| Conservatism is interpreted to mean that accountants more frequently report current "bad news" about future cash flows in contemporaneous earnings than current "good news." Earnings reported under GAAP should thus be more timely in reporting "bad news" about future cash flows than "good news." This dissertation, using the firm's stook return as a measure of news, examines the asymmetric sensitivity of earnings to news. It is shown that the contemporaneous association between earnings and negative returns is two to five times as large as the contemporaneous association between earnings and positive returns. It is also shown that the greater timeliness of earnings relative to cash flow measures is largely due to a greater sensitivity to concurrent negative returns. These results are consistent with accountants recording accruals conservatively. Another implication of conservatism is that negative earnings surprises are likely to be less persistent than positive earnings surprises, because earnings reports more bad news concurrently than good news, with the latter being spread over several periods. This is shown to be true empirically. It is predicted and found that earnings response coefficients are higher for positive earnings changes than for negative earnings changes, which is consistent with the market correcting for the difference in persistence in conservatively determined earnings. The results are robust to different specifications of earnings and return variables, different measurement intervals and different time periods. It is found that the sensitivity of earnings to negative returns has more than quadrupled since 1980 relative to the previous two decades, whereas the sensitivity to positive returns has decreased by two-thirds since 1980, suggesting that earnings measurement has become more conservative since 1980. The increases in conservatism are correlated with increases in auditors' exposure to legal liability, but no causal inferences are drawn. |
