The Earnings-Sensitivity Difference as an Indicator of Conditional Conservatism: Evidence from U.K. Earnings Components

Following Basu (1997), the excess of the sensitivity of accounting earnings to contemporaneous negative share return over its sensitivity to contemporaneous positive share return (the earnings-sensitivity difference (ESD)) has been widely interpreted as an indicator of conditional-conservatism-induced asymmetric timeliness in earnings. Although this interpretation is supported by substantial evidence that the ESD is associated with likely contracting-related demands for accounting conservatism, concerns have arisen that the ESD measure may reflect factors not directly related to conservatism, and that this may adversely affect its validity as an indicator of that phenomenon. This paper contributes to the literature on the ESD by examining whether the ESD for a sample of U.K. firms reporting under FRS 3: Reporting Financial Performance arises from earnings components that, in light of accounting regulation and practice, are likely to be affected by conditional conservatism or from other components that are not likely to be affected by conditional conservatism. Although a substantial proportion of the ESD emanates from cash flow from operating and investing activities (CFOI), which cannot directly reflect accounting conservatism, its incidence across other components of earnings is predominantly consistent with the conditional-conservatism interpretation of the ESD.

Introduction
Basu  (1997)  defines  accounting  conservatism as  a  tendency  on  the  part  of  accountants  ‘to  require  a  higher degree  of  verification  for  recognizing  good  news  than  bad  news  in  financial  statements’,  resulting  in accounting earnings being more  timely  in  its  recognition of bad news  than  in  its  recognition of good news. This  news-dependent  concept  of  conservatism  that  gives  rise  to  asymmetric  timeliness  in  earnings  is
sometimes  termed  ‘conditional  conservatism’,  with  news-independent  conservatism  being  termed ‘unconditional  conservatism’  (Beaver  and Ryan, 2005). Basu  (1997) proposes  as  an  indicator  of  conditional
conservatism the excess of the sensitivity of earnings to contemporaneous negative share return, assumed to be indicative of bad news, over its sensitivity to contemporaneous positive share return, assumed to be indicative of  good  news.  In  this  paper  we  term  this  excess  the  earnings-sensitivity  difference  (ESD).  Although  the conditional-conservatism interpretation of the ESD is supported by substantial evidence that the ESD measure is associated with  likely contracting-related demands  for accounting conservatism,  there are concerns  that  it  may  reflect  factors not directly  related  to conservatism,  and  that  this may adversely affect  its validity as an indicator of that phenomenon. This paper contributes to the literature on the Basu (1997) ESD by examining whether,  for a sample of U.K.  firms  reporting under FRS 3: Reporting Financial Performance  (ASB, 1992), the ESD arises from earnings components that, in light of accounting regulation and practice, are likely to be affected by conditional conservatism or from other components that are not likely to be affected by conditional conservatism

Author: Audrey Hsu, John O’Hanlon and Ken Peasnell

Source: Lancaster University Management School