The Nonlinear Relationship Between Accruals Persistence and Accounting Conservatism
Shu-Hua Lee/Department of Accounting National Taipei University
Chi-Chuang Hsieh/Department of Finance Chung Hua University
Abstract
Earnings Persistence impacts pricing of the firms and past studies find that
conservatism is negatively related to earnings persistence. Extending these prior studies,
we examine how earnings persistence varies when the level of conservatism changes. The
results show that, when the level of conservatism increases, earnings persistence
coefficient first increases and then decreases afterwards. Sample firms with conservatism
index near zero (i.e., when the firms’ accounting is neutral) have the most persistent
earnings. The relationship between earnings persistence and conservatism is a kinked
nonlinear function. Decomposing earnings into the accrual component and the operating
cash flow component, we also find that the kinked nonlinear relationship only exists
between persistence of the accruals component and conservatism. Based on this result, we
further decompose the accrual component into the discretionary component and the
non-discretionary component and document that the effect of conservatism on the
discretionary accruals component is the sole cause of the kinked nonlinear relationship. To
address the inconsistency between conservatism and neutrality, the IASB excludes
conservatism from the notion of faithful presentation. The empirical results, that earnings
are more persistent when accounting is neutral, in this paper are consistent with this IASB
decision.
Keywords
Conservatism accountingEarnings persistencePersistence of accrualsPersistence of discretionary accruals
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