thesis.eur.nl merinda_3… · web viewthesis.eur.nl

ERASMUS UNIVERSITY ROTTERDAM

Erasmus School of Economics

Department of Business Economics

Section: Accounting, Auditing and Control

The Persistence, Conservatism and Value Relevance of Earnings throughout the Business Cycle

Master Thesis

2011/2012

MASTER THESIS ACCOUNTING, AUDITING & CONTROL

Date 19-07-2012

Student Bebi Merinda 326348

Supervisor Drs. Rob van der Wal RA

Co-reader Dr. Lil Dai

69

AbstractThis thesis explores the behavior of earnings persistence, earnings conservatism and value

relevance of earnings throughout the business cycle. The main thought of this thesis is that the

fluctuations in macroeconomic situations have influences on the accounting information

particularly earnings and on the response of the investors as the users of financial statements.

The findings demonstrate that earnings persistence is higher in expansions relative to

contractions whereas earnings conservatism is lower during expansion periods than during

contraction periods. Due to higher earnings persistence and lower conservatism, earnings appear

to be more useful for the investors in expansion periods than in contraction periods. This can be

indicated from higher value relevance of current and future earnings during expansion periods

than contraction periods. Further this thesis reconciles the mixed results between Johnson (1999)

and Jenkins et al. (2009) concerning the value relevance of earnings. Value relevance of current

and future earnings is higher in expansion periods when earnings are more persistent and less

conservative.

Key words: persistence, conservatism, value relevance, business cycle

2

Acknowledgements

This thesis is written as a final paper to conclude the master’s program Accounting, Auditing and

Control at the Erasmus University Rotterdam. I have done an empirical research in the field of

market-based accounting research. Before starting with the introduction, I would like to express

my gratitude to certain people.

First, I would like to thank my thesis supervisor at the faculty Erasmus School of Economics,

Drs. Rob van der Wal for his suggestions, critical comments and ingenious ideas. His

professional knowledge and guidance has been very useful for the completion of this thesis. I

also thank the data-team at the Erasmus University’s library. Their assistance was very helpful

for me in order to attain the appropriate data from many sources available at the library.

Finally I wish to thank my parents, my fiancé Leroy, and my friends for their support and

encouragement during my studies. During the year, they have motivated me in the

accomplishment of my master’s degree.

Thank you!

Rotterdam, July 2012

Bebi Merinda

3

Table of Contents

1. Introduction............................................................................................................................................6

1.1. Chapter Introduction......................................................................................................................6

1.2. Motivation......................................................................................................................................6

1.3. Relevance and Contribution...........................................................................................................8

1.4. Problem Definition and Methodology...........................................................................................9

1.5. Structure, Boundary and Limitation............................................................................................11

1.6. Chapter Conclusion......................................................................................................................11

2. Financial Accounting Theory..............................................................................................................13

2.1. Chapter Introduction....................................................................................................................13

2.2. Efficient market theory................................................................................................................13

2.3. Agency theory..............................................................................................................................14

2.4. Positive accounting theory...........................................................................................................14


3. Value Relevance, Earnings Persistence and Conservatism.................................................................17


3.2. Value relevance of earnings.........................................................................................................17

3.3. Earnings Persistence....................................................................................................................21

3.4. Conservatism................................................................................................................................25

3.5. Business cycle..............................................................................................................................28


4. Literature Review.................................................................................................................................31


4.2. Earnings persistence and Conservatism.......................................................................................31

4

4.3. Conservatism and Value relevance..............................................................................................33

4.4. Earnings persistence and Value relevance...................................................................................37

4.5. Conservatism, earnings persistence and value relevance throughout business cycle..................38


5. Hypothesis Development and Methodology........................................................................................43


5.2. Hypotheses Development............................................................................................................43

5.3. Methodology................................................................................................................................45

5.3.1. Measurement........................................................................................................................45

5.3.2. Data sample..........................................................................................................................47

5.3.3. Descriptive Statistics............................................................................................................49

5.3.4. Findings................................................................................................................................52

5.4. Analysis........................................................................................................................................55


6. Conclusion...........................................................................................................................................59

6.1. Thesis Conclusion........................................................................................................................59

6.2. Limitations and Suggestions........................................................................................................60

References....................................................................................................................................................62

Appendix......................................................................................................................................................66

1. Summary of literature reviews.....................................................................................................66

2. Sample distribution......................................................................................................................69

5

1. Introduction

1.1. Chapter Introduction

Accounting information is a formal way for the management to communicate the firm’s financial

performance. Financial statements have an important role for investors’ decision-making process. Prior

studies document that the usefulness of accounting information particularly accounting earnings vary

according to the fluctuations in macroeconomic situations namely the business cycle (Johnson 1999;

Jenkins et al. 2009). This thesis investigates the usefulness of financial statements including earnings

persistence and earnings conservatism throughout the business cycle. This chapter elaborates on the

background, problem definition and structure of this thesis.

1.2. Motivation

Every single entity aims for a steady growth in order to maintain its competitive position. In fact the

accounting principle of going concern assumes that every firm involves in strategic investments and

business operations in an attempt of longer term existence. The positive outcome of these strategic

decisions is a sustained level of current earnings and an expected increase of future earnings.

Nevertheless, another flip of the coin is a possibility of lower level of earnings in which the competitive

position of the corresponding firm is degraded.

Financial analysts and investors investigate any observable features such as earnings persistence to assess

the performance of firms’ strategic decisions. Earnings persistence is the autocorrelation between current

earnings and future earnings. Earnings persistence reflects ‘the effect of a current earnings innovation

upon the whole stream of future realizations of the earnings series’ (Baginski et al. 1999, pp. 109). Prior

accounting research documents evidences of firm-specific characteristics that drive a persistence level of

earnings such as barriers to entry, capital intensity, firm size and product type (Lev, 1983). For instance a

larger firm usually has higher capital intensity and quick access to financial resources than a smaller firm

which leads to a stable growth and a more persistent earnings stream. Nevertheless most accounting

studies relate earnings persistence only to the internal characteristics of the firms (Baginski et al. 1999),

leave the macroeconomic situations outside the scope of research.

Prior research shows that the relation between stock returns and earnings varies with respect to macro-

economic condition. Johnson (1999) finds that earnings persistence and value relevance of earnings are

higher during economic expansions than during contractions. Johnson (1999) reasons that the aggregate

investing and financing opportunity set varies across different stages of business cycle i.e. expansion and

6

recession which leads to variations in the response of stock market to accounting earnings. Value

relevance of earnings is the usefulness1 of earnings information to the equity market. Johnson (1999)

suggests that positive growth and high economic activity during an expansion imply a higher level of

earnings persistence and value relevance of earnings in an expansion than in a contraction.

The usefulness of earnings information is not only affected by economic growth and earnings persistence

but also on the way of the financial statement has been prepared. The most common way of

communicating a firm’s business performance is by disclosing its financial information in a formal form

called a financial statement. Publishing financial statements is mandatory for public listed firms while for

smaller firms financial statements are mainly used for limited purpose for example to obtain a loan from a

bank. For larger firms, financial statements cover various purposes such as tax and legal purposes. The

information provided in a financial statement is also useful for the analysts and investors in assessing the

firm’s level of performance. Due to the series of accounting scandals in 2001, the Sarbanes-Oxley (SOX)

Act has been introduced to enhance the quality of firm’s internal control and constrain managerial

discretion over financial reporting. Lobo and Zhou (2006) find an increase in conservatism in financial

reporting following the implementation of SOX.

Contrary to the Johnson (1999) line of reasoning, Jenkins et al. (2009) argue that a greater demand for

conservative accounting numbers during a contraction resulted in a higher value relevance of earnings

during a contraction period than during an expansion period. Jenkins et al. (2009) state as follows: “To

the extent that reporting firms respond to the increased demand for conservative earnings during

contractions by reporting more conservatively, there should be a positive effect on the value relevance of

current earnings” (p. 1042). While Johnson (1999) finds higher earnings persistence and value relevance

during expansions than recessions, Jenkins et al. (2009) find that conservatism and value relevance of

earnings are higher in a recession than in an expansion. Jenkins et al. (2009) comment on the proxy of

value relevance used by Johnson (1999) which does not take into account the expectation of future

earnings. These mixed results in the earnings-returns relation throughout the business cycle draws my

attention and therefore I find it interesting to carry on this subject as a research topic for my master thesis.

This paper is also motivated by the lack of empirical research which related value relevance of earnings

and economic situation that is the business cycle stages. Instead, a great body of study has mainly focused

on the influence of firm-specific characteristics rather than macroeconomic situations (Clinch and Wei

2011). To my knowledge, there are only two empirical literatures i.e. Johnson (1999) and Jenkins et al.

(2009) that study the relation between earnings and returns with respect to business cycle. Johnson (1999)

1 Later on these words value relevance and usefulness are used randomly in this thesis.

7

relates the fluctuation during business cycle with earnings persistence and value relevance of earnings

while Jenkins et al. (2009) associate the business cycle with conservatism and value relevance of

earnings. In this paper, I investigate the earnings persistence, conservatism and value relevance of

earnings throughout business cycle in one research setting.

1.3. Relevance and Contribution

This research is relevant for those who are interested at the development of accounting practices in the

United States. Since this research investigates three important topics in accounting i.e. value relevance,

earnings conservatism and earnings persistence therefore this paper may serve the wide interest of future

researchers who are going to investigate the usefulness of accounting information across business cycle.

This thesis is related to value relevance literatures. Value relevance falls into the category of market-

based accounting study that is branch of accounting which “investigates the relation between accounting

data and firm valuation” (Bernard, 1989, p. 72). This is done by associating the change in accounting

measures with the level or change in the stock market.

This research contributes in three ways; first it reveals whether the investors use the accounting numbers

differently depending on the economic situation. This gives an insight on how the investors approach the

earnings number for their decision making throughout different stages of business cycle. Earlier studies

raise a concern on the decrease in the usefulness of financial statements to investors (Francis and

Schipper, 1999; Lev and Zarowin, 1999). Several reasons have been claimed as a possible cause of the

decrease in the usefulness of accounting numbers such as increasing rate of business change and

inadequate accounting standards in facilitating the high pact of business change (Lev and Zarowin, 1999).

This paper provides evidence whether value relevance of accounting information differs throughout the

business cycle and how the persistence of earnings and conservative accounting relates to the value

relevance of financial statements.

Second it reminds the standard-setters that different economic situations may alter the behavior of

investors and firms. For example fair-value accounting evaluates asset values based on market price and

therefore using fair value accounting for firm evaluation will result in different asset values during

economic contractions than economic expansions. The market price during a contraction will be lower

than during an expansion. It implies that during an extreme economic situation some exceptional rule

perhaps should be made in order to facilitate a better financial reporting practice. Knowing that investors

react differently towards accounting information throughout different stages of business cycle suggests

that another measurement method is perhaps more appropriate than a daily best practice.

8

Third, for future research it is important to take into account the economic fluctuation in making inference

from available sample. Macroeconomic variation such as a deep recession may have different

characteristics such as (lower earnings persistence and higher conservatism: depend on the outcome of

this paper, rewrite again). For example previous research suggests that implementation of SOX in 2002

increase the level of conservatism (Lobo and Zhou, 2006). However, this result might be partly caused by

the aftermath of economic downturn in 2001. Therefore understanding the role of macroeconomic

situation on the earnings-return relation supports a right inference for the future research.

1.4. Problem Definition and Methodology

As mentioned before, this research is motivated by the mixed results between the influence of earnings

persistence and conservatism to the value relevance of earnings across the business cycle fluctuation.

Johnson (1999) argues that higher earning persistence during expansion leads to higher value relevance

during expansion periods relative to contraction. However Jenkins et al. (2009) claim that higher demand

of conservative earnings during contraction leads to higher value relevance during contraction than during

expansion period. Therefore to investigate this mixed result, I formulate the research question as follows:

‘How do earnings persistence, conservatism and value relevance of earnings vary throughout the

business cycle?’ The sub-questions below assist this research in order to arrive on the right conclusion.

1. What are relevant financial accounting theories for this research? (Chapter 2)

2. What are value relevance, earnings persistence, conservatism and business cycle? (Chapter 3)

3. Based on prior studies, what is the relation among value relevance of earnings, earnings

persistence and conservatism; and how does it vary across business cycle? (Chapter 4)

4. Based on empirical data, how do earnings persistence, conservatism and value relevance change

throughout the business cycle? (Chapter 5 and 6)

The methodology of this paper is base on both qualitative and quantitative research. To study the effect of

earnings persistence and earnings conservatism on the value relevance of earnings an adequate

understanding of these three concepts is necessary. Therefore a qualitative research is done before

employing quantitative data. A qualitative research is done by selecting financial accounting theories and

prior empirical literatures which are relevant in solving the research question. A large amount of study

has been done in this area and to discuss all relevant literatures will be redundant. Therefore only the most

relevant literatures will be discussed. The relevant literatures are literatures which focused on earnings

9

attributes such as persistence, conservatism and value relevance and how it relates with the fluctuation in

business cycle.

Accounting information is useful for the decision-making process for rational investors. Based on Scott

(2006) there are two versions of decision usefulness approach: information perspective and measurement

perspective. Information perspective assumes that reporting information is useful in predicting future firm

performance disregard the form of disclosures. The form of disclosures is not important because in an

efficient market, informed investors quickly react to available information from any source and

incorporate it directly in stock prices. Empirical researches under this perspective assess the usefulness of

accounting measures in terms of its association with equity market measures. Measurement perspective

implies greater incorporation of fair values in financial statements to enhance the usefulness of reporting

information in assisting investors to predict firm value. Measurement perspective questions the

assumption of efficient security market and the capability of historical cost accounting to provide reliable

information for the investors.

In this paper the information perspective is applied and therefore efficient security market is an important

assumption. To study the information content of earnings, the empirical part of this paper examines the

association between accounting measures e.g. earnings and equity market measures such as stock returns.

This methodology assumes that earnings is more value relevant if it has more decision useful inputs to

equity valuation model (Dechow et al. 2010). Based on the theories and the findings of prior research

some hypotheses are developed. These hypotheses are tested using a sample of listed firms in the U.S.

The data is obtained from the Compustat databank. Using statistical analysis software Eviews, these data

are tested according to the applicable models. The applied models are auto-regression model, asymmetric-

timeliness model and earnings model. The proxies in these models indicate the behavior of earnings

persistence, earnings conservatism and value relevance of earnings respectively throughout business

cycle. Ultimately in this paper I do not use a short window time period (i.e. days) because it is unlikely

that business cycle changes in just a couple of days. Therefore it is necessary to take a longer period such

as several years in order to observe the effect of business cycle.

10

1.5. Structure, Boundary and Limitation

This paper has a similar research approach as two prior empirical literatures; they are Johnson (1999) and

Jenkins et al. (2009). To my knowledge, these are the only empirical studies that document the difference

in the level of value relevance of earnings throughout the business cycles. Johnson (1999) distinguishes

four stages of business cycle namely expansion, credit crunch, recession and reliquification whereas

Jenkins et al. (2009) define business cycle merely to two stages of expansion and contraction. To improve

comparison, I divide business cycle only to two stages of expansion and contraction. The reason is related

to the purpose of this research in examining the mixed result of value relevance during expansion and

contraction. However restricting only to expansion and contraction constrains the comparison purely on

these two stages of business cycle. Another limitation is in the sample selection which is merely based on

the U.S. public firms. To investigate the mixed results between Johnson (1999) and Jenkins et al. (2009),

I determine to use sample from similar country that is the United States. Nevertheless, including other

countries will add more value to the research. I leave this for future research.

This thesis is structured as follows. The first chapter gives short introduction of the topic, research

motivation and structure of this thesis. The second chapter provides theoretical background relevant for

this thesis as well as answering the first sub-question. The third chapter elaborates on the definition of the

main concepts used in this research; they are value relevance, earnings persistence, earnings conservatism

and business cycle. The third chapter answers the second sub-question. The fourth chapter reviews

empirical literature of the main concepts described beforehand including the answer of the third sub-

question. The fifth chapter is devoted for hypotheses development, methodology to test these hypotheses

which consists of descriptive statistics of the sample, the applied models to test the hypotheses and

findings, and analysis of the statistical results. Finally the sixth chapter concludes by answering the main

research question. Limitation and suggestions for future research are also provided in chapter six. The

flow chart of this thesis depicts in figure 1 on the next page.

1.6. Chapter Conclusion

Mixed results between Johnson (1999) and Jenkins et al. (2009) on the value relevance of earning

throughout the business cycle have drawn my interest to carry on this research topic. This thesis is

interested for investors, standard-setters and future researcher who want to know whether macro-

economic situations affect the usefulness of accounting earnings, the persistence of earnings and

conservatism throughout the business cycle. The main research question is defined and additional sub-

questions are useful as a guidance to answer the research question. Restricted sample only to the US firms

11

Chapter 1Motivation

Chapter 2Theoretical background

Chapter 3Main concepts

Chapter 4Literature review

Chapter 5Hypotheses, methodology, findings, & analysis

Chapter 6Conclusion

limits the generalization of the research findings. The subsequent chapter explains the financial

accounting theory relevant for this thesis.

Figure 1: The thesis flowchart

12

2. Financial Accounting Theory


In order to gain some understanding on the usefulness of accounting information for the capital market,

this chapter provides the underlying theories behind financial reporting. This chapter aims to answer the

first sub-question. There are three financial accounting theories applicable here: efficient market theory,

agency theory and positive accounting theory. Efficient market theory assumes that stock price reflects all

publicly available information included information provided in the financial statements. Agency theory

implies that financial statements are prepared in order to reconcile the asymmetrical information between

investors as the principals and managements as the agents. Positive accounting theory reveals why the

applied accounting methods are of interests for both parties.

2.2. Efficient market theory

Efficient market theory assumes that the price of a security reflects all available information and will

adjust quickly to the newly released information. The information of many investors is accumulated in the

capital market and this information is reflected in security prices. A security price is determined based on

the net present value of future cash flows expected from that security. If there is information indicated a

positive net present value, investors with that information will choose to buy that stock. Their attempts

increase the demand of that stock and escalate the stock’s price. Correspondingly investors with

information that selling a stock had a positive net present value will sell the stock and result in a drop on

the stock’s price (Berk and DeMarzo, 2007). Thus the competition among investors eliminates all positive

trading opportunities and leads to a fairly stock’s price is referred as the efficient market hypothesis.

To form an expectation of future cash flows, investors and financial analysts obtain information about the

specific firm from many sources outside the accounting information. If there is new information

becoming available which changes the beliefs of investors on future expected cash flows, the security

price is expected to change (Deegan, 2009, p. 261). There are three versions of efficient market: strong,

semi-strong and weak. Under perfect conditions, the security price fully reflects all information including

the insider information and therefore the market value of that security is equal to the fundamental value.

This is known as the strong form of efficient market. Under imperfect condition, market stock prices only

reflect publicly available information. The weak form assumes that stock prices reflect the historical

publicly available information whereas the semi-strong form predicts that stock prices reflect all publicly

available information and future expectations about those stocks (Scott, 2006). The difference exists

13

because of insider information and insider trading (Scott, 2006, p. 104). The definition that I shall use

here is the semi-strong form.

In practice, a perfect efficient market does not seem to hold because of information asymmetry.

Information asymmetry between agencies involved in the stock markets may lead to a failure in the stock

market, for example the collapse of Enron and WorldCom after large accounting scandals in 2001.

Information asymmetry is costly and difficult to avoid. The cost which results from information

asymmetry is entitled as agency costs. The next section elaborates more on the agency theory.

2.3. Agency theory

As mentioned before, information asymmetry may have an adverse effect on the functioning of capital

market. The agency theory highlights the contract relation between principal and agent in which the agent

(the manager) agree to render its service on behalf of the principal (the owners). In order to perform this

service, it is necessary for the principle to assign some decision making authority to the agent over the

principal’s resources. However, this discretion provides an opportunity to the agent to pursue its own

interest instead of the principal’s interest. Hereby some agency problems may emerge because of three

reasons below (Clegg et. al., 1996, p125).

1. The agent has typically different interest than the principal (conflict of interests).

2. The principle is unable to monitor the actions of the agent perfectly and costless.

3. The principle is unable to obtain the information available to or attained by the agent perfectly and

costless.

The costs related to the reduction of these agency problems are called the agency costs. A common way

to mitigate or eliminate the agency costs is through a profit-share bearing in which both the principal and

agents benefits from the alleviation of the agency costs. The positive accounting theory explains further

the implication of principal-agent relation on the financial reporting practice.

2.4. Positive accounting theory

Positive accounting theory gives an explanation on manager’s preference of particular accounting

methods as opposed to others. This theory was formulated by Watts and Zimmerman (1978) who seeks to

explain and predict manager’s choices of accounting methods to present the performance of a firm in the

favorable way. This theory examines the relationship among individuals within and outside the firm and

explains how accounting methods can be used to decrease the costly implications of each contracting

party pursuing their own interest (Deegan & Unerman, 2011). The contractual agreements of the

14

corresponding parties are based on the output of applied accounting method and therefore the accounting

method is of the interest for both parties. The assumptions behind this theory are efficient market and

self-interest individual. There are three central hypotheses in positive accounting theory:

1. The bonus hypothesis

This hypothesis predicts that managers will manipulate the performance indicators such as

earnings in order to generate a higher bonus. One way to reduce agency costs is by tying the

manager’s bonus schemes with the firm’s performance. This way self-interested manager is

motivated to perform in the bests interests of the owners as it will also increase his/her bonus.

The firm’s performance is mostly measured based on accounting numbers. Therefore the manager

prefers accounting method which has a positive impact on the bonus payout.

2. The debt hypothesis

This hypothesis predicts that managers will apply accounting methods that minimize the effect of

debt covenant. If the debt/equity ratio is too high, the cost of attaining new debt capital is higher.

This hypothesis predicts that the manager is motivated to attain higher earnings in order to change

the investors’ perception on the creditworthiness level of the firm.

3. The political cost hypothesis

This hypothesis predicts that managers will apply accounting methods that minimize earnings in

order to reduce the level of political scrutiny. If a firm earns higher profit than expected, it will

adversely attract the attention from media and community. For example the same high level of

profit in time of recession will attract more media attention than during an economic expansion.

Hence managers will adopt accounting methods that leads to lower level of reported profit.


This chapter aims to answer the first sub-question related to the financial theories relevant for this thesis.

The semi-strong form of efficient market theory assumes that the security price reflects all publicly

available information in the market. The agency theory predicts the inevitable effect of information

asymmetry which leads to agency costs. Positive accounting theory explains three hypotheses predict the

behavior of management towards available discretion inside the applicable accounting standards. In

practice, a perfect efficient market does not exist due to asymmetrical information between the principal

and the agency. The principal that is the investor cannot fully monitor the agent which leads to the

existence of agency costs. The agency which is the management benefits from the asymmetrical

15

information by opportunistically applying accounting methods in the management’s best interests. Their

action may distort the usefulness or value relevance of accounting information for the investors. Next

chapter explains further the value relevance of earnings including two important properties of earnings;

they are earnings persistence and earnings conservatism.

16

3. Value Relevance, Earnings Persistence and Conservatism


Previous chapter elaborates on theories which explain the importance of accounting information for both

managers and owners. The owners are indeed the investors, the one who provides fund for firm’s

operation. This chapter focus on the usefulness of accounting number particularly earnings for the

investors and how it has been investigated empirically. The definition of value relevance and the

applicable model are discussed here. Earnings persistence and conservatism are two concepts which have

influence on the usefulness of accounting numbers for the investors. The relationships between these two

accounting phenomena with value relevance of earnings also are also explained below. Most of the

studies employed in this chapter are from the earlier research. The recent literatures will be discussed in

the next chapter.

3.2. Value relevance of earnings

As mentioned in the previous chapter, the importance of earnings is crucial for both managers and owners

(investors) of a firm. The investors evaluate a firm’s performance by looking at the earnings figure and

the manager’s bonus scheme is tied to the accounting earnings. That is why management sometimes

manages the earnings number in order to impress the investors. The usefulness of accounting earnings for

the investor’s decision-making is called the value relevance of earnings. ‘Value relevance research

measures the usefulness of accounting information from the perspective of equity investors’ (Beisland,

2009, p.8).

There are different ways to measure the usefulness of accounting information for the equity market

values. One way to do this is by examining the association between accounting measures and equity

measures. If a change in the accounting measures is also incorporated in the equity measures then it can

be proved that accounting information are value relevant for the capital market. Holthausen and Watts

(2001) identify three valuation models that are commonly used in value relevance research.

Table 1: Value Relevance models

Earnings model Balance sheet model Ohlson(1995) model

Associated earnings with equity

returns

Rit = β0 + β1Eit + β2∆Eit + εit

Associated book value (BV) with

equity value

Pit = γ0 + γ1BVit + εit

Associated BV + Earnings with

equity value

Pit = α0 + α1Eit + α2BVit + εit

17

Three models mentioned above are the basic model. These models can be adapted according to the

research purpose by changing or adding additional proxy into the equation. As an example Kouesenidis et

al. (2009) employ the Ohlson (1995) model by using stock return instead of stock price as a proxy for

equity value. For my research purpose, earnings model is the relevant model because this thesis focuses

on the value relevance of earnings.

Prior literatures suggest several factors that have influence on the value relevance of earnings. A short

overview of these factors is provided below:

1. Business change

In the past two decades, business enterprises have experienced increased rate of changes. Innovation in

technology is basically the major initiator of change. In financial reporting, these innovative activities are

recorded mostly as a form of investment in intangible assets such as research and development (R&D),

information technology (IT), brands and human resources. However the current reporting system is still

using the old-fashioned tangible assets and inadequate to facilitate the accounting treatment of these

innovative activities, causing mismatch between costs and revenues. This is an example to describe the

inconsistencies in current accounting rules. When a firm develops equipment internally, it is not allowed

to capitalize the development costs on the balance sheet. In contrast if the firm purchases a similar

instrument, the value of the equipment are allowed to be capitalized as an asset. Accordingly the

investments in intangible assets such as R&D costs should be immediately expensed while the benefits

(e.g. improvement in efficiency or a new product) are gradually recognized later which does not match

with the earlier investment expenses.

Lev and Zarowin (1999) find a positive association between the rate of business change and intangible

investment in R&D. Investment in R&D is important to survive in today high competitive business

environment. Lev and Zarowin (1999) also find a positive association between the increase in R&D

spending and the decline of value relevance of earnings. To improve the value relevance of financial

information, Lev and Zarowin (1999) propose a fundamental change in current accounting treatment of

intangible assets. They claim that current accounting approach on capitalization of intangibles assets is

partly accountable for the decline in the value relevance of accounting information. Current financial

accounting information perhaps is not relevant in reflecting the firm values with high amounts of

unwritten intangible assets.

2. Mismatch costs and revenues

Current reporting practices restraint the timeliness of periodically matching costs and revenues. The

prudence concept of accounting applies a higher degree of verification on the recognition of assets and

gains in order to avoid the overstatement of assets and income as well as the understatement of liabilities

18

and expenses. Current accounting standards accentuate more on objectivity and verifiability than

timeliness (Francis and Schipper, 1999). Consequently the contemporaneous costs and revenues are not

match which seriously deteriorate the value relevance of earnings. Mismatch between costs and revenues

have two consequences: 1) a lag on how earnings reflecting information related to stock prices; and 2) an

asymmetric timeliness on how earnings reflecting good news versus bad news (Ryan and Zarowin, 2003).

The first factor is induced by the recognition of income which is based on historical cost valuation. The

historical cost valuation does not consider future cash flows causing lags in the capability of earnings to

capture stock prices. Ryan and Zarowin (2003) suggest the application of fair value accounting in order to

take into account the future elements. The second factor is related to conservative accounting. According

to Watts (2003), conservatism is defined as early recognition of losses (bad news) than gains (good news)

in financial statements. This asymmetry in gains and losses recognition brings systematic differences

between the period of bad news and good news in the timeliness and persistence of earnings (Basu, 1997).

Ryan and Zarowin (2003) claim the conservative nature of accounting principles and increasing legal

liability as the reasons of increased conservatism.

3. Less persistence components and reported losses

Investors put less weight on earnings which include a large amount of non-recurring items because less

persistence components such as non-recurring items2 are interpreted as more transitory than ‘core’

earnings3 (Eliott and Hanna, 1996). Emphasizing on special items, Eliott and Hanna (1996) find an

increase in the frequency of a firm reporting special items in its financial statement. An increase in the

occurrence of non-recurring items indicates that these items have become more persistent. Hence the

regularity in the occurrence of non recurring items suggests that these items are also value relevant for a

firm valuation. Nevertheless investors fail to distinguish the relevance between the permanent and

transitory components of the reported earnings (Eliott and Hanna, 1996). Because investors place less

weight on this ‘regular’ non-recurring item, the relevance of reported earnings for investor’s valuation is

also decreasing as indicated by the lower value relevance of earnings. Collins et al. (1997) who examine

the effect of non-recurring items on the value relevance of earnings report that the non-recurring items are

partly responsible for the observable decline in the value relevance of earnings across time.

Reported losses are less persistent than profits because no firm is willing to stay in a business with

negative earnings. The transitory nature of losses is less informative for the investors because investors

have a choice to drop a stock with negative earnings. Hence firms with losses are likely to be less value

2 Non-recurring items are categorized into three elements: extraordinary items, discontinued operations and special items (Eliott and Hanna, 1996).3 Core earnings capture the income from a firm’s core business while non-recurring items are infrequent and not part of ongoing business and therefore will be less persistent (Nichols and Wahlen 2004).

19

relevance because of lower earnings persistence (Dechow et al., 2010). Hereby the persistence of earnings

plays a great role to increase the usefulness of accounting earnings for the firm valuation.

4. Firm size

The earnings of larger firms tend to be more stable than smaller firms because smaller firms have more

uncertainty on its ongoing position and higher chance of liquidation. Because smaller firms are likely to

have lower earnings persistence, investors perceived the earnings of smaller firm as less relevant for their

decision making process. For a smaller firm in which earnings are less persistent, investors consider the

book value as more value relevant for their decision making than the earnings number (Collins et al.,

1997). Hayn (1995) found that smaller firms report losses more frequent than larger firms. A plausible

explanation is a more diversified operation protects the larger firms from reporting losses in an economy

downturn (Collins et al. 1997). As mentioned before reported losses are proven to be less persistent and

therefore less value relevant.

5. Earnings management

The remuneration of managers is often measured based on the earnings number. Managers manipulate the

earnings number as an attempt to impress shareholders. This has a severe consequence since the reported

earnings are not reliable indicators of the firm’s performance anymore. If investors realize that the

reported earnings are not reliable, the earnings will be less relevant for their investment decisions.

Marquardt and Wiedman (2004) presume that the book values are less useful for the investors when

earnings management is expected to take place. Their findings demonstrate a decline in the value

relevance of net income in a setting of secondary offering4 in which investors expect earnings

management to emerge.

6. External information

As indicated before, in the midst of fast innovative changes current accounting information fails to

support the investors in their investment decisions. Therefore investors inquire supplementary and

timelier update from external sources such as non-financial information (Amir and Lev, 1996). Another

information sources such as the forecasts of financial analysts are usually available before the issuance of

financial reporting. Non-informational trading activities also indirectly affect the payoffs of the trading

securities (Grossman, 1995). Dontoh et al. (2004) demonstrate that the decline of value relevance of

accounting information could be driven by the increase in non-information based trading activity. Non-

information based trading weakens the ability of stock prices to capture reported earnings, hence affects

the value relevance of earnings.

4 Secondary offering is the issuance of new security from a company whose security has been previously issued at initial public offering (IPO).

20

7. Accounting standard setters

The development of accounting standards and differences in the standard setting bodies influence the

value relevance of accounting information. The change in business environment - which is outside the

control of standard setters - enforces the amendment of existing accounting standards by the standard

setting bodies in order to suit current business development. Accordingly Ely and Waymire (1999) claim

that accounting standard setters may affect the value relevant of accounting information by the way

accounting standards have been developed across time.

As mentioned in the second chapter the market price of a stock is determined by the present value of

future cash flow expected from that particular stock. Therefore a high level of earnings persistence is

important for the decision making of investors whether to buy/sell a stock. A high level of earnings

persistence provides a better indication for investors in forecasting future cash flows from the stock

(Dechow et al., 2010). Incorrect judgment on future cash flow of a stock may induce a significant security

mispricing, leading to overvaluation or undervaluation of the stock (Sloan, 1996).

The untimely recognition of gains and losses may also reduce the relevance of earnings for investors

because market price of the stock fails to reflect the economic value of the firm accurately. This might be

caused by conservatism in earnings. According to Watts (2003), conservatism is defined as early

recognition of losses (bad news) than gains (good news) in financial statements. The asymmetry in gains

and losses recognition brings systematic differences between the period of bad news and good news in the

timeliness and persistence of earnings (Basu, 1997). Prior research also documents that the usefulness of

earnings has been decline over time due to the conservatism in earnings (Lev and Zarowin, 1999; Francis

and Schipper, 1999; Core et al. 2003). Next Section provides definition of two important properties of

earnings: earnings persistence and earnings conservatism.

3.3. Earnings Persistence

Earnings persistence captures the effect of current earnings innovation on the future realization of

earnings series. Firms entangle in business investments and innovations in order to have a persistent

stream of earnings. Excluding any exogenous shocks, the earnings level is expected to persist into the

foreseeable future. Because earnings are often used for equity analysis and firms valuation therefore

earnings persistence is an important key for an effective financial analysis (Subramanyam and Wild,

2009). Earnings persistence has been used as a proxy to measure earnings quality with underlying

assumption that high persistence earnings are more useful for equity valuation (Dechow et al., 2010).

More persistent earnings provide better information to equity valuation model and therefore it has higher

quality than less persistent earnings.

21

Current earningsExpected future earnings

Current stock priceExpected future dividends

Based on efficient market theory, capital market price adjusts quickly to the publicly available

information. The capital market reacts to useful information available from any source including financial

statements. Beaver (1998) develops a theoretical framework that relates earnings with stock prices. There

are three theoretical links:

1. Current earnings contain information to predict future earnings.

2. Future earnings provide information to form expectation of future dividends.

3. Expected future dividends provide information to judge the stock value, assuming that stock

prices reflect the present value of all expected future dividends.

Figure 2: The theoretical links between earnings and stock prices (Beaver, 1998)

The theoretical links above depict the importance of earnings as predictive information for future stock

price. The first link predicts that earnings (provided in the firm’s financial statement) gives information

about current and expected future performance to form expectation of the future earnings. The second

link predicts that current and expected future earnings provide investors with information about current

and expected future dividends. Based on the capital pricing theory, stock price equals to the present value

of future dividends expected to flow out from owning the stock. Therefore the third link predicts that

stock price equals to the present value of expected future dividends. These theoretical links imply that

accounting information particularly earnings induces an expectation change of future dividends for the

investors which account to a change in the market value of the firm. This theoretical framework provides

a line of reasoning for understanding the connection between earnings and stock value. Current reported

earnings provide the investors information to develop expectation of future earnings which eventually

used as the basis for valuing the stock (market price). The next question is whether this theoretical

framework holds in practice.

This has been worked out by prior researchers such as Ball and Brown (1968), Kormendi and Lipe (1987)

and Nichols and Wahlen (2004). Ball and Brown (1968) is the first empirical study that document

evidences of the usefulness of accounting information to the stock market (value relevance). They study

the association between accounting income numbers and changes in stock returns. Ball and Brown (1968)

find that on average firms with good news (i.e. firm’s reported earnings are larger than market

22

expectation) enjoyed positive abnormal returns and bad news had negative abnormal returns. Abnormal

return is the difference between actual return of a share with the expected return. Kormendi and Lipe

(1987) found that the persistence of past and current earnings is positively related to the unexpected

earnings on stock return. Kormendi and Lipe (1987) conclude that earnings persistence positively affect

the value relevance of earnings to the investor. Nichols and Wahlen (2004) who replicate Kormendi and

Lipe (1987) also reported that earnings persistence is important for the evaluation of firm’s value.

Dechow et al. (2010) quote three model specifications to estimate earnings persistence. The first model is

simply the first autocorrelation of earnings which assume that current earnings are useful to estimate the

next period earnings. The second model comes from Sloan (1996) who decomposes total earnings into

cash flow and accruals components. This model is commonly used to compare the persistence between

these two components of earnings. The third model is the extension of second model which further

specify the components of total accruals and cash flows. Table below provides summary of each model.

Other empirical studies on the relation between earnings persistence and value relevance are discussed in

the next chapter.

Table 2: Earnings Persistence models

Persistence models Model specification

The lag model Earnings t+1 = b0 + b1Earnings t + t

The persistence of earnings components (Sloan 1996)

Earnings t+1 = b0 + b1Cashflow t + b2Accruals t + t

The persistence of accruals and cash flow components

Earnings t+1 = b0+ b1Earnings t + b2 financial statements components t + b3 other information t + t

Subramanyam and Wild (2009) mentioned four determinants of earnings persistence such as:

Earnings trends

The trend in a firm’s earnings stream is highly dependent on the characteristics of the firm. Commonly

there are two essential characteristics: the size of firm and firm’s growth. Firm size affects the persistence

of earnings because the size of a firm is closely related to the competitive position of a company. Capital

requirements, scale economies, barriers-to-entry and industry concentration are closely related to

industry-level profitability (Schmalensee, 1989). Baginski et al. (1999) find that capital intensity, barriers-

to-entry and product-type are significantly related to earnings persistence. Growth affects earnings

persistence because a stable growth corresponds to a persistent stream of earnings and firm’s profitability.

Future profitability and firm value are related to the growth of net operating assets and current

profitability (Ohlson, 1995; Feltham and Ohlson, 1995). Shroff (1995) finds that earnings of firms with a

high price-to-earnings (P/E) ratio together with a high return on equity (ROE) provides ex ante indication

23

of earnings growth. The earnings of firms with these features demonstrate a positive correlation with

future earnings and also a higher explanatory power for returns than earnings of firms with a high P/E and

a low ROE.

Variability

Variability in earnings is determined by the volatility of earnings flows. Persistent and transitory items in

earnings by large determine the variability of earnings. Large earnings changes and losses are transitory

and unlikely to persist in the future. Earnings tend to return to the previous level before the large earnings

changes (Brooks and Buckmaster, 1976). Large earnings changes may result from positive economic

shock such as technological changes. Because of the nature of this positive shock which is one-time

event, the effect of larger earnings changes is unlikely to stay in the future. Losses are another source of

less persistent earnings. Losses are less persistent than gains for two reasons; first, due to conservatism in

accounting practice, expected losses are recognized more timely than expected gains (Basu, 1997);

second, losses caused by negative shocks (e.g. natural disaster, strike) and asset liquidations are likely to

be immediately recognized while positive gains are realized gradually over time (Hayn, 1995).

Management incentives

As explained in the prior chapter management as an agent has different interests than the principal. As a

person in charge of the firm’s resources management has incentives to regulate earnings to attain results

according to his/her best interest. These incentives may relate to personal objectives, distress firms,

preserving hard-earned reputations in the case of prosperous firms, bonus schemes, and accounting-based

incentives and constraints. An example of how management can influence earnings persistence is by

deciding to postpone a certain investment undertaking in order to constrain current costs yet in expense of

long term earnings sustainability. There is no future return can be earned without any new investment.

Earnings management

Earnings management is an act to manipulate a firm’s financial earnings either directly through

accounting methods such as changing accounting assumptions, offsetting extraordinary gains and losses

or indirectly such as big baths, write-downs, timing revenue and expense recognition. Earnings

management has consequences on earnings persistence because it affects particularly the accrual

component of earnings. Accrual component of earnings is less persistent than the cash flow component.

Sloan (1996) finds that the persistence of earnings performance depends on the relative magnitudes of the

cash and accrual components. He concludes that investors seems only focusing on aggregate earnings and

fail to discern information contained in both earnings components (accruals and cash flows) until that

information impacts future earnings. Richardson et al. (2005) who extend Sloan’s (1996) work also

confirm that less persistent accruals lead to lower earnings persistence which mislead investors who do

not fully aware of the lower earnings persistence, leading to security mispricing. In the long term when

24

accruals eventually due, there will be no difference between accrual and cash flow in explaining earnings

persistence.

3.4. Conservatism

Conservatism is not a new concept in accounting. The influence of conservatism in accounting practice

and theory has been existed for centuries (Basu, 1997). Traditionally, conservatism was expressed as the

rule “anticipate no profits but anticipate all losses” (Bliss, 1924). This means that conservative reporting

recognizes events with an expected unfavorable outcome immediately while the recognition of expected

favorable outcome is delayed. In the beginning of the 20th century, this view is common for accountants.

The least favorable valuation is adopted in order to anticipate too optimistic or even fraudulent

management which may mislead the users of financial statements.

Nowadays, conservatism is less favorable because it does not lead to a true and fair view of the firm’s

financial performance. Indeed the Financial Accounting Standards Board (FASB) attempts to mitigate

conservatism from accounting practice. They state as follows: “conservatism … introduces a bias into

financial reporting, it tends to conflict with significant qualitative characteristics, such as

representational faithfulness, neutrality, and comparability (including consistency)” (FASB, 1980,

paragraph 92). Prior empirical study mentions conservatism as one reason of the declining earnings

usefulness for investors (Francis and Schipper, 1999).

Regardless of its popularity there is no authoritative definition of conservatism. Conservatism is defined

distinctly based on the research purpose. The Statement of Concepts No. 2 of the FASB defines

conservatism as “a prudent reaction to uncertainty to try to ensure that uncertainty and risks inherent in

business situations are adequately considered.” Basu (1997) interpreted conservatism as "the

accountant's tendency to require a higher degree of verification to recognize good news as gains than to

recognize bad news as losses" (p. 7). Conservatism can be seen as asymmetric treatment of gains and

losses in the financial reporting. Despite of various definitions of conservatism, there is one common

accord that a consequence of conservative reporting is the systematic understatement of net asset values

relative to their economic values (Watts, 2003a).

According to Givoly et al. (2006), there are different features of reporting which may result in

understatement of net asset values. The first feature is the ‘conservative’ selection of accounting methods.

For example immediate expense of investment in certain asset such as internally generated intangible

asset (e.g. R&D) and accelerated depreciation lead to net asset understatement on the balance sheet

(known as “balance sheet conservatism”). Asset understatement on the balance sheet is also related to a

reduction in income (“earnings conservatism”). For example the capitalization of costs protects current

earnings from certain expense - although in the future this capitalized cost will need to be amortized

25

reducing future earnings - and higher depreciation costs in current earnings because of accelerated

depreciation will followed by lower depreciation charges in the next accounting period. The second

reporting feature that leads to assets understatement is the asymmetric timeliness in losses recognition

relative to gains. An eminent example is the implementation of the lower-of-cost-or-market (LCM)5

approach in valuing the impaired value of assets when they are reasonably foreseen while the recognition

gains and appreciation has to wait until they are realized.

Above mentioned reporting features originate from the tendency of accountants to attain a substantial

degree of verification for the recognition of asset than liabilities (Basu, 1997; Watts, 2003a). Balance

sheet conservatism is sometimes referred to “unconditional conservatism”. Unconditional conservatism is

ex ante and independent of any underlying economic events. A common example of unconditional

conservatism is an immediate expense of R&D costs (as mentioned above). Earnings conservatism

sometimes referred as “conditional conservatism” because it is triggered by a contemporaneous economic

event (see the example mentioned before). The unconditional conservatism emphasizes on the difficulty

of valuing certain economic assets/liabilities while the focus of unconditional conservatism is on

improving contracting efficiency by written down book values under adverse situation but not upward-

biased under favorable events (Ball and Shivakumar, 2005). Ball and Shivakumar (2005) who introduce

these terms mention that conditional conservatism can increase the contracting efficiency because it

protects lenders by triggers debt covenant violation earlier after economic losses emerged and provides

less incentive for managers to undertake negative present value investment projects whereas

unconditional conservatism appears inefficient or neutral in contracting.

In this paper, the concern is on the conditional conservatism and/or earnings conservatism. As mentioned

in the first chapter, the purpose of this paper is to examine earnings persistence, conservatism and value

relevance throughout business cycle. Business cycle fluctuates based on the macroeconomic situations i.e.

expansion and recession. Hence unconditional conservatism will not be affected by the economic

situation since this type of conservatism is independent of the underlying economic events. Therefore

conditional conservatism is more relevant for my research purpose than unconditional conservatism. This

will have implication on the measurement method applied in the empirical part of this thesis. Based on

Wang et al. (2008), there are five measures of conservatism which are widely used in accounting

research. The Basu (1997) measure is the most popular model of conservatism in the empirical literatures

(Ryan, 2006; Wang et al., 2008).

Table 3: Conservatism models

Conservatism Authors Model specification

5 Lower of cost or market (LCM) is a rule to write down inventory based on market value when its carrying value is above market price. The decline in the inventory value is reported as loss. However there is no written-up of inventory when the historical costs fall below market price.

26

model

Market-to-Book

(MTB) ratio

Feltham and

Ohlson (1995)

MTB = Market ValueBook Value

A higher MTB indicate a higher degree of conservatism

Asymmetric

timeliness measure

(AT)

Basu (1997) Eit = β0+ β1Rit + β2DRit + β3Rit * DRit + εit

E = earnings, R = equity return,

DR = 1 if Rit < 0 otherwise 0, it = firm i year t

Coefficient β3 indicates asymmetric timeliness and hence higher

β3 suggest a higher degree of conservatism

Negative-accruals

(NA) measure

Givoly and

Hayn (2000)

Increase in accumulated negative accruals indicates

conservatism in the firm’s book value

Hidden-reserves

measure (HR)

Penman and

Zhang (2002)

Index of conservatism : C-score= ERit / NOAit

ER =Estimated hidden reserve due to conservative accounting

NOA = Net operating assets

Asymmetric-cash-

flow-to-accruals

measure

Ball and

Shivakumar

(2005)

ACCt = β0 + β1DCFOt + β2CFOt + β3DCFOt *CFOt + εt

ACCt: Accruals6, CFOt: Cash-flow for period t,

DCFOt = 1 if CFOt < 1 otherwise 0

Higher β3 indicates a higher degree of conservatism.

Despite of some controversy in the application of conservatism, conservatism still exists in accounting

practice because of its considerable role in financial reporting. Watts (2003a) identifies four reasons on

why conservatism continues to exist in financial reporting. These four reasons are as follows:

1. Contracting explanation

Conservative accounting improves contracting efficiency in the organization of the firm and its

various contracting parties because it reduces the agency costs by addressing moral hazard caused by

asymmetric information, asymmetric payoffs, limited horizons, and limited liability among

contracting parties. Conservative accounting is used as instrument to improve contracting efficiency.

Watts (2003a) discerns three important contracts: debt contract, manager compensation contract and

firm governance. Debt contract addresses the ability of debt-holder to repay its creditor; manager

compensation addresses the conflict of interest between management and shareholders in choosing a

project to be undertaken; and firm governance addresses the appropriate action of dealing with losses

timely when losses occur. 6 Accruals calculated from Δ inventory + Δ Debtors + Δ other current assets – Δ Creditors – Δ other current liabilities – Depreciation.

27

2. Shareholder litigation

For firms with high liquidation probability, understating net assets is more likely to reduce the

litigation costs than overstating the firm’s net assets. Conservative accounting undervalues net assets

and current earnings which accordingly reduce the firm’s expected litigation costs. By understating

net assets and earnings, managers and other parties such as auditor lower the risk of being prosecuted

by the shareholders.

3. Taxation

Conservative accounting accelerates the recognition of expense and postpones the recognition gain to

defer tax payments. Deference of tax payments allowed profitable firms to lower the present value of

taxes charges and ultimately increase the current value of the firm. An empirical study by Desai et al.

(2009) shows that the amount of firms reduces their earnings aiming to lower their tax burdens is

substantially increased.

4. Accounting regulation

Standard setters and regulators have a political responsibility with regard to the consequences of the

accounting standards they developed. The regulators are likely to be less criticized when firms

understate net assets than when firms overstate net assets. Hence for the regulators to encourage

conservative accounting is more beneficial because it reduces the political costs impose on them.

3.5. Business cycle

The distribution of macro-economic activity varies over time, following an irregular pattern of economic

expansions and contractions. Expansion and contraction occur around a trend growth path in the

economy. Business cycle refers to the fluctuations around the trend (Johnson, 1999). Based on the

impulse-propagation approach7, these fluctuations occur because of an impulse which drives the cycle and

the propagation mechanism determines how the impulse is transmitted (Burda and Wyplosz, 2005).

A business cycle can be divided into four stages: expansion, peak, contraction, and trough. Expansion is

indicated with a positive economic growth rate and a high level of GDP. Peak is the highest point in an

expansion period. A failure to expand further leads the economy to a recession or a contraction which

marked by a low even negative growth rate and a substantially low level of GDP. The lowest point in a

contraction is trough (see figure 4). In a contraction the government and the central bank commonly

intervene through the fiscal and monetary policy to save the economy from declining even further.

Eventually the economy starts to climb up from trough and start expanding again. The graph of U.S.

7 Macroeconomist approaches business cycle in two ways; first is business cycle as self-renewing phenomena which is largely predictable and the second as an impulse-propagation mechanism.

28

business cycle based on the U.S. GDP (obtained from the U.S. Bureau of Economic Analysis (BEA)) is

provided below.

-6

-4

-2

0

2

4

6

8

Business Cycle in the United States

GD

P

Figure 3: Business cycles in the U.S. for years 1960-2011

Despite of well-known existence of business cycle, the effects of business cycle is difficult to define and

measure accurately. One way to measure business cycle is by using the definition from a well known

research institution. In this paper I use the business cycle definition from the National Bureau of

Economic Research (NBER)8. To define business cycle in the United States, NBER designs a

measurement method that applies multiple variables to define the monthly business cycle. These multiple

variables include employment, personal income, industrial and manufacturing production, and trade sales.

Although NBER also provided data about the peak and trough during a business cycle, for the sake of

simplicity and comparison with the findings of other empirical study this paper will only classified the

business cycle into two stages of expansion and contraction. Figure 4 depicts the NBER business cycle.

Figure 4: Business cycle based on NBER

Financing and investment opportunity sets change throughout expansion and recession. As we see in the

practice nowadays, in a recession internal financing is limited and therefore firms are relied more on 8 NBER is a leading nonprofit research organization specialized in the area of Economics and Business in the United States.

29

external financings. To negotiate a debt covenant, the external funds ask for a higher degree of reliability

of the information provided in the financial statement. Hence, this might increase the level of

conservatism in the earnings. With regard to earnings persistence, because of an economy contraction

sustaining former level of earnings becomes really difficult. In the glorious period of expansion firms are

able to finance their project internally because excessive internal funds are likely available. However

during a contraction, the availability of both external and internal funding is very limited. Therefore it is

expected that the level of earnings persistence will decrease during a contraction.


This chapter has elaborated on theory and important concepts which are necessary for grounded

understanding of this research. Based on the agency theory, asymmetric information motivates the

manager and other contracting parties to keep the practice of conservative accounting. Earnings

persistence is the capability of current earnings to predict future earnings. High earnings persistence is

necessary for security valuation. Conservatism is a prudent action for requiring a higher verification in

gains recognition than losses recognition. The asymmetric treatment between gains and losses recognition

may lead to cumulative net assets understatement in the financial statement which reduce the usefulness

of financial report. Both conservatism and earnings persistence may affect the value relevance of

earnings. Value relevance of earnings can be defined as the usefulness of earnings for investors in the

firm’s valuation. Prior research suggests that earnings persistence, conservatism and value relevance vary

throughout the business cycle (Johnson 1999; Jenkins et al. 2009). In the next chapter, some empirical

literatures provide evidences on how these accounting phenomena relate to each other based on previous

empirical studies.

30

4. Literature Review


The definition of value relevance, earnings persistence and conservatism has been explained in the

previous chapter. This chapter elaborates on the empirical studies which relates to value relevance of

earnings, earnings persistence and conservatism. The aim of this chapter is to answer the third sub-

question which is to find out from prior empirical studies the relation among value relevance of earnings,

earnings persistence and conservatism; and whether it varies across business cycle.

4.2. Earnings persistence and Conservatism

The existence of conservatism in the accounting practice has been well known. Prior studies have

documented evidences on the existence of conservative accounting (Basu, 1997; Givoly and Hayn, 2000).

Basu (1997) examines the influence of conservatism on the properties of earnings. He made four

hypotheses to investigate whether conservatism has asymmetric impact in good news period relative to

bad news period. A good news period is indicated by positive returns while bad news period as period

with negative returns. One of his hypotheses predicts that negative earnings changes tend to be reversed

in the next period than positive earning changes. In other word, negative earning changes are less

persistent than positive earnings changes. The sample consists of the US public listed firms in total

36,394 firm-year observations during the period of 1964-1990. Basu (1997) uses a regression analysis

with independent variables consist of the changes in earnings and a dummy which equal to one for good

news firms otherwise zero and the dependent variable is the stock return. This regression analysis is well

known as Basu (1997) asymmetric timeliness (see table 3) which is the most adopted conservatism

measures (Wang et al., 2008). Lower adjusted R2 from negative earning changes than positive earnings

changes indicates that bad news earnings changes tend to reverse in the next period than good news

earnings changes. Basu (1997) argues that a higher persistence of earnings changes in good news period

is affected by conservatism. Under conservative accounting losses (bad news) should be immediately

recognized whereas gain recognition is recognized gradually which implies that gains tend to persist into

the next period.

Paek et al. (2007) examine the effect of conservative accounting on earnings persistence and the stock

market’s valuation of earnings. They hypothesize that more conservative earnings are less persistent than

less conservative earnings. The argument behind this hypothesis is the mismatching between current-

period revenues and future-period revenues due to conservative accounting adds noise into earnings.

Hereby an important assumption is a match between contemporaneous revenues and expenses is

31

necessary to give a true and fair view of the firm’s performance (Dechow, 1994). The sample was

obtained from the US Compustat database which consists of 431,194 firm-year observations during year

1984-2003. The firms with non-December fiscal year were excluded in order to avoid the effects of

different economic conditions related to different fiscal year. Further financial service and utility

companies were also excluded from the sample because these firms have different institutional and

regulatory natures.

Paek et al. (2007) use four different conservatism measures. These are the asymmetric timeliness of Basu

(1997), the cumulative non-operating accruals (Givoly and Hayn, 2000) over the past five years, the

negative of response coefficient of change in operating income on change in lagged operating income and

the response coefficient of accruals on cash flow (Ball and Shivakumar, 2005; Ruddock et al. (2006). The

earnings persistence is measured by the first autocorrelation between earnings of two consecutive years.

The magnitude of these measures indicates the level of conservatism in the earnings. The larger the

magnitude is the more conservative earnings are. To test the hypothesis, Paek et al. (2007) regress

current-period earnings included a dummy variable as independent variable with the next-period earnings

as dependent variable. A dummy variable represents conservatism in current period and equals to one if

the conservatism measure is greater than the yearly median and otherwise zero. Each conservatism

measure is tested separately. The findings show that less conservative earnings are likely to persist into

the next period than more conservative earnings regardless which conservatism measure being applied.

This means that more conservative earnings are less persistent compared to less persistent earnings.

Sloan (1996) investigates whether the relative magnitudes of earnings components affect the persistence

of current earnings. The autocorrelation of current and future earnings can be expressed as:

Earnings t+1 = b0 + b1Earnings t + et

Recall that earnings constitute accruals and cash flow, this equation can be specified as:

Earnings t+1 = b0 + b1Cashflow t + b2Accruals t + et

Sloan (1996) hypothesizes that the persistent of current earnings is decreasing in the magnitude of the

accrual and increasing in the magnitude of the cash flow. His sample was obtained from the U.S.

Compustat database which contained 40,679 firm years during the period of 1962-1991. The findings

show a smaller coefficient on accruals (b1) relative to cash flows (b2) which means that accrual and cash

flow components of current earnings have different implications in explaining future earnings. The

accrual component of earnings demonstrates lower persistence for the assessment of future earnings than

the cash flow component of earnings. The finding of Sloan (1996) is important to interpret the findings of

the next paper on how accruals relates to earnings persistence and conservatism.

32

Wakil and Alam (2012) investigate the effect of conservatism on accruals persistence in predicting future

earnings. They hypothesize that higher degree of conservatism will positively affect the accruals

persistence in high accrual firms relatively more than low accrual firms. A firm with high accrual has

more uncertainty in the future earnings compared to low accruals firm. Accruals have higher subjectivity

and transitory nature than cash flow (Sloan, 1996) and therefore higher verifiability is required in

determining accruals than cash flows. Hereby conservatism plays a role. A firm with high accrual is

expected to have a higher degree of conservatism in order to reduce information asymmetry between

shareholders and management.

Wakil and Alam (2012) employ three different metrics to measure a firm’s conservatism. They are Basu

(1997) asymmetric timeliness, C-score (Penman and Zhang (2002) which is estimated from three

reserves: LIFO inventory, R&D, and advertising, and market-to-book (MTB) ratio (Giovaly and Hayn,

2000). The level of conservatism from these metrics is included in the regression analysis in which

operated cash flow, operating accruals, level of conservatism and a dummy variable as independent

variable and future earnings as dependent variable. A dummy variable is equal to one for firms belong to

the high accrual deciles, otherwise zero.

The sample was obtained from the US Compustat and CRSP (Center for Research on Security Prices)

databases and comprises of 30,944 firm year observations during the period of 1987-2008. Similar to the

reasoning of Paek et al. (2007), Wakil and Alam (2012) also exclude non-December fiscal year-end

observation and firms in financial and utility industries. Likewise Sloan (1996) findings, they find a

higher magnitude of persistence coefficients for cash flows than accruals. Further they find evidence

confirming their hypothesis that conservatism increases accrual persistence of firms belong to high

accruals deciles more than firms belong to low accruals deciles. In other words, the effect of conservatism

is higher for firms with high accruals than firms with low accruals. How does this relate to earnings

persistence? Following from Sloan (1996) current earnings persistence is decreasing in the magnitude of

accrual component. Hence the higher the accruals, the stronger effect conservatism has on earnings, the

lower the persistent of earnings are.

4.3. Conservatism and Value relevance

Brown et al. (2006) examine the relationship between conditional conservatism and the value relevance of

accounting earnings across 20 countries. Brown et al. (2006) hypothesize the association between value

relevance and conditional conservatism is positively related to the accrual intensity. He argue that in the

country with high accrual intensity the effect of conditional conservatism on value relevance of earnings

will be higher due to more accounting choices available through the accruals accounting. Accrual

33

accounting supports for better matching of revenues and expenses than cash accounting and hence is

expected to yield more value-relevant earnings. (Dechow, 1994). However accrual accounting introduces

more noise in the earnings because of the higher degree of subjectivity in estimating the amount of

accruals (Dechow and Dichev, 2002). Accordingly accruals allow managers to opportunistically benefit

from their choices in estimating and presenting accruals for their private gains. Hung (2001) finds that

low shareholder protection allows managers to use accruals which increase opportunistic behavior of

managers and as a result reduces the value relevance of earnings. Watts (2003a) argues that conditional

conservatism constrains manager behavior to manage earnings upward. Guay and Verrechia (2006) find

that conservatism introduces higher costs on managers who are likely to manipulate earnings upward.

Thus conditional conservatism is expected to increase value relevance of earnings when accruals intensity

is high because higher accrual intensity allows opportunistic behavior of managers.

Using a sample of firms from 20 countries9 during the period of 1993-2004, Brown et al. (2006) find

support for their hypothesis. The sample comprises of 47,802 firm-year observations obtained from the

Compustat Global database. Only the industrial firms include in the sample in order to enhance the

comparability of the outcomes across countries. The value relevance of earnings is calculated as the mean

returns of the earnings-based portfolio scaled by the mean return of the return-based hedge portfolio.

Brown et al. (2006) do not use the earnings-return regression approach but rather the portfolio approach

since the portfolio approach controls for the different volatility of market returns across countries.

Conditional conservatism is calculated using the asymmetric timeliness of Basu (1997) model and

association between accruals and cash flows (Ball and Shivakumar, 2005). Brown et al. (2006) also

calculate the market-to-book ratio (Givoly and Hayn, 2000) to capture the unconditional conservatism.

MTB ratio reflects the cumulative effect of net asset understatement. To estimate the relation between

conditional conservatism, value relevance of earnings and the accrual intensity, Brown et al. (2006) use

regression equation which consists of accrual index, tax-book conformity, conditional conservatism, and

unconditional conservatism as dependent variable, and value relevance of earnings as independent

variable. Accrual index exhibits the degree that the accounting system departs from a cash measure. Tax-

book conformity expresses the convergence between tax reporting and financial accounting. Both accrual

index and tax-book conformity are attained from Hung (2001).

The coefficients of accrual index and conditional conservatism show a negative value means that higher

accrual intensity and high conditional conservatism negatively related to the value relevance of earnings.

However the coefficient of the interaction between accrual intensity and conditional conservatism shows

a positive association with the value relevance of earnings both including and excluding unconditional

9 These are Australia, Belgium, Canada, Denmark, Finland, France, Germany, Hong Kong, Italy, Japan, The Netherlands, New Zealand, Norway, Singapore, South Africa, Spain, Sweden, Switzerland, UK, and USA.

34

conservatism. This supports the hypothesis that the accrual intensity positively increases the association

between conditional conservatism and the value relevance of earnings. Conditional conservatism

increases the value relevance of earnings only for countries with high accrual intensity.

Kousenidis et al. (2009) investigate the association between conservatism and value relevance of earnings

in Greece. They made three hypotheses; the first hypothesis is the presence of conservatism in the

accounting practice of Greek firms, the second hypothesis is that conservatism increase the value

relevance of accounting earnings and the third hypothesis is that the conservatism level of post-crisis

period of 2000-2003 is relatively higher than the period of 1989-1999. The traditional Greek accounting

system addresses mainly the firm’s tax liability and hence is considered to be conservative by nature

(Ballas, 1994). Moreover after the implementation of the Fourth EU Directive put forth, the valuation

should be made at the lower price between the historical cost and the market price which even increase

conservative accounting. Therefore Kousenidis et al. (2009) argue that conservatism presents in the data.

The implementation of IFRS (International Financial Reporting Standards) in 2005 could also have an

impact on the level of conservatism and for that reason Kousenidis et al. (2009) constraint their sample

period only until year 2003.

The data was obtained from the Profile database for the accounting data and the Athens Stock Exchange

for the stock price data. The total sample consists of 1,035 firm year observations from the period of

1989-2003. Due to different reporting requirements, financial industry has been excluded from the

sample. Basu (1997) model was used to measure the level of conservatism in the data. The significant

value of Basu (1997) measure indicates the presence of conservatism in the data. To investigate the

effects of conservatism on value relevance, the sample are separated into three groups according to the

level of conservatism. The lower and upper thirty percent are classified as the low conservatism group

and the high conservatism group whereas the remainder forty percent as the medium conservatism group.

The value relevance of accounting earnings is estimated based on the Easton and Harris (1991) model.

This model regressed earnings and changes in earnings as independent variable with stock returns as

dependent variable. To deal with heterogeneity the fixed/random effects estimator is included in the

equation.

With regard to the second hypothesis, the findings show that the value relevance of medium-conservatism

group is higher than the low-conservatism group suggesting that conservative accounting enhances the

value relevance of earnings. However the high-conservatism group exhibits lower value relevance of

earnings although it is slightly higher than the low conservatism group. Kousenidis et al. (2009) suggests

that “the excessive exercise of conservatism appears to distort the explanatory power of accounting

information” (p. 231). They conclude that the effect of conservatism on value relevance of earnings is

35

non-linear. Value relevance of earnings improves only in the medium-conservatism group and declines in

the low- and high-conservatism group. To test the third hypothesis, Kousenidis et al. (2009) divide their

sample period into two sub-samples that is the period of 1989-1999 and the period of 2000-2003. The

results show a higher and significant level of conservatism in the post-crisis period of 2000-2003 than

before the crisis i.e. the period of 1989-1999. This finding supports the view of Watts (2003a) that the

concern of litigation and increased accounting regulation during a market downturn may lead to more

conservative accounting. Furthermore the results also show that in the time of recession the value

relevance for low and high conservatism group is relatively lower than the medium conservatism group.

This demonstrates that investors value both high and low conservative earnings to be equally irrelevant in

the market downturn.

Despite of these two literatures that document evidence of conservatism’s effect on earnings,

Balachandran and Mohanram (2010) found no evidence that conservative accounting reduce the value

relevance of accounting information. They examine the association between value relevance of

accounting information and conservatism. The sample consists of 100,894 firm-year observations of the

U.S. firms during the period of 1975-2004, which obtained from the Compustat and CRSP databases. The

sample constitutes all industries except for firms with negative book value. The value relevance of

accounting information is measured by using three approaches: 1) price value relevance is the regression

of earnings and book values per share with stock price per share; 2) returns value relevance is the

regression of earnings and changes in earnings with the annual stock return; 3) perfect measures foresight

is the regression earnings, change in earnings and book value with the market-adjusted return.

Conservatism is measured by using two proxies: 1) Beaver and Ryan (2000) approach by regressing the

lags of stock returns10 with book-to-market ratio; 2) C-score (Penman and Zhang 2002). Please note that

these proxies measure unconditional conservatism.

Balachandran and Mohanram (2010) found that conservatism has substantially increased over the 30

years sample period using either proxy. They argue that increase in conservatism is driven by significant

growth of intangible assets and reporting standards which become more conservative. As mentioned in

the previous chapter, valuation of intangible assets allows certain level of subjectivity which is greatly

influenced by conservatism. With regard to the trend in value relevance, all three approaches demonstrate

a declining trend. Consistent with the findings of previous empirical literatures (Francis and Schipper

1999; Lev and Zarowin 1999), the value relevance of accounting information has declined over time. To

investigate whether the decline in value relevance related to the increase in conservatism, Balachandran

and Mohanram (2010) separate the sample of each year into two groups (high and low) based on the level

10 The coefficient of lagged stock returns captures the delayed recognition due to conservative accounting.

36

of conservatism and independently two groups (steady and increasing) based on conservatism growth.

They find that the decline in price and returns value relevance is more pronounced for groups with steady

conservatism growth than those with increasing conservatism. However for the value relevance for

perfect measures foresight, there is no difference between steady and increasing groups. They conclude

that the decline in value relevance is not related with increasing level of conservatism.

4.4. Earnings persistence and Value relevance

Earlier studies such as Kormendi and Lipe (1987), Easton and Zmijewski (1989) and Collins and Kothari

(1989) have proved that persistent earnings impose a higher response of stock price. It has been well

established by prior researches that more persistent earnings are more relevant for stock valuation than

less persistent earnings. Kormendi and Lipe (1987) and Easton and Zmijewski (1988) record a positive

relationship between earnings persistence and the earnings response coefficients (ERC) of the earnings-

return relation. Earnings response coefficient is a proxy for the usefulness of earnings information for the

equity market in other words a proxy for value relevance. Kormendi and Lipe (1987) analyze whether the

magnitude of the relationship between unexpected earnings on stock return (measured by an ERC) is

(positively) correlated with the present value of revisions in expected future earnings. Revision

coefficient is a proxy of earnings persistence which relates current earnings to future earnings. It

measures the extent to which earnings changes in the former years continued in the current year. The

greater the influence of the former year’s earnings changes on current year’s earnings change, the greater

the persistence of these former earnings. Their sample consists of US listed firms during the period of

1947-1980 which obtained from Compustat and CRSP databases. Using a univariate time-series model,

the results show a positive relation between persistence and ERC.

Easton and Zmijewski (1989) use revision coefficients to examine ERC relation with earnings

persistence. They hypothesize that ERC is positively correlated with revision coefficients and negatively

associated with systematic risk. Firm size is included as control variable. They use the quarterly earnings

of US listed firms during the period of 1975-1980. They find evidence supporting their hypothesis that

earnings persistence estimated by revision coefficients is positively associated with ERC. ERC is

negatively related to systematic risk and positively related to firm size however the results are not

statistically significant.

Collins and Kothari (1989) investigate the inter-temporal and cross-sectional determinants of ERC. They

included earnings persistence as one of independent variables in their multivariate models (growth, risk-

free interest rate, systematic risk and return) and find a statistically significant of earnings persistence

coefficient. Their sample consists of firms listed on the New York Stock Exchange (NYSE) over the

period 1968-1982 which obtained from the Compustat database. Although Collins and Kothari (1989)

37

unable to discern between the effect of growth and earnings persistence on ERC, they suggest that

earnings persistence is an important determinant of the value relevance of earnings.

Nichols and Wahlen (2004) who replicate Kormendi and Lipe (1987) show the importance of earnings

persistence for stock valuation. They hypothesize that firms with high persistent earnings will have higher

abnormal returns for earnings increases than firms with low persistent earnings. Contrary to Kormendi

and Lipe (1987), for earnings decrease Nichols and Wahlen (2004) predict relatively small differences in

abnormal returns between high-and low-persistence firms because earnings decreases or losses are not

likely to persist in the future. Firms with earnings decreases will improve their operations to avoid losses

in the next period.

Nichols and Wahlen (2004) examine on how the accounting information specifically earnings numbers

related to the stock returns. They use data of annual earnings and stock returns of publicly traded U.S.

firms. The sample comprises of 31,923 firm-year observations obtained from Compustat and CRSP

databases during the period of 1988-2001. They divide the sample firms into two portfolios: firms with

earnings increases and earnings decreases. Based on the magnitude of earnings changes, each portfolio is

sorted into ten deciles. The earnings persistence of each firm is ranked into ten deciles based on the

magnitude of earnings changes. The results show that during years with earnings increases, firms with

high earnings persistence earn on average higher abnormal returns than low-persistence firms. However

during years with earnings decreases there is only small difference in abnormal returns between high and

low persistence firms. This result supports the hypothesis of Nichols and Wahlen (2004).

4.5. Conservatism, earnings persistence and value relevance throughout

business cycle

Johnson (1999) investigates the impact of business cycle on the association between reported earnings

and stock returns. She argues that fluctuations in macroeconomic performances influence both the

investment and financing opportunity sets which will be reflected by the variation in earnings persistence

throughout the business cycle. Johnson (1999) divides the variation in business cycle into four stages;

expansion, credit crunch, recession and reliquification. Credit crunch is defined as a period during the

peak leading to recession. On the demand side, firms have insufficient internal-generated funds to finance

desired investment projects and therefore depend highly on external financing. On the supply side the

Federal Reserve is tightening supply funds and reduces the availability of external funds. Reliquification

occurs during the trough, mainly at late recession and early recovery periods. The periods of expansion

and recessions are defined based on the National Bureau of Economic Research (NBER) while periods of

credit crunch and reliquification are define based on the US largest forecasting firm called Data

38

Resources, Inc (DRI). Johnson (1999) made four hypotheses; the first two hypotheses are related to

earnings persistence and the rest related to value relevance of earnings. The first hypothesis predicts that

‘earnings are more persistent in expansions than in recessions’ (p.98) because of higher aggregate

availability of investment opportunities leads to more stable earnings during expansions and more

transitory during recessions. The second hypothesis predicts that ‘earnings are more persistent in credit

crunch periods than in reliquification periods’ (p.100). During a credit crunch period, the difference

between the capital costs from external fund is higher than internal fund compare to reliquification period.

Therefore firms rely as much as possible on internal fund. This implies a higher positive relation between

internal funds and earnings persistence during credit crunch periods. Using a sample of 53.324 quarterly

earnings during 1970-1987, the results support both earnings persistence hypotheses and indicate that

earnings persistence varies throughout business cycle.

Next to earnings persistence Johnson (1999) also investigates the value relevance of earnings estimated

by ERC throughout business cycle. She hypothesizes that ERCs are ‘larger in expansions than in

recessions’. As likely to persistence hypotheses she also predicts that ERCs are ‘larger in credit crunch

periods than in reliquification periods’. Johnson (1999) uses cumulative abnormal returns11 as dependent

variable and unexpected earnings per share12 as independent variable. To capture variations across

business cycle, three dummy variables for expansion, credit crunch and reliquification are included in the

regression model. Her results support both hypotheses, indicating that value relevance of earnings varies

throughout business cycle. Johnson (1999) demonstrates that value relevance of earnings is higher during

expansion periods relative to recessions and also higher during credit crunch periods relative to

reliquification periods.

Jenkins et al. (2009) relate business cycle variations with changes in earnings conservatism and value

relevance. Unlike Johnson (1999) who distinguishes business cycles into four stages, Jenkins et al. (2009)

divide the fluctuations in a business cycle only into two stages, namely expansions and contractions.

Further on, in their hypotheses they apprehend the value relevance of current earnings from the expected

future earnings. They formulate three hypotheses. The first hypothesis relates to earnings conservatism.

The second and third hypotheses are related to value relevance. The first hypothesis predicts that earnings

are more conservative during contractions relative to expansion periods. Jenkins et al. (2009) argue that

during contractions, the debt suppliers will demand more conservative earnings because it better reflects

the risk of default. In the second hypothesis, they predict that value relevance of current earnings,

controlling for future earnings expectations, is higher in contractions than in expansions. They criticize

the model used by Johnson (1999) which does not distinguish between current and expected future

11 Abnormal return is the difference between actual return and expected return of capital asset pricing model.12 Unexpected earning is the difference between actual EPS and Value Line forecasts of EPS.

39

earnings. Consequently the effect of expected future earnings is captured by the proxy of current earnings

and ‘mask the true contemporaneous return earnings relation’ (Jenkins et al., 1999, p. 1045). They argue

that more conservative earnings during contractions benefit investors for prediction of future earnings

using current earnings. Higher uncertainty during contractions and more conservative earnings imply that

earnings information is more reliable for the investors to form expectations compared to other informal

sources. The timely reporting of bad news due to conservative accounting helps investors to evaluate the

increased default risk. Therefore investors perceive earnings as more value relevant during contractions.

Hence this leads to higher association between returns and current earnings. Accordingly the ERC of

current earnings will be larger in contractions than in expansions.

Additionally, the third hypothesis predicts a higher value relevance of expected future earnings in

expansions than contractions. Jenkins et al. (2009) predict that during expansions investors will focus

more on the future cash flow and growth opportunity instead of the downside risk and conservative

earnings likewise in case of contractions. Further during expansions investors are likely to rely more on

expected future earnings to determine firm’s value instead of on historical earnings. Therefore expected

future earnings are more value relevant during expansions than contractions.

Jenkins et al. (2009) regress between annual stock return as dependent variable with annual earnings and

change of annual earnings as independent variable. They applied Basu (1997) asymmetric timeliness to

estimate earnings conservatism. They further specify the realized earnings as having expected and

unexpected components. Therefore, to examine the second and third hypotheses, they include future

returns as a proxy for future unexpected earnings and actual future earnings as a proxy for future expected

earnings. Their sample consists of 120,070 firm-year observations of U.S. firms during the period of

1980-2003 from the Compustat database. During that period, there were in total five contractions and

nineteen expansions as determined by NBER. They find evidence supporting all their hypotheses.

Earnings are more conservative during expansions relative to contractions. They submit that their findings

are somewhat contradictive from the findings of Johnson (1999), however this might be caused by the

difference in the return-earnings model being applied and the explanatory variables included in the model.

Jenkins et al. (2009) argue that current earnings are more value relevant in expansion than in contraction

if the expected future earnings (as a proxy for growth prospects) are omitted from the return-earnings

model. By controlling for the effects of future earnings expectation, their results indicate that value

relevance of current earnings may actually be lower in expansion than in contraction. The confirmation of

the third hypothesis demonstrates that the value relevance of expected future earnings is larger during

expansions relative to contractions, when the relation between past earnings information and future

growth prospects is likely to weaken.

40

Clinch and Wei (2011) apply a simple approach to examine the earnings-returns relation by regressing

abnormal returns and earnings. Instead of using definition from certain research bureau, Clinch and Wei

(2011) use macroeconomic indicators to define business cycle. These macroeconomic indicators are GDP

growth rate and market index return of each country. The year of sample periods are divided based on

negative, small positive and large positive of macroeconomic performance, depending on which indicator

being applied. They use sample firms from three countries – Australia (during years 1987-2008), the U.S.

(1971-2008) and China (1991-2008). Although the sample periods include years of the current crisis, they

do not investigate the current crisis extensively. The recent global financial crisis is viewed as motivating

interest of doing the research and not the purpose of their research.

For the US sample, they document evidence of a stronger earnings and returns relation in times of large

positive performance measured by GDP growth rate. However, if market index returns are used as the

macroeconomic performance indicator, the difference between positive and negative market return years

are not as significant as the results obtained from the test using GDP growth rate as the indicator.

Contrarily, Australian and Chinese firms demonstrate no evidence that ERCs are significantly different

across the three periods. However, these results differ when market index is used as macroeconomic

performance indicator. For US firms, the ERCs for negative market return years are not different from

small positive market return years while Chinese firms show smaller ERCs for negative market return

years than positive market return years. None of these countries show increased ERCs in years of

negative market returns. Australian firms show no difference in the earnings-returns relation across the

three periods. They conclude that only when GDP growth is used as an indicator for macroeconomic

performance, and only for the US firms, there is evidence of a stronger association between returns and

earnings in times of high macroeconomic performance. A stronger association between returns and

earnings indicate that earnings are perceived as more value relevant for the investors.


This chapter has elaborated on the findings of several empirical literatures regarding earnings persistence,

conservatism and value relevance. Earlier studies demonstrate that earnings persistence is negatively

related to conservatism. Paek et al. (2007) find that more conservative earnings are less persistent than

less conservative earnings. Related to accruals components of earnings, Sloan (1996) finds that accruals

have lower persistence than cash flows. Conservatism increases accruals persistence however this is only

valid for firms with high accruals (Wakil and Alam, 2012). Basu (1997) finds that due to conservatism

earnings changes during good news period are more persistent than during bad news period. Herewith

conservatism is expected to be higher during bad news period that is contraction than during good news

period or expansion.

41

Brown et al. (2006) find a negative correlation between conditional conservatism and value relevance of

earnings. Kousenidis et al. (2009) also demonstrate that high conservatism reduce the value relevance of

earnings. However firm with low conservatism is also perceived to be less value relevant for the

investors. Balachandran and Mohanram (2010) find a significant increase in conservatism along with a

declining trend of value relevance. Contrary to prior literatures that suspect conservatism as a reason of

declining value relevance (Francis and Schipper, 1999; Lev and Zarowin, 1999), Balachandran and

Mohanram (2010) demonstrate that firms with high conservatism do not necessarily less value relevant

for investors.

Earlier researches demonstrate that earning persistent is positively associated with the value relevance of

earnings (Kormendi and Lipe, 1987; Easton and Zmijewski, 1989; Collins and Kothari, 1989). Recent

study from Nichols and Wahlen (2004) confirm the findings of Kormendi and Lipe (1987) that firms with

higher persistence earnings are more value relevant for investors as indicated by higher abnormal returns

earned by these firms.

Related to fluctuations in business cycle, Clinch and Wei (2011) find that US firms show higher value

relevance in time of large positive GDP. Nevertheless there is no significant difference between positive

and negative GDP periods for Australian and China firms. Periods with positive GDP can be seen as the

expansion stage of business cycle. Indeed based on NBER business cycle, GDP is one of the indicators

which used to determine different stage of business cycle. Johnson (1999) finds that earnings persistence

and value relevance are higher during expansions than during recessions. Contrarily Jenkins et al. (2009)

find that value relevance of current earnings is higher during contractions than expansions. Jenkins et al.

(2009) argue that higher conservatism during contractions leads to higher value relevance during

contractions than expansions. Value relevance of future expected earnings is found to be higher during

expansions than contractions (Jenkins et al. 2009). These mixed results are investigated further in the next

chapter. Based on conclusions of prior literatures, some hypotheses are developed and tested using

empirical data from the U.S. listed firms.

42

5. Hypothesis Development and Methodology


This chapter is the quantitative part of this thesis in order to find evidences on value relevance, earning

persistent and earnings conservatism throughout business cycle. To test the relation among value

relevance, earnings persistent and earnings conservatism, several hypotheses are developed and tested

with the help of Eviews statistical software. The hypotheses are developed based on prior empirical

studies provided in chapter four. Likewise the methodology on testing these hypotheses is provided here.

Further the findings and the analysis are presented at the end of this chapter.

5.2. Hypotheses Development

During market downturn, firms rely more on external financing because the internally generated funds are

likely to be lower than during an expansion. Firms face more difficulty to cover their fixed costs because

fewer goods are being sold and due to lower demand, the market price of inventories will be lower.

Consequently reporting losses occur more frequent during a market downturn. Based on Basu (1997)

conservatism is the tendency of accountants to acquire higher verification regarding gains compared to

losses. Because losses are likely to appear during a contraction, therefore the level of conservatism

appears to be higher during a contraction. Realized that the litigation risk is higher during a recession,

debt suppliers require firms to present their results conservatively because conservative accounting better

informs about the risk of default (Jenkins et al. 2009). Accordingly firms apply conservative accounting

in order to get access to new loan and to conform to the expectation of debt suppliers. High conservatism

in a market downturn can be noticed in the more conservative earnings during contractions relative to

expansions. Jenkins et al. (2009) show that earnings are more conservative during contractions than

expansion. Therefore I predict that:

H1: Earnings conservatism is relatively higher during contraction periods than during expansion periods.

During an expansion, business activity is higher and there is less uncertainty in the market. An expansion

is indicated by higher economic growth and positive GDP. This steady growth during an expansion offers

firms more persistent income than during a contraction. Nichols and Wahlen (2004) find that earnings

persistence is higher during years of earnings increases. Johnson (1999) demonstrates that earnings are

more persistent during expansions period than during contractions period. Therefore I predict that:

H2: The persistence of earnings is relatively higher during expansion periods than during contraction

periods.

43

Prior research has documented positive association between earnings persistence and value relevance

(Collins and Kothari, 1989; Nichols and Wahlen, 2004). Because earning persistence is predicted to be

higher during expansions periods, it seems logical to predict that value relevance is higher during

expansions compared to contractions. However whether conservatism has an effect on value relevance

prior literatures found mixed evidence. Brown et al. (2006) suggest that conditional conservatism is

negatively related to value relevance of earnings. However Kousenidis et al. (2009) argue that both

absence and excessive conservatism lead to less value relevance earnings. Balachandran and Mohanram

(2010) show that conservatism has no effect on value relevance. If the proposition of Balachandran and

Mohanram (2010) is correct then it can be expected that value relevance of earnings will be higher during

expansions and recessions which is consistent with the findings of Johnson (1999). The value relevance

of earnings with or without controlling future earnings expectations should be higher during expansions

than contractions. Nevertheless, Jenkins et al (2009) - who control for future earnings expectation -

demonstrate that value relevance of earnings is lower during contraction periods than during expansions.

However Jenkins et al. (2009) do not consider earnings persistence which is likely to be lower during

contraction and likewise lowering the value relevance of earnings. To reconcile these mixed results

between Johnson (1999) and Jenkins et al (2009), I develop two hypotheses as follows:

H3: Controlling for future earnings expectations, current earnings are relatively more value relevant

during expansion periods than during contraction periods.

H4: The expected future earnings are relatively more value relevant during expansion periods than during

contraction periods.

Summary of the four hypotheses and their relations with the research question is provided in table 4.

Expansion periods Expected sign Contraction periods Research Question

H1 Conservatism exp < Conservatism cont Higher earnings persistence and lower conservatism during

expansion leads to higher value relevance of current

and future earnings in expansions than

contractions

H2 Persistence exp > Persistence cont

H3 Value relevance exp

of current earnings

> Value relevance cont of current earnings

H4 Value relevance exp

of future earnings

> Value relevance cont of future earnings

Table 4: Hypotheses summary

44

5.3. Methodology

This section elaborates on the applied methods for testing the four hypotheses above. Measurement

explains the models used to estimate earnings persistence, conservatism and value relevance of earnings

throughout the periods. Data sample provides information on the data which is employed to test these

hypotheses. Descriptive statistics test the suitability of the data available to be used for statistical analysis.

Last but not least findings show the statistical result and analysis of the tested hypotheses using the

available data.

5.3.1. Measurement

Starting from the first hypothesis, there are five methods to estimate conservatism as have been

mentioned in the third chapter. The method to be used is depending on the purpose of the research.

Asymmetric timeliness of Basu (1997) is the most applied method in empirical research (Wang et al.,

2008). For the purpose of this thesis, the asymmetric timeliness of Basu (1997) is the most appropriate for

three reasons: 1) this model measures conservatism in earnings which is the subject of this thesis; 2) this

model includes capital market measure i.e. stock returns which is also affected by the business cycle; and

3) this model is similar to the conservatism proxy applied by Jenkins et al. (2009). Perhaps it is not a very

strong argument to apply the same proxy because another literature applies similar model as well.

Nevertheless in this case it is favorable to apply similar model with Jenkins et al. (2009) in order to

enhance the comparability of this outcome with the one from Jenkins et al. (2009). Recall the aim of this

thesis is to investigate the mixed results between Johnson (1999) and Jenkins et al. (2009). The

asymmetric timeliness of Basu (1997) is based on the semi-strong form of efficient market hypothesis that

stock returns symmetrically and quickly reflect information from all publicly available information.

Returns are used to measures the available ‘news’. The greater timeliness of earnings for bad ‘news’

indicates that earnings is more sensitive to bad news (negative returns) than good news (positive returns)

which is measured by the slope coefficient and R2 from a reverse regression of earnings on returns (Basu,

1997).

Coefficient β1 reflects the earnings response to return if returns are positive while coefficient (β 1 + β3)

reflects the earnings response to returns if returns are negative. If coefficient (β 1 + β3) is greater than β1, it

indicates asymmetric timeliness of earnings for bad news versus good news. Rewrite again (β 1 + β3) > β1 is

equal to β3 > 0. Hence if β3 is significantly greater than zero then it can be concluded that earnings are

conservative. To investigate whether earnings conservatism differs throughout business cycles, the

original Basu (1997) model is modified as follows:

Eit = β0 + β1Rit + β2DRit + β3Rit*DRit + β4Expt + β5Expt*Rit + β6Expt*DRit + β7Exp*Rit* DRit + it + εit

45

In this modified version, a dummy variable representing business cycle is included. Exp is a dummy

variable which equals to one during an expansion and zero for contraction. As mentioned in the first

chapter, this thesis defines business cycle only to two stages of expansion and contraction. Coefficient β5

captures the impact of business cycle on the earnings timeliness of good news recognition while (β 5 + β7)

captures the effect of business cycle on the earnings timeliness of bad news recognition. Likewise if (β5 +

β7) > β5 (or β7 > 0), it indicates that earnings are more conservative during expansion. Contrariwise if

coefficient β7 is significantly negative, this provides support for the first hypothesis that earnings are less

conservative during expansions relative to contraction.

For the second hypothesis, earnings persistence is estimated using the lag model of earnings. The

persistence of earnings is measured by the first auto-correlation coefficient between current earnings and

future earnings. This model does not take into account the different persistence between earnings

components which are accruals and cash flow. The second hypothesis does not particularly focus on

earnings components but on the aggregate earnings therefore the lag model is applied. Moreover to

enhance comparability with the findings of Johnson (1999), I apply the lag model which is similar to the

model applied in Johnson (1999). To include the business cycle effect, the model is modified as follows:

E t+1 = 0 + 1Et + 2Expt + 3Expt *Etit + t

A dummy variable representing business cycle is included. Exp is a dummy variable which equals to one

during an expansion and zero for contraction. Coefficient β3 reflects the effect of expansion on the

persistence of current earnings. If coefficient β3 > 0, it demonstrates that earnings persistence is higher

during the expansion periods than during the recession periods. Therefore a positive β3 coefficient

provides support for the second hypothesis that the persistence of earnings is higher during expansions

relatively to contractions.

The third and fourth hypotheses are related to value relevance of earnings. As mentioned in the third

chapter, there are three models which are commonly used in value relevance research. To measure the

value relevance of accounting information for the capital market, it can be done by associating stock

returns with earnings and/or book value. The last two hypotheses are focusing on earnings and not on

book value. For this reason, earnings model is the suitable model to apply. Following Jenkins et al. (2009)

I utilize the next period earnings and returns as proxies for future earnings expectation. Future earnings

has both expected and unexpected components which are not directly observable. The expected part of

future earnings is captured by the next period earnings while the unexpected shock to future earnings i.e.

earnings surprise is captured by future stock returns (Jenkins et al., 2009). Therefore to control for future

earnings expectations, the earnings model is modified as follows:

46

Rit = β0 + β1Eit + β2∆Eit + β3Eit+1 + β4Rit+1 + β5Expt + β6Expt*Eit + β7Expt*∆Eit + β8Exp*Eit+1 + β9Exp*Rit+1 +

it + εit

The next period earnings and stock returns are included as control for future earnings expectations. If

coefficients β6 > 0, it shows that value relevance of current earnings – controlling for future earnings

expectations - are higher during expansions than during contractions. The value relevance of expected

future earnings is captured by coefficient β8. If coefficient β8 > 0, then it can be concluded that the value

relevance of expected future earnings is higher during expansions than contractions.

Please note here that the regression formula have two dimensions: firm (i) and year (t) namely for panel

data. Data with only one dimension for example only firms is called cross-section data and if only for

year period is called time-series data. Whereas the inclusion of both dimensions firms and year periods

called panel data analysis. Not all statistic packages contain features for panel data analysis. For this

thesis I use Eviews statistic software which is commonly used for financial analysis. In the formula, the

symbol it stands for fixed effect estimator. The fixed effect model is a suitable specification for the

analysis which inference is restricted to the specific sets of items, in this case a set of firms (Baltagi,

2008). Including fixed effect estimator remove the effect of different characteristics between the

individual so allowing the regression coefficient to estimate only the independent variables’ net effect.

Various firm-specific characteristics among firms may bias the dependent and independent variables.

Therefore fixed effect parameter is applied to control for this bias.

5.3.2. Data sample

The sample contains of 364 companies listed in Standard & Poor 500 (S&P 500) list in the United States.

The S&P 500 concentrates on the listed company in the United States that has a large capitalization of the

market. The S&P 500 includes approximately 75% coverage of U.S. equities and it is therefore an ideal

proxy of the total US capital market. Additionally using listed company with large market capitalization

reduces size differences between companies, excluding size effect from the sample. The data are taken

from Compustat database. The data of earnings per share (eps) and stock prices are numbers drawn from

firm’s consolidated annual statement. During the sample period 1988-2011, there are in total 582

companies which have and ever been listed in the S&P 500. There are more than 50 companies because

throughout the years there are new firms enter the market and become listed while some lose their

competitiveness and went bankrupt or become a private company.

To enhance the comparability of business cycle effects between firms, firms with fiscal year ending other

than December are excluded from the sample. There are 437 firms remained after excluding 145 firms

which have fiscal year ending other than December. Moreover firms with SIC code higher than 6000 -

47

which are firms in sectors: financial, insurance and public administration - are also excluded from the

sample. Financial and insurance sectors often have different accounting regulations while public

administration sector is less likely to be affected by fluctuations in the business cycle. After excluding 63

companies with SIC code higher than 6000, there are 374 companies that meet these criteria. Companies

which do not have complete earnings and returns data of at least two consecutive years are removed from

the sample. The remaining sample contains of 364 companies. Stock return is calculated by subtracting

prior year stock price from current stock price and divided by prior year stock price. To calculate the

stock return of year 1988, the stock price of year 1987 is therefore required.

The sample period is between years 1988-2011 which contains in total 18 years of expansions and 6 years

of contractions. Summing from prior expansion to the next expansion, there are in total three business

cycles during the sample period of 1988-2011.

Year NBER Business Cycle Classification Duration

1988-1989 Expansion 2years1990-1991 Contraction 2 years

1992 – 2000 Expansion 9 years2001 Contraction 1 year

2002 – 2006 Expansion 5years2007 – 2009 Contraction 3 years2010 – 2011 Expansion 2 years1988-2011 Three business cycles 24 years

Table 5: Business cycles in US for periods 1988-2011

Figure 5: The business cycles during sample periods 1988-2011 (adapted from www.BEA.gov)

The business cycle stages i.e. expansion or contraction are represented by the dummy, one equal to

expansion and zero for contraction. The dash line is the second-moving average trend line around the U.S.

GDP line. The graph clearly demonstrates the ups and downs of the U.S economics. In line with the

48

88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11

-6

-4

-2

0

2

4

6

US Business Cycle

GD

P

NBER definition of business cycle a contraction period is indicated by a low level of GDP. The graph of

US business cycle is provided in figure 5.

5.3.3. Descriptive Statistics

i. Sample distribution

There are in total 7000 observations obtained from 364 companies between years 1988-2011. It is an

unbalanced panel data because not every company has full observations for sample period 1988-2011.

From the frequency graph below it can be seen that the availability of the data increasing throughout the

time however start to decline again before the financial crisis in year 2008-2009. It seems that there are

fewer companies who are able to survive the current crisis resulting in the declining of data.

Figure 6: Data frequency

Table 6 depicts the descriptive statistics of the sample. EPS1 represents eps t+1 and RET1 represents rett+1.

There are less eps1 and ret1 because for year 2011 there is no sample of year 2012 are included and also

some firms does not have full sample which also reduces the availability sample for EPS1 and RET1.

Jarque-Bera (JB) tests for the normality of the sample which is calculated from the skewness and

kurtosis13. The null hypothesis of JB test is a normal distribution sample. None of the variables has a

normal distribution as the null hypothesis of JB test is rejected for all variables (see the probability which

is lower than 5%). One way to normalize a skewed distribution is by taking logarithm function of the

variables. However this cannot be done here since the sample is also included negative numbers. Based

on Brooks (2008), skewed distribution has little consequences for a large sample size. Therefore there is

no special treatment for this non-normal distribution sample. Looking at the graph of earnings per share

13 Skewness refers to the asymmetry of a sample distribution in which the length of the tail is important and kurtosis refers to the variation in the frequencies of the distribution sample for example extreme outliers and highly concentrated data values which increases the distribution peak.

49

88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 110

50

100

150

200

250

300

350

Unbalanced panel data

frequency

(eps) and return distribution (see appendix 2), non-normal distribution is particularly caused by long tail

of some eps and returns observation. Deleting these outliers will reduce the valuable information

contained in these data from the total sample. Graph 1 and 2 in the appendix demonstrate the non-

normality distribution of the eps and returns sample.

Mean Median Max.Value

Min.value

Std.dev.

Skewness Kurtosis JB p.val

TotalObs.

Full sampleEPS 1.941 1.91 68.85 -76.52 3.699 -2.318 18.791 0.000 7000RET 0.124 0.056 29.833 -0.991 0.924 89.679 499.911 0.000 7000EPS1 1.922 1.91 68.85 -76.52 3.713 -2.536 92.104 0.000 6636RET1 0.122 0.051 29.833 -0.991 0.937 18.879 497.237 0.000 6636DR 0.422 0 1 0 0.494 0.317 1.1 0.000 7000Exp 0.754 1 1 0 0.431 -1.180 2.393 0.000 7000

ExpansionEPS 2.012 1.9 41.27 -44.08 3.17 -0.057 47.309 0.000 5279RET 0.136 0.075 26.492 -0.991 0.797 19.516 568.994 0.000 5279

ContractionEPS 1.689 1.95 30.31 -76.52 4.457 -6.475 555180.3 0.000 1721RET 0.038 -0.069 29.833 -0.983 1.3017 17.042 7023100. 0.000 1721Table 6: Descriptive statistics

Looking at the correlation between variable, there is no multicollinearity between the variables.

Multicollineariy implies a high correlation between independent and dependent variables which is

troublesome to disentangle the effects of different independent variables on dependent variable.

Multicollinearity can be identified from correlation matrix between variables which is provided below.

Because there is no variable which is highly correlated with each other, hereby there is no concern of

multicollinearity.

CorrelationDEPS EPS1 RET RET1

EPS 0.521662 0.492518 0.041543 -0.132176DEPS 0.15522 0.190929 0.004319EPS1 0.001881 0.001881RET 0.017482Table 7: Correlation matrix between variables

ii. Validity framework

The effectiveness of an experiment in financial accounting is depending on the internal and external

validity. Internal validity refers to the degree to which variation in the independent variables attribute to

the variation of the dependent variable while external validity deals with the generalization of the

experimental findings beyond the specific procedures, measures and samples applied in the study (Libby

50

ConservatismPersistenceBusiness cycle stagesFirm size

Accounting information Capital market response

StockReturn

Earnings per share

Independent variables Dependent variables Control variables

Conceptual

Operational

et al., 2002). Lack of internal validity produces a misleading evidence of the relation between

independent and dependent variables whereas lack of external validity brings on results that are not in line

with the purpose of the study (Libby et al., 2002).

With regard to this study, the internal validity of this study is determined by the relation between earnings

and stock market returns. In order to measures the effect of accounting information on the capital market,

earnings per share is employed as an independent variable and regresses with stock return as the

dependent variable. The effect of earnings information to the equity market is measured by the earnings

response coefficient that is the slope coefficient of a linear equation between earnings and stock returns.

The external validity is accomplished by controlling for different stages of business cycle. As mentioned

in the first chapter the purpose of this study is to find the relation between value relevance, earnings

persistence and earnings conservatism throughout the business cycle. Therefore the state of earnings

persistence and earnings conservatism throughout the business cycle stages are being monitored as well.

Moreover the sample selection which consists of firms with large market capitalization controlled for the

firm size effect. Validity framework of this study depicts in figure 7.

Figure 7: Predictive validity framework

51

5.3.4. Findings The regression coefficient and p-value of all hypotheses are summarized in this subsection. The first

regression analysis is done by applying the panel least squares method. However looking at the

conservatism and the value relevance models, both earnings per share and stock returns may be

endogenous variables (Jenkins et al. 2009). It means that earnings and stock returns are influencing each

other simultaneously. This can be problematic because when for example eps is used as dependent

variable and stock return as explanatory variable the error term of the regression test is correlated with the

dependent variable. This is because the dependent variable has a simultaneous effect on one of the

explanatory variable. Earnings per share and return may affect each other in both directions; high

earnings induce high return and high return may increase future earnings. The regression coefficient is

therefore biased because the error term is correlated with the dependent variable.

Therefore I employ the two-stages least squares (TSLS) method as robustness check. Basically TSLS

method is done by running least squares regression in two stages. In the first stage of regression, earnings

are regressed with returns. The estimated values of earnings and returns (Ehat or Rhat) from the first stage

regressions are substituted for Eit in model 1a and for Rit in model 3b. There is no the two-stages least

squares performed for the earnings persistence test (model 2). The theoretical reason behind it is because

there is no return included in model 2. It is also unlikely that future earnings (E t+1) as dependent variable

affects the predictor variable current earnings (Et). Future earnings cannot influence back the past

earnings. Therefore endogeneity problem in the persistence test is very unlikely.

i. Hypothesis 1: Earnings conservatism test

The result from earnings conservatism tests (model 1 and 1a) are shown in table below. Model 1 is

provided to compare the sample with the findings of Basu (1997). All coefficients from Model 1 are

significant and have positive sign which are similar to the findings of Basu (1997). From Model 1 the

interaction term between return and the dummy of negative returns (Rit*DRit) is positive and significant at

1% level. This implies that earnings are about 12 times (11.90 = [0.34 + 3.718]/0.34) more sensitive to

negative return as it is to positive returns. With regard to the first hypothesis, the negative and significant

result of coefficient β7 on 1% significant level provides support for the first hypothesis. This implies that

earnings are less conservative during expansions than during recessions. In other words earnings are more

conservative during the market downturn relatively to the expansion periods. Moreover the robustness

check of TSLS method also confirms this result. Coefficient of interaction term DR*Exp*Ret is negative

and still significant at 5% level.

52

Model 1: Eit = β0 + β1Rit + β2DRit + β3Rit*DRit + it + εit

Model 1a: Eit = β0 + β1Rit + β2DRit + β3Rit*DRit + β4Expt + β5Expt*Rit + β6Expt*DRit + β7Exp*Rit* DRit + it

+ εit

Coefficient(p-value)

Least squares Robustness check: TSLS*Model 1 Model 1a Model 1a

Intercept 2.184 (0.000) 1.947 (0.000) 1.807 (0.000)Rit 0.088 (0.06) 0.013 (0.848) 0.071 (0.141)DRit 0.34 (0.002) 0.867 (0.000) -1.096 (0.000)Rit*DRit 3.718 (0.000) 5.312 (0.000) 0.34 (0.379)Expt 0.282 (0.031) 0.164 (0.198)Expt*Rit 0.154 (0.096) 0.071 (0.139)Expt*DRit -0.734 (0.004) 0.357 (0.045)Expt *Rit*DRit -2.631 (0.000) -0.159 (0.045)R-squared 0.299 0.302 0.289*Note: Concerning the robustness test, the return (Rit ) variable is substituted with the fitted value of return (i.e. Rhatit) which is estimated value from the earnings and returns regression.Table 8: The results of earnings conservatism test

ii. Hypothesis 2: Earnings persistence test

The results of earnings persistence test is provided in table 9. Model 2 is provided as a benchmark model

that excludes business cycle effects. The positive and highly significant coefficient of current earnings in

Model 2 shows that current earnings are useful in predicting future earnings. Moreover when including

the expansion dummy, model 2a shows that during expansions current earnings has more power in

predicting future earnings than in contraction periods. The intercept of dummy expansion (Exp t) and the

interaction term of current earnings and expansion (Expt * Et) are positive and significant at 5% level.

This implies that earnings persistence is higher in expansion than contractions. The positive and

significant coefficient of 3 on 5% significant level provides support for the second hypothesis that

earnings persistence is higher during expansion periods than during recessions.

Model 2: E t+1 = 0 + 1Et it + t

Model 2a: E t+1 = 0 + 1Et + 2Expt + 3Expt * Etit + t


Least squaresModel 2 Model 2a

Intercept 1.321 (0.000) 0.749 (0.000)Et or Epshatit 0.314 (0.000) 0.481 (0.000)Expt 0.226 (0.023)Expt * Et 0.057 (0.012)R-squared 0.342 0.245Table 9: The results of earnings persistence test

iii. Hypothesis 3 and 4: Value relevance tests

53

The results of value relevance tests are demonstrated in table 10. Model 3 is provided as basic model

which preclude business cycle effects. One particular note here, the variable earnings has a negative and

significant value. This implies that capital market response negatively to earnings increase. This seems

awkward and different from prior research (Jenkins et al. 2009) which finds positive coefficient of

earnings. What is the explanation behind this negative coefficient? This is perhaps has something to do

with the sample year included in my sample. One third of my sample consists of years 2001-2011. Due to

major accounting scandal in 2001 the accounting information has been accused not to give a true and fair

view of a firm’s performance. It seems that the capital market has learned to gather information from

other sources instead of a simple earnings number. This does not mean that earnings have no explanation

power on return because the earnings change (∆Eit) coefficient still has a positive and significant value. A

positive and significant value of earnings change coefficient implies that higher earnings change

positively affects the firm’s stock return. Model 3a expands model 3 by including future earnings (Eit+1) as

a proxy for expected future earnings on year t stock return and future returns as a proxy for unexpected

earnings. Consistent with the result of Jenkins et al. (2009), model 3a shows a positive and significant

coefficient on actual year-ahead earnings (at 10% level) and a negative and significant coefficient on

actual year-ahead returns (at 1% level).

A positive coefficient β6 demonstrates that value relevant of current earnings – controlling for future

earnings – is higher in expansion periods than contraction periods. This finding provides support for the

third hypothesis (H3). However this coefficient is not significant, so based on least squares method it

cannot be concluded that the value relevance of current earnings is significantly different between

expansions and contractions. Looking further on the robustness check, the interaction coefficient between

dummy expansion and Ehatit is positive and significant on 1% significant level. Therefore it can be

concluded that value relevance of current earnings is higher during expansions than contractions. This is

in line with the result of Johnson (1999) and the prediction from prior literature that value relevance of

current earnings will be higher during expansions than contractions.

With regards to the fourth hypothesis, a positive and significant coefficient β8 shows that value relevance

of expected future earnings is higher during the expansion than contractions. The interaction term

between dummy expansion and future earnings (Exp*Eit+1) is significant at 5% level. This implies that the

expected future earnings are more value relevant during expansions than during contractions. The

robustness check shows the same conclusion however the coefficient β8 is significant at 10% level. The

next section provides the analysis of all hypotheses tests and their relations with the research question.

Model 3: Rit = β0 + β1Eit + β2∆Eit + it + εit

Model 3a: Rit = β0 + β1Eit + β2∆Eit + β3Eit+1 + β4Rit+1 + it + εit

54

Model 3b: Rit = β0 + β1Eit + β2∆Eit + β3Eit+1 + β4Rit+1 + β5Expt + β6Expt*Eit + β7Expt*∆Eit + β8Exp*Eit+1 + β9Exp*Rit+1 + it + εit


Least squares Robustness check: TSLS*Model 3 Model 3a Model 3b Model 3b

Intercept 0.142 (0.000) 0.154 (0.000) 0.159 (0.000) 0.265 (0.000)Eit -0.01 (0.023) -0.016 (0.002) -0.02 (0.011) -1.127 (0.000)∆Eit 0.05 (0.000) 0.06 (0.000) 0.048 (0.000) 0.053 (0.000)Eit+1 0.007 (0.054) -0.001 (0.823) 0.002 (0.795)Rit+1 -0.054 (0.000) 0.071 (0.000) 0.068 (0.001)Expt -0.019 (0.54) -0.102 (0.009)Expt*Eit 0.005 (0.561) 0.757 (0.000)Expt * ∆Eit 0.024 (0.005) 0.017 (0.024)Exp*Eit+1 0.017 (0.025) 0.0129 (0.069)Exp*Rit+1 -0.21 (0.000) -0.208 (0.000)R-squared 0.087 0.102 0.115 0.117*Note: Concerning the robustness test, the earnings (Eit ) variable is substituted with the fitted value of earnings (i.e. Ehatit) which is the estimated value of earnings from the earnings and returns regression.Table 10: The results of value relevance test

Summary of the findings from these hypotheses tests is provided in table 11.

Expansion periodsExpected sign Contraction periods Findings

H1 Conservatism exp < Conservatism cont SupportedH2 Persistence exp > Persistence cont Supported

H3 Value relevance exp of

current earnings

> Value relevance cont of current earnings

Supported

H4 Value relevance exp of

future earnings

> Value relevance cont of future earnings

Supported

Table 11: Summary of the findings

5.4. Analysis

Prior section demonstrates results from all hypotheses tests. There are four key findings from these

hypotheses tests. First, it shows that business cycle has an impact on the earnings and the earnings-returns

relation. Earnings conservatism, earnings persistence and value relevance of earnings vary throughout

different stages of business cycle. Earnings conservatism is lower in expansions than in contractions

whereas earnings persistence is higher in expansions than in contractions. Current earnings and future

earnings are more value relevant in expansion periods than in contractions periods. Business cycle

therefore has a significant effect on the accounting information in this case thus earnings and on the

55

association between accounting information particularly earnings and the response of capital market

measured by stock returns.

Second, more conservative earnings during contractions do not result in higher value relevance of current

earnings in contractions which is contrary to the result of Jenkins et al. (2009). Jenkins et al. (2009) argue

that more conservative earnings have higher predictive value which should result in higher value

relevance of earnings. In contrast to Jenkins et al. (2009) prediction, the value relevance test shows that

less conservative earnings during expansion periods are more value relevant than more conservative

earnings in contraction periods. This is in line with Brown et al. (2006) who suggest that conditional

conservatism is negatively related to the value relevance of earnings.

Third, the higher earnings persistence in expansions results in higher value relevance for both current

earnings and future earnings in expansions relative to contractions. As suggested by Dechow et al. (2010)

high persistent earnings are more useful for firm’s valuation because of its higher predictive value. In line

with the result from Johnson (1999) and Nichols and Wahlen (2004) earnings persistence is higher in the

years of earnings increase for example during periods with steady economic growth namely an expansion.

Fourth, current earnings and expected future earnings behave in the same way throughout the business

cycle. This is in contrast to the proposition of Jenkins et al. (2009) who find that value relevance of

current earnings is actually lower in expansions if the future earnings are included as a proxy of future

earnings expectation. The capital market commonly employs current earnings in forecasting a firm’s

future earnings. Based on this forecast, investors assess the firm’s value and decide on the most profitable

investment choice. As mentioned before, earnings with higher persistent are more useful and provide

better estimation for earnings forecast. Therefore the relevance of current earnings and future earnings for

the equity market valuation should demonstrate a similar pattern throughout different stages of business

cycle. Consequently, both current and future earnings appear to be more value relevant in expansions than

in contractions.

Comparing the findings with prior research, the results are similar to previous studies (Johnson, 1999;

Jenkins et al. 2009) except for the value relevance of current earnings. The outcome of earnings

conservatism test that conservatism is higher in contractions than in expansions is in line with Jenkins et

al. (2009). The outcome of earnings persistence test that earnings persistence is higher in expansions than

in contractions is similar to the findings of Johnson (1999). With regard to the value relevance test,

current earnings and future earnings are more value relevant in expansions relative to contractions. This is

in line with the results of Johnson (1999) who finds higher value relevance of current earnings in

expansions than in contractions. However Jenkins et al. (2009) find that current earnings to be more value

56

relevant in contractions than in expansions. Jenkins et al. (2009) argue that a higher demand of

conservative accounting during contraction periods enhances the value relevance of earnings in

contraction periods. Yet Brown et al. (2006) and Kousenidis et al. (2009) demonstrate that high

conservatism reduces the value relevance of earnings. This means that Jenkins et al (2009) argument does

not seem to hold although they found evidence supporting their arguments. Lower conservatism also

implies that earnings capture the true firm’s performance more accurately. Moreover Jenkins et al. (2009)

did not consider the positive effect of higher earnings persistence on the value relevance of earnings.

Higher persistence of earnings improves the predictive power of current earnings to forecast the future

earnings. Investors establish their evaluations on this forecast. All together, less conservative and higher

persistent earnings contribute to the higher value relevance of earnings during expansion periods than

during contraction periods.

One important question still remains: why do Jenkins et al. (2009) find evidences supporting their

proposition that value relevance of current earnings is higher in contractions than in expansions? With

regard to the value relevance model, I employ exactly similar model to the model applied in Jenkins et al.

(2009). Therefore the source of differences does not cause by the applied model. The possible explanation

lies in the different sample firms and sample periods. Firstly, Jenkins et al. (2009) use all firm-years listed

on the Compustat database whereas my sample constrains to the firms with large market capitalization.

As explained in chapter three, larger firms have more persistent earnings and are less likely to report

losses than smaller firms. Jenkins et al. (2009) do not take into account the size-effect in their sample

selection. Including all firms (from the small to the large ones) might lower the persistence of earnings

during expansion which leads to lower value relevance of current earnings in expansions than in

contractions. Because Jenkins et al. (2009) do not measure earnings persistence of their sample; it is

difficult to conclude whether including all firms might be the reason of different results between my

findings and Jenkins et al. (2009). Furthermore Jenkins et al. (2009) also include financial, insurance and

public administration sectors, which assemble the effect of various firm-specific characteristics in their

research findings. Jenkins et al. (2009) also do not distinguish firms with different fiscal-year periods. All

together the findings of Jenkins et al. (2009) are entangled with various other factors i.e. firm-size and

firm-specific characteristics which make the interpretation of their findings problematic.

Secondly, the sample periods of Jenkins et al. (2009) include years 1980-2003 while my sample periods

are years 1988-2011. Although there is overlapping in my sample periods with the sample periods of

Jenkins et al. (2009), yet it is unknown whether the business cycles in these periods are comparable.

Jenkins et al (2009) - who also use the NBER business cycle classifications - categorize years 1980-1982

as contractions. Nevertheless, three years of consecutive contractions 1980-1982 might not be comparable

57

to the consecutive contractions of years 2007-2009 in my sample, resulting in different outcomes between

the findings of my current earnings value relevance test and of Jenkins et al. (2009).


This chapter elaborates on the empirical part of this thesis. This chapter aims to answer the fourth sub-

question on how earnings persistence, conservatism and value relevance change throughout the business

cycle. In order to answer this question, four hypotheses are developed and tested using the US firms

sample listed on S&P500. Based on the earnings conservatism test (H1) earnings are less conservative

during the expansion periods relative to the contractions. Due to the higher chance of reporting losses in a

contraction, therefore the level of conservatism in earnings appears to be higher in a contraction relative

to an expansion. From the earnings persistence test (H2) earnings are more persistent in expansions than

in contractions. In an expansion when the economics are growing, a persistent flow of income is more

feasible than in a contraction when external and internal financing sources are hardly available. Based on

the value relevance test (H3 and H4) current earnings and future earnings are higher in expansion periods

than contraction periods. Value relevance of earnings is higher during expansions when earnings

conservatism is lower and earnings persistence is higher. This result is different from Jenkins et al. (2009)

who find higher value relevance of current earnings in contractions than in expansions. This might be

caused by different sample periods and sample firms employed in Jenkins et al. (2009).

58

6. Conclusion

6.1. Thesis Conclusion

Recall the research question of this thesis: ‘How do earnings persistence, conservatism and value

relevance of earnings vary throughout the business cycle?’ The answer to this question is that earnings

persistence and value relevance of earnings are higher during the expansion periods than the contraction

periods while earnings conservatism is lower during the expansion periods than the contraction periods.

The value relevance of current and future earnings appears to be higher in expansion that is when

conservatism is lower and persistence is higher in earnings.

This thesis investigates whether earnings persistence, conservatism and value relevance of earnings vary

throughout business cycle. In this thesis, the business cycle is distinguished into two stages of expansion

and contraction. During an expansion when the economy is growing, internal and external financing

sources are more feasible to obtain than during a contraction. Four hypotheses related to the variations of

earnings persistence, earnings conservatism and value relevance of earnings throughout business cycle are

developed. The underlying thought of the hypotheses development is that the fluctuations in

macroeconomic situation should have influence on the information provided in the financial statements

particularly earnings and on the response of the investors as the users of financial statements which

measured by stock returns.

Hereby the asymmetric timeliness of Basu (1997), the lag model and the earnings model are employed in

order to test earnings conservatism, earnings persistence and value relevance of earnings respectively.

The hypotheses tests have indicated that earnings persistence, earnings conservatism and value relevance

of earnings vary throughout the business cycle. In line with the findings of Johnson (1999), earnings

persistence appears to be significantly higher during expansion periods than during contraction periods.

From the conservatism test, earnings are less conservative in expansions relative to the contractions. This

is in line with Jenkins et al. (2009) who find that earnings conservatism is higher during contraction

periods than expansion periods.

With regards to the value relevance test, current earnings and future earnings are more value relevant in

expansions relative to contractions. This is in line with the result of Johnson (1999) and somewhat

contrary to Jenkins et al. (2009). Jenkins et al. (2009) find current earnings to be less value relevant in

expansions compared to contractions while future earnings are vice versa. As mentioned in the first

chapter, the motivation of this thesis is to reconcile the mixed results between Johnson (1999) and Jenkins

et al. (2009). Less conservative earnings and higher persistent earnings in expansion periods enhance the

59

usefulness and hence the value relevance of both current and future earnings for the equity market

valuations. My findings are consistent with Jenkins et al. (2009) except for the value relevance of current

earnings. Different sample periods and sample firms are the sources of these different outcomes. Jenkins

et al (2009) do not control for other factors in their sample such as different firm-size and firm-specific

characteristics which might distort their findings. Jenkins et al. (2009) do not take into account that large

firms have more persistent earnings than smaller firms. Further, Jenkins et al. (2009) did not measure the

earnings persistence level of their sample which makes it more difficult to establish whether earnings

persistence is the cause of different outcome. Earnings persistence has a positive effect on value relevance

of earnings (Collins and Kothari, 1989; Nichols and Wahlen, 2004). Higher earnings persistence

improves the predictive power of current earnings in forecasting future earnings. Investors base their

investments decisions on this forecast when assessing the performance of a firm’s stock. Further lower

conservatism implies that earnings capture the true firm’s performance more accurately in expansions

than in contraction periods when earnings are more conservative. Collectively, less conservative and

higher persistent earnings contribute to the higher value relevance of current and future earnings in

expansion periods than in contraction periods.

At last this thesis contributes to the existence literatures in three ways; first it provides evidences of the

business cycle impacts on earnings. Fluctuations in the macroeconomic conditions lead to variations in

earnings persistence, earnings conservatism and value relevance of earnings. Investors, standard-setters

and future researchers should take the effect of business cycle into account in their decision-making

process. Second the findings reconcile the mixed results of value relevance tests between Johnson (1999)

and Jenkins et al. (2009). Value relevance of both future and current earnings are higher during the

expansion periods that are when earnings are less conservative and more persistence. Third, this thesis

enriches value relevance literatures particularly related to the influence of macroeconomic situations on

value relevance. As suggested by Clinch and Wei (2011), a large part of study has mainly focused on the

impact of firm-specific characteristics rather than macroeconomic variations.

6.2. Limitations and Suggestions

As indicated in the first chapter, this thesis has some limitations. The first limitation comes from the

relationships among earnings conservatism, earnings persistence and value relevance of earnings. This

thesis expects direct connections of earnings conservatism and earning persistence with value relevance

of earnings. Less conservative earnings and high persistent earnings are expected to increase the value

relevance of earnings. However other factors may also have influence on value relevance of earnings as

listed in chapter three, to mention a few: different standard setters affect the development of accounting

standards (Ely and Waymire, 1999), earnings management reduces the usefulness of earnings for the

60

investors (Marquardt and Wiedman, 2004) and external information decreases the value relevance of

accounting information (Dontoh et al., 2004).

The second limitation lies in the sample. The sample is only limited to the firms with large market

capitalization from the United States. Including merely large firms restricts the generalization of the

research outcome only to large-size firms. Further the research findings may not hold in another country

since the sample includes only the U.S. firms. Other countries have different accounting standards than

the U.S. which may have an impact on the research outcomes.

The third limitation is related to the statistical test. Because of the non-normality in the sample, the

coefficient in the regression equation is no longer the best prediction. Using a large sample reduces the

severe consequences of running a regression analysis on non-normal distribution. Nevertheless any

conclusion deriving from the tests should be done cautiously.

Suggestion for the future research is to focus on the causal relationships among earnings conservatism,

earnings persistence and value relevance of earnings. Enlarge the sample by including other countries is

also interesting for example to investigate whether variations in institutional factors between countries

have an impact on the fluctuation in the value relevance of earnings throughout the business cycle.

However this might be complicated due to different accounting standards between countries.

61

References

Amir, E., and B. Lev. 1996. Value Relevance of Nonfinancial Information: The Wireless Communications Industry. Journal of Accounting and Economics 22 (August-December): 3-30.

Baginski, S.P., Lorek, K.S., Willinger, G.L., and Branson. B.S. 1999. The Relationship between Economic Characteristics and Alternative Annual Earnings Persistence Measures. The Accounting Review, Vol. 74, No. 1(January), pp. 105-120.

Balachandran, S. and Mohanram, P. 2010. Is the Decline in the Value relevance of Accounting Driven by Increased Conservatism? Review Accounting Studies. Vol. 6. Pp. 272–301.

Ball, R. and Shivakumar, L. 2005. Earnings Quality in UK Private Firms: Comparative Loss Recognition Timeliness. Journal of Accounting and Economics. Vol. 39. Pp. 83-128.

Ball, R.J. and Brown, P. 1968. An Empirical Evaluation of Accounting Income Numbers. Journal of Accounting Research, Volume 6, Issue 2, pp. 159-178.

Ballas, A. 1994. Accounting in Greece. European Accounting Review, 1, 107−121.

Baltagi, H.B. 2008. Economectic Analysis of Panel Data. John Wiley & Sons Ltd. West Sussex: UK. Fourth Edition

Basu, S. 1997.The Conservatism Principle and the Asymmetric Timeliness of Earnings, Journal of Accounting and Economics, Vol. 24, Issue 1, pp. 3-37.

Beaver, W. 1998. Financial reporting: an accounting revolution. Prentice Hall: Upper Saddle, New Jersey. Third Edition.

Beaver, W., and Ryan, S. 2000. Biases and lags in book value and their effects on the ability of the book-to- market ratio to predict book return on equity. Journal of Accounting Research Vol. 38. Pp. 127–148.

Beisland, L.A. 2008. Essays on the Value Relevance of Accounting Information, Dissertation Norwegian School of Economics and Business Administration, Bergen, Norway.

Berk, J. and DeMarzo, P. 2007. Corporate Finance. Pearson International Edition

Bernard, V. 1989. Capital markets research in accounting during the 1980's: A critical review, in The State of Accounting Research as We Enter the 1990s. Ed.,Thomas J. Frecka, University of Illinois at Urbana-Champaign, Urbana, IL.

Bliss, J.H. 1924. Management through Accounts. The Ronals Press Co. New York, United States of America.

Brooks, C. 2008. Introductory Econometrics for Finance. Cambridge University Press. Second Edition.

Brown, W.D., Haihong, H. and Teitel, K. 2006. Conditional Conservatism and the Value Relevance of Accounting Earnings: An International Study. European Accounting Review. Vol. 15, No. 4. Pp. 605-626

Burda, M. and Wyplosz, C. 2005. Macroeconomics: A European text. Oxford University Press, New York. Fourth edition.

Clegg, S.R., Hardy, C. and Nord, R. 1996. Handbook of organization studies. SAGE: London, United Kingdom.

62

Clinch, G. and Z. Wei. 2011. The Association Between Earnings and Returns and Macroeconomic Performance: Evidence from Australia, the US and China. Australian accounting review. Vol. 21. No. 56: 54-63.

Collins, D. and S.P. Kothari. 1989. An Intertemporal and Cross-sectional Determinants of Earnings Response Coefficients. Journal of Accounting and Economics. Vol. 11, No. 2&3: 143–182.

Collins, D., Maydew, E., and Weiss, I., 1997. Changes in the value-relevance of earnings and book values over the past forty years. Journal of Accounting and Economics. Vol. 24. Pp. 39–67.

Core, J., Guay, W., and VanBuskirk, A., 2003. Market valuations in the new economy: an investigation of what has changed. Journal of Accounting and Economics. Vol. 34. Pp. 43–67.

Dechow, P. 1994. Accounting earnings and cash flows as measures of firm performance: the role of accounting accruals, Journal of Accounting and Economics. Vol. 18. Pp. 3–42.

Dechow, P. and I. Dichev, 2002. The quality of accruals and earnings: The role of accrual estimation errors. The Accounting Review. Vol. 77 (Supplement). Pp. 35-59.

Dechow, P., W. Ge, C. Schrand. 2010. Understanding earnings quality: A review of the proxies, their determinants and their consequences. Journal of Accounting and Economics. Vol. 50: 344–401

Deegan, C., and Unerman, J. 2011. Financial Accounting Theory: second European Edition. McGraw-Hill Education. Berkshire, United Kingdom.

Deegan, C. 2009. Financial Accounting Theory. Mc-Graw Hill. Australia. Third Edition.

Desai, M.A., and Dharmapala, D. 2009. Earnings Management, Corporate Tax Shelters, and Book-Tax Alignment. National Tax Journal. Vol. 62, Issue 1, pp 169-186.

Dontoh, A., Radhakrishnan, S., and Ronen, J. 2004. The declining value-relevance of accounting information and non-information-based trading: An empirical analysis. Contemporary Accounting Research. Vol. 21. Pp. 795–812.

Easton, P. D., and Harris, T. S. 1991. Earnings as an explanatory variable for returns. Journal of Accounting Research. Vol. 29. Pp. 19−36.

Easton, P.D. and M.E. Zmijewski. 1989. Cross-sectional variation in the stock market response to accounting earnings announcements. Journal of Accounting and Economics. Vol. 11: 117-41.

Elliott, J.A., and J.D. Hanna. 1996. Repeated Accounting Write-Offs and the Information Content of Earnings. Journal of Accounting Research. Vol. 34 (Supplement): 135-155.

Ely, K., and G. Waymire. 1999. Accounting standard-setting organizations and earnings relevance: longitudinal evidence from NYSE common stocks, 1927-93, Journal of Accounting Research, vol. 37, no. 2, pp. 293-317

FASB. 1980. Statement of Financial Accounting Concepts, Issue 2 - Qualitative Characteristics of Accounting Information. Norwalk, Concepts: FASB.

Feltham, G. A. and Ohlson J. A. 1995. Valuation and clean surplus accounting for operating and financial activities. Contemporary Accounting Research. Volume 11. Issue 2, pp. 689–731.

Francis, J. and Schipper, K. 1999. Have Financial Statements Lost their Relevance? Journal of Accounting Research. Vol. 37, Issue 2, pp. 319–52.

63

Frankel, R. and Litov, L. 2009. Earnings Persistence. Journal of Accounting and Economics. Vol 47. pp. 182-190

Givoly, D., and Hayn, C. 2000. The changing time-series properties of earnings, cash flows, and accruals: Has financial reporting become more conservative? Journal of Accounting and Economics. Vol. 29. Pp. 287–320.

Givoly, D., Hayn, C., and Natarayan, A. 2006. Measuring reporting conservatism. The Accounting Review. Vol. 82. Pp. 65−106.

Grossman, S. 1995. Dynamic asset allocation and the informational efficiency of markets. The Journal of Finance. Vol. 50 (July): 773-787.

Guay, W. and Verrecchia, R. 2006. Discussion of an economic framework for conservative accounting and Bushman and Piotroski (2006). Journal of Accounting and Economics. Vol. 42, pp. 149–165.

Hayn, C. 1995. The information content of losses. Journal of Accounting and Economics. Vol. 20 (September): 125-153.

Holthausen, R. W. and Watts R. L. 2001. The relevance of the value-relevance literature for financial accounting standard setting, Journal of Accounting and Economics, Vol. 31, Issue 1-3, pp. 3–75.

Hung, M. 2001. Accounting standards and value relevance of financial statements: an international analysis. Journal of Accounting and Economics. Vol. 30. Pp. 401–420.

Jenkins, D.S., Kane, G., and Velury, U. 2009. Earnings Conservatism and Value Relevance Across the Business Cycle, Journal of Business Finance & Accounting, Vol. 39, Issue 9-10, pp. 1041-1058.

Johnson, M.F. 1999. Business cycles and the Relation between Security Returns and Earnings, Review of Accounting Studies, Volume 4, Issue 2, p. 93-117.

Kormendi, R. and R. Lipe. 1987. Earnings Innovations, Earnings Persistence, and Stock Returns. Journal of Business. Vol. 60: 323-45.

Kousenidis, D.V., Ladas, A.C. and Negakis, C.I. 2009. Value Relevance of Conservative and Non-Conservative Accounting Information. The International Journal of Accounting. Vol. 44. 219–238.

Lev, B. 1983. Some economic determinants of time-series properties of earnings. Journal of Accounting and Economics. Vol. 5 (April): 31-48.

Lev, B. and P. Zarowin. 1999. The Boundaries of Financial Reporting and How to Extend Them. Journal of Accounting Research. Vol. 37, No. 2: 353–85.

Libby, R., Bloomfield, R. and Nelson, M.W. 2002. Experimental Research in Financial Accounting. Accounting, Organizations and Society. Vol. 27. Pp.775-810

Lobo, G and Zhou, J. 2006. Did Conservatism in Financial Reporting Increase after the Sarbanes-Oxley Act? Initial Evidence. Accounting Horizons. Vol. 20. No. 1. Pp. 57-73.

Marquardt, C.A., and C.I. Wiedman. 2004. The Effect of Earnings Management on the Value Relevance of Accounting Information. Journal of Business Finance & Accounting. Vol. 31 (April-May): 297-332.

Nichols, D.C., and J.M. Wahlen. 2004. How Do Earnings Numbers Relate to Stock Returns? A Review of Classic Accounting Research with Updated Evidence. Accounting Horizons. Vol.18(December): 263-286.

Ohlson, J.A., 1995. Earnings, Book Values, and Dividends in Equity Valuation, Contemporary Accounting Research. Vol. 11, Issue 2, pp. 661-687.

64

Paek, W. Chen, L. H. and Sami, H. 2007. Accounting Conservatism, Earnings Persistence and Pricing Multiples on Earnings. Journal of Contemporary Accounting and Economics Symposium. Available at: http://ssrn.com/abstract=964250.

Penman, S., and Zhang, X. 2002. Accounting conservatism, the quality of earnings, and stock returns. The Accounting Review. Vol. 77. Pp. 237–264.

Richardson, S., R. Sloan, M., Soliman, and I. Tuna. 2005. Accrual reliability, earnings persistence and stock prices. Journal of Accounting and Economics 39: 437-485.

Ruddock, C., Taylor, S. J., and Taylor, S. L., 2006. Nonaudit services and earnings conservatism: Is auditor independence impaired? Contemporary Accounting Research. Vol. 23. Pp. 701−746.

Ryan, S.G. 2006. Identifying Conditional Conservatism. European Accounting Review. Vol. 15. No. 4. Pp. 511-525.

Ryan, S.G., and P.A. Zarowin. 2003. Why Has the Contemporaneous Linear Returns-Earnings Relation Declined? The Accounting Review 78 (April): 523-553.

Schmalensee, R., 1989. Inter-industry studies of structure and performance. In: Schmalensee, R., Willig, R. (Eds.), Handbook of Industrial Organization. North-Holland, Amsterdam, pp. 951–1009.

Scott, W.R. 2006. Financial Accounting Theory. Prentice Hall. Canada. Fourth edition.

Shroff, P. 1995. Determinants of the Returns-earnings Correlation. Contemporary Accounting Research. Vol. 11, pp.1±55.

Sloan, R.G. 1996. Do Stock Prices Fully Reflect Information in Accruals and Cash Flows About Future Earnings? The Accounting Review. Vol. 71: 289-315.

Wakil, G. and Alam, P. 2012. Conservatism, Earnings Persistence, and the Accruals Anomaly. CAAA Annual Conference 2012. Working papers series.

Wang, R. Z., hÓgartaigh, C.O. and Zijl, T. 2008. Measures 0f Accounting Conservatism: A Construct Validity Perspective. Forthcoming in Journal of Accounting Literature.

Watts, R. 2003a. Conservatism in accounting Part I: Explanations and implications, Accounting Horizons, Volume. 17, Issue 3, pp. 207-221.

Watts, R. 2003b. Conservatism in accounting Part II: Evidence and research Opportunities, Accounting Horizons, Volume. 17, Issue 4, pp. 287-301.

Watts, R. L. and Zimmerman, J. L. 1986. Positive Accounting Theory. Englewood Cliffs, New Jersey: Prentice-Hall.

Website Financial Accounting Standards Board: www.FASB.org

Website U.S. Bureau of Economic Analysis: www.BEA.gov

Website U.S. National Bureau of Economic Research: www.NBER.org

65

http://www.NBER.org/

http://www.BEA.gov/

http://www.FASB.org/

Appendix

1. Summary of literature reviews

Earnings persistence and conservatismAuthors Objective Methodology Sample ResultBasu (1997) Re-examine the

conservatism principle Asymmetric timeliness which regress earnings changes and a dummy represents good news versus bad news with stock returns

US sample during the period 1964-1990

Earnings changes during bad news period are less persistent than during good news period.

Paek et al. (2007)

The effect of conservative accounting on earnings persistence

Conservatism: 1. Asymmetric timeliness of good news

and bad news2. Cumulative accruals3. Change in lagged operating income4. Response coefficients of accruals

Earnings persistence:The first autocorrelation between earnings of two consecutive years

US sample during the period of 1984-2003

Less conservative earnings are likely to persist into the next period than more conservative earnings

Sloan (1996) The effect of earnings components on earnings persistence

The first autocorrelation of current earnings components i.e. accruals and cash flows in predicting next year earnings.


accruals have lower persistence for the assessment of future earnings than cash flow

Wakil and Alam (2012)

the effect of conservatism on accruals persistence in predicting future earnings

Conservatism:1. Asymmetric timeliness2. C-score 3. Market-to-Book ratio

Regression analysis which includes cash flow, accruals and dummy of conservatism


conservatism increases accrual persistence of firms with high accruals deciles more than firms with low accruals

Conservatism and Value RelevanceBrown et al. (2006)

the relationship between conditional conservatism and the

Conservatism:1. Asymmetric timeliness 2. Market-to-Book ratio

Sample from 20 countries during the period of 1993-2004

conditional conservatism and accrual intensity are negatively related to the value

69

value relevance earnings

Value relevance is measured by the mean returns of the earnings-based portfolio

relevance of earnings

Kousenidis et al. (2009)

the association between conservatism and value relevance of earnings

Conservatism: Basu (1997) asymmetric timeliness; Value relevance: Easton and Harris (1991) model which regressed stock returns with earnings and changes in earnings

Greek firms over period 1989-2003

Non-linear association between conservatism and value relevance which means that high and low conservatism is perceived as less value relevant relative to medium conservatism.

Balachandram and Mohanram (2010)

The relation between value relevance and conservatism

Conservatism:1. Regression of lagged of returns with

the book-to-market ratio2. C-Score

Value Relevance1. Price and earnings regression2. Returns regressed with earnings and

book value3. earnings, change in earnings and

book value regressed with market-adjusted return

The US listed firms over period 1975-2004

- significant increase of conservatism across the time

- declining trend of value relevance

- The decline in value relevance is not related to the increase in conservatism

Earnings Persistence and Value RelevanceKormendi and Lipe (1987)

The effect of Earnings persistence on the earnings-return relation

Regression analysis between changes in earnings and stock returnUnivariate time-series model of persistence and earnings response coefficient

US listed firm during 1947-1980

ERC is positively related to earnings persistence

Easton and Zmijewski (1989)

Stock market response to earnings announcements

Multiple regression models included abnormal returns, unexpected earnings, systematic risk and firm size.


ERC is positively related to earnings persistence and negatively related to systematic risk

Collins and Kothari (1989)

inter-temporal and cross-sectional determinants of earnings response coefficient (ERC)

Multivariate model consists of growth, risk-free interest, systematic risk, earnings persistence and stock return


ERC is positively related to growth and/or earnings persistence and negatively related with the risk-free interest and systematic risk

Nichols and The relation between Firms are divided into two portfolios of US listed firms During years of earnings increases,

67

Wahlen (2004) earnings and stock returns

earnings increases and decreases. Each portfolio is divided into ten deciles based on the magnitude of earnings changes.

over the period 1988-2001

high persistence firms earn higher abnormal return than low persistence firms but only small difference during years of earnings decreases

Conservatism, earnings persistence and value relevance throughout business cycleJohnson (1999) the impact of business

cycle on the association between accounting earnings and stock returns

Persistence: Regression analysis of first autocorrelation quarterly earnings per shareValue relevance: regression analysis of unexpected earnings and cumulative abnormal return

US listed firm over period 1970-1987

Earnings are more persistent and more value relevant during expansions (credit crunch) than during recessions (reliquification period)

Jenkins et al. (2009)

business cycle variation with changes in earnings conservatism and value relevance

Conservatism: asymmetric timelinessValue relevance: Earnings model which includes change in earnings, next period return and a dummy represents business cycle

US listed firm over period 1980-2003

During contractions, current earnings are more conservative and more value relevant than during expansions. Future expected earnings are more value relevant during expansions than during contractions

Clinch and Wei (2011)

Investigate the relation between accounting earnings and stock returns

Business cycle is defined based on GDP growth and market returnsRegression analysis between abnormal returns and earnings

Australia (1987-2008), the US (1971-2008) and China (1991-2008)

Stronger associations between returns and earnings during large positive GDP periods only for the US firms and only when GDP growth is used to macro-economic indicator.

68

2. Sample distribution

i. Earnings per share distribution

.00

.02

.04

.06

.08

.10

.12

.14

.16

-80 -60 -40 -20 0 20 40 60 80

Den

sity

EPS

ii. Returns distribution

0

500

1,000

1,500

2,000

2,500

3,000

3,500

4,000

-4 0 4 8 12 16 20 24 28 32

Freq

uenc

y

RET

69

thesis.eur.nl merinda_3… · web viewthesis.eur.nl

Documents