensitivity of

earnings to bad versus good news for fiscal year t. Our hypotheses relate to the

association between c

GNt

BNt 11 ββ −

t and balance sheet conservatism, proxied by the market-to-book

ratio, Pt-1/Bt-1, where Pt-1 (Bt-1) represents the market (book) value of equity at the end of

fiscal year t–1. For brevity in the text of the paper, we refer to the latter as the P/B ratio,

suppressing subscripts.

We draw on Watts’ conservatism explanations to support three hypotheses (stated

in alternate form).

H1a: ct > 0 for all t. That is, earnings are conservative in all periods examined.

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H2a: With earnings as the dependent variable, ct is negatively associated with Pt-1/Bt-1. That is, earnings conservatism is negatively associated with balance sheet conservatism. H3a: With accruals as the dependent variable, ct is negatively associated with Pt-1/Bt-1. That is, accrual conservatism is negatively associated with balance sheet conservatism.

We expect our tests to support hypotheses 1 through 3; however, since

accountants implement earnings conservatism through the accrual component of

earnings, we do not expect the cash flow conservatism to be related to P/B. We

therefore state the fourth hypothesis in its null form.

H40: With operating cash flows as the dependent variable, ct is independent of Pt-1/Bt-1. That is, cash flow conservatism is not associated with balance sheet conservatism.

Conceptual support for hypotheses

Watts (1993, 2003) discusses alternative explanations for accounting

conservatism and their implications for accounting regulators. Other papers analytically

examine limited aspects of conservatism.3 However, the breadth of Watts’ less formal

examination suits our purposes because it covers all of the facets of conservatism

germane to our hypotheses. Watts gives four main explanations for conservatism:

contracting, shareholder litigation, regulation, and taxes. We educe support for our

hypotheses from each explanation, summarized below.

3 Kwon, Newman, and Suh (2001) analyze conservatism in a limited liability setting, in which conservative reporting forces accounting numbers into a “good news” region where contracting is not constrained by an assumption of limited liability. Gigler and Hemmer (2001), Gjesdal and Antle (2001), and Scott (1975) also address the demand for conservative accounting.

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Contracting

Accounting and auditing have long provided measures used in contracts

constraining managers from exceeding their decision rights in expending resources and

splitting returns among firm claimants (Holthausen and Leftwich, 1983; Watts and

Zimmerman, 1986). Verifiability of profits is essential to legal contracting because

contracts based on unverifiable accounting numbers are not enforceable. Contracts

relying on earnings numbers include management compensation agreements, debt

contracts, cost-plus contracts, and employment contracts.

Management compensation agreements

Watts (2003) explains that accounting conservatism in contracts efficiently

constrains managers’ tendency to have the firm make opportunistic payments to

themselves and other parties, such as shareholders. Managers with limited tenure have

incentives to inflate earnings to increase their bonus compensation and increase the value

of their stock options. Recovery of excess compensation payments and reparation for

losses due to a manager’s negative-net-present-value investments is difficult if the

manager leaves the firm before it realizes the associated cash flows. Thus, as Barclay et

al. (2000) argue, it is efficient for bonuses based on accounting income to reflect

“delivered performance” in a given period. Earnings conservatism facilitates delivered

performance measurement by deferring the recognition of gains until they are verifiable.

We hypothesize that earnings conservatism is negatively associated with the P/B

ratio in the context of management compensation contracts for the following reason. A

decrease in P/B signals a decline in a firm’s future growth opportunities. The decline in

growth opportunities increases managers’ preference for current versus deferred

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compensation because it reduces the expected present value of deferred compensation

based on future realized earnings. The reduction in the expected present value of deferred

compensation follows from an increase in the probability that either the firm will go

bankrupt or the managers will be fired during the deferral period. A decrease in P/B, then,

motivates managers to overstate current earnings to increase the value of their current

year bonus and stock option compensation. Overstatement of earnings, in turn, is likely to

involve not recording verifiable losses and/or recording unverifiable profits.

Watts (2003, note 3) points out that because verifiability is management

controlled, it is not effective to specify such biases a priori in contracts based on

accounting numbers. Rather, it is efficient for contractors to rely on the expectation that

accounting conservatism—the excess verifiability required to recognize gains versus

losses—will be greater in situations where managers have greater incentives to overstate

earnings. Mechanisms for increasing conservatism in this context include additional

scrutiny by the auditor and independent members of the board of directors.

Debt contracts

Debt covenants aim to restrict the firm from making unrecoverable payments to

shareholders and junior claimants (Leftwich, 1983). Like managers who receive excess

compensation payments, recipients of excessive dividend payments do not generally need

to return them to the firm in the event of future financial trouble. Debt covenants

generally limit dividend payments to “unrestricted” retained earnings calculated using

conservative accounting principles, compelling management to protect debt-holders by

maintaining, within the firm, assets with a given lower bound value. Absent such

restrictions, corporations could not borrow because management could distribute the

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assets to shareholders and, given limited liability, leave the creditors with nothing and no

way of recovering their loans. Debt covenants also restrict additional borrowing by

placing upper limits on firms’ debt/equity ratios. Absent such restrictions, corporations

would either be unable to borrow or need to pay excessive interest. Relying on

conservative book value measures, legislation governing corporations often reinforces the

protection of senior claim holders by mandating that “dividend distributions neither make

a company insolvent nor impair its capital,” (Murphy, 1992, p. 44).

We hypothesize that earnings conservatism is negatively associated with the P/B

ratio in the context of debt covenants for the following reason. As the P/B ratio decreases,

the probability of a firm defaulting on its obligations to senior claim holders increases

because the value of the firm’s expected future cash flows (reflected in the numerator)

decreases in relation to the principal amount of the debt. Following a decrease in P/B,

debt holders wish to tighten constraints on excessive payouts and additional borrowing.

The contractual constraints protecting debt holders against excessive payouts generally

refer to earnings (often before interest and taxes) based on generally accepted accounting

principles, not equity market-based earnings measures. The contractual constraints

protecting them against excessive additional borrowing generally refer to a maximum

allowed value of the debt/equity ratio based on a book value equity measure, not a market

value equity measure.

Earnings conservatism directly constrains dividend and compensation payouts

based on earnings. Earnings conservatism also triggers impaired asset write-offs and

recognition of unrecorded liabilities in the income statement, pushing the debt/equity

ratio closer to its maximum limit and tightening the constraint on additional borrowing. It

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is efficient for debt holders to rely on earnings conservatism increasing as P/B decreases,

offsetting managers’ increasing incentives to overstate earnings, overstate assets, and

understate liabilities.

Shareholder litigation

Watts (1993, 2003), Kothari et al. (1988), and Beaver (1993) maintain that

earnings conservatism reduces the expected present value of shareholder litigation costs

because shareholders are much more likely to litigate when earnings and net assets are

overstated than when they are understated.4 Overstatement facilitates shareholder

litigation in case stock prices later plummet because shareholders can point to the

overstatement of earnings or overvaluation of firms’ net assets as a pretext for suing the

firm, the firm’s auditors, and management to recoup their losses. Thus, managers and

auditors have incentives to report conservative values for earnings and net assets.

We hypothesize that earnings conservatism is negatively associated with P/B

ratios in the context of shareholder litigation for the following reason. As a firm’s P/B

ratio decreases, it becomes more likely that net asset carrying values exceed fair values.

Indeed, Statement of Financial Accounting Standards No. 142 (FASB 2001) mandates

goodwill impairment write-downs when the book value of a reporting unit’s equity

exceeds the market value of equity.5 As P/B declines, the probability of shareholder

litigation increases because it becomes easier for shareholders to substantiate claims that

4 Kellogg (1984) finds that the number of security buyers’ lawsuits against auditors and firms greatly exceeds the number of sellers’ lawsuits. During the period Kellogg examines, the ratio of the number of buyers’ lawsuits to the number of sellers’ lawsuits is 13 to one.

5 Paragraph 23 of Statement of Financial Accounting Standards No. 142 (FASB 2001) states “… the fair value of a reporting unit refers to the amount at which the unit as a whole could be bought or sold in a current transaction between willing parties. Quoted market prices in active markets are the best evidence of fair value and shall be used as the basis for the measurement, if available.”

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assets are misleadingly overvalued. Moreover, the likely magnitude of claimed damages

increases because investors can claim that asset carrying values are farther below fair

values. Hence, to reduce expected litigation costs, it is efficient for both auditors and

managers to increase the degree of earnings conservatism as P/B decreases.

Regulation

Watts (1977) argues that investor losses from overvalued assets and overstated

earnings are more observable and usable in the political process than forgone gains due to

undervalued assets or understated earnings. For example, some commentators blamed

non-conservative accounting for the overvaluation of New York Stock Exchange stocks

in 1929 (Benston 1969). Thus, standard-setters have incentives to set conservative GAAP

and regulators like the SEC have incentives to enforce GAAP in a conservative fashion.

After releasing Staff Accounting Bulletin 101, a response to investor losses relating to

revenue recognition abuses during the dot-com boom, the SEC began enforcing

extremely conservative revenue recognition rules (Vogt, 2001). Following recent

accounting debacles, particularly the bankruptcy of Enron in December 2001, FASB

(2003) proposed more conservative accounting rules for recognizing earnings, assets, and

liabilities related to special-purpose entities.

We hypothesize that earnings conservatism is negatively associated with P/B

ratios in the context of regulation for the following reason. Low P/B ratios imply poor

future prospects for companies and are consistent with recent declines in values having

occurred, making it likely that investors will blame regulators for permitting misleading

accounting practices. Thus, both the wording and required implementation of many

accounting standards imply a negative association between earnings conservatism and the

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P/B ratio. Accounting for inventory is generally at the lower of cost or market. Since P

reflects inventory market values and B reflects inventory costs, the probability of

inventory write-downs is negatively associated with P/B by construction. Similarly, asset

impairment write-downs are likely to occur when asset book values (B) exceed expected

future cash flows (reflected in P). SFAS 142 recently mandated goodwill impairment

write-downs if book value exceeds fair value, replacing an earlier standard requiring

goodwill amortization. Interestingly, Watts (2003) does not view SFAS 142 as a

conservative standard. He states, “…future cash flows are unlikely to be verifiable and

contractible…they, and valuation based on them, are likely to be manipulated.

Conservatism does not allow the use of such measures.” However, because SFAS 142

mandates price/book comparisons as goodwill impairment triggers, we still expect to

observe earnings conservatism being negatively related to P/B in the implementation of

the standard.

SFAS 5 (FASB 1975) mandates contingent loss recognition when the losses are

probable, but generally prohibits contingent gain recognition.6 Thus, the standard

mandates earnings conservatism for any P/B ratio; however, it also results in a negative

association between conservatism and P/B because the market value of equity reflects an

expected loss as a continuous function of the probability of loss. A declining P/B ratio

6 Paragraph 8 of SFAS No. 5 states “An estimated loss from a loss contingency…shall be accrued by a charge to income if both of the following conditions are met: a. Information available prior to issuance of the financial statements indicates that it is probable that an asset had been impaired or a liability had been incurred at the date of the financial statements…b. The amount of loss can be reasonably estimated.” With respect to gains, in contrast, paragraph 17 states “…a. Contingencies that might result in gains usually are not reflected in the accounts since to do so might be to recognize revenue prior to its realization. b. Adequate disclosure shall be made of contingencies that might result in gains, but care shall be exercised to avoid misleading implications as to the likelihood of realization”.

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therefore reflects an increasing probability of loss, eventually triggering recognition in

earnings.7

Taxes

Links between income taxation and financial reporting can enhance earnings

conservatism (Watts, 2003; Smith and Watts, 1982; Watts and Zimmerman, 1979).

Guenther et al. (1997) and Shackelford and Shevlin (2001) suggest that taxes provide

incentives for firms to conform reported accounting income to tax incentives because

court decisions on reporting methods serve as precedents for tax methods and IRS

behavior. Thus, there are incentives for profitable firms with taxable income to defer

income to reduce the present value of taxes.

Links between the P/B ratio and tax-driven earnings conservatism are less clear

than those between the P/B ratio and conservatism relating to contracting, shareholder

litigation, and regulation. For example, managers have incentives to increase reported

income to increase their bonuses but decrease reported income to save corporate taxes;

however, it is unclear how declines in P/B affect the tradeoff.8 Consequently, we limit our

analysis of the implications of Watts’ (2003) conservatism explanations to contracting,

litigation, and regulation. 7 Paragraph 3 of SFAS No. 5 states, “When a loss contingency exists, the likelihood that the future event or events will confirm the loss or impairment of an asset or the incurrence of a liability can range from probable to remote. This Statement uses the terms probable, reasonably possible, and remote to identify three areas within that range…” Accountants would accrue the loss when they judged the probability to change from reasonably possible to probable.

8 On the one hand, as the P/B ratio increases, shareholders can better afford to have the firm sell stock at high earnings multiples to finance the firm’s tax bill, decreasing any pressure on managers to reduce taxable income at the expense of their bonuses. This supports the hypothesized negative association between earnings conservatism and the P/B ratio. On the other hand, if increases in P/B are associated with increases in product prices leading to the adoption of conservative LIFO inventory accounting, tax-driven earnings conservatism is positively associated with the P/B ratio. We would need to collect and analyze firm-specific tax and compensation parameters to make directional predictions. This investigation is beyond the scope of the present study.

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Summary of conceptual support for hypotheses

In summary, Watts’ (2003) contracting explanation for conservatism implies that

earnings conservatism is negatively associated with P/B because a decline in P/B

enhances junior claim holder incentives to overstate earnings in order to garner excessive

earnings-linked payouts. Thus, senior claim holders demand more earnings

conservatism—i.e., a greater amount of differential verification for the recognition of

gains versus losses—as P/B declines. Watts’ shareholder litigation explanation implies

that earnings conservatism is negatively associated with P/B because expected

shareholder litigation costs increase as P/B decreases, making it efficient for both auditors

and managers to increase earnings conservatism. Finally, Watts’ regulation explanation

implies that earnings conservatism is negatively associated with P/B because lower P/B

ratios imply poorer future prospects for companies and are consistent with recent declines

in values having occurred, making it more likely that investors will blame regulators for

allowing companies to record inflated earnings and net asset values. Thus, both the

wording and implementation of many accounting standards imply a negative association

between earnings conservatism and the P/B ratio, and SEC enforcement incentives

enhance this association.

IV. DATA AND DESCRIPTIVE STATISTICS

We compute annual stock returns (R) for years ending three months after firms’

fiscal yearends by compounding CRSP monthly stock returns. Earnings, components of

earnings, and other variables come from COMPUSTAT. Earnings (NI) are the bottom

line number in the income statement (COMPUSTAT #172). Accruals (ACC) are the

change in non-cash and non-debt working capital (∆#4 - ∆#1 - ∆#5 + ∆#34) plus

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depreciation (#14). Operating cash flows (OCF) are the difference between earnings and

accruals. If cash flow statements are available, we obtain operating cash flows directly

from them (#308), and compute accruals as the difference between earnings and

operating cash flows.9 We deflate earnings, operating cash flows, and accruals by the

beginning-of-year equity market value. To mitigate the effect of extreme observations,

we delete observations in the top and bottom percentiles of earnings, operating cash

flows, accruals, and stock returns. We also delete observations with negative equity book

value. The resulting sample contains 119,983 firm-year observations from 1970 through

2001.

Insert Table 1

Panel A of Table 1 gives descriptive statistics for the full sample. The median

annual stock return is 4 percent; median earnings are 6 percent of beginning-of-year

equity market value. Median accruals are negative; median operating cash flows are

positive. The median P/B ratio, 1.61, indicates that most balance sheets are conservative.

We partition the sample into a group of 65,044 firms with non-negative annual

stock returns (“good news” firms) and a group of 54,939 firms with negative annual stock

returns (“bad news” firms). Panels B and C give descriptive statistics for the good and

bad news sub-samples, respectively. Median annual stock returns are 31 percent (minus

26 percent) for the good (bad) news firms. On average, compared with bad news firms,

good news firms have greater market capitalization, annual sales, earnings, and operating

cash flows. Good and bad news firms exhibit no difference in accruals, however. Thus,

9 As described later, we repeat all our testing using only post-1987 data, so that cash flow data are directly available from cash flow statements. Results are qualitatively similar.

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the absolute values of accruals are greater in proportion to earnings and operating cash

flows for bad news firms than for good news firms.

Insert Table 2

Table 2 gives Pearson and Spearman correlations among selected variables. In

Panel A, annual stock returns are positively associated with earnings and operating cash

flows but unassociated with accruals. Consistent with prior studies, operating cash flows

are negatively correlated with accruals. Panels B and C show that the correlations

between the variable R and the variables NI, ACC, and OCF are significant but very

small for good news firms, but are significant and much larger for bad news firms. This

pattern suggests that the high correlations between returns and earnings or operating cash

flows for the bad news firms are largely responsible for similarly high correlations in

Panel A for the full sample. Correlations between returns and accruals are positive for

bad news firms (0.077) but negative for good news firms (–0.028). This finding is

consistent with the idea that accruals enhance the recognition bad news in earnings but

tend to smooth earnings when there is good news. The stronger negative Pearson

correlation coefficient between operating cash flows and accruals in the good news

sample (–0.741) than in the bad news sample (–0.535) is also consistent with this idea.

Good (bad) news firms’ earnings are more highly correlated with operating cash flows

(accruals) than with accruals (operating cash flows).

V. RESEARCH DESIGN

As section III outlined, our measure of the timeliness with which earnings,

accruals, or cash flows reflect annual returns in a sample of firms in year t is the

coefficient β1t in the cross sectional regression . In this regression ititttit RX εββ ++= 10

19

model, Xit represents firm i’s earnings, accruals, or operating cash flows for the fiscal

year ending at time t, deflated by the market value of equity at the end of fiscal year t–1;

Rit represents firm i’s annual stock returns for the year ending three months after t. Our

conservatism measure is ct ≡ , where βGNt

BNt 11 ββ − 1t

BN (β1tGN) is the slope coefficient in the

regression of earnings, accruals, or operating cash flows on returns for bad (good) news

firms. That is, we measure earnings conservatism as the difference between the slope

coefficients for bad and good news firms. Prior studies use other conservatism measures:

Givoly and Hayn (2000) use the ratio of bad news slopes to good news slopes to measure

conservatism; Basu (1997) compares regression R2 for bad and good news firms to infer

conservatism.

We do not use R2 because both timeliness and dependent variable measurement

error affect R2. Absorbed in the regression disturbance term ( ), dependent variable

measurement error decreases R

itε

2 but does not affect slope coefficient estimation (Greene,

1990). We expect that earnings contain more measurement error for bad news firms

because, by definition, conservative accounting recognizes bad news to a greater degree

than good news. In cross section, if the same contingent liability affected a group of bad

news firms, the liability accrued would differ across firms because accountants would

differ in their judgment of whether the occurrence of the contingency was probable or

reasonably possible.10 However, if the same contingent asset affected a group of good

news firms, all firms would accrue nothing. In a reverse regression context, these two

effects counteract each other in R2: Increased timeliness increases the slope but the

10 See footnote 7.

20

measurement error associated with making timely accruals decreases R2. We therefore

focus on slope coefficients rather than R2.

We examine the difference between slope coefficients in sub-samples of bad and

good news firms rather than their ratio for three reasons:

1) Differences in sensitivities to good and bad news relate to the structure of accounting

standards, auditor behavior, and SEC enforcement. Under conservative accounting,

accountants write off more absolute dollars in response to bad news than good news.

They do not accrue “ten times more dollars” in response to bad news than good news.

That is, if an asset is impaired and worth zero dollars, accountants write off the whole

carrying value; if it is worth half its carrying value, they write off half the carrying

value, but they still write off the dollar amount of the impairment without referring to

how much good news they are recognizing in earnings.

2) Because we must partition the sample in many different ways to test our hypotheses,

ratios pose practical difficulties that did not affect prior studies: In some sub-samples,

slope coefficients are negative, so ratio measures are not meaningful. In other sub-

samples, slope coefficients are insignificantly different from zero. Any ratio measure

involving such measures would then be noise, but the difference between a significant

coefficient in one subsample and a coefficient that is insignificantly different from

zero in another subsample is still a significant difference.

3) Small, insignificant coefficients dramatically influence ratios of coefficients but not

differences between coefficients.

Insert Table 3

21

VI. HYPOTHESIS TESTS

H1a: Earnings are conservative in all periods examined.

Table 3 contains the results of annually regressing earnings on returns from 1970

to 2001 for good and bad news firms. It also reports mean coefficient estimates and mean

adjusted R2s. Consistent with Basu (1997), the sensitivity coefficient estimates are greater

for bad than good news firms (i.e., ) in all 32 periods. The mean of the 32

coefficient estimates is much higher for bad news firms than for good news firms. The

mean difference between the bad and good news coefficients is 0.279, with a highly

significant t-statistic of 12.5. These results strongly support H1

GNBN11 ββ >

a: Earnings are

conservative in all periods examined, i.e., earnings recognize bad news in a timelier

fashion than good news.

Insert Tables 4 and 5

H2a: Earnings conservatism is negatively associated with balance sheet conservatism

Table 4 gives descriptive statistics for key variables after allocating firm-year

observations to five portfolios based on the beginning-of-year P/B ratio. We allocate

firms with P/B ratios less than one to Portfolio I (16,226 observations) and Portfolio II

(16,227 observations). Similarly, we allocate to Portfolios III through V the remaining

firms with P/B ratios greater than or equal to one. Each of Portfolios III through V

contains about 29,200 firm-year observations. Because of this allocation procedure, each

portfolio contains good and bad news observations in different proportions: the

proportion of bad news firm-years tends to increase with the P/B ratio as one goes from

22

Portfolio I to V. However, within each portfolio, the average P/B ratios of good and bad

news observations are about the same.

Table 2 showed that good news firms are generally larger (as measured by total

market capitalization) than bad news firms; Table 4 shows that this is so for all five P/B

portfolios. Firm size also increases with the P/B ratio as one goes from Portfolio I to

Portfolio V. This implies that increases in P/B ratios are not due merely to low equity

book values.

In Table 5, for each of the five P/B portfolios, we estimate the sensitivities of

earnings, accruals, and cash flows to good and bad news. The regression coefficients

β1GN (β BN

1 ) reflect dependent variable sensitivities to good (bad) news in each of the five

portfolios. We measure earnings conservatism in each portfolio as the difference between

the sensitivities to bad and good news, , i = I, II…V. GN(i)1

BN(i)1 ββ −≡ic

Panel A estimates overall earnings conservatism in the five portfolios. As

hypothesized, earnings conservatism increases monotonically as the P/B ratio declines

through portfolios V (high P/B) to I (low P/B). Each increase is individually significant

except the increase occurring between portfolios II and I, both of which contain

observations with P/B less than one. For the portfolio I (V), the lowest (highest) P/B

portfolio, the earnings conservatism measure is 0.542 (0.152). The difference between the

conservatism measures in these extreme portfolios is 0.390 with a t-statistic of 7.92.

These results strongly support H2a: earnings conservatism is negatively associated with

P/B.

23

H3a: Accrual conservatism is negatively associated with balance sheet conservatism.

The dependent variables in Panels B and C are the accrual and cash flow

components of earnings. By construction, for a given sub-sample of firm-years, the slope

coefficient relating earnings to returns is the sum of the corresponding coefficient relating

operating cash flows to returns plus that relating accruals to returns. This breakdown

affords an assessment of the relative contribution of accruals and operating cash flows to

the overall relation between earnings and returns.

Reflecting the fact that conservatism is primarily an accrual accounting

phenomenon, H3a is that accrual conservatism is negatively associated with P/B.

Consistent with H3a, accrual conservatism increases monotonically as the P/B ratio

declines in P/B portfolios V through I. Each increase is individually significant except the

increase that occurs between portfolios III and II, the break point between observations

with P/B greater than or equal to one and P/B less than one. For portfolio I (V), the

lowest (highest) P/B portfolio, the accrual conservatism measure is 0.361 (0.020). The

difference between these measures is 0.341, with a t-statistic of 5.47. In portfolio V, the

highest P/B portfolio, the conservatism measure is insignificantly positive. Moreover, for

the good news firms, three of the five sensitivity coefficients β1GN(i), i = I, II,…V are

negative and none of the five is statistically significant. For the bad news firms, all of the

five sensitivity coefficients β1BN(i), i = I, II,…V are positive and all but the coefficient in

the highest P/B portfolio are statistically significant. This pattern accounts for the fact

that all of the conservatism measures, which are differences between the sensitivity

coefficients for bad and good news portfolios, are significant except the one in portfolio

24

V, the highest P/B portfolio. These results strongly support H3a: accrual conservatism is

negatively associated with P/B.

H40: Cash flow conservatism is not associated with balance sheet conservatism.

Panel C contains the regression results with operating cash flows as the dependent

variable. The conservatism measures, , i = I, II…V, are positive and

significant in all five portfolios. However, c

GN(i)1

BN(i)1 ββ −≡ic

is unrelated to P/B. None of the changes in cii

is statistically significant as one goes from portfolio V (highest P/B) through I (lowest

P/B). Indeed, the changes are not even consistently positive: cash flow conservatism

decreases along with a decrease in P/B as one goes from portfolio II to portfolio I. For

portfolio I (V), the lowest (highest) P/B portfolio, the cash flow conservatism measure is

0.180 (0.132). The difference between these measures is 0.048 with an insignificant t-

statistic of 1.04. These results do not reject H4o: cash flow conservatism is unrelated to

balance sheet conservatism.

The result that cash flow conservatism is positive (though unrelated to P/B)

simply means that operating cash flows are more sensitive to bad news than good news.

Inverting this result, one can argue that negative returns are less persistent with respect to

cash flows than positive returns are with respect to cash flows. Although this is not the

focus of the paper, we conjecture that the result is due to firms’ real option to abandon

operations when the projected net present value of staying in a particular line of business

is negative (Hayn 1995).

Insert Figure 1

25

Summary of hypothesis test results

Figure 1 summarizes the results of our hypothesis tests, plotting the conservatism

coefficients , i = I, II…V, in each P/B group, for overall earnings

(H2

GN(i)1

BN(i)1 ββ −≡ic

a), accruals (H3a), and operating cash flows (H40). The figure shows graphically why

the results fail to reject H40, but suggest that both overall earnings conservatism and

accrual conservatism are negatively associated with balance sheet conservatism. The

accrual component of earnings accounts for 87 percent (0.341/0.390 × 100) of the

difference in earnings conservatism between the low and high P/B portfolio; the cash

flow component of earnings accounts for only 13 percent of this difference.

Insert Table 6

Additional support for hypotheses

Table 6 contains 2 × 2 partitions of sample observations. Aiming to enhance the

interpretation of the hypothesis tests above, we allocate observations to the groups that

are most and least likely to display earnings conservatism, partitioning along two

dimensions—the level of accruals and the size of the P/B ratio. We expect that low-

accruals, low-P/B firms exhibit the most earnings conservatism and high-accruals high-

P/B firms the least, if any, earnings conservatism.

Results summarized in panels A (earnings), B (accruals), and C (cash flows)

largely confirm these expectations. Panel A reveals that c, the difference between the bad

news and good news slope coefficients with earnings as the dependent variable is greatest

(0.630 – 0.050 = 0. 580) when both P/B and accruals are low and is the least when both

are high (0.146 – 0.015 = 0.131). The difference between earnings conservatism in the

26

low P/B, low accrual portfolio and earnings conservatism in the high P/B, high accrual

portfolio is 0.449 (i.e., 0.580 – 0.131); this difference is highly significant, with a t-

statistic of 10.83.

Panels B and C reinforce the results from Table 5, that earnings conservatism

stems chiefly from the accrual component of earnings, not the cash flow component. In

Panel B, with accruals as the dependent variable, accrual conservatism for the low P/B,

low accrual firms is 0.331 (i.e., 0.278 – [–0.053]) versus – 0.048 (i.e., –0.024 –0.024) for

the high P/B, high accrual firms. The difference between accrual conservatism for the

low P/B, low accrual firms and accrual conservatism for the high P/B, high accrual firms

is 0.379 (i.e., 0.331 – [–00.048]); again this difference is highly significant, with a t-

statistic of 9.70.

In Panel C, with operating cash flows as the dependent variable, the conservatism

measure is more similar for the low P/B, low accrual firms (0.352 – 0.103 = 0.249) and

the high P/B, high accrual firms (.171 – [–0.008])=0.179) than it was in Panels A and B.

The difference in cash flow conservatism between the low P/B, low accrual firms and the

high P/B, high accrual firms is only 0.070 (i.e., 0.249 – 0.179). Although this difference

in conservatism between the low P/B, low accrual portfolio and the high P/B, high

accrual portfolio is small compared with the corresponding differences in Panels A and

B, the t-statistic of 2.47 is significant at conventional levels. Accruals account for 84

percent (i.e., 0.379/0.449 × 100) of the overall earnings conservatism difference between

these two extreme portfolios; cash flow conservatism accounts for only 16 percent (i.e.,

0.070/0.449 × 100) of the conservatism difference.

27

Summary of contribution

In summary, our results are consistent with Basu’s (1997) finding that earnings

are conservative, i.e., earnings are more strongly associated with returns for bad news

firms than for good news firms. However, we make two new contributions to the

literature. First, earnings conservatism is negatively associated with balance sheet

conservatism. Second, earnings conservatism’s negative association with P/B is primarily

an accrual phenomenon, not a cash flow phenomenon. These results are intuitively

appealing because accruals are the mechanism for implementing earnings conservatism.

We conjecture that the results have important implications for any time-series or cross-

sectional (across firms, industries or countries) examination of conservatism. In the next

section, we present some preliminary evidence confirming this conjecture.

VII. ASSESSING CHANGES IN EARNINGS CONSERVATISM OVER TIME:

GIVOLY AND HAYN REVISITED

Our main results imply that one must control for changes in balance sheet

conservatism in order to infer changes in earnings conservatism over time. To test this

conjecture, we extend Givoly and Hayn (2000) by estimating equation (1) below, which

has the same form as theirs, and equation (2) below, which incorporates P/B to capture

the effect of P/B on earnings conservatism:

(1) itititititit RDRDX εββββ +×+++= 3210

ititit

itititititit

RPBDRPB

PBDPBRDRDX

εββ

ββββββ

+××+×+

×++×+++=

)()(

)()(

76

543210 (2)

28

In these equations, Xit represents net income deflated by the beginning-of-year equity

market value; Rit is annual stock returns for the year ending three months after fiscal

period end; Dit is an indicator variable taking the value 1 (0) when annual stock returns

are negative (non-negative). PB is a dummy variable taking the value 1 (0) when P/B is

less than (greater than or equal to) one. Thus, the coefficient β3 is a measure of

conservatism for firms with P/B greater than or equal to one; β7 is a measure of the extra

conservatism exhibited by firms with P/B less than one.

Givoly and Hayn estimate equation (1) over five-year intervals from 1950-1988,

concluding that earnings conservatism increased over that period. They also report (in

their Figure 4) an initial decline in P/B, then an increase, which they attribute to

increasing earnings conservatism that accumulates to manifest itself in balance sheet

conservatism. However, they do not explore the link between the two results. Given

rising P/B ratios, all else being equal, we expect earnings conservatism to fall, not rise. Of

course, other factors influencing conservatism also changed over the period. For example,

an increase in litigiousness or an increase in the conservatism built into GAAP could also

account for an observed increase in overall earnings conservatism. The examination of

such factors is beyond the scope of both their paper and ours. Still, in not controlling for

P/B, we conjecture that Givoly and Hayn underestimate the full extent of the increase in

earnings conservatism over time. Since the proportion of firms with low P/B must have

declined over Givoly and Hayn’s sample period, there are two explanations for the

overall increase in earnings conservatism.

1) Timeliness of the recognition of bad news for the firms that did have low P/B ratios

increased dramatically.

29

2) Earnings conservatism for all firms, whatever the level of P/B, increased

dramatically.

The explanations are not mutually exclusive.

Insert Table 7 and Figure 2

Table 7 and Figure 2 present the results of estimating pooled regressions using the

constant sample of 788 firms that existed throughout our 1970-2001 test period.11 To

determine how earnings conservatism evolved for low and high P/B firms, we estimate

the two equations above for six sub-periods, each of which contains five years except the

first and last sub-periods, 1970-75 and 1996-2001, which contain six years. The main

results of this analysis are:

1) In equation (1), like Givoly and Hayn, we find that β3, representing the overall level

of earnings conservatism, generally increases until 1990. However, consistent with

Ryan and Zarowin (2003), we find that the overall level of earnings conservatism is

less in the 1996-2001 period than it is in the prior periods; it does not continue to

increase as the Givoly and Hayn pattern might suggest.12

2) In equation (2), β3, the coefficient on D × R representing conservatism for firms with

P/B greater than or equal to one, also increases until 1990 then declines. This pattern

is similar to the general pattern observed in equation (1).

3) In equation (2), for the full sample period and across each sub-period, β7, the

coefficient on D × PB × R representing the extra conservatism for firms with P/B less

11 We impose this restriction for comparability with the analysis in Givoly and Hayn. However, relaxing this constraint and estimating equations 1 and 2 using the full sample do not affect our inferences.

12 Ryan and Zarowin (2003) speculate that the recent decline in conservatism may be due to the passage of the Private Securities Litigation Reform Act of 1995.

30

than one, is highly significant and is generally two to three times larger than β3 in

either equation (1) or equation (2).

4) In equation (2) the coefficient β7 increases monotonically from the 1970-1975 to the

1991-1995 period; β7 increases more consistently with time than β3 in either equation

(1) or (2), which declines in one or two of the sub-periods.

In sum, the negative association between earnings conservatism and P/B accounts for a

very significant proportion of any changes in overall earnings conservatism observed in

the past three decades. The increase in the negative association between earnings

conservatism and P/B is also largely responsible for Givoly and Hayn’s finding that

earnings conservatism increased up to 1988 despite the fact that P/B ratios generally

increased.

VIII. TESTS FOR ROBUSTNESS AND EXAMINATION OF ALTERNATE EXPLANATIONS FOR RESULTS

We compute annual stock returns for the year ending three months after the fiscal

yearend in order to ensure that all accounting information is available before the

beginning of the return period. As an additional check, we repeat the tests using annual

stock returns calculated for the fiscal period. The results (not reported) are robust to the

choice of the return period.

Hribar and Collins (2002) note that using balance sheet data to calculate accruals

and cash flows introduces measurement error for firms involved in acquisitions or

divestitures. To ensure that our results are not sensitive to the use of balance sheet data to

calculate accruals, we repeat our tests using only post-1987 data obtained directly from

cash flow statements. The results are qualitatively similar.

31

Because we rely on market returns incorporating good and bad news, market

efficiency is a maintained assumption in this study. Fama and French (1992) report a

strong negative cross-sectional association between P/B and security returns, concluding

that it is unclear whether this association reflects rational pricing of risk related to P/B or

market mis-pricing.13 Even if the P/B effect of Fama and French represented mis-pricing,

however, it is likely that this would bias our tests against, not in favor of, finding the

hypothesized effects. Suppose that low P/B firms are systematically under-priced. When

the market later corrects this mis-pricing, triggering higher returns in subsequent periods,

security returns measure the news of the period with error for low P/B firms. This

measurement error would attenuate, not increase, the observed sensitivity of earnings to

returns for low P/B firms. Thus, we maintain that market inefficiency is not a viable

alternate explanation for our results.

IX. CONCLUSIONS, LIMITATIONS, AND FUTURE RESEARCH

Defining earnings conservatism as the degree to which a firm’s accounting

income reflects expected losses in a timelier fashion than expected gains in a given fiscal

year, and balance sheet conservatism as the firm’s market-to-book ratio at the beginning

of the year, we hypothesize and find: (1) Earnings conservatism is negatively related to

balance sheet conservatism. (2) The link between earnings and balance sheet

conservatism is primarily due to the accrual component of earnings, not the operating

cash flow component of earnings. Besides being consistent with the hypotheses, this

13 Fama and French (1993) express their findings in terms of a positive association between B/P (the book-to-market ratio) and later returns. This of course implies a negative association between P/B and later returns.

32

second finding confirms the intuition that accruals are the mechanism for instigating

earnings conservatism.

Since our hypotheses stem from Watts’ (2003) conservatism explanations, our

results are consistent with his explanations. Our results are also consistent with Watts’

contention that, because verifiability is management controlled, it is not effective to

attempt to specify conservative accounting biases a priori in contracts based on

accounting numbers. Rather, it is efficient for contractors to rely on the expectation that

accounting conservatism—the excess verifiability required to recognize gains versus

losses—will be greater in situations where managers have greater incentives to overstate

earnings. Since managers’ incentives to overstate earnings increase as the price-to-book

ratio decreases, our finding that earnings conservatism is negatively associated with the

price-to-book ratio is consistent with Watts’ contention. Mechanisms for increasing

conservatism in this context include additional scrutiny by the auditor and independent

members of the board of directors.

Both Watts’ contention and our findings are consistent with FASB Concepts

Statement No. 2’s description of conservatism as “a prudent reaction to uncertainty, to try

to ensure that uncertainties and risks inherent in business situations are adequately

considered” (FASB 1980, paragraph 95, emphasis added). Since a decline in the price-to-

book ratio is a change in a firm’s business situation that is likely to motivate

overstatements of earnings and net assets under uncertainty, increased conservatism is a

prudent reaction to such a change that enhances the usefulness of accounting information.

Consistency with Watts’ conceptual perspective and the FASB’s description of

33

conservatism in its Concepts Statement greatly enhances confidence in the interpretation

of our findings and their implications.

Our results indicate that incorporating the link between earnings conservatism and

balance sheet conservatism is essential if one uses earnings-returns associations to

investigate cross-sectional (e.g., across industries or across countries) or time-series

differences in earnings conservatism. To perform a preliminary test of this important

implication of our findings, we revisit a previous study that inferred changes in earnings

conservatism over time but did not incorporate our newly reported link in the research

design. We find that incorporating the market-to-book in the research design greatly

enhances the inferences from that prior study.

Future research could fruitfully build on our results by examining the effects of

recent accounting pronouncements that purport to enhance the degree of conservatism

embedded in generally accepted accounting principles. For example, the SEC recently

enforced more conservative revenue recognition rules. The FASB recently proposed more

conservative accounting for special purpose entities in both the income statement and the

balance sheet, and mandated impairment testing for goodwill triggered by market/book

comparisons. Because these institutional changes respond to demands for increased

earnings conservatism to counteract managerial opportunism, we expect that they not

only increased earnings conservatism generally, but also increased the negative

association between earnings conservatism (especially accrual conservatism) and balance

sheet conservatism.

Another potentially fertile extension of our results lies in incorporating the

market-to-book ratio in research testing the impact of changes in the degree of

34

litigiousness on earnings conservatism, and its negative association with balance sheet

conservatism, at decisive points such as the institution of class action suits in the U.S.

Future research could also compare earnings conservatism across countries with tests that

allow for cross-country variation in the relation between earnings conservatism and

balance sheet conservatism. We conjecture that variation across countries in the

institutional features that give rise to conservatism (such as legal systems, insider trading

regulations, and accounting standard setting mechanisms) also results in cross-country

variation in the association between earnings conservatism and balance sheet

conservatism.

35

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Watts, R.L. 1977. Corporate financial statements, a product of the market and political processes. Australian Journal of Management 2 (April): 53-75.

________. 1993. “A Proposal for Research on Conservatism.” Working Paper, University of Rochester, presented at the American Accounting Association convention, August.

________ . 2003. “Conservatism in Accounting: Explanations and Implications” Bradley Policy Research Center Financial Research and Policy Working Paper No. FR 02-21, University of Rochester, May. Forthcoming, Accounting Horizons.

________. and J.L. Zimmerman. 1979. The demand for and supply of accounting theories: The market for excuses. The Accounting Review 54 (April): 273-305.

________. 1986. Positive Accounting Theory, Prentice-Hall, Englewood Cliffs, NJ.

38

Table 1: Descriptive Statistics of Key Variables

Panel A: Full Sample – 119,983 observations

Variable Mean Standard Deviation

First Quartile Median Third

Quartile Min Max

R 0.12 0.58 -0.23 0.04 0.34 -0.97 8.39 NI 0.03 0.20 -0.01 0.06 0.11 -2.46 0.98

ACC -0.09 0.23 -0.14 -0.04 0.01 -3.61 1.17 OCF 0.11 0.23 0.00 0.09 0.20 -1.25 3.34 MV 1,114.29 7,322.57 16.92 69.47 358.05 0.06 467,096

Sales 1,045.27 4,917.51 25.35 104.07 447.47 -203.75 217,799 P/B 3.82 60.65 0.96 1.61 2.90 0.03 10,474

Panel B: Good News (non-negative returns) – 65,044 observations

Variable Mean Standard Deviation

First Quartile Median Third

Quartile Min Max

R 0.47 0.56 0.14 0.31 0.61 0.00 8.39 NI 0.07 0.17 0.04 0.08 0.14 -2.36 0.98

ACC -0.09 0.23 -0.14 -0.05 0.01 -3.22 1.17 OCF 0.16 0.24 0.04 0.13 0.24 -1.11 3.34 MV 1,417.60 8,338.03 25.68 108.49 542.50 0.06 467,096

Sales 1,265.43 5,440.95 36.05 139.89 595.05 -4.39 217,799 P/B 3.26 66.71 0.89 1.45 2.53 0.03 10,474

Panel C: Bad News (negative returns) – 54,939 observations

Variable Mean Standard Deviation

First Quartile Median Third

Quartile Min Max

R -0.30 0.22 -0.44 -0.26 -0.12 -0.97 0.00 NI -0.03 0.21 -0.07 0.03 0.07 -2.46 0.90

ACC -0.09 0.24 -0.13 -0.04 0.01 -3.61 1.07 OCF 0.06 0.20 -0.03 0.05 0.14 -1.25 2.83 MV 755.17 5,878.21 11.38 42.03 196.37 0.07 422,640

Sales 784.61 4,199.74 17.19 72.28 303.65 -203.75 195,805 P/B 4.49 52.58 1.06 1.83 3.39 0.03 6,620

R is annual stock returns for the year ending three months after fiscal period-end. NI is net income. ACC is accruals measured by the change in working capital (excluding cash) plus depreciation. OCF is cash flow from operation measured by net income minus ACC. If cash flow statement is available, OCF is obtained from cash flow statement and accruals are calculated as net income minus OCF. NI, ACC and OCF are deflated by the beginning market value of equity. MV is the market value of equity at fiscal year end. P/B is the ratio of the market value of equity to the book value of equity measured at the beginning of fiscal period. Sales are annual sales. Good (bad) news is represented by non-negative (negative) stock returns.

39

Table 2: Correlation Coefficients among Key Variables

Pearson (Spearman) correlation coefficients are above (below) the diagonal; p-values are in parentheses. Panel A: Full Sample (119,983 observations)

Variable R NI OCF ACC MV Sales P/B R 0.220 0.189 0.002 0.029 0.009 -0.008

(<0.01) (<0.01) (0.54) (<0.01) (<0.01) (<0.01)

NI 0.398 0.411 0.447 0.019 0.040 -0.010 (<0.01) (<0.01) (<0.01) (<0.01) (<0.01) (<0.01)

OCF 0.298 0.523 -0.632 -0.001 0.045 -0.021 (<0.01) (<0.01) (<0.01) (0.68) (<0.01) (<0.01)

ACC -0.021 0.176 -0.616 0.018 -0.010 0.012 (<0.01) (<0.01) (<0.01) (<0.01) (<0.01) (<0.01)

MV 0.208 0.141 0.137 0.036 0.624 0.005 (<0.01) (<0.01) (<0.01) (<0.01) (<0.01) (0.06)

Sales 0.148 0.288 0.326 -0.086 0.796 -0.003 (<0.01) (<0.01) (<0.01) (<0.01) (<0.01) (0.27)

P/B -0.160 -0.294 -0.395 0.293 0.298 -0.055 (<0.01) (<0.01) (<0.01) (<0.01) (<0.01) (<0.01)

Panel B: Good News (non-negative returns, 65,044 observations)

Variable R NI OCF ACC MV Sales P/B R -0.024 0.010 -0.028 -0.012 -0.060 0.004

(<0.01) (0.01) (<0.01) (<0.01) (<0.01) (0.29)

NI 0.089 0.426 0.292 -0.014 0.006 -0.011 (<0.01) (<0.01) (<0.01) (<0.01) (0.15) (<0.01)

OCF 0.033 0.503 -0.741 -0.025 0.021 -0.017 (<0.01) (<0.01) (<0.01) (<0.01) (<0.01) (<0.01)

ACC -0.011 0.074 -0.720 0.016 -0.018 0.010 (0.01) (<0.01) (<0.01) (<0.01) (<0.01) (0.01)

MV -0.054 -0.092 -0.009 0.013 0.642 0.005 (<0.01) (<0.01) (0.03) (<0.01) (<0.01) (0.25)

Sales -0.126 0.138 0.227 -0.111 0.813 -0.002 (<0.01) (<0.01) (<0.01) (<0.01) (<0.01) (0.55)

P/B 0.006 -0.384 -0.441 0.303 0.390 0.034 (0.12) (<0.01) (<0.01) (<0.01) (<0.01) (<0.01)

40

Panel C: Bad News (negative returns, 54,939 observations) Variable R NI OCF ACC MV Sales P/B

R 0.312 0.244 0.077 0.049 0.079 -0.027 (<0.01) (<0.01) (<0.01) (<0.01) (<0.01) (<0.01)

NI 0.399 0.333 0.618 0.038 0.058 -0.004 (<0.01) (<0.01) (<0.01) (<0.01) (<0.01) (0.33)

OCF 0.307 0.462 -0.535 0.016 0.062 -0.022 (<0.01) (<0.01) (<0.01) (<0.01) (<0.01) (<0.01)

ACC 0.031 0.349 -0.523 0.020 0.000 0.015 (<0.01) (<0.01) (<0.01) (<0.01) (1.00) (<0.01)

MV 0.231 0.262 0.191 0.082 0.584 0.009 (<0.01) (<0.01) (<0.01) (<0.01) (<0.01) (0.04)

Sales 0.237 0.359 0.368 -0.045 0.760 -0.003 (<0.01) (<0.01) (<0.01) (<0.01) (<0.01) (0.43)

P/B -0.215 -0.128 -0.302 0.279 0.274 -0.115 (<0.01) (<0.01) (<0.01) (<0.01) (<0.01) (<0.01)

R is annual stock returns for the year ending three months after fiscal period-end. NI is net income. ACC is accruals measured by the change in working capital (excluding cash) plus depreciation. OCF is cash flow from operation measured by net income minus ACC. If cash flow statement is available, OCF is obtained from cash flow statement and accruals are calculated as net income minus OCF. NI, ACC and OCF are deflated by the beginning market value of equity. MV is the market value of equity at fiscal year end. P/B is the ratio of the market value of equity to the book value of equity measured at the beginning of fiscal period. Sales are annual sales. Good (bad) news is represented by non-negative (negative) stock returns.

41

Table 3: The Relation between Earnings and Annual Stock Returns: Good News versus Bad News

Good News (GN) Bad News (BN)

Year Number

of obser-vations

β0 β1Adusted

R2

Number of

obser-vations

β0 β1Adusted

R2

GNBN11 ββ −

1970 825 0.055 0.023 0.015 594 0.043 0.116 0.059 0.093 1971 940 0.067 0.030 0.014 707 0.057 0.236 0.083 0.206 1972 527 0.081 -0.009 -0.001 1,221 0.093 0.130 0.081 0.139 1973 609 0.120 0.053 0.015 1,874 0.129 0.175 0.155 0.122 1974 1,020 0.163 0.099 0.023 1,909 0.170 0.255 0.082 0.156 1975 2,458 0.123 0.147 0.076 417 0.049 0.260 0.007 0.113 1976 1,791 0.168 0.115 0.074 866 0.159 0.385 0.093 0.270 1977 1,981 0.139 0.092 0.074 818 0.137 0.441 0.103 0.349 1978 2,149 0.156 0.066 0.035 634 0.138 0.264 0.034 0.198 1979 1,590 0.175 0.021 0.003 1,280 0.207 0.482 0.162 0.461 1980 2,552 0.118 0.033 0.017 479 0.036 0.227 0.016 0.194 1981 1,017 0.142 0.102 0.034 2,062 0.136 0.272 0.140 0.170 1982 2,581 0.058 0.021 0.009 733 -0.013 0.144 0.021 0.123 1983 1,939 0.078 0.003 0.000 1,434 0.058 0.296 0.072 0.293 1984 1,795 0.074 0.049 0.017 1,825 0.060 0.281 0.159 0.232 1985 2,279 0.043 0.035 0.008 1,374 0.025 0.439 0.120 0.404 1986 2,088 0.041 -0.001 0.000 1,532 0.011 0.350 0.090 0.351 1987 1,235 0.060 -0.020 0.001 2,621 0.075 0.309 0.146 0.329 1988 2,372 0.052 0.040 0.007 1,900 0.043 0.400 0.134 0.360 1989 2,099 0.051 0.021 0.002 2,057 0.055 0.441 0.141 0.420 1990 1,763 0.045 -0.012 0.000 2,429 0.064 0.408 0.125 0.420 1991 2,641 0.022 -0.004 0.000 1,556 0.027 0.694 0.110 0.698 1992 2,421 0.020 0.024 0.003 1,883 0.013 0.316 0.068 0.292 1993 2,542 0.027 0.009 0.000 2,064 0.025 0.277 0.071 0.268 1994 2,472 0.044 0.008 0.000 2,612 0.052 0.273 0.144 0.265 1995 3,598 0.050 -0.025 0.010 1,747 0.014 0.260 0.078 0.285 1996 2,956 0.051 0.004 0.000 2,606 0.036 0.268 0.128 0.264 1997 3,811 0.034 0.005 0.000 2,016 0.014 0.271 0.118 0.266 1998 1,499 0.034 -0.051 0.033 4,172 0.059 0.208 0.112 0.259 1999 2,954 0.024 -0.023 0.038 2,368 0.049 0.224 0.068 0.247 2000 1,977 0.058 0.007 0.000 3,132 0.055 0.233 0.123 0.226 2001 2,563 -0.003 -0.020 0.001 2,017 -0.036 0.417 0.079 0.437

Mean 0.074 0.026 0.016 0.064 0.305 0.098 0.279 (t-value) (8.50) (3.31) (6.49) (14.58) (12.50) Xit is net income deflated by the beginning market value of equity. Rit is annual stock returns for the year ending three months after fiscal period end. The sample is partitioned into the good and bad news sub samples depending on whether annual stock returns are positive or negative. and denote the coefficient estimates on annual stock returns on the good news (GN) and bad news (BN) sub samples, respectively.

GN1β

BN1β

42

Table 4: Descriptive Statistics of Key Variables: Portfolios Partitioned by the Beginning-of-Year Market-to-Book Ratio

Good News (Number of observations 65,044 ) Bad News (Number of observations 54,939)

Variable Mean First Quartile Median Third

Quartile Mean First Quartile Median Third

Quartile Portfolio I (low P/B): Number of observations 10,270 Number of observations 5,956

P/B 0.51 0.41 0.53 0.62 0.52 0.43 0.54 0.63 R 0.50 0.17 0.36 0.65 -0.24 -0.35 -0.20 -0.09 NI 0.11 0.04 0.16 0.26 -0.12 -0.26 0.01 0.13

ACC -0.23 -0.40 -0.17 -0.01 -0.27 -0.45 -0.20 -0.01 OCF 0.34 0.11 0.30 0.52 0.15 -0.04 0.14 0.33 MV 141.75 7.32 19.46 62.84 68.25 3.69 10.16 30.77

Portfolio II: Number of observations 9,765 Number of observations 6,462 P/B 0.85 0.78 0.85 0.93 0.85 0.78 0.86 0.93 R 0.44 0.14 0.30 0.57 -0.25 -0.36 -0.20 -0.10 NI 0.11 0.06 0.13 0.19 -0.03 -0.10 0.04 0.12

ACC -0.11 -0.21 -0.10 0.00 -0.14 -0.24 -0.10 0.01 OCF 0.22 0.09 0.21 0.33 0.10 -0.01 0.11 0.23 MV 454.49 17.92 55.45 214.38 218.25 7.57 22.97 78.07

Portfolio III: Number of observations 16,917 Number of observations 12,259 P/B 1.30 1.14 1.29 1.46 1.31 1.15 1.30 1.47 R 0.43 0.13 0.28 0.54 -0.26 -0.38 -0.22 -0.10 NI 0.09 0.06 0.10 0.14 -0.01 -0.06 0.04 0.09

ACC -0.07 -0.14 -0.07 0.00 -0.09 -0.16 -0.07 0.01 OCF 0.16 0.08 0.16 0.24 0.08 -0.01 0.09 0.17 MV 890.58 34.41 130.91 534.44 417.74 12.06 41.86 173.49

Portfolio IV: Number of observations 15,189 Number of observations 13,988 P/B 2.19 1.87 2.14 2.49 2.21 1.88 2.16 2.51 R 0.46 0.14 0.30 0.60 -0.29 -0.43 -0.25 -0.12 NI 0.06 0.05 0.08 0.10 0.00 -0.03 0.04 0.07

ACC -0.04 -0.09 -0.04 0.01 -0.05 -0.10 -0.04 0.01 OCF 0.10 0.05 0.10 0.16 0.05 -0.02 0.06 0.12 MV 1,686.24 57.11 226.92 926.16 717.20 16.52 65.44 293.96

Portfolio V (high P/B): Number of observations 12,909 Number of observations 16,274 P/B 11.11 3.55 4.57 6.81 11.75 3.71 5.00 8.09 R 0.55 0.15 0.35 0.71 -0.37 -0.55 -0.34 -0.17 NI 0.02 0.01 0.05 0.07 -0.03 -0.06 0.01 0.04

ACC -0.02 -0.05 -0.01 0.01 -0.03 -0.05 -0.01 0.01 OCF 0.05 0.00 0.05 0.10 0.00 -0.05 0.01 0.06 MV 3,537.63 59.93 280.38 1,308.91 1,507.00 18.04 70.57 346.05

R is annual stock returns for the year ending three months after fiscal period-end. NI is net income. ACC is accruals measured by the change in working capital (excluding cash) plus depreciation. OCF is cash flow from operation measured by net income minus ACC. If cash flow statement is available, OCF is obtained from cash flow statement and accruals are calculated as net income minus OCF. NI, ACC and OCF are deflated by the beginning market value of equity. MV is the market value of equity at fiscal year end. P/B is the ratio of the market value of equity to the book value of equity measured at the beginning of fiscal period. Good (bad) news is represented by non-negative (negative) stock returns. The sample is partitioned into five portfolios by the beginning market-to-book ratio (P/B). First, we partition the full sample into firms with P/B ratios less than one and others. Second, we partition the firms with P/B ratios less than one into two portfolios. Finally, we partition the remaining firms into three portfolios. Portfolio I includes firms with the lowest P/B ratios, and portfolio V includes firms with the highest P/B ratios.

43

Table 5: Market-to-Book Ratios and the Relation between Earnings, Components of Earnings and Returns

it itttit RX εββ ++= 10

Xit is net income, accruals or operating cash flows deflated by the beginning market value of equity. Rit is annual stock returns for the year ending three months after fiscal period end. The sample is partitioned into the good and bad news sub samples depending on whether annual stock returns are positive or negative. The sample is partitioned into five portfolios by the market-to-book ratio (P/B), which is the ratio of the market value of equity to the book value of equity measured at the beginning of fiscal period. First, we partition the full sample into firms with P/B ratios less than one and others. Second, we partition the firms with P/B ratios less than one into two portfolios. Finally, we partition the remaining firms into three portfolios. Portfolio I includes firms with the lowest P/B ratios, and portfolio V includes firms with the highest P/B ratios. and denote the coefficient estimates on annual stock returns on the good news (GN) and bad news (BN) sub samples, respectively.

GN1β

BN1β

Panel A: Earnings as Dependent Variable

Good News (GN) Bad News (BN) P/B

β0 β1 Adj. R2 β0 β1 Adj. R2

GNBN11 ββ −

Increase over next highest P/B portfolio

I 0.029 0.062 0.023 0.009 0.604 0.127 0.542 0.060 (low) (1.50) (4.56) (0.44) (10.82) (9.87) (1.67)

II 0.081 0.042 0.034 0.086 0.524 0.171 0.482 0.135 (7.80) (3.80) (6.77) (13.11) (11.69) (4.85)

III 0.085 0.024 0.016 0.090 0.371 0.152 0.347 0.114 (11.88) (4.82) (11.89) (12.59) (11.45) (6.50)

IV 0.068 0.019 0.029 0.079 0.252 0.132 0.233 0.081 (18.19) (2.55) (14.87) (15.98) (11.82) (5.12)

V 0.038 0.006 0.015 0.041 0.158 0.077 0.152

Mean of Annual

regressions (t-value)

(high) (9.58) (1.04) (9.23) (14.12) (10.83) 0.056 0.446 0.390 P/B(V)

1P/B(I)

1 ββ − (4.66) (8.67) (7.92)

Panel B: Accruals as Dependent Variable

Good News (GN) Bad News (BN) P/B

β0 β1 Adj. R2 β0 β1 Adj. R2

GNBN11 ββ −

Increase over next highest P/B portfolio

I -0.196 -0.013 0.000 -0.187 0.348 0.033 0.361 0.113 (low) (-12.62) (-1.06) (-10.21) (5.52) (5.53) (2.16)

II -0.103 -0.015 0.004 -0.085 0.233 0.034 0.248 0.084 (-13.00) (-1.63) (-8.72) (5.46) (5.64) (1.80)

III -0.071 0.003 0.002 -0.046 0.167 0.029 0.164 0.083 (-11.73) (0.56) (-8.36) (4.32) (4.39) (2.96)

IV -0.033 -0.004 0.006 -0.022 0.077 0.013 0.081 0.061 (-7.67) (-0.57) (-4.90) (4.83) (4.45) (3.01)

V -0.018 0.005 0.004 -0.009 0.025 0.007 0.020

Mean of Annual

regressions (t-value)

(high) (-5.83) (1.00) (-2.82) (1.86) (1.31) -0.018 0.323 0.341 P/B(V)

1P/B(I)

1 ββ − (-1.53) (5.35) (5.47)

44

Panel C: Operating Cash Flows as Dependent Variable Good News (GN) Bad News (BN)

P/B β0 β1 Adj. R2 β0 β1 Adj. R2

GNBN11 ββ −

Increase over next highest P/B portfolio

I 0.224 0.075 0.018 0.196 0.255 0.024 0.180 -0.055 (low) (16.23) (3.68) (13.75) (5.20) (3.74) (-1.20)

II 0.184 0.057 0.011 0.171 0.292 0.047 0.235 0.052 (24.36) (4.96) (22.69) (12.52) (8.99) (1.29)

III 0.155 0.021 0.005 0.136 0.204 0.054 0.183 0.031 (27.92) (3.06) (21.64) (6.14) (5.38) (1.17)

IV 0.101 0.023 0.019 0.101 0.175 0.062 0.152 0.020 (28.18) (1.92) (26.60) (13.68) (8.31) (0.81)

V 0.056 0.001 0.012 0.050 0.133 0.050 0.132

Mean of Annual

regressions (t-value)

(high) (13.05) (0.13) (10.58) (10.14) (7.50) 0.074 0.122 0.048 P/B(V)

1P/B(I)

1 ββ − (3.98) (2.66) (1.04)

45

Table 6: The Relation between Earnings, Components of Earnings and Returns: Market-to-Book Ratios and Levels of Accruals

it itttit RX εββ ++= 10

Xit is net income, accruals or operating cash flows deflated by the beginning market value of equity. Rit is annual stock returns for the year ending three months after fiscal yearend. The sample is partitioned into the good and bad news sub samples depending on whether annual stock returns are positive or negative. Next, the sample is partitioned into five portfolios by the market-to-book ratio (P/B), which is the ratio of the market value of equity to the book value of equity measured at the beginning of fiscal period. First, we partition the full sample into firms with P/B ratios less than one and others. Second, we partition the firms with P/B ratios less than one into two portfolios. Finally, we partition the remaining firms into three portfolios. Portfolio I includes firms with the lowest P/B ratios, and portfolio V includes firms with the highest P/B ratios. The sample is further partitioned into quintiles each year by the levels of (signed) accruals. Portfolios I and II are grouped together, and portfolios III, IV, and IV are grouped together. We estimate the above regression for these four P/B ratios and levels of accruals portfolios, each year separately for the good and bad news samples, and report the means of the coefficient estimates on annual stock returns. T-values are reported in parentheses. and denote the coefficient estimates on annual stock returns for the good news (GN) and bad news (BN) sub-samples, respectively.

GN1β

BN1β

Panel A: Earnings as Dependent Variable

Good News ( ) GN1β Bad News ( ) BN

1β ACC ACC

P/B [I, II] [III,IV,V] P/B (I, II) (III,IV,V)

[I, II] 0.050 (3.71)

0.059 (6.23)

[I, II] 0.630 (13.50)

0.293 (11.11)

[III,IV,V] 0.008 (0.86)

0.015 (3.15)

[III,IV,V] 0.395 (17.31)

0.146 (17.99)

Difference (c = ) GNBN

11 ββ −

ACC

P/B [I, II] [III,IV,V]

[I, II] 0.580 (12.58)

0.234 (8.49)

[III,IV,V] 0.387 (15.56)

0.131 (12.55)

Difference in c between P/B & ACC [I, II] and P/B & ACC [III, IV, V] is 0.449 (t = 10.83)

46

Panel B: Accruals as Dependent Variable

Good News( ) GN1β Bad News ( ) BN

1β ACC ACC

P/B [I, II] [III,IV,V] P/B [I, II] [III,IV,V]

[I, II] -0.053 (-5.64)

0.048 (6.19)

[I, II] 0.278 (7.42)

-0.064 (-3.18)

[III,IV,V] -0.025 (-4.44)

0.024 (7.47)

[III,IV,V] 0.166 (4.67)

-0.024 (-2.93)

Difference (c = ) GNBN

11 ββ −

ACC

P/B [I, II] [III,IV,V]

[I, II] 0.331 (8.58)

-0.112 (-5.40)

[III,IV,V] 0.191 (5.23)

-0.048 (-5.10)

Difference in c between P/B & ACC [I, II] and P/B & ACC [III, IV, V]is 0.379 (t = 9.70)

Panel C: Operating Cash Flows as Dependent Variable

Good News ( ) GN1β Bad News ( ) BN

1β ACC ACC

P/B [I, II] [III,IV,V] P/B [I, II] [III,IV,V]

[I, II] 0.103 (5.61)

0.011 (1.07)

[I, II] 0.352 (11.82)

0.357 (11.80)

[III,IV,V] 0.033 (3.00)

-0.008 (-1.79)

[III,IV,V] 0.229 (6.46)

0.171 (18.46)

Difference (c = ) GNBN

11 ββ −

ACC

P/B [I, II] [III,IV,V]

[I, II] 0.249 (8.76)

0.346 (11.57)

[III,IV,V] 0.196 (4.61)

0.179 (17.19)

Difference in c between P/B & ACC [I, II] and P/B & ACC [III, IV, V] is 0.070 (t = 2.47)

47

Table 7: Market-to-Book Ratios and the Relation between Earnings and Returns: Pooled Estimation Within Sub-periods: Constant Sample of 788 Firms

itititititit RDRDX εββββ +×+++= 3210 (1)

ititit

itititititit

RPBDRPB

PBDPBRDRDX

εββ

ββββββ

+××+×+

×++×+++=

)()(

)()(

76

543210 (2)

Xit is net income deflated by the beginning market value of equity. Rit is annual stock returns for the year ending three months after fiscal period end. Dit is a dummy variable taking on 1 (0) when annual stock returns are negative (positive). PB is a dummy variable taking on 1 (0) when the market-to-book ratio, which is the ratio of the market value of equity to the book value of equity measured at the beginning of fiscal period, is less (greater) than 1. The analysis is restricted to a sample of 788 firms that exist over the sample period 1970 to 2001. T-value is reported in parentheses.

Time Period (number of

observations)

Equation β0 β1 β2 β3 β4 β5 β6 β7

Adjusted R2

All Years 1 0.086 0.008 0.049 0.221 0.093 (20,758) (51.86) (2.63) (14.49) (21.92)

2 0.077 0.006 0.026 0.149 0.039 0.012 0.040 0.395 0.134 (39.07) (1.61) (6.10) (13.12) (11.23) (1.87) (5.86) (17.05)

1970 – 1975 1 0.093 0.016 0.122 0.026 0.123 (3,108) (20.75) (2.27) (13.10) (1.26)

2 0.076 0.010 0.035 0.050 0.053 0.016 0.122 0.107 0.214 (13.17) (1.22) (2.57) (2.02) (6.23) (1.15) (6.82) (2.40)

1976 – 1980 1 0.153 0.000 0.051 0.260 0.094 (3,368) (44.87) (-0.01) (7.75) (7.50)

2 0.129 -0.011 0.021 0.138 0.045 0.032 0.057 0.286 0.161 (26.65) (-1.15) (2.30) (3.11) (6.76) (2.30) (4.56) (4.24)

1981 – 1985 1 0.101 -0.006 0.030 0.232 0.081 (3,388) (23.65) (-0.72) (3.93) (8.15)

2 0.095 -0.007 0.020 0.142 0.017 0.008 0.018 0.373 0.104 (16.49) (-0.69) (1.81) (4.16) (1.97) (0.47) (1.21) (6.07)

1986 – 1990 1 0.073 0.028 0.040 0.414 0.165 (3,359) (17.49) (4.04) (3.44) (16.31)

2 0.078 0.021 0.032 0.304 -0.037 0.017 0.047 0.409 0.223 (17.74) (2.86) (2.49) (10.93) (-3.34) (0.97) (1.78) (6.93)

1991 – 1995 1 0.043 0.023 0.049 0.404 0.102 (3,404) (10.65) (2.96) (5.21) (12.33)

2 0.055 0.008 0.032 0.230 -0.070 0.050 0.082 0.656 0.183 (12.79) (1.04) (3.04) (6.48) (-6.81) (2.59) (4.04) (8.66)

1996 – 2001 1 0.060 0.014 0.006 0.225 0.078 (4,126) (17.88) (2.31) (0.89) (13.35)

2 0.063 0.014 0.008 0.167 -0.028 -0.018 0.001 0.325 0.140 (17.58) (2.26) (1.12) (9.35) (-3.11) (-1.05) (0.08) (7.19)

48

Figure 1: Conservatism Measures for Earnings, Accruals, and Operating

Cash Flows for Firms Grouped in Order of Increasing Market-to-Book

0.000

0.100

0.200

0.300

0.400

0.500

0.600

I II III IV VMarket to Book Group

Con

serv

atis

m

Market to book less than 1

OperatingCash Flows

Accruals

Earnings

Market to book greater than 1

Mean and median market to book ratios (see Table 4) increase in groups I through V.

49

Figure 2 - Conservatism Measures with and without P/B Controls

0.000

0.100

0.200

0.300

0.400

0.500

0.600

0.700

70-75 76-80 81-85 86-90 91-95 96-2001

Time Period

Bet

a Va

lues

GHβ3

β3

β7

GH β3 is Givoly and Hayn’s (2000) conservatism measure. In Table 7, this is the

coefficient β3 in equation (1). β3: From Table 7, this is the coefficient β3 in equation (2). β7: From Table 7, this is the coefficient β7 in equation (2).