Accounting conservatism, earnings quality, and firm valuation

• Main Author: Chan, Ling-Ching
• Published: University of Manchester 2005
• Subjects: 332.63
• Online Access: http://ethos.bl.uk/OrderDetails.do?uin=uk.bl.ethos.629937

This thesis explores the relation between conservatism and earnings quality, and its economic consequences. The principle of conservatism has played an important role in dealing with uncertainties in the process of financial reporting. In the past ten years, substantial market-based accounting research has been devoted to the study of conservatism but few studies have attempted to examine how the nature of conservatism affects earnings quality from an information perspective and whether conservative accounting provides information that is useful in helping investors make investment decisions. The present work provides UK evidence on the relation between accounting conservatism and several earnings attributes and on how this relation affects investors' required rates of return. It comprises three major pieces of empirical work. First, I investigate the effect of earnings components--cash flow from operations, operating and non-operating accruals--on earnings conservatism using three different regression models. These are the augmented forward and reverse return--earnings regressions, and the earnings persistence regressions. The results show that non-operating accruals has the most significant effect on estimates of conservatism in all three models. Second, I examine the association between ex-ante/ex-post conservatism and several earnings characteristics: the value-relevance, informativeness, persistence, and predictability of reported earnings. These earnings attributes are important determinants of earnings quality from an information perspective and greater values of these earnings attributes imply that reported earnings are more useful for decision-making purposes. The results show that ex-ante (balance sheet) conservatism has a positive relation with earnings quality. However, there is no direct relation between ex-post (earnings) conservatism and earnings quality, and extreme ex-post conservatism may undermine the quality of reported earnings. Third, I examine how the relation between conservatism and earnings quality affects investors' required rates of return. I find that higher ex-ante conservative earnings are related to lower costs of equity capital and that there is no significant relation between ex-post conservatism and investors' required rates of returs. Based on the findings in this thesis, I conclude that accounting conservatism is an essential concept in financial reporting and that investors understand the nature of conservatism and price firm value rationally.