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Ray Ball
University of Chicago Booth School of Business
5807 South Woodlawn Avenue, Chicago, IL 60637
(773) 834-5941
ray.ball@chicagobooth.edu
S.P. Kothari
MIT Sloan School of Management
50 Memorial Drive, E52-325 Cambridge, MA 02142-1261
(617) 253-0994
kothari@mit.edu
Valeri Nikolaev
University of Chicago Booth School of Business
5807 South Woodlawn Avenue, Chicago, IL 60637
(773) 834-4116
valeri.nikolaev@chicagobooth.edu
Keywords: Capital markets; Conditional conservatism; Timely loss recognition; Basu model;
Returns-earnings regressions; Earnings response coefficients
Econometrics of the Basu Asymmetric Timeliness Coefficient
and Accounting Conservatism
1. Introduction
Conservatism has been a central accounting principle for centuries (Watts and Zimmerman,
1986; Basu, 1997; Watts, 2003a). Basu (1997, p. 7) defines conservatism as the accountants
tendency to require a higher degree of verification to recognize good news as gains than to recognize
bad news as losses, a definition that is consistent with the adage anticipate no profits but anticipate
all losses. Basu therefore expects accounting income to be timelier in incorporating negative shocks
to firm value (bad news) than positive shocks (good news). He tests this expectation using a
measure of asymmetric timeliness constructed as follows. In an efficient market, stock return reflects
all public information affecting the value of equity that arrives during the period, and therefore
provides a valid measure of economic shocks to firm value. Consequently, the contemporaneous
return-earnings relation is expected to differ between periods of positive stock return (a proxy for
good news) and periods of negative return (a proxy for bad news). In a piecewise-linear regression of
accounting income on fiscal-period stock return, the incremental coefficient on negative return is
assumed to be a valid measure of this accounting asymmetry.1 Basu predicts and finds that the
Basu and many since refers to the incremental coefficient on negative return as the
asymmetric timeliness coefficient, and employs it as a valid measure of conservatism. Under this
definition of conservatism, accounting income is contingent on the sign of the shock to firm value, so
Ball and Shivakumar (2005) and Beaver and Ryan (2005) term it conditional conservatism. This
1
We use the term validity as shorthand for what commonly is described as construct validity, which Peter (1981, p.
134) notes generally is used to refer to the vertical correspondence between a construct which is at an unobservable,
conceptual level and a purported measure of it which is at an operational level. The notion is developed more fully in the
classic Cook and Campbell (1979) text and following editions.
2
The model and its origins are described in Basu (2009).
2
contrasts with defining conservatism as the practice of reporting unconditionally low accounting
outcomes for earnings or book value of equity. The key difference between these concepts is that
accounting income on stock returns has become one of the principal models of the financial
in our understanding of financial reporting practice. It therefore is not surprising that, following its
introduction in Basu (1997) and its application in an international context in Ball, Kothari, and Robin
(2000), the asymmetric timeliness coefficient has been used extensively in the accounting literature.4
accounting (i) as a function of countries market, political, legal and taxation regimes;5 (ii) over time,
due to regime change;6 (iii) across fiscal quarters;7 (iv) as a function of litigation, auditors legal
liability, earnings management or auditor malfeasance;8 (v) as a function of the different demands on
financial reporting of public companies, private companies and not-for-profit organizations, and of
family ownership;9 (vi) to study the effect of conditional conservatism on the equity cost of capital;10
3
See also Ball, Kothari, and Robin (2000, fn. 15), Basu (2005, Section 2) and Ball and Shivakumar (2005, 2008a). Other
things equal, conditional conservatism implies unconditional conservatism, but the converse does not hold. Conditional
conservatism is the stricter concept, in the sense that it requires a correlation with real shocks to firm value.
4
As of 26 February 2010, Basu (1997) has 1058 citations in Google Scholar and 205 citations in the Social Sciences
Citation Index, making it one of the most highly referenced papers in the modern accounting literature.
5
Ball, Kothari, and Robin (2000), Pope and Walker (1999), Giner and Rees (2001), Cao and Lee (2002), Ball, Robin, and
Wu (2000, 2003), Huijgen and Lubberink (2005), Jindrichovska and Kuo (2004), Tazawa (2003), Peek, Buijink, and
Coppens (2004), Chandra, Wasley, and Waymire (2004), Basu, Huang, Mitsudome and Weintrop (2005), Garca Lara and
Mora (2005), Brown, He and Teitel (2006), Bushman and Piotroski (2006), Gassen, Fuelbier and Sellhorn (2006),
Grambovas, Giner and Christodoulou (2006), Kwon, Yin and Han (2006), Mak, Strong, and Walker (2006), and Ball,
Robin and Sadka (2007).
6
Basu (1997), Ball, Kothari, and Robin (2000), Givoly and Hayn (2000), Holthausen and Watts (2001), Ryan and
Zarowin (2003), Sivakumar and Waymire (2003), Raonic, McLeay, and Asimakopoulous (2004), Grambovas, Giner and
Christodoulou (2006).
7
Basu, Hwang, and Jan (2001a).
8
Basu (1997), Ball, Kothari, and Robin (2000), Basu, Hwang, and Jan (2001b), Gul, Srinidhi, and Sheih (2002), Chaney
and Philipich (2003), Kelley, Shores, and Tong (2004), Garca Lara, Garca Osma and Mora (2005), Ruddock, Taylor,
and Taylor (2006), Krishnan (2005a, 2005b, 2007), and Qiang (2007).
9
Ball and Shivakumar (2005, 2008a), Burgstahler, Hail and Leuz (2006), Wang (2006), and Barragato and Basu (2007).
3
(vii) to study the role of debt;11 (viii) to examine the role of accounting accruals;12 (ix) to study
management compensation, independent directors, and corporate governance;13 (x) to study the effect
environmental uncertainty and the investment cycle.15 These studies analyze asymmetric
conservatism from a variety of perspectives, including costly contracting and agency theory, legal
institutions, and political and tax influences on financial reporting. The concept of asymmetric
earnings timeliness also has been utilized to increase our understanding of phenomena such as the
shape of the earnings distribution and the properties of analysts earnings forecast errors (Gu and Wu,
2003), the payoff function for analysts (Basu and Markov, 2004), and the properties of accounting
accruals (Ball and Shivakumar, 2006). The range and importance of these applications is testimony to
confidence in the validity of their estimates of it. These studies regularly report differences in
conditional conservatism that are consistent with a variety of plausible hypotheses, which provides
Despite its importance and popularity, the measure of asymmetric timeliness of earnings has
been challenged on several grounds. We attribute this largely to ambiguity arising from the absence
That is, the Basu model has been assumed to be well-specified and to produce valid measures of
conditional conservatism, based largely on its intuitive appeal, or by informal analysis.16 The need
10
Francis, LaFond, Olsson, and Schipper (2004).
11
Ball, Bushman and Vasvari (2007), Ball, Robin and Sadka (2008), Wittenberg-Moerman (2008), Callen et al. (2009),
Hammermeister and Werner (2009), and Nikolaev (2009).
12
Basu (1997, Table 2), Ball, Kothari and Robin (2000, Table 6), and Ball and Shivakumar (2005, 2006).
13
Lubberink and Huijgen (2001), Beekes, Pope, and Young (2004), Cuijpers, Moers and Peek (2005), Leone, Wu and
Zimmerman (2006), Ahmed and Duellman (2007), and Garcia Lara, Garcia Osama and Penalva (2009).
14
Bushman, Piotroski and Smith (2007), Francis and Martin (2010).
15
Khan and Watts (2009).
16
Basu (1997) offers no formal proof. Increasingly formal analyses are offered over time in Ball, Kothari and Robin
(2000), Pope and Walker (1999), Ryan and Zarowin (2003), and Beaver and Ryan (2005).
4
for a formal econometric analysis is heightened by several claims that the Basu asymmetric
timeliness coefficient is not a valid measure of conservatism, and indeed that it can be observed even
in the absence of conditional conservatism. The primary goal of this paper thus is to clarify the
econometrics of the asymmetric timeliness methodology and to stimulate its application in different
First, before we begin a discussion of the properties of the Basu model, we discuss the typical
research objective of the studies that employ it, which we believe to be a major source of
misconception in the literature. We therefore provide the more formal econometric analysis needed to
resolve these concerns about model specification. Specifically, we consider the case where returns are
Second, and more importantly, we propose a model of the relation between accounting
income and economic income that is based on the salient properties of income recognition as it is
practiced in accounting. We then use the model to derive and analyze the earnings asymmetric
timeliness coefficient. The model distinguishes four components of information that financial
reporting rules and practices cause to be incorporated in accounting income at different points in
could include news about present-period cash flows (i.e., the realized cash flow for the period versus
expected). It also could include news about future cash flows that is verifiable at low cost and can be
incorporated in income through accruals, such as news about accounts receivable collectability or
lag, depending on its sign or magnitude. This earnings component is the source of conditional
conservatism, which arises because negative news about future cash flows is subject to a lower
accounting verification threshold than positive news (Basu, 1997, p.4). It could include news about
the present value of future-period cash flows from booked assets, including purchased assets in
5
place and purchased intangible assets such as patents and goodwill, and also could include news
about the present value of future-period obligations such as lawsuit settlements. The third information
component in our model always is incorporated with a lag, such as news about unbooked rents or
growth options. The first three information components are assumed to affect security prices, even
when they are not recognized in current earnings (i.e., when disclosed via other information
channels). The model also has accounting income reflecting noise that reverses over time, due to
accounts receivable with error, affects accounting income in successive periods with opposite signs.
We believe this is the first model of the relation between accounting and economic incomes, or
earnings and returns, to incorporate the salient properties of accounting recognition rules and
practices.
accounting income might cause returns, or vice versa. Nevertheless, for reasons outlined below we
are not concerned about causality, as distinct from association, so the direction or directions of the
This framework allows a more formal derivation and improves intuitive understanding of the
Basu measure of conservatism, and of how it relates to and interacts with other attributes of a firms
information system. In particular, our analysis shows that Basu coefficient is not a structural (causal)
parameter that needs to be identified but rather is a function of more fundamental properties of the
accounting information system. Several criticisms of the Basu measure, in our view, are attributable
Third, we extend and formalize the Roychowdhury and Watts (2007) analysis of the market-
to-book ratio. Our analysis develops a conjecture in Ball, Kothari and Robin (2000, p. 48), that
earnings timeliness is decreasing in the importance of information about growth options. We use our
6
earnings-returns model to demonstrate that the asymmetrically timely loss recognition coefficient
decreases in the variance of information about growth options, holding other things equal, because
accounting recognition lags growth option news. Intuitively, the market-to-book ratio is likely to
proxy for the proportion of price changes associated with growth options, so a negative relation
between market-to-book ratios and asymmetric timeliness coefficients is expected. We view the
negative relation between the market-to-book ratio and the Basu asymmetric timeliness coefficient as
a property of income recognition in accounting, which is different from the perspective offered by
Roychowdhury and Watts (2007), even though the approaches make similar predictions. The model
Section 2 begins with some observations about the implications of the research objective for
the econometric model relating accounting income and stock return, and proceeds with a more formal
econometric analysis and justification for model specification in Basu (1997). Section 3 outlines a
simple model of the income-return relation, an essential feature of which is the well-known
phenomenon that accounting income reflects considerable news about economic fundamentals with a
lag: that is, prices lead earnings. Section 3.3 derives the Basu asymmetric timeliness coefficient as a
function of information attributes. In section 3.4 we show that a negative correlation between the
market-to-book ratio and the asymmetric timeliness coefficient is expected empirically, and discuss a
conservatism that do not involve regressions of accounting income on returns. Section 5 reviews
challenges that have been raised to the validity of the Basu asymmetric timeliness coefficient. A short
In this section, we clarify the econometrics of the Basu (1997) model. We start with a
discussion of whether estimating a regression of earnings on returns is appropriate, and whether this
gives rise to econometric issues. We then discuss whether partitioning on stock return, which itself is
driven in part by earnings information, is appropriate. Subsequently, we discuss whether there are
restrictive assumptions that are unlikely to be satisfied in practice, and in particular we show that
asymmetry in earnings and return distributions (skewness) does not invalidate the Basu (1997)
We start with a general observation that the appropriate econometric model specification
relating accounting income and stock returns depends on the researchers objective. When the
research objective is to explain a certain property of accounting income, as actually reported by firms,
the appropriate explained (or dependent) variable is accounting income, not stock return. In Basu
(1997), the property of accounting income being investigated is asymmetrically timely incorporation
of economic gains and losses in accounting income, so it is appropriate to specify accounting income
as the dependent variable and stock return (the proxy for economic income) as the independent
variable. 17
More formally, the objective of researchers using the model in Basu (1997) generally is to
understand the expected timeliness with which earnings reflect the information that becomes public
over a certain interval. Over a firms life, each dollar of information in stock returns translates into a
dollar of earnings, and vice versa. Over shorter time periods (e.g., years), however, there is no one-
to-one mapping between earnings and returns and thus, for modeling purposes, they can be viewed as
17
Stock return is the natural dependent variable when studying information effects on prices (e.g., when estimating
market efficiency or the effect of earnings announcements). Even then, one might be cautious in specifying earnings news
as the independent variable because it is measured with error, due to error in measuring expected earnings.
8
random variables sharing a joint distribution. The question of interest is how timely accounting
earnings are in reflecting the information available to the market, and whether this timeliness differs
depending on the direction of economic news. Econometrically, the question of earnings timeliness
translates into the question of the conditional expectation of earnings (It), given a stock returns
realization (Rt); in other words, what portion of a given dollar of economic income over a period is, in
show, requires minimum restrictive assumptions, for example about the shape of the distribution, or
about the extent to which stock returns are caused by accounting income or, vice versa, about the
extent to which the accounting system directly reflects information provided to accountants by stock
market events. The latter distinction is, in fact, irrelevant as the identification of causal links is not an
One misconception is that the research objective in Basu (1997) and following studies is to
identify causality running from earnings to returns by estimating the inverse of the earnings response
coefficient. Dietrich et al. (2007) assume linearity in the return-earnings relation and propose the
Rt = I t + t (2.1)
where, for simplicity, the error term t is independent of It and all variables have zero mean. Given
these assumptions, the OLS estimator of is unbiased. Reversing regression (2.1) makes it
impossible to identify (the inverse of) this coefficient, because the error term t in the OLS regression:
1 1
It = Rt t = Rt + t (2.2)
18
See also Beaver et al. (1997) and Beaver et al. (2008).
9
is not independent of Rt and thus the OLS estimate of is a biased estimate of 1/ .19 Can one
conclude, based on this, that the regression of returns on earnings is misspecified if estimating 1/ is
As discussed earlier, the goal of a Basu (1997) regression is to identify the conditional
Given the functional form (.) of the conditional expectation (which should be guided by theory, as
we discuss later), minimizing the sum of least squared deviations from the conditional mean (i.e.,
running OLS when the function is linear in the parameters) must provide an unbiased estimate of the
conditional expectation function.20 Therefore, keeping the previously stated research objective in
mind, the least squares regression of earnings on returns indeed is appropriate. Such a regression
does not aim to or allow the researcher to identify the separate causal effects of earnings on
returns and vice versa, but it allows identifying the portion of the aggregated information in stock
accounting income, namely, timeliness or asymmetric timeliness, then accounting income is the
appropriate dependent (i.e., explained) variable, and the fact that stock returns are in part caused by
accounting income simply is irrelevant. This is because we are interested in how the information
19
Dietrich et al. (2007) call this sample-variance-ratio bias.
20
Dietrich et al. (2007) assume a linear relation between returns and earnings, i.e., they assume away conservatism. Given
the linearity assumption, ( Rt ) = E ( I t | Rt ) = Rt . The solution to the least squares minimization problem defined
above is given by * = E ( Rt I t ) / E ( Rt ) . At the same time we can write I t = E ( I t | Rt ) + t = Rt + t where the
2
error term is mean independent of R (to see this, note that E ( | R ) = E ( I E ( R | I ) | R ) = 0 ). This implies a
weaker condition E ( R ) = E ( RE ( | R )) = 0 . Therefore, E ( R( I R )) = 0 and the true expectation parameter is
given by = E ( Rt I t ) / E ( Rt ) . In other words, least squares regression correctly identifies the conditional expectation
2
about economic gains and losses is incorporated (or reflected) in accounting income, regardless of
whether the source of new information is accounting income itself. Moreover, in this research
context, models designed to estimate the separate causal effects of returns on earnings, and of
Perhaps a more serious criticism of the model estimated in Basu (1997) is that partitioning
returns based on their sign may not be appropriate as it causes truncation bias due to the endogenous
nature of returns. For example, Dietrich et al. (2007) claim that such partitioning will result in
evidence of conservatism when in fact none is present. We revisit this claim, adopting for this
purpose those authors assumption of linearity in the return-earnings relation to rule out the presence
of conditional (i.e., news dependent) conservatism. Linearity implies the following functional form:
The structural model in (2.1) assumed by Dietrich et al. indeed implies that E ( I tt | Rt > 0) 0
and E ( I tt | Rt < 0) 0 . Does this introduce sample truncation bias, and is this bias a function of the
shape of the earnings/returns distribution? To answer this question we need to evaluate the following
probability limits:
21
Short-window event studies such as Foster, Olsen and Shevlin (1984) and Bernard and Thomas (1990) show at least some
causality running from earnings to returns. However, we have known since Ball and Brown (1968) that this effect is small:
accounting income is primarily anticipated. Ball and Shivakumar (2008b) report that the average quarterly earnings
announcement accounts for approximately 2% only of annual stock return variance. Thus, even if the Dietrich et al. (2007)
claim that return endogeneity biases the Basu model slopes were valid, their conclusion that Basu (1997) asymmetric
timeliness coefficients are due to such bias would be highly unlikely. Return endogeneity simply is not important enough
in practice to be a substantial issue. Ryan (2006) offers a similar assessment.
11
It may seem that these probability limits are arbitrary constants and, depending on the shape of the
distribution, will not be the same (Dietrich et al. 2007). However, a closer look concludes otherwise.
First, we perform the following decomposition, which can be applied to any random variable:
cov( Rt , E ( I t | Rt ) + t | Rt 0) cov( Rt , E ( I t | Rt ) | Rt 0)
plim(0 )= = , (2.6a)
var( Rt | Rt 0) var( Rt | Rt 0)
cov( Rt , Rt | Rt 0)
plim(0 )= = , and plim(1 ) = (2.7)
var( Rt | Rt 0)
Eq. (2.7) implies that conditional conservatism is identified correctly, and that it will not be
observed due to any bias arising from partitioning on Rt. That is, the Basu regression would
appropriately indicate the true absence of conservatism. The intuition for why sample truncation bias
does not arise in these circumstances is straightforward. Although the explanatory variable may be
endogenous, truncation here is with respect to the conditioning variable, and not the variable that is
being conditioned. It therefore does not introduce a mechanical negative correlation with the error
term, which in turn would have lead to truncation bias.22 The assumption E ( I tt | Rt > 0) 0 , while
true, is not relevant, but what is relevant is that E ( Rt | Rt > 0) = 0 . This, however, is easy to see
22
Truncation is depicted incorrectly in Dietrich et al. (2007, Figure 2), where the regression of earnings on returns
minimizes the horizontal (squared) deviations from the regression line, not the vertical deviations. After one notes this, it
immediately becomes clear from the graph that no truncation bias takes place.
12
since: E ( Rtt | Rt > 0) = E ( E ( Rtt | Rt ) | Rt > 0) (smaller information set dominates) and
Note that we did not make any assumptions about the shape of the distribution. Therefore, the
result above implies that the Basu (1997) methodology is not biased by asymmetry/skewness in the
It also is helpful to examine the case when earnings actually are conditionally conservative. In
this case one should expect that, due to asymmetry in accounting rules and practices, the conditional
expectation function depends on the type and sign of economic news. One simple representation of
ad hoc, but our analysis in the following section implies it is warranted). It simply implies that
earnings are expected to reflect economic news differentially, depending on their sign (consistent
Thus, the methodology in Basu (1997) correctly identifies asymmetric timeliness . We conclude
that this methodology is valid for estimating conditional conservatism, despite concerns expressed
Dietrich et al. (2007, p. 97) go so far as to conclude that all results in the literature using
estimates of asymmetric timeliness are attributable to biased test statistics, and thus cannot be
13
interpreted as evidence of accounting conservatism. The basis for this conclusion is the alleged
problems addressed in the two previous subsections: (i) accounting income has a causal effect on
returns, which allegedly biases the OLS estimate of conditional conservatism; and (ii) the piecewise
return-earnings distributions also allegedly leads to bias. We reach the opposite conclusion, and
believe the Dietrich et al. (2007) view is based on faulty econometric analysis.
on their type. The model is based on realistic and intuitive assumptions about the incorporation of
information about economic value into accounting income, and demonstrates that under these
assumptions the Basu (1997) piecewise linear regression of accounting income on stock returns
provides valid estimates of conditional conservatism. The central assumptions are that accounting
recognition rules and practices cause earnings to lag price changes generally, and that conditional
conservatism in the form of different verifiability thresholds for gains and losses causes the expected
lag for price decreases to be less than for price increases. We formalize accounting recognition lags in
a simple one-lag model. We then use this model as a framework to show that Basu model parameters
validly capture the underlying construct of asymmetrically timely recognition of economic gains and
losses.
efficient and discount rates are constant through time. We believe violation of these assumptions
would not be central in typical studies using the Basu model. First, most studies use relatively long-
horizon returns (one year or one quarter) which, as argued in Ball et al. (2000), substantially mitigates
14
concerns about the informational efficiency of security prices. Second, while changes in expected
rates of return through time naturally affect return variability (Fama, 1990), our primary objective is
to understand the covariability of firm-level earnings and returns due to firm-level information about
future cash flows.23 Therefore, we assume discount rates are constant, which means all return
The analysis is performed using continuously compounded growth rates (i.e., log growth
rates) in income and stock prices, for analytical tractability and simplicity. However, the intuition
from the analysis is equally applicable using other, conventional measures of growth rates or levels of
income and prices. Under the maintained hypotheses of market efficiency and constant expected
rates of return, stock prices follow a random walk, and thus growth in prices is permanent and
returns are serially uncorrelated (Bachelier 1900, Samuelson 1965, Fama, 1970; Campbell, Lo, and
MacKinlay, 1997). We therefore assume growth in price and all its components are permanent.
We propose what we believe to be the first model of the relation between accounting and
economic incomes to incorporate the salient properties of accounting recognition rules and practices.
The origins of the model can be traced back to Ball and Brown (1968), Beaver, Lambert, and Morse
(1980), Fama (1990), Kothari and Sloan (1992), Basu (1997), Kothari (2001), and others. We first
present a general form of the model and subsequently offer simpler cases.
Since we assume capital markets are informationally efficient, prices reflect all publicly
available information in a timely fashion. In contrast, accounting rules and practice emphasize
verifiability, objectivity, and conservatism, as reflected for example in the historical cost principle
and revenue recognition rules, and hence accounting income in any period incorporates some but not
23
Ball and Brown (1968), Basu (1997), Ball et al. (2000) and Ball et al. (2003) control for market-wide returns when
constructing firm-level news proxies. These excess returns are zero-sum in cross-section and hence in principle they
are diversifiable and riskless, somewhat finessing the issue of variation in expected returns.
15
all the information that becomes publicly available during the period. The consequence is that
accounting income incorporates some information with a lag: that is, prices lead earnings. 24
Information in our model can be made public via earnings or any other information channel.
We do not implicitly or explicitly assume that accounting has no informational role in price formation
(or that equity prices would be the same in the absence of earnings announcements). Instead, we
assume that to the extent the market responds to reported earnings, it understands its components. In
particular, we assume the market distinguishes the components that reflect information made public
Note that asymmetric accounting conservatism should also apply to the way private
information revealed by the manager is incorporated in earnings (e.g., private information about bad
debt expense). If the private information that a manager intends to communicate to the market in a
particular period does not meet a certain verifiability standard, that information must be
communicated via channels other than earnings. If the verification standard is asymmetric, private
bad news is more likely to be conveyed through earnings than private bad news, and private bad news
The model decomposes the total revision in security price (i.e., stock return) into three
Rt = xt + yt + gt (3.1)
Rt = security return expressed as the continuously compounded growth rate in price, i.e., the
natural logarithm of the firms economic income deflated by beginning-of-period price;
24
The fact that prices lead earnings is clear from the graphs in Ball and Brown (1968), Foster, Olsen and Shevlin (1984) and
Bernard and Thomas (1990), from longer-horizon studies such as Beaver, Lambert and Morse (1980) and Kothari and Sloan
(1992), and from even a casual reading of the financial press.
16
xt = portion of the total growth rate in security price Rt that invariably is contemporaneously
captured in accounting income, It;
yt = portion of the total growth rate in the security price that is not contemporaneously captured in
It unless required by conservative accounting;
wt = is an indicator variable that takes the value of one when conservative accounting rules and
practices lead to recognition of y in the current period; and
gt = portion of the total growth rate in the security price that never is contemporaneously captured
in It, but always is incorporated with a lag;
For analytical tractability, we assume xt, yt, gt, and t are stationary, symmetric,25 and time-
independent (i.e., serially uncorrelated) 26 random variables whose variances are denoted by x2, y2,
corr(xt, yt) = xy > 0, corr(xt, gt) = xg > 0, and corr(yt, gt) = yg > 0 (3.3)
In this model, financial reporting rules and practices lead to accounting income always
contemporaneously incorporating the information component xt, regardless of its sign or magnitude
(i.e., without conditional conservatism). The intuition is that this component represents the least
costly source of information to verify, and thus it invariably is recognized in the same period as it
affects returns. This type of information could include current-period news about current-period cash
flow, such as learning the actual realizations of current period revenues and expenses in comparison
with their expectations. It also could include news about future cash flows that is verifiable at low
cost, and that is incorporated symmetrically in accounting income via working capital accruals.
25
We discuss the case of asymmetric distributions in Section 2, and show that asymmetry does not invalidate the
specification in Basu (1997).
26
As expected returns are assumed to be constant, market efficiency requires returns and thus their components to be
independent over time.
17
accounts receivable, accounts payable and inventory information. For example, accruals are used to
adjust current-period cash flow for both increases and decreases in closing inventory relative to
opening inventory, because they are approximately equally low in cost to verify. Similarly, cash
collections from customers are adjusted for both increases and decreases in accounts receivable.
These working capital accruals incorporate into accounting income current information about future
cash flows. For example, other things equal an increase in closing inventory is information that less
cash will be spent on purchasing inventory in future periods, and it is verifiable at low cost regardless
of its sign. In some limited circumstances, symmetrically low-cost verification can apply to long-
cycle information as well, an example being index funds, in which gains and losses on long term
investments in traded stocks are symmetrically low-cost to verify and in practice are accounted on a
daily basis.
The second component of stock return, yt, is incorporated in accounting income either
contemporaneously or with a lag, depending on the accounting operator wt. The intuition here is that
yt represents information that is costly to verify and, because the verification threshold is lower for
negative than for positive news (Basu 1997, page 4), this information is incorporated asymmetrically.
Such information could include the current-period revision in the expectation of unrealized future-
period cash flows from booked assets, including purchased assets in place and purchased intangible
assets such as patents and goodwill. This component also could include news about the present value
of future-period cash outflows, such as lawsuit settlements. Using accrual accounting to bring
forward shocks to expected future cash flows is known as timely gain and loss recognition.
Conditional conservatism implies that w is more likely to be triggered by bad news (adverse shocks
to expected future cash flows) than good news, and hence that loss recognition generally is timelier
than gain recognition. Thus, w can be thought of as an accounting write-down indicator (specified
In the event that timely recognition is not triggered and thus the return component yt is not
contemporaneously incorporated in income, it is incorporated with a lag, the intuition being that some
revisions in expectations of future cash flows are not reflected in accounting income until the actual
cash flow realizations occur. Conditional conservatism implies that incorporation with a lag is more
likely for good news than bad. The effect of asymmetrically delayed incorporation of information is
that, in a two-period model, the total effect on current period income of revisions in cash flow
expectations is wt yt + (1 wt-1)yt-1.
factors. Identification of these factors is the principal objective of the extensive literature surveyed in
our Introduction. The factors studied include economic incentives, debt and compensation
contracting, governance, GAAP, regulation, and taxes (e.g., Watts and Zimmerman 1986, and Watts
2003a,b), in addition to properties of information such as verifiability. Since our objective is not to
provide an equilibrium model of the extent of conditional conservatism, but rather to investigate the
validity of the Basu (1997) measure of conditional conservatism used in this literature, our model
takes the extent of the asymmetry as a given, and studies the properties of its measurement. In our
The third component of stock return, gt-1, invariably is incorporated in accounting income
with a lag. One source of this component would be revisions in the value of growth options. Because
they by definition are not booked as assets on balance sheets, shocks to firms growth opportunities
ultimately are incorporated in earnings only when the associated cash flows are (or are not) realized.
A related source of this component would be revisions in expectations of future monopoly rents
27
Alternatively, write-downs can occur with probability p which can be a function of y, i.e., Pr(w=1| y) = p(y)).
19
The model also has accounting income incorporating uncorrelated noise that reverses over
time. One source of this earnings component would be accounting errors arising from imperfect
accounting accruals. Errors that reverse over time include miscounting inventory, which affects
current and future cost of goods sold and hence earnings with opposing signs. Other examples are
errors in estimating uncollectible accounts receivable, errors in forecasting deferred tax liabilities, the
effects of using historical-cost interest rates on debt, and errors in estimating assets useful lives.
Because accounting errors reverse over time, in our two-period model the error term is reversed out
in the following period.28 For tractability we assume accounting error is uncorrelated with other
variables, and thus we ignore earnings management or smoothing, which could produce a non-
In this formulation, yt-1 and gt-1 are the two sources of delayed recognition of economic
income in accounting earnings. They generate the anticipated or stale component of earnings growth
whose value consequences are reflected in price prior to the period in which they are incorporated in
accounting income. They are uncorrelated with current period return Rt, which is influenced only by
stock return as a natural feature of the income recognition process in accounting, which can be
economic and political institutions). As will become evident, we do not view or model the
recognition lag as a measurement error issue, but as a property of accounting income that the
While yt-1 and gt-1 are assumed to be uncorrelated with xt, yt, and gt, and, therefore, with Rt,
there are economic reasons to expect a positive correlation among xt, yt, and gt. Recall that all three
28
Knowledge of t-1 would help predict earnings, but not returns. We assume the market unravels the current accounting
error t and does not react to it. This assumption can be relaxed without altering our conclusions.
20
components are a consequence of economic news affecting investors cash flow expectations.
However, only the news generating the stock price growth rate component xt, and possibly also yt
generating the return component gt finds its way into accounting income in the following period.
Some news is likely to be common to the three components. For example, an unexpected increase in
sales in the current period could affect current earnings and hence xt, but simultaneously it could
affect the expectation of sales growth in the next period and hence the growth rate yt. The news then
is partly reflected in both current returns and earnings (xt or yt), and in current returns and future
earnings (gt or yt). The positive correlation between xt and yt provides the basis for the piecewise-
Despite its simplifying assumptions, we believe the earnings process modeled in (3.2)
captures the important properties of asymmetric accounting recognition rules and practices, and how
they affect reported earnings. We next use this framework to investigate the properties of the Basu
measure and develop empirical implications for the benefit of future research.
We start with a baseline case where timely gain or loss recognition does not take place (i.e., wt
= 0), and hence accounting treats y and g equivalently, and examine the econometric properties of
It = + Rt + t (3.4)
The regression slope reflects the extent to which accounting income contemporaneously captures
Equation (3.5) obtains because the lagged income components, yt-1 and gt-1, do not correlate
with xt, yt, and gt. In equation (3.5), the estimated slope coefficient from a regression of earnings on
contemporaneous returns increases in the timeliness of earnings, var(xt)/var(yt + gt), which is the ratio
of the information in returns that accounting income incorporates in a timely fashion to the
current accounting income It of stale cash flow news, yt-1 and gt-1, diminishes. In this model of the
accounting process, accounting income is 100% timely with respect to economic income if var(yt)
and var(gt) both are zero, in which case the estimate of converges to one and accounting income
Our analysis incorporates what we believe to be a realistic scenario, that xt, yt, and gt are
positively correlated. While we would like to continue the analysis under that assumption, the
Basu (1997) estimates the asymmetric timeliness coefficient from the regression model:
I t = 1 + 2 Dt + 1Rt + 2 Dt Rt + t (3.6)
incremental coefficient on negative return (the proxy for negative economic income), and is predicted
Let 2 denote the OLS estimate of 2 from equation (3.6). Then we have:
plim2 = 2 1 , (3.7)
22
Our model (3.2) of accounting income recognition assumes that timely recognition is
triggered when the unobserved information component y falls below a threshold value, such as zero.
However, the Basu regression model (3.6) conditions the regression slope on total return R, which the
researcher observes. We now show that the incremental regression coefficient 2 = 0 if earnings is
information in yt in the current period t, even if it indicates an adverse shock to future cash flows, and
thus wt always is 0. It is easy to see that the assumption of symmetry in the distributions of xt, yt, and
gt implies that var(Rt |Rt 0) = var(Rt |Rt < 0), and cov(It, Rt |Rt 0) = cov(It, Rt |Rt < 0). It
immediately follows that plim 2 = 0. Thus, under the null hypothesis of no conditional conservatism,
the Basu coefficient is zero, which indeed should be the case if the model is well-specified and the
derive the estimate for the 2 coefficient under conditionally conservative accounting, and then show
that it behaves in a predictable fashion as a function of the firms information environment. We begin
cov( xt + wt yt + (1 wt 1 ) yt 1 + t t 1 , xt + yt | Rt 0)
1 = (3.8a)
var( Rt | Rt 0)
cov( xt , xt + yt | Rt 0) + cov( wt yt , xt + yt | Rt 0)
= (3.8b)
var( Rt | Rt 0)
23
Equation (3.8b) follows from the assumption that all components of stock returns (and thus total
Now recall that (in this section) we make the assumption that the distributions of earnings and
returns are symmetric. While this is a simplifying assumption, it is necessary to keep the analysis
tractable. As we discuss in Section 2, asymmetry in the distributions of return and earnings does not
per se bias the analysis in Basu (1997). The symmetry assumption implies var(Rt |Rt 0) = var(Rt |Rt
Henceforth we drop the subscript t for expositional ease, and all variables are measured at time t
sufficiently bad news. We assume w = 1 if y < c and zero otherwise, where c is a threshold below
which current period recognition is required (e.g., through impairment). In an unrealistic limiting
case where c = + , timely recognition of y always occurs and there is symmetric recognition of
good and bad news. Thus, plim 2 = 0. The same result follows in the limiting case of c = , where
timely recognition of y never occurs. We set the threshold c to zero to be in line with adage
anticipate no profits, but anticipate all losses and to reconcile with the empirical formulation of the
Basu (1997) regression. In practice, c could be expected to be negative and close to zero. To the best
of our knowledge, this assumption is not restrictive and does not bias the results.
1 2
(3.12)
0 y 0 + 0 +
+ xy ( x, y | R < 0)dxdy y xy ( x, y | R 0)dxdy + E ( x + y | R 0) x ( x, y | y < 0)dxdy
3 4
The integrals can be evaluated explicitly, and under normality (see Appendix for derivation):
(
= 2 1 y x 1 xy2 1 + arctan( ) 1 + 2 , ) (3.13)
y + x xy2
where = (0, +) .
(1 xy2 )0.5 x
It further can be shown that for any positive , the expression for is positive (to see this consider
the intervals (0,1] , (1, 3] , and ( 3, +) ). This result implies the Basu incremental coefficient on
These results demonstrate that the Basu coefficient 2 is not driven by a single structural
parameter, but rather is a function of conditional accounting conservatism and other attributes of the
information environment, including information about growth options and rents, discussed next.
Collins and Kothari (1989) and Easton and Zmijewski (1989) document that the market-to-
book ratio correlates with return-earnings regression slope coefficients, though they do not study
asymmetric timelines. Ball, Kothari and Robin (2000, p. 48) conjecture that the proportion of
growth options relative to assets in place influences Basu asymmetric timeliness coefficients. This
conjecture is based on the rule of thumb that market value of equity can be viewed as the sum of
29
See also Pope and Walker (1999), Ryan and Zarowin (2003) and Beaver and Ryan (2005).
25
assets in place and the value of growth opportunities (Brealey et al., 2006, pp. 72-76; Ross et al.,
2005, p. 120). Stock return then reflects news about the values of both assets in place and growth
opportunities. Pae et al. (2005), Givoly et al. (2007) and Roychowdhury and Watts (2007) confirm
the conjecture empirically, reporting evidence that the asymmetric timeliness coefficient is negatively
correlated with the market-to-book ratio, a widely used proxy for the importance of growth options.
Consider the case where the (variance of) the information component g in economic income is
non-zero. Current-period accounting income then includes a component that represents a linkage to
past positive shocks to the firms growth opportunities, as in equation (3.2) where shocks to growth
cov( y , x ) + cov( y , g )
Define z x + g , z2 var( z ), and corr( z , y ) = .
var( y ) var( x + g )
In this set up with innovations to growth opportunities, the Basu asymmetric timeliness coefficient is
=
2 y z 1 2
( 2) var( R)
(1 + arctan( )
1 1 )
1 + 12 > 0 (3.14)
y +z
where 1 = (0, + ) .
(1 2 ) 0.5 z
Several limiting cases are of interest. To avoid cumbersome notation, here we loosely refer to
y
lim 1 2 = (3.15)
y +z
26
This result is intuitive and suggests the asymmetric timeliness coefficient depends on the fraction of
the variance of y in the total variance of returns, as one would expect when the components are
perfectly correlated. 30 As one also would expect, lim y 2 = 1 , and lim y 0 2 = 0 . In the first case
the variation in y subsumes all other components, while in the second there is no role of conditionally
previous results, and also are intuitive. The limiting cases suggest the Basu specification captures the
We now show that the Basu asymmetric timeliness coefficient declines in the variance of
growth opportunities, and thus is expected to be negatively correlated with the market-to-book ratio.
2
=
2 y 1 2
z ( 2)( y + 2 y z + z )
2 2 2 (
( y z y2 z y ) arctan( ) y z 1 2 , )
(3.16)
values of the parameters and the expression for 2 is symmetric in x and g . Since z is
increasing in both x and g , it follows that, holding the correlation coefficient constant, 2 is
decreasing in x and g . This result is intuitive, in that the x and g components of revision in price
are treated symmetrically in financial reporting (fully incorporated and fully ignored, respectively),
30
Equation (3.14) seems to suggest that 2 approaches zero as approaches 1. This, however, is not the case since
1 tends to plus infinity in this case.
27
parameters are fixed at the following levels: xz = xg = 0.3 and x = 0.2 .31 As expected, the
coefficient increases in the variance of y (reaching 1 in the limit), that is as timely loss recognition
becomes more important. It also follows from Figure 1 that asymmetrically timely loss recognition
decreases in the variance of g (information about growth options), reaching zero in the limit. This
also is intuitive. Since changes in growth expectations g are not captured contemporaneously in
accounting income, in a regression of accounting income on stock returns the variability due to
changing growth prospects dampens the coefficient on returns, consistent with the conjecture in Ball,
31
Analogous results obtain when other parameters are fixed at different levels, including correlation coefficients of zero.
For illustration, we therefore report the results only under one set of parameters.
28
decreases in the relative variance of shocks to growth opportunities. This variance, var(g), is expected
to be increasing in the magnitude of those opportunities. Because growth opportunities are less likely
to be recorded on firms books than other assets, firms with higher market-to-book ratios are likely to
experience relatively larger shocks, positive or negative, to their growth opportunities. Indeed,
empirically return variability increases in market-to-book, controlling for firm size.32 Consequently,
the market-to-book ratio acts as a proxy for the extent to which revision in price is associated with
revision in booked versus unbooked items, but does not per se determine the Basu slope. This
implies that market-to-book need not be used as a control variable (depending on the question at
stake) but rather can be used as an instrument for the degree of conservatism, in line with Khan and
Watts (2009).
Another implication of the graph above is that the relation between the Basu slope and the
interact with each other. This prediction is straightforward to test empirically. Finally, designing a
powerful test to detect conditional conservatism can be a challenge for high market-to-book firms,
because timely loss recognition is harder to detect for high growth firms and firms with larger
portions of unbooked intangible assets. This, however, does not mean that conditional conservatism
is absent, or that Basu model is mis-specified. To detect conditional conservatism in such companies,
it is helpful to identify settings or an economic event where firms experience substantial shocks to
assets in place (rather than growth opportunities), since timely loss recognition is increasing in the
The result that asymmetric timeliness is decreasing in x also is intuitive in our setup and
represents another empirical prediction. This implies that companies with short operating cycles and
32
For example, Lewellen (1999) and Ali, Hwang and Trombley (2003).
29
short investment cycles, or companies that have a substantial realized component of economic
income (such as mature companies) should exhibit lower levels of timely loss recognition. This
reconciles with the evidence reported in Khan and Watts (2009), and also with their predictions about
related to the variance of x and positively related to the variance of y (due to different verification
requirements for earnings components that are more uncertain and more costly to verify).
The model also implies that asymmetric timeliness declines as one extends the earnings
horizon. In line with this result, Basu (1997, 5.1) shows that the timeliness asymmetry declines with
the length of the accounting period (he studies periods of one to four years) and Roychowdhury and
Watts (2007) show that the negative association between growth opportunities and the asymmetric
timeliness coefficient diminishes as the return horizon is extended back. Intuitively, as the return
period is extended back, current-period earnings reflects more of the growth opportunities at the
beginning of the period. Further, shocks to growth opportunities are more likely to flow through the
financials over longer horizons. One can think of these as increasing the variance of x relative to the
variance of the other components of I, and hence the asymmetric timeliness coefficient is attenuated.
This is an implication of the more general proposition that, under clean surplus accounting,
Finally, we note that Pae et al. (2005), Givoly et al. (2007) and Roychowdhury and Watts
(2007) cast the negative correlation between market/book and the asymmetric timeliness coefficient
as a measurement error problem, whereas our analysis views it is a fundamental property of income
recognition in accounting interacting with properties of firms. We return to this important distinction
in Section 5. We argue that for the purposes of studying actual reporting behavior by firms, the true
notion of income.
correlations among the information components that drive returns but are reflected in earnings in
different periods. We use equation (3.14) to plot 2 as a function of the correlations xg and yg (we
do not separately consider yx since it is easy to see that its effect is the same as that of yg ). Figure
2 presents the results when other parameters are fixed at levels: xy = 0.3 and x = y = g = 0.2 .
As the figure shows, asymmetric timeliness increases in yg , the correlation between y and g,
and it decreases in xg , the correlation between x and g. Intuitively, the first result obtains because in
our model y exhibits timely recognition, but the researcher observes total return Rt, which also
31
contains other information components. As the correlation between the return components y and g
strengthens, the Basu models negative-return variable improves as an indicator of the negative news
coefficient increases. Similarly, the second result obtains because variation in the sum of the
and the conditional conservatism asymmetry becomes less salient. Thus, the correlations and
interactions between different information components are expected to have an effect on timely loss
recognition empirically.
A large body of literature in finance and economics starting with Shiller (1981) argues that the
volatility of stock returns is large relative to that of dividends and accounting income.33 One
interpretation of this result is that prices have excessive volatility compared to underlying
fundamentals, due for example to investors overreacting to economic news or due to frequent
changes in discount rates. We show that the volatility of stock returns is expected to be large relative
to that of accounting income due to the way accounting income is calculated. The lack of timeliness
of accounting income makes it a function of both current and lagged stock returns, and hence the time
In our model, the components of the firms total economic growth rate that are incorporated in
growth in accounting income in a timely and lagged fashion are xt and (yt-1 and gt-1), respectively. A
quantitative measure of timeliness of accounting income therefore is the relative variances of xt and
(yt-1+gt-1). The higher the variance of xt, other things equal, the timelier is accounting income in
33
See also Campbell and Shiller (1988), Fama (1990), Campbell (1991), Campbell and Ammer (1993), Kothari and
Shanken (1992), Collins et al. (1994), Shiller (2000), Vuolteenaho (2002), and Hecht and Vuolteenaho (2006).
32
capturing the information in economic income.34 Recall that xt is intended to capture information that
is symmetrically low-cost to verify, such as actual realizations of current-period cash flows and
working capital accruals, and that consequentially it is incorporated in income regardless of its sign
or magnitude. Because yt-1 is simply the lagged value of yt and the process is stationary across time,
their variances are equal. Moreover, all information affecting the stock price in the current period
(i.e., xt, yt, and gt) is not correlated with the stale components yt-1 and gt-1 of earnings growth. To
simplify the presentation, and without loss of generality, we restrict the variances of growth options
gt and accounting error t to zero. The variance of accounting income then is:
The last result follows because cov(xt, wtyt) = E(wtytxt) = E(ytxt)/2 = cov(xt, yt)/2, and var(wtyt-1) =
The variability of returns also is a function of the variances of its components, xt and yt:
Comparing equations (3.17) and (3.18), stock return is more variable than accounting income
because it incorporates the positively-correlated shocks xt and yt, whereas accounting income
incorporates xt, but (unless there is timely loss recognition) incorporates the other as an uncorrelated
shock yt-1 from the previous period. The sum of the uncorrelated shocks xt and yt-1 to accounting
income is less variable than the sum of the positively-correlated shocks xt and yt to stock return. In
34
This is due to our casting differences between accounting and economic income as a property of income recognition
rules in accounting, and not as a measurement error issue. Consequently, differences in the amount of information
conveyed in the two variables directly map into differences in their true variances. In other words, the variances need not
be interpreted as indicators of measurement error.
33
the absence of a positive correlation between the xt and yt components, it is straightforward to show
This result is clearer in the reasonable case where the loss recognition threshold c = 0, which
A consequence of accounting income being less timely than stock returns in reflecting
economic income, due largely to historical cost accounting, therefore is a smoother time series for
earnings than returns. The effect is evident in our two-period model, and would be magnified in a
The difference between dividend and return volatilities is expected to be even greater than is
evident for earnings. Corporations smooth dividends as a function of past accounting income
(relevant evidence dates back to Lintner, 1956, and more recently Ball et al., 2000, and Sadka, 2007).
To the extent that dividends are a weighted sum of current and past accounting income, they will
exhibit an even smoother time series than accounting income, and hence than stock returns.
Finally, changes in expectations about growth options will affect stock prices, and will thus
generate volatility, but some of these changes will never affect accounting earnings or dividends. For
example, an increase in growth prospects in one year one can be offset entirely by a decrease in the
following year. Since the changes are offsetting, they will not affect accounting earnings but will
returns does not explore the implications of prices leading earnings and dividends for their relative
volatilities, and consequently tends to over-estimate excess volatility. The implicit assumption in
the excess volatility literature that income and dividend volatilities provide a valid benchmark for
34
return volatility is not consistent with the economic roles and fundamental properties of accounting
income and dividend distributions. The time series of accounting income and dividends are smoother
than prices because they convey the information in price revision with a lag. An interesting empirical
question, in our view, is the extent to which the volatility of stock returns relative to the volatility of
earnings is explained by the properties of accounting earnings, such as timeliness and conservatism,
Our analysis of the incorporation of information about economic value into accounting income
concludes that the Basu (1997) asymmetric timeliness coefficient from a piecewise linear regression
alternative approach to establishing validity is to compare the predictions based on the asymmetric
Starting with the time-series measure of Basu (1997), the literature has developed alternative
measures of conditional conservatism that do not involve regressions of accounting income on stock
returns, in large part to address concerns about the validity of returns-based asymmetric timeliness
coefficients.35 At least three alternative research designs use proxies for positive and negative
economic news based on variables other than market returns. The results based on these measures are
similar to those from returns-based measures, and also reconcile in a predictable way with many
economic hypotheses, thereby providing useful evidence on the validity of the returns-based
asymmetric timeliness measure. We discuss their strengths and weaknesses this section.
35
See discussion in Ball, Kothari and Robin (2000, p. 48) and Ball, Robin and Wu (2003, p.255).
35
Basu (1997, Table 3) conducts a piecewise linear regression of change in earnings on prior-
period change in earnings, and shows that negative earnings changes are more transitory than positive
changes (i.e., more likely to revert). This asymmetry measure is based on the notion that economic
income is uncorrelated over time, which implies successive changes in economic income are
earnings are more likely to revert when they are incorporating negative economic income than when
incorporating positive economic income, and hence negative earnings changes are more likely to
exhibit negative first-order autocorrelation. In this time-series measure, the implied proxy for the sign
The time-series asymmetry measure avoids problems one might ascribe to using stock returns
as a proxy for economic income, but it has two potential deficiencies of its own. First, because it does
not condition on returns, it only measures whether negative earnings changes are more transitory than
positive changes, and does not measure timeliness. For example, similar results would be obtained if
all firms earnings delayed the recognition of gains and losses by an arbitrarily long amount of time.
Second, the time-series asymmetry measure does not distinguish between true economic income and
noise in accounting income, both of which are transitory. 37 Despite these potential deficiencies,
Basus (1997, Table 3) results from this alternative asymmetry measure are remarkably similar to
those from his returns-based measure. Subsequent studies reach much the same conclusion, both in a
range of countries,38 in private and public firms,39 and in the context of auditor liability.40
36
It is important that this variable is specified as earnings changes, not levels as in Hayn (1995), primarily because the
construct for which it proxies is new information. Another advantage of a changes specification is that it is substantially
less susceptible than a levels specification to survivorship-induced reversion bias, because a decrease in earnings does not
imply the firm has negative earnings.
37
Random errors in balance sheet amounts affect earnings in successive periods with opposing signs, inducing negative
serial correlation in earnings levels. Balance sheet amounts such as accounts receivable valuations, marketable security
valuations, derivatives valuations, loss provisions and inventory counts inevitably are not perfectly accurate, and
subsequent events cause them to be revised. For example, under-forecasting future loan losses over-estimates the balance
sheet value of receivables, adding positive error to current-period earnings and negative error to future earnings.
38
Ball and Robin (1999) and Ball, Robin and Wu (2003, Table 4).
36
Similar observations can be made about viewing the extent of left skew in accounting income
(relative to the skew in stock returns and cash flows) as an indicator of conditional conservatism.
Conditional conservatism produces left skew in accounting income by incorporating bad news in
larger amounts and lower frequency than good news, which is more likely to be spread out over time.
However, left skew also could be generated, for example, by write-offs against earnings that are
uncorrelated with stock returns, at any lag. Nevertheless, predictions that relative skew is a function
of variables that plausibly influence conditional conservatism are borne out in Basu (1997), Ball et al.
(2000), Givoly and Hayn (2000), Ball et al. (2003), and Krishnan (2005).
Ball and Shivakumar (2005, 2006) propose a measure of conditional conservatism in the
relation between accruals and cash flows, which is potentially useful in a setting where stock returns
are not available. The research designs utilizes a piecewise-linear relation of accruals on cash flows
(depending on their sign), and generally it is concluded that accruals function in predictable ways to
incorporate losses in a more timely fashion than gains. Besides providing insight into the role of
accrual accounting, the results have the added advantage of utilizing non-price proxies for the sign of
economic income. Potential disadvantages of this measure are similar to those of the asymmetric
earnings persistence tests. For example, cash flow changes are noisy proxies of economic income and
thus the presence of conditional conservatism is harder to detect with this measure. On the benefit
side, this measure facilitates studying the reporting properties of private companies, since it does not
A related validity concern arises from evidence that cash flow itself is a non-linear function of
returns, as reported in Basu (1997, Table 2) and Ball, Kothari and Robin (2000, Table 6), potentially
fueling the criticism discussed above that there could be some known or unknown biases in Basu
39
Ball and Shivakumar (2005).
40
Basu, Hwang and Jan (2001a,b), and Krishnan (2005a,b).
37
coefficient estimation. We make three points. First, most of the asymmetric timeliness of earnings
nevertheless arises from accruals, not cash flow. The coefficient on negative returns is lower for cash
flow than for earnings (Basu, 1997, Table 2; Ball, Kothari and Robin, 2000, Table 6). Second, it is
unlikely that the efficient response of operating cash flow to news is completely symmetric
(Papadakis, 2007). The optimal response to bad news might be to increase current-period cash
spending (e.g., increased advertising in response to a fall in demand; increased use of consultants and
investment bankers in response to strategic threats; or increased maintenance, repair and warranty
costs in response to a plant or product failure), but the optimal response to good news might not be to
increased demand). Third, there are errors in separating earnings into its cash flow and accruals
components, especially using balance sheet data (Hribar and Collins, 2002). When researchers
estimate accruals as earnings less cash flows, the effect is that errors in one component of earnings
are mirrored by errors in the other. The implication is that the measured properties of cash flows and
In sum, research using alternative measures provides corroborating evidence of the existence
of conditional conservatism. When used in combination with the more familiar returns-based
measure, they produce similar results. When used in contexts where stock returns are unavailable,
notably private companies, they generally behave as conditional conservatism is predicted to behave.
They provide reassuring evidence of the validity of the returns-based asymmetric timeliness
Feltham and Ohlson (1995, 1996), Beaver and Ryan (2000 and 2005), Easton (2001), Easton
and Pae (2004), Givoly and Hayn (2000), Dietrich et al. (2007) Givoly, Hayn and Natarajan (2007),
38
and others model the entire difference between the market and book values of equity as resulting
from accounting conservatism. Following Roychowdhury and Watts (2007), we view only a portion
of the difference between the market and book values of equity as resulting from accounting
conservatism (specifically, the difference between the net asset value and the book value of net
assets). Similar views are held in Basu (1997), Holthausen and Watts (2001), Watts (2003a and
2003b), Ball and Shivakumar (2006), Roychowdhury and Watts (2007), and others. Because the
objective of financial reporting is not to value the firm or its equity (FASB, 1978, 41), some
components of market value would not be recorded in book value even in the absence of
conservatism. For example, operating synergies among assets are central to the existence of the firm
(Coase, 1937), but they are not recorded on balance sheets because the accounting system is
transactions-based and therefore focuses on individual assets and not on aggregate firm value. It is
omitted from book values until they are realized over time as net revenues from the firms operating
activities.41 Thus, we view the market-to-book ratio as a proxy for conditional conservatism that is at
Several studies criticize the asymmetric timeliness as a proxy for conditional conservatism by
making an observation that there is a negative relation between the Basu asymmetric timeliness
41
The accounting focus on prices paid for individual assets in arms length transactions (historical costs) presumably is
because actual transactions are considerably less costly to verify than the private information of managers about future
cash flows that would be required to calculate and report firm values.
42
Of course, one could define conservatism as the book/market ratio, and hence encompass all sources of difference
between book and market values, but that would be at the expense of discarding correspondence with the meaning of
conservatism in accounting. For example, this would make conservatism the reason accounting is transactions-based and
not valuation-based, whose economic origin is symmetrically high costs of verifying private information (see prior
footnote). Conservatism then also would encompass symmetric random errors in book values (e.g., arising from errors in
counting closing inventory, or in accruals generally), whose economic origin is the cost of operating an accounting
system, not conservatism. Conservatism would be a symmetric function of any lags in incorporating information into
earnings, whose source also lies in accounting costs. Oddly, conservatism then would be a function of changes in
expected returns (discount rates) that affect market prices, including both increases and decreases in expected returns
symmetrically. More importantly, the correspondence between conservatism and the long-standing dictum anticipate all
losses and no gains would be severed. Yet this is precisely what the Dietrich et al. model does.
39
coefficient and the market-to-book ratio.43 Pae et al. (2005), Givoly et al. (2007) and Roychowdhury
and Watts (2007) cast the negative correlation between market/book and the asymmetric timeliness
coefficient as a measurement problem, the implication being that the coefficient is an inherently
flawed conservatism measure. For example, Givoly et al. (2007, p. 67) conclude that because the
correlation has lent credence to criticisms that (i) the Basu asymmetric timeliness coefficient is
econometrically biased, and/or (ii) it picks up something other than accounting conservatism, such as
We do not view the negative correlation with book-to-market as a problem. In our model, the
negative correlation of conditional conservatism and growth options (for which book-to-market is a
proxy) is a natural result of the accounting income recognition practices. Our results confirm the
original conjecture of Ball, Kothari and Robin (2000, p. 48) that asymmetric earnings timeliness is a
Our analysis most closely relates to Roychowdhury and Watts (2007), who argue that the
negative relation between the market-to-book ratio and the Basu asymmetric timeliness coefficient
occurs because both measure conservatism with error, and that this error diminishes as the
measurement horizon is increased. The rationale is that a high market-to-book ratio might indicate
the presence of rents (or growth opportunities) which serve as a buffer against having to record
subsequent losses, thus lowering asymmetric timeliness. Cross-sectional variation in the beginning-
of-period market-to-book ratio therefore is likely to add correlated error when measuring conditional
conservatism. Over longer horizons, the market-to-book ratio likely is a less noisy measure of
43
See Gigler and Hemmer (2001), Richardson and Tinaikar (2004), Beaver and Ryan (2005), Price (2005), Pae,
Thornton, and Welker (2005), Givoly, Hayn, and Natarajan (2007), and Roychowdhury and Watts (2007).
40
conditional conservatism, for example because rents present in the beginning of the period tend to
Our analysis has several distinctions. First, we do not rely on the presence of a buffer that
dampens loss recognition in subsequent periods. Despite its appeal, this argument relies on the
assumption that subsequent bad news is treated as a reversal of unbooked rents, which need not be
the case (for example, that the presence of growth options reduces the likelihood of accounting
impairment of spoiled inventory). It may well be that bad news affects the value of booked assets or
affects proportionally both the value of rents and the value of separable assets, in which case a
negative relation between the proportion of rents in the book-to-market ratio and asymmetric
timeliness does not arise. Our second distinction is that the absence of recognition of rents is not
important. Roychowdhury and Watts (2007, p. 12), argue that since increases or decreases in rents
(or unverifiable assets) are not recognized by accountants, this reduces asymmetric timeliness. While
this argument holds, our analysis shows that even in a hypothetical case where rents are recorded by
accountants, their presence can lower the asymmetric timeliness coefficient. The key is their
symmetric treatment by the accounting system. Our analysis suggests the asymmetric timeliness
coefficient decreases in the proportion of return components that are either symmetrically recognized
or symmetrically deferred.
conservatism, evidence of a negative association has been taken by some as challenging the
studying actual reporting behavior by firms, we conclude that the true level of conditional
Our prior belief is that conditional conservatism is a true property of accounting income, not
merely a statistical artifact. As Basu (1997) notes, the adage anticipate no profits but anticipate all
losses is centuries old, so there are strong priors in favor of an asymmetry existing in fact. The
Financial Accounting Standards Boards Accounting Standards Codification (FASB, 2009) lists
impairment rules for debt and equity securities, property, plant and equipment, goodwill, intangibles,
receivables, beneficial interests, servicing assets, loans, deferred costs, exchange memberships, life
settlement contracts, joint ventures, capital leases, non-refundable fees, and cumulative foreign
exchange translation adjustments for foreign subsidiaries, among other things. Furthermore, asset
impairment charges and restructuring charges were practiced well before formal standards such as
SFAS No. 121 (issued 1995, since superseded) required them, but upward revaluation of long-term
assets is comparatively rare. More importantly, the economic incentives of financial statement
preparers are biased toward timely loss recognition relative to gain recognition, particularly in
Our priors that conditional conservatism is a true property of accounting income are
reinforced by the variety of studies (briefly summarized in our introductory section) in which
estimated asymmetric timeliness coefficients reveal predictable associations with economic, legal and
political institutional variables, at the firm, industry, and jurisdictional levels. The variety and
consistency of the predicted associations further suggests that estimated asymmetric timeliness
coefficients capture a true property of accounting income, not some statistical artifact. In addition,
asymmetric timeliness estimates based on alternative research designs discussed in the previous
section generally produce similar results to the Basu regression coefficients, and vary in predictable
ways with its economic determinants, such as listing status (public/private) and listing jurisdiction.
42
These research designs provide additional evidence that the more conventional price-based estimates
In sum, since asymmetrically timely loss recognition is a basic property of GAAP, exhibits
predictable associations with economic, legal and political institutional variables, and behaves
consistently under alternative measures, claims that go so far as to conclude that the results of prior
studies employing the asymmetric timeliness measure are attributable to biases, and cannot be
interpreted as evidence of accounting conservatism, can be discounted. The claims have developed
We address these claims by presenting a model of accounting income that is based on salient
properties of income recognition in accounting, and use it to analyze the econometrics of the Basu
asymmetric timeliness coefficient. The analysis addresses conceptual and econometric challenges to
the coefficients validity as a measure of conditional conservatism. We show that the Basu measure
is unbiased under the null hypothesis of zero asymmetry, and that under the alternative hypothesis it
captures conditional conservatism as formulated in our model. We also demonstrate that any
differential persistence in economic gains and losses (as opposed to differential persistence in the
gains and losses that are recognized in accounting) does not explain the Basu coefficient. We
extend the Roychowdhury and Watts (2007) analysis and demonstrate econometrically that a
negative relation between market-to-book ratio and the asymmetric timeliness coefficient is expected
options are reflected in earnings. The market-to-book ratio does not per se determine asymmetric
timeliness; its effect arises because it is correlated with the amount of price revision associated with
We trust that the analysis will clarify the econometrics of the asymmetric timeliness
Appendix:
We derive the asymmetric timeliness coefficient for a general case where all three
components of return, x, y, and g, are considered. The cases when some of these components are
omitted follow immediately. We omit subscripts t when all random variables are contemporaneous.
cov( xt + wt yt + (1 wt 1 ) yt 1 + g t 1 + t t 1 , xt + yt + g t | Rt 0)
1 =
var( R | R 0)
cov( xt + wt yt , xt + yt + g t | Rt 0)
= (A1)
var( R | R 0)
cov( x, x + y + g | R 0) + cov( wy , x + y + g | R 0)
=
var( R | R 0)
and
plim2 = 2 1 =
cov( wy, x + y + g | R < 0) cov( wy, x + y + g | R 0)
= (A3)
var( R | R < 0) var( R | R 0)
cov( wy, x + y + g | R < 0) cov( wy, x + y + g | R 0)
=
var( R | R 0)
where w = 1( y < 0) is an indicator variable taking a value of one in case y < 0 and zero otherwise.
cov( y, x) + cov( y, g ) xy x + yg g
corr( z , y ) = = .
var( y ) var( x + g ) x2 + 2 xg x g + g2
0 y 0 +
= y ( z, y | R < 0)dzdy y ( z , y | R 0)dzdy +
2 2
y
1 2
0 y 0 + 0 +
+ zy ( z , y | R < 0)dzdy y zy ( z , y | R 0)dzdy + E ( z + y | R 0) y ( z , y | y < 0)dzdy
3 4
(A4)
1 1 z 2 2 zy y 2
where ( z , y ) = exp + is bivariate normal
2 z y (1 2 ) 0.5 2(1 2 ) z2 z y y2
(0) 2 z2 + 2 z y + y2
density and E ( z + y | R 0) = E ( R | R 0) = var( R) = .
1 (0) 2
The integrals can be evaluated explicitly under the normality assumption, first noting that symmetry
1
0
1 z 2 2 zy y 2
=
2 z y (1 2 ) 0.5 Pr( R < 0)
y exp + dzdy
2(1 2 ) z2 z y y2
0 y z z y
2
1 y 1 y2 dzdy
= y 2(1 2 ) (1 ) (1 2 ) 0.5 z y + (1 ) 2
2 2
exp
z (1 2 ) 0.5 y (A5)
y y z z y
= u= ,v= , dy = y du , dz = z (1 2 ) 0.5 dv
y (1 2 ) 0.5 z y
y 0
1 2
1 2 2 y
=
u exp u
2
du 2
exp v dv =
2
Further, making the same transformation, and integrating by parts it can be shown that:
45
y 0 y y z z y
2
2
y2 1 2 y
1 = y2 2(1 2 ) (1 ) (1 2 )0.5 z y +
2
exp (1 ) dzdy
z (1 2 )0.5 2
y
y y z z y y +z
= u= ,v= , dy = du , dz = (1 2 0.5
) dv , u u
y (1 2 )0.5 z y
y z
(1 2 )0.5 z
y2 0 u
1 2 2
y 2
=
u exp 2
2
( v + u )
dvdu =
+ 1 + 2
(A6)
y +z
where = / 2 arctan( ) , and = (0, + ) .
(1 2 ) 0.5 z
y2 0
1 2 2
y 2
2 = u u exp 2 ( v + u ) dvdu = 1 + 2
2
(A7)
1
0 y 1 z2 zy 2 y2 2 y
2
3 =
z y (1 2 )0.5 zy exp
2(1 2 ) z2
2
+
2
+ (1 )
2
dzdy
z y y y
y y z z y y +z
= u= ,v= , dy = y du , dz = z (1 2 )0.5 dv, u u
y (1 ) z y
2 0.5
(1 2 )0.5 z
z y 0 u
1
= u (v 1 2 + u ) exp ( v 2 + u 2 ) dvdu
2
z y 1
= 1 2 + + ,
1+ 2
1 + 2 (A8)
and, by analogy,
z y 0
1
4 = u (v 1 2 + u ) exp ( v 2 + u 2 ) dvdu
u 2
z y 1
= 1 1 + 2 + 1 + 2 .
2
(A9)
0 y 0 + 0 +
=
( y 2 + zy ) f ( z , y ) dzdy
y
( y 2 + zy ) f ( z , y ) dzdy + E ( z + y | R > 0)
y f ( x, y ) dzdy
2 z2 + 2 z y + y2 y2 y
2
= 1 2 + 3 4 + = + 2
2 1+ 1 + 2
z y 1 z y 1
+ 1 2 + + 2
1 2 +
1+ 2
1 + 1+ 2
1 + 2
2 y 2 z + 2 z y + y
2 2
.
2 2 (A10)
y 2 2 z 1 2
= ( y + z )( 2 + ) + 2 z 1 2 1 + 2
1+ 2
1+ 2
2 y z 1 2
=
(1 + arctan( ) )
1 + 2 > 0.
(A11)
2 =
=
2 y z 1 2
var( R | R > 0) ( 2) var( R )
(
1 + arctan( ) 1 + 2 > 0 ) (A12)
2
where we use the result that var( z + y | R > 0) = var( R ) E ( R | R > 0) 2 = var( R ) 1 .
47
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