Accounting Conservatism, the Quality of Earnings, and Stock Returns

2002 ◽  
Vol 77 (2) ◽  
pp. 237-264 ◽  
Author(s):  
Stephen H. Penman ◽  
Xiao-Jun Zhang
Keyword(s):  
Stock Returns ◽  
Joint Effect ◽  
Accounting Conservatism ◽  
Future Earnings ◽  
Diagnostic Measures ◽  
Conservative Accounting ◽  
Future Return ◽  
Net Operating Assets ◽  
Reported Earnings

When a firm practices conservative accounting, changes in the amount of its investments can affect the quality of its earnings. Growth in investment reduces reported earnings and creates reserves. Reducing investment releases those reserves, increasing earnings. If the change in investment is temporary, then current earnings is temporarily depressed or inflated, and thus is not a good indicator of future earnings. This study develops diagnostic measures of this joint effect of investment and conservative accounting. We find that these measures forecast differences in future return on net operating assets relative to current return on net operating assets. Moreover, these measures also forecast stock returns—indicating that investors do not appreciate how conservatism and changes in investment combine to raise questions about the quality of reported earnings.

scholarly journals Is Egyptian corporate financial reporting becoming more conservative?

2017 ◽  
Vol 15 (3) ◽  
pp. 333-346 ◽  
Author(s):  
Ahmed H. Ahmed ◽  
Khaled Hussainey
Keyword(s):  
Financial Reporting ◽  
Accounting Conservatism ◽  
Firm Characteristics ◽  
Content Type ◽  
Conservative Accounting ◽  
Quality Of Accounting Information ◽  
Prior Literature ◽  
Second Period ◽  
Practical Implications

Purpose The study aims to compare the level of accounting conservatism amongst the sample companies prior to the 2011 uprising and after that uprising. The study proceeds further to examine the association between accounting conservatism and the level of leverage and profitability of the sample companies covering the same period. Design/methodology/approach First, a review of the extant literature on accounting conservatism is undertaken. Second, the sample comprises all the non-financial companies listed on the Egyptian Exchange. Accounting conservatism is measured using the market-to-book (MTB) ratio, which is one of the most widely used proxies for determining the extent of accounting conservatism in prior literature. The two-sample t-test has been used to compare the level of accounting conservatism six years prior to the 2011 uprising and four years following that uprising. Univariate and multivariate analyses have been used to examine the association between some firm characteristics and the level of accounting conservatism amongst the sample companies at the two investigated periods. Findings The evidence implies that the sample companies are actually engaging in less-conservative accounting policies following the uprising. The results also reveal that data for the first period seems to have greater variations in the first period than in the second period, as can be seen from the values of the standard deviation. The multivariate analysis reported a significant positive relationship between only size and the level of accounting conservatism at both periods. Research limitations/implications This study adds Egyptian evidence with respect to the directions of accounting conservatism throughout crisis periods, as the majority of prior studies focus on countries with developed capital markets. In addition, the absence of any specific evidence concerning the direction of accounting conservatism during crisis periods will lead to naïve investors misinterpreting earnings figures and not realising the actual value of their shares. Practical implications The results reported in this study may encourage those investors to seek out extensive, widely-sourced information regarding investee firms before deciding whether to hold or sell their holdings. Furthermore, the results presented in this paper should therefore be of interest to regulators and standard-setters charged with developing accounting standards to improve the quality of accounting information. Originality/value To the best of authors’ knowledge, this is the first and most recent study that examines the level of accounting conservatism amongst non-financial companies in a developing country like Egypt.

scholarly journals Accounting Conservatism, Changes In Real Investment, And Analysts Earnings Forecasts

2015 ◽  
Vol 31 (2) ◽  
pp. 727-742
Author(s):  
Kyong Soo Choi ◽  
Se Joong Lee ◽  
Soo Yeon Park ◽  
Yong Keun Yoo
Keyword(s):  
Market Efficiency ◽  
Earnings Quality ◽  
Earnings Forecasts ◽  
Accounting Conservatism ◽  
Real Activity ◽  
Joint Effects ◽  
Future Earnings ◽  
Earnings Expectation ◽  
Real Investment

This study examines whether sell-side analysts fully incorporate into their earnings forecasts the joint effects between accounting conservatism and changes in real investment on the quality of current earnings. Our results indicate that sell-side analysts do not fully incorporate such effects when they forecast future earnings so that they overestimate (underestimate) future earnings when current earnings are inflated (depressed) by those effects. Thus, we conclude that sell-side analysts do not recognize fully the joint effects between accounting conservatism and real activity on the earnings quality and that they need to mitigate their bias to enhance market efficiency by providing investors with a good benchmark for their earnings expectation.

Reported Earnings Quality Under Conservative Accounting and Auditing

2005 ◽  
Vol 20 (3) ◽  
pp. 229-256 ◽  
Author(s):  
Pradyot K. Sen
Keyword(s):  
Firm Value ◽  
Informational Efficiency ◽  
High Quality ◽  
Cost Estimates ◽  
Future Earnings ◽  
Current Period ◽  
Conservative Accounting ◽  
Reported Earnings ◽  
Investment Firm ◽  
Investment Growth

While conservatism may lead to a reduction of the current period's income, a consistent use of conservative accounting builds a hidden reserve that can inflate future earnings when investment growth slows down. For the same reason, reported earnings may be of a lower quality in terms of predictability of future cash flow when investments are growing. Managers of a growing firm, therefore, must choose to report a conservative but lower quality number or to undo the effects of conservatism by less conservative current-period cost estimates to improve the quality of reported earnings. Such departure from conservatism in the current period may lead to a conflict with the auditor, which may affect firm value as well as the manager's own wealth. Managers of a steady-state investment firm, on the other hand, have an opportunity either to report conservative and high quality earnings or to slow down its investments and/or choose less conservative current period cost estimates to report higher earnings in order to effectively mimic the (high quality) report of the growing firm. In this environment, an increase in auditor's conservatism may improve the informational efficiency of the market by reducing the incentives of the nongrowing firms to mimic a growing firm's disclosure. An increase in incentives that are based on firm value tends to increase a growing firm manager's propensity to report higher quality earnings while increasing the nongrowing firm's manager's propensity to cut back investment. Thus, we are faced with a situation where improving incentives for reporting higher quality earnings may be associated with an incentive to reduce investments by some firms.

Timeliness and persistence of conservative earnings in an emerging market

2020 ◽  
Vol 18 (3) ◽  
pp. 483-503
Author(s):  
Afsheena P. ◽  
Shijin Santhakumar
Keyword(s):  
Stock Returns ◽  
Financial Reporting ◽  
Emerging Market ◽  
Accounting Information ◽  
Accounting Conservatism ◽  
Earnings Persistence ◽  
Content Type ◽  
Ex Post ◽  
Ex Ante ◽  
Reported Earnings

Purpose The asymmetric effect of conservatism on earnings and its other components serves as a contrivance to incorporate transparency and timeliness in financial reporting. This study aims to explore cash flow-return association, which provides insight into the accruals’ contribution that traverses through conservatism-earnings persistence liaison and its associated effects on stock returns. Design/methodology/approach The study used asymmetric timeliness (AT) model and two firm-year measures, namely, C-Score and conservatism ratio, to capture conservatism. The firm-year measures of conservatism, in addition to the AT measure, facilitate a better understanding of the persistence of reported earnings that branch out the study from the existing literature. Further, the study used panel regression analysis to evaluate the timeliness and persistence of earnings under the conservative approach with a sample of Indian corporate data from 2000 to 2017. Findings The findings of the study reveal that conservative earnings are less persistent and the accruals recognize bad news timelier than good news. The unfavorable change in earnings shows a lower earnings response coefficient in contrast to favorable earnings variations. However, the appropriate loss recognition nature of conservative reporting has little or no influence on stock returns in an emerging market such as India. Research limitations/implications Accounting conservatism is a captivating feature accounting information, especially pertinent to many decision-makers. Thus, the study has implications for the investors while evaluating the adverse and positive changes in accounting earnings; also, the results are helpful for the standard setters in ongoing debate related to accounting conservatism vs fair evaluation. The present study focuses exclusively on ex-post conservatism, while the ex post and ex ante conservatism are having a significant role in accounting practices. Future research on the differential effects of ex post and ex ante conservatism on accounting information in an emerging market, is worth promising. Originality/value The study reveals the first Indian evidence on accounting conservatism and earnings persistence relationship, which would bring a different dimension to investors’ perception in evaluating the characteristic variations of reported earnings. The findings add value to the accounting standard setters concerning the asymmetric verification as Indian Accounting standards are on the verge of convergence with International Financial Reporting Standards (IFRS).

scholarly journals The Effect Of Accounting Conservatism And Life-Cycle Stages On Firm Valuation

2011 ◽  
Vol 22 (3) ◽  
Author(s):  
Yonpae Park ◽  
Kung H. Chen
Keyword(s):  
Life Cycle ◽  
Value Relevance ◽  
Accounting Information ◽  
Life Cycle Stage ◽  
Joint Effect ◽  
Accounting Conservatism ◽  
Valuation Model ◽  
Conservative Accounting ◽  
Life Cycle Stages ◽  
Corporate Life Cycle

<p class="MsoNormal" style="text-justify: inter-ideograph; text-align: justify; margin: 0in 34.2pt 0pt 0.5in;"><span style="font-size: 10pt;"><span style="font-family: Times New Roman;">This paper investigates how accounting conservatism affects the value-relevance of accounting information under different economic attributes. A firm&rsquo;s value is driven by the underlying economics, such as its production function, investment opportunity set, and risk. The corporate life-cycle stage can capture general differences in these underlying economics. From the perspective of the Feltham and Ohlson (1995)&rsquo;s valuation model, this suggests that firms in different life-cycle stages have different financial characteristics that affect the value-relevance of the accounting information. Their valuation model depicts theoretically that, under conservative accounting, the expected growth in net operating assets affects a firm&rsquo;s market valuation. This paper predicts that the pricing multiples of the value components of the valuation model will differ in different corporate life-cycle stages and accounting conservatism will have a joint effect with the life-cycle stage on the value-relevance of accounting information. This study conducts its hypothesis tests using comprehensive proxies such as conservatism estimates from the valuation model and corporate life-cycle stages.<span style="mso-spacerun: yes;">&nbsp; </span>These enable this study to examine the overall effects of accounting information, accounting conservatism as well as economic attributes on firm value. According to those comprehensive proxies, sample firms are classified into two conservatism groups, and three life-cycle stages. The results of this study provide evidence that accounting conservatism has a joint effect with the life-cycle stage on the value-relevance of accounting information.<span style="mso-spacerun: yes;">&nbsp; </span></span></span></p>

scholarly journals The Correlation Between Accounting Conservatism and the Efficiency of Investment Decisions in View of Managerial Ownership: A Field Study of Jordanian Environment

2018 ◽  
pp. 1-26
Author(s):  
Muayad Mohammed Ali Al-fadhel ◽  
Keyword(s):  
Practical Implication ◽  
Investment Decisions ◽  
Accounting Conservatism ◽  
Managerial Ownership ◽  
Investment Efficiency ◽  
Financial Reports ◽  
Asymmetry Of Information ◽  
Conservative Accounting ◽  
The Difference

The study aims to examine the correlation between accounting conservatism and the efficiency of investment decisions in view of managerial ownership variance which is regarded as one of the main principles of determining investment decisions efficiency. Methodology: A model was designed based on the consideration that accounting conservatism represents the independent variable, while the investment decisions efficiency represents the dependent variable. The research measured the accounting conservatism in the companies of the sample by using Basu scale (1997); while using Biddle et. al. (2009) model to measure the dependent variable. To achieve the objective of the study, the study tested the hypothesis by implementing the designed model but with different levels of managerial ownership on a sample of 87 Jordanian companies from 2013 to 2017. Results: The results of the study supported its hypothesis; as it showed the existence of different correlations between accounting conservatism and investment efficiency decisions according to the difference in the ratio of managerial ownership. Practical implication: It was revealed that the majority of the Jordanian companies don’t implement conservative accounting policies. This has led to the prevalence of the phenomenon of asymmetry of information and consequently, inefficiency of investment decisions. The results also revealed that in conservative companies, the efficiency of investment decisions depended on the level of marginal conservatism, which differs from one managerial ownership level to another. Scientific authenticity: The significance of the study lies in refuting the concept that the benefit of the accounting conservative in improving the quality of financial reports, the efficiency of investment decisions as well as reducing agency problems; is absolute and is not affected by the management benefit. Moreover, the study proposes what the research named as ‘The Marginal Level of Conservative Benefit’, which resulted as a consequence of the correlation between conservatism and managers’ motivation.

scholarly journals The quality of reported earnings and the monitoring role of the board: Evidence from small and medium companies

2019 ◽  
Vol 19 ◽  
pp. 52-73
Author(s):  
A Smith
Keyword(s):  
South African ◽  
Financial Reporting ◽  
Earnings Quality ◽  
Executive Directors ◽  
Corporate Boards ◽  
Asymmetric Timeliness ◽  
Conservative Accounting ◽  
Reported Earnings

The purpose of this paper is to investigate whether corporate governance initiatives in South Africa that relate to the monitoring ability of the non-executive directors on the board of small and medium companies have improved earnings quality by adopting conservative accounting practices. The sample construct includes the 2008 – 2011 reporting periods of South African companies listed on the Alternative Exchange (AltX). A reverse regression of earnings on returns was used to examine the market-based attributes of earnings quality, i.e. conservatism and the timeliness of earnings. No evidence was found that the boards of small and medium-sized companies are inclined to adopt conservative accounting practices that will result in the asymmetric timeliness of earnings. There is also no evidence that the quality of reported earnings improved as a result of the monitoring ability of the board with reference to the representation of non-executive directors on the board. The findings can be of interest to investors, managers and regulators as the efficiency of corporate boards and the transparency of financial reporting have implications for all of them.

Accounting Conservatism, Earnings Persistence, and Pricing Multiples on Earnings

2013 ◽  
Vol 28 (2) ◽  
pp. 233-260 ◽  
Author(s):  
Lucy Huajing Chen ◽  
David M. Folsom ◽  
Wonsun Paek ◽  
Heibatollah Sami
Keyword(s):  
Accounting Conservatism ◽  
Earnings Persistence ◽  
Conservative Accounting ◽  
Reported Earnings ◽  
Jel Classifications

SYNOPSIS We examine the effect of accounting conservatism on earnings persistence and the stock market's valuation of earnings. Using a sample of U.S. companies during the period of 1988–2010, we find that firms with more conservative accounting generate less persistent earnings than firms with less conservative accounting. We also document that the pricing multiple on more conservative earnings is smaller than pricing multiples on less conservative earnings. Finally, we show that conditionally conservative earnings are less persistent than unconditionally conservative earnings, and the pricing multiple on earnings is smaller for conditionally conservative earnings than for unconditionally conservative earnings. Our results improve our understanding of the characteristics of conservatively reported earnings. JEL Classifications: M41; C23; D21; G38; N20

METHODS ASSESSMENT QUALITY OF ACCOUNTING REPORTING AND MODELS OF THEIR MEASUREMENT

2020 ◽  
Vol 3 (3) ◽  
pp. 95-99
Author(s):  
E. H. ABU ◽  
Keyword(s):  
Internal Control ◽  
Stock Prices ◽  
Control Method ◽  
Financial Statements ◽  
Accounting Conservatism ◽  
Standardized Assessment ◽  
Accrual Quality ◽  
Indirect Measures

The article explores individual approaches used to measure and evaluate the quality of financial state-ments: standardized assessment, accrual-based models (accrual quality), Beneise models (M-Score), in-dexes - the internal control method and the degree of accounting conservatism. The reason for the great dependence on the use of indirect measures (proxies for the quality of financial statements or stock prices) is that some of the qualities of financial statements are unobservable.

Sign in / Sign up

Export Citation Format

Share Document