Abstract
Since Basu (Journal of Accounting and Economics, 24, 3–37, 1997), the difference between the response of earnings to good news (as proxied by positive stock return) and its response to bad news (as proxied by negative stock return) has been referred to as evidence of asymmetric timeliness in the response of earnings to good and bad news and the difference has been termed a measure of asymmetric timeliness. This measure of asymmetric timeliness has been extensively used in assessing accounting conservatism and its economic consequences. In this study, I seek to contribute to the debate on the sources of asymmetric timeliness by testing for its existence across a range of components of earnings. When clean surplus earnings are decomposed into cash flow and accrual components, I find that asymmetric timeliness in operating cash flow is larger than that in accruals. Moreover, using articulated data, the decomposition across line items also finds little evidence with regard to the application of three prominent standards (i.e., the LCM rule, the impairment tests, and the bad debt provision) that incorporate asymmetric verification criteria. These results call into question whether asymmetric timeliness of earnings is a consequence of accounting conservatism.
Notes
- 1.
Moral hazard refers to the tendency of the agent who is imperfectly monitored by the principal to engage in dishonest or otherwise undesirable activities.
- 2.
Conservatism can also reduce the possibility that management make a liquidating dividend to shareholders at the expense of debt holders by manipulating earnings upwards. Other contracting explanations such as tax, litigation can refer to Watts (2003).
- 3.
There are other aspects of earnings conservatism. For example, the historical cost convention does not recognize the excess expected NPV (economic rent) at the time of acquisition; the choice of income-deferring accounting methods (i.e., depreciation or inventory).
- 4.
The equivalent international standard is IAS 36 impairment of assets, issued in 1998. The FRS treats intangible assets in much the same way as goodwill while the IAS aligns their treatment to that of tangible assets.
- 5.
The recoverable amount is determined by the higher of its net realisable value and its value in use. Value in use is to be calculated by discounting the expected future cash flows at an estimate of the rate the market would expect on an equally risky investment.
- 6.
The Company Act 1985 permits either historical cost accounting or the use of an alternative basis of valuation. The issuance of FRS 15 in 1999 has removed considerable flexibility in the previous revaluation practice. FRS 15 requires companies to revalue the assets on a regular basis and does not permit revaluation of individual assets from same class.
- 7.
Exceptional are material items which derive from events or transactions that fall within the ordinary activities of the reporting entity and which individually or, if of a similar type, in aggregate, need to be disclosed by virtue of their size or incidence if the financial statements are to give a true and fair view (FRS 3, Para.5). FRS 3 requires the “gains and losses from sales or termination of continued and discontinued operations,” “gains and losses from sales of fixed assets,” and “reorganisation” be separately disclosed as special items after operating profit.
- 8.
Among all dirty surplus flows, goodwill and revaluation reserve deserve some notice as they constitute the major part of dirty surplus flows. The goodwill treatment that requires the written-off against shareholders’ equity in acquisition accounting (SSAP 22: Accounting for Goodwill) has long been criticised on the grounds that it overstates earnings and produce other mismeasurement problems. As such, FRS 10 (Goodwill and Intangible assets) eliminated dirty surplus treatment of goodwill write-offs in 1998. FRS 10 requires purchased goodwill and intangible assets to be capitalized and amortized through the profit and loss account over their useful economic lives. All goodwill previously eliminated against reserves has been reinstated as an asset on the balance sheet by way of a prior year adjustment.
- 9.
On the contrary, proponents of dirty surplus accounting argue that reported earnings should abstract from transitory effects to reflect current operating performance, enhancing the predictive ability for valuation purposes (Black 1993) because the inclusion of some unusual items in reported earnings is likely to cause misleading inferences, and managers are in a better position to identify those unusual items.
- 10.
Apart from operating cash flow, FRS1 requires the separate disclosure of cash flow for net interests and tax payments. The possibility that this assumption can double count the two items as cash flow components is minimal, given that the tax and net interest are not included in the operating cash flows.
- 11.
One of the reasons to use a reverse regression is to facilitate the exploration of the extent to which accounting earnings can capture the contemporaneously economic performance. Besides, some econometric benefits arise from this reverse regression. As the measurement error of earnings can bias downwards the coefficient of ERC and the R2 in the normal price-earnings regression, in the reverse regression, the measurement errors will be placed in the disturbance term rather than in the explanatory term, and thus the coefficient will be measured with less errors.
- 12.
I exclude financial firms because I expect them to exhibit a significant different association between earnings and market returns than do nonfinancial firms. For example, financial firms usually apply fair value accounting to a greater extent than nonfinancial firms and could result in a higher intensity in applying asset impairment rules.
- 13.
Financial Reporting Standards 3: reporting financial performance. FRS3 requires that the information about change in shareholders’ funds should be disclosed in a supplementary statement, “Reconciliation of Movements in Shareholders’ Funds.”
- 14.
For example, the discrepancy between “ending book value of shareholders’ funds” in the previous period and the “opening book value of shareholders’ funds” in current period; the discrepancy between “the sum of opening book value of shareholders’ funds and current-period movements in shareholders’ funds” and “the ending book value of shareholders’ funds.”
- 15.
The non-missing variables requirements might cause some survivorship bias, but some analysis shows that my sample is economically representative of the population both in terms of the market value distribution and industry composition.
- 16.
The results are qualitatively similar if those two line items are taken exclusively as accrual components.
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Appendix 1 The UK Financial Statements
Appendix 1 The UK Financial Statements
I extract the financial statements of Boots Plc. as of 1999 to demonstrate the presentation formats of the UK “profit and loss accounts,” the “statement of total recognised gains and losses,” and “reconciliation of movements in shareholders’ funds.”
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1.
Format of the UK profit and loss accounts
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Note 1: denotes the line items covered in this entry
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2.
Statement of total recognized gains and losses
It is suggested that the profit and loss account is not sufficient on its own as a report of a company’s financial performance. FRS3 introduces the statement of total recognized gains and losses to present details of the other elements making up a company’s performance.
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3.
Reconciliation of movements in shareholders’ funds
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Note 1: denotes the line items covered in this entry
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Note 2: denotes the five classes of dirty surplus flows. There are five classes of dirty surplus flows: (1) asset revaluation, (2) currency translation, (3) other gains and losses, (4) prior year adjustment, (5) goodwill write-offs and disposition. All dirty surplus flows except goodwill are disclosed in the “statement of total recognised gains and losses.” Goodwill acquisition and disposition are recorded in the “reconciliation of movements in shareholders’ funds.”
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Note 3: Financial Reporting Standard 10: Goodwill and Intangible Assets requires purchased goodwill and intangible assets to be capitalized and amortized through the profit and loss account over their useful economic lives. FRS10 eliminated this dirty surplus treatment of goodwill write-offs in 1998
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Hsu, W. (2021). Accruals and the Asymmetric Timeliness of Earnings: A Decomposition Analysis. In: Lee, CF., Lee, A.C. (eds) Encyclopedia of Finance. Springer, Cham. https://doi.org/10.1007/978-3-030-73443-5_79-1
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