Dan Givoly

Measuring Reporting Conservatism

The paper examines the power and reliability of the differential timeliness (DT) measure developed by Basu (1997) to gauge reporting conservatism. We identify certain characteristics of the information environment unrelated to conservatism that affect the DT measure and find that it is sensitive to the degree of uniformity in the content of the news during the examined period, the types of events occurring in the period, and firms’ disclosure policies. Our tests, based on both actual and simulated data, indicate that assessing the extent of reporting conservatism requires the recognition of, and control for, these characteristics. We also find that the difference in the timeliness of reporting bad versus good news is likely to be more pronounced than previously reported. Further, we provide additional evidence on the negative association between the DT measure and alternative aspects of conservatism, suggesting that the exclusive reliance on any single measure to assess the overall conservatism of a reporting regime (firms, countries or time periods) is likely to lead to incorrect inferences. Measuring Reporting Conservatism

Rising Conservatism: Implications for Financial Analysis

We provide evidence that is consistent with an increase in reporting conservatism by U.S. companies in the past few decades. Using a constant sample of almost 900 companies, we examined several measures of accounting conservatism, including the level and rate of accumulation over time of negative nonoperating accruals, the differential timeliness of incorporating good news versus bad news in reported earnings, the skewness and variability of the earnings distribution relative to the cash flows distribution, and changes in the market-to-book ratio. The increased conservatism has contributed to a persistent and prevalent decline in reported profitability, an increase in the incidence of losses, and an increase in the dispersion of earnings. Increased conservatism affects financial ratios and P/E multiples. Thus, incorporating information on the level of a companys reporting conservatism improves valuations and the yield to investment strategies that are based on these ratios. Anecdotal evidence suggests that financial reporting by U.S. companies has become more conservative in recent decades. For example, most of the new accounting pronouncements have had the effect of accelerating expense recognition and further deferring the recognition of revenues. Furthermore, U.S. capital markets have become more litigious, which induces company managers to be less aggressive in their financial reporting and auditors to be more cautious and prudent in their audits. The observation of an increase in the frequency of losses in recent years, although undoubtedly caused by a number of factors, is consistent with an increase in reporting conservatism. The fact that generally accepted accounting principles have a built-in conservative bias is widely recognized, but the recent trend toward an even greater conservatism has not been systematically documented. We examine the change in the degree of conservatism in financial reporting over the 1950–98 period and discuss its implications for financial statement analysis. Using a constant sample of almost 900 companies, we identify several measures of conservatism, including the level and rate of accumulation over time of negative nonoperating accruals (defined as the difference between net income and cash flows from operations, excluding depreciation and changes in the balance of noncash working capital accounts), the differential speed of incorporating good and bad news in reported earnings, the skewness and variability of the earnings distribution relative to the cash flows distribution, and changes in the market-to-book ratio (M/B). The results of a series of tests are consistent with an increase in reporting conservatism, particularly since about 1980. For example, reported profitability gauged by such ratios as return on assets shows a persistent decline over time without a parallel drop in operational cash flows. In fact, the gap between reported earnings and operational cash flows has widened in recent years, which reflects a systematic and material accumulation of negative nonoperating accounting accruals. This trend is consistent with a transition to a more conservative reporting regime. Other measures of conservatism, among them the speedier incorporation in the financial statements of bad news relative to good news, indicate a similar trend. The finding of increased conservatism suggests that the high M/B values and P/E multiples that peaked in the late 1990s arose, in part, because of changes in the financial reporting regime. Thus, they may indicate more than overpricing. When adjusted for conservatism, an adjustment that takes the form of removing from the income numbers the accumulation of negative nonoperating accruals, the sharp rise in M/Bs and P/Es in the 1980s and 1990s becomes much more modest. We provide at least one measure of change in reporting conservatism that is readily available to analysts as a way to improve fundamental analysis—the current accumulation of nonoperating accruals. We demonstrate that this measure can be used to characterize the reporting regime of individual companies and, therefore, to adjust the earnings and equity multiples computed for a company.

Do Analysts Account for Earnings Management

This paper examines whether analysts earnings forecasts incorporate or exclude the managed earnings component. The results, based on a sample of 285 restatements and a much larger sample of cases where earnings are likely to have been managed upward, are consistent with analysts predicting the earnings number that will eventually be reported by the firm.. Further, the managed earnings component appears to influence analysts’ subsequent earnings forecasts, leading to upward forecast revisions and upgraded stock recommendations. The findings are further consistent with management signaling through earnings management favorable future performance. What do Analysts Really Predict? Inferences from Earnings Restatements and Managed EarningsWe examine whether analysts include the managed earnings component in their forecasts or are surprised by the managed earnings component. We also investigate whether analysts’ earnings forecasts for future periods and their stock recommendations are affected by earnings management in the current period. The results, based on a sample of 583 restatements and a much larger sample of cases where earnings are likely to have been managed upward, are consistent with analysts forecasting the managed earnings number. Further, the managed earnings component appears to influence analysts’ subsequent earnings forecasts, leading to upward forecast revisions and upgraded stock recommendations which appear to be unwarranted given the firms’ subsequent operating performance.

The Changing Relevance of Accounting Information to Debt Holders over Time

We examine the change over time in the information content of accounting numbers from the perspective of bondholders and the causes for this change. Using proprietary longitudinal data, we find that, in contrast to the decline in the information content of accounting numbers to equity holders over time, the information content to bondholders has held steady or risen. The rise is attributable to economic factors such as an increase in risk and in the frequency of unfavorable news to which the valuation of debt is more sensitive than that of equity. There are indications, however, that reporting factors, specifically an increase in conservatism over the last four decades, is associated with this rise. The findings contribute to the scant literature on the use of financial information by bondholders and the extent to which financial reporting meets their unique information needs. Given debt holders prominence as users of financial statements, the findings have important implications for accounting standard setting.

Private Ownership and the Cost of Public Debt: Evidence from the Bond Market

A number of studies have examined the effect of public and private ownership on the cost of debt and concluded that the cost of debt of privately owned firms is higher, driven mainly by the poorer information environment in which these firms operate. We extend this strand of research in two ways. First, we identify and empirically establish the mechanisms that bring about a higher cost of debt to privately owned firms—namely, the limited access that these firms have to the equity capital market, their high rate of management and private-equity ownership, and their less conservative reporting. Second, we improve the reliability of the estimates of the effect of ownership type on the cost of debt by controlling for the different information environments in which privately and publicly owned firms operate. This is accomplished through the use of a sample consisting of publicly owned and privately owned firms that have public debt and are therefore subject to identical reporting and disclosure requirements. C...

Aggregate Earnings Expectations and Stock Market Behavior

The paper examines the degree of association between cross-sectional aggregate measures of earnings forecasts and the market rate of return. Various measures of “market” earnings forecasts are devised. The results indicate that while changes in earnings forecasts of individual companies are correlated with the price behavior of the respective stocks, very weak association exists between the aggregate measure of earnings forecasts and the market rate of return. This lack of association (which suggests that information on aggregate changes in earnings forecasts is not very useful to investors) is due primarily to the very low commonality in the revisions of earnings forecasts across companies.

Key Performance Indicators: The Incremental News in Their Disclosures and the Properties of Their Analyst Forecasts

The documented decline in the information content of earnings numbers has paralleled the emergence of disclosures, mostly voluntary, of industry-specific key performance indicators (KPIs). We find that the incremental information content conveyed by KPI news is significant for many KPIs, yet it is diminished when details about the computation of the KPI are absent or when the computation of the KPI changes over time. Consistent with analysts responding to investor information demand, we find that analysts are more likely to produce forecasts for a KPI when that KPI has more information content and when earnings are less informative. We also analyze the properties of analysts’ KPI forecasts, and we find that KPI forecasts are more accurate than mechanical forecasts, and their accuracy exceeds that of earnings forecasts. Our study contributes to the literature on the information content of KPIs and increases our understanding of the factors that affect this content. We provide evidence pertinent to the debate on whether and how to regulate KPI disclosures. This study further contributes to research on the properties of analysts’ forecasts.