Ebook Asymmetric timeliness of earnings, market-to-book and conservatism in financial reporting
Basu (1997) defines conservatism as the accountant’s tendency to require a higher degree of verification for recognizing good news in earnings than for bad news. Since annual unexpected returns capture news arrival during the year, this definition has implications for the earnings-return relation. In a regression of annual earnings on returns, Basu (1997) predicts and finds that earnings respond more to negative returns (bad news) than positive returns (good news). He calls this differential response the asymmetric timeliness of earnings and uses it as a measure of conservatism.
Since Basu (1997), a significant number of studies use his asymmetric timeliness of earnings conservatism measure. Many of those studies use this Basu measure exclusively, rather than using a variety of conservatism measures. Prominent examples are Ball, Kothari and Robin (2000), Ball Robin and Wu (2003) and Pope and Walker (1999), all of which study differences in conservatism across countries. Other studies use a variety of conservatism measures. For example, Givoly and Hayn (2000) use the Basu and other measures to draw conclusions on trends in conservatism through time. Studies using multiple measures tend to generate consistent results across measures (see Watts, 2003b).
Recently, some studies question whether the Basu measure is a reliable empirical measure of conservatism. For example, Givoly, Hayn and Natarajan (2003) (GHN) analyze the Basu measure and conclude that (a) it captures only one possible source of conservatism and (b) it has a number of limitations even as a gauge of asymmetric timeliness. GHN further point out that the Basu measure is negatively correlated with other conservatism measures, in particular, the ratio of market value of equity to book value of equity, or market-to-book. They view this as a potential shortcoming of the Basu measure.
The negative correlation between market-to-book (MTB) and asymmetric timeliness has been documented by other studies, for example, Francis, LaFond, Olsson and Schipper (2003). Richardson and Tinaikar (2004) distinguish between what they term ex ante conservatism, such as the unconditional expensing of R&D and advertising expenses that leads to higher MTB, and ex post conservatism, that is, asymmetric response of earnings to bad news as opposed to good news. Beaver and Ryan (2004), in a recent working paper, refer to the same concepts as unconditional conservatism and conditional conservatism respectively. They point out that non-capitalization of assets also eliminates the need for asset write-offs on arrival of bad news about the projected benefits of the assets. Thus, they predict a negative correlation between unconditional conservatism and conditional conservatism. Pae, Thornton and Welker (2004) argue that the negative correlation is a result of managerial attempts to substitute balance sheet conservatism with earnings conservatism.
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