Conditional conservatism and disaggregated bad news indicators in accrual models

Abstract

Conditional conservatism is an integral but often unmodeled part of the normal accrual process. The standard economic determinants of accruals contain information about unrealized losses. We argue that accountants recognize these unrealized losses as disaggregated write-downs for small asset pools. Modeling disaggregated impairments yields new economic insights about accruals and improved accrual models. We predict that accrual conservatism manifests as a sum of asymmetries for a vector of news indicators, rather than as an asymmetry for a scalar aggregate news proxy. We argue that more detailed segment-level and quarterly indicators have an incremental effect on annual firm-level accruals. We also predict a dynamic effect of successive loss indicators because accountants look for consistent patterns in these variables. Empirical results for U.S. firms support our predictions. The asymmetries in accruals are consistent with conservatism in validation tests. We also document improved statistical power and type I error in earnings management tests.

Director-Liability-Reduction Laws and Conditional Conservatism

“…Following Byzalov and Basu [2016], we show that accruals respond less asymmetrically after the law enactments to bad news indicators other than stock returns. We also find that firms are less likely to choose a Big N auditor after the laws are enacted, which is one way to reduce their commitment to conservative accounting.…”

“…Small subsamples from these two states would cause a low-power test of the impact of director-liability-reduction laws on conditional conservatism. inventory component of accruals, but there is no symmetric higher-of-cost-or-market rule for current liabilities (Ijiri and Nakano [1989]; Byzalov and Basu [2016]).…”

“…Following Byzalov and Basu [2016], we decompose change in noncash current assets ΔCA into change in inventories (ΔINV) and change in receivables (ΔREC) and examine them separately.…”

Asymmetric Learning from Prices and Post‐Earnings‐Announcement Drift

“…We should note that our model does not incorporate the effects of conservatism (Basu ). For example, Byzalov and Basu () show that when one segment in a firm performs well and another performs poorly, the firm is likely to record impairments in the poorly performing segment, but the firm is less likely to have asset write‐ups in the high‐performing segment. The result is that earnings are not linear in performance, an effect that our model does not capture.…”

Historical Cost and Conservatism Are Joint Adaptations That Help Identify Opportunity Cost

“…Byzalov and Basu (2016) report that auditors use disaggregated internal performance data (e. g. quarterly and segment income) in their impairment decisions, which is sensible if assets are tested for impairment in a disaggregated manner at the segment level (goodwill), pool level (inventory) or at the individual level (buildings). Both papers show that auditors give additional weight to consistent negative signals (i. e. over and above their individual weights as independent negative signals) when impairing assets, so asset impairments are credible indicators of poor expected cash flows.…”