Accounting conservatism in expected earnings: a European study

Electronic versions

Documents

  • Christina Dargenidou

Abstract

Much recent international accounting research has focused on a comparison of the properties of reported earnings, and in this respect the diversity of accounting has been confirmed on an international scale. It is argued that such diversity in accounting may entail information barriers that create an impediment to capital market integration, whereby information disadvantages to foreign investors result in less foreign investment (Gordon and Bovenbeg, 1996) and information advantages to domestic investors lead to a home bias in investing attitudes (Gehrig, 1996). However, it is important to recognise that comparisons of accounting systems in terms of their outcomes in the form of reported earnings are not sufficient to assess the impact of accounting diversity as an information barrier. Thus, this thesis proposes that the evaluation of accounting diversity should take the perspective of market participants, and model not the reported accounting earnings but the forward earnings that market participants use for equity valuation.
In this context, accounting diversity will be considered here in terms of cross-country variation in the degree of bias introduced by the principle of accounting conservatism. Indeed, to the extent that market participants are able to unravel the various degrees of bias introduced in accounting numbers due to the particularities of local GAAP, accounting diversity is likely to be of no serious consequence for cross-border equity valuation, and thus would constitute an information barrier of only minor importance. It is in this spirit that accounting diversity is evaluated here, that is, in terms of how market participants perceive these numbers in a cross-country setting, how they interpret their properties, and the implications of the inherent accounting bias for equity valuation.
Recent developments in equity valuation modelling, such as the residual income model and the abnormal earnings model, have provided the necessary basis from which to develop a framework that describes the process of removing the biases that characterise accounting. Indeed, the common feature of these accounting based valuation models is that they rely upon accounting expectations to account for the correction of bias introduced by accounting conservatism. This provides additional support for the view that accounting diversity (defined here as the cross-country diversity in the degree of
accounting conservatism) should be evaluated not only in terms of current earnings but, more importantly, by understanding the process through which accounting biases are reversed in earnings' expectations.
In summary, whilst the first contribution of this thesis is to address market participants' perceptions of earnings rather than GAAP reported earnings in order to identify cross-country diversity, the second contribution is to build a framework within the context of contemporary equity valuation modelling that will describe the process of removing the biases that characterise accounting and determine accounting diversity. The empirical analysis that is reported in this thesis provides evidence in support of this theoretical framework.
This thesis starts by setting out a framework in Chapter 1 that links accounting biases in terms of earnings conservatism with expected earnings growth, thereby describing the process underlying the reversal of conservatism. With this framework in mind, Chapter 2 reviews the prior evidence on the non-contemporaneous association of earnings and price changes, including the empirical regularity that earnings reflect price changes with a lag, which is commonly summarised as "Prices Lead Earnings". The research studies that provided the first indication of the reversal of conservatism are also reviewed, together with the existing evidence that conservatism reverses asymmetrically with respect to the sign of price changes. Chapter 2 establishes that there has been no study to date to assess the reversal of conservatism in the context of
expected earnings. It is on this basis, and motivated by the mechanisms developed in Chapter 1, that the research carried out for the present thesis employs market participants' expectations in the form of analysts' forecasts.
Given the above, Chapter 3 provides a review of the research literature on the
rationality of analysts' forecasts, explaining why concerns about their bias and accuracy may not be well founded. In particular, it is argued that these statistical characteristics are a natural consequence of the properties of reported accounting numbers and do not contradict the notion of earnings forecast rationality. In addition, since this thesis examines cross-country variation in accounting properties, recent developments in international accounting research are also reviewed, in Chapter 4. The review shows that international accounting diversity has been explored mainly, as already mentioned, with respect to the properties of accounting numbers that are reported, and not with respect to the forecasted numbers that are generally employed in equity valuation. Another important point that arises from this review is that international accounting research has yet to consider capital market dynamics as an important force that shapes accounting numbers. In Chapter 4, it is shown that, within the context of international finance research, the degree of capital market integration may be evaluated by assessing
country effects in expected and realised stock returns, and by comparing any decline in their influence with that of sector effects. It is suggested in Chapter 4 that, in a similar spirit, accounting diversity may be evaluated by testing for country effects in current and expected earnings and their valuations, after taking account of sector effects. Chapter 4 concludes by revisiting the framework developed at the outset that links accounting biases in terms of earnings conservatism with expected earnings growth, in order to introduce country and sector effects into the research design.
The following Chapters 5 and 6 present the corresponding empirical evidence. Chapter 5 tests for country effects in accounting earnings within the short term i.e., with regard to current and one year ahead earnings forecasts. The findings reported in Chapter 5 show that there is considerable cross-country variation with respect to the recognition of positive value shocks, which is the main driver of accounting diversity, even when capital markets are alleged to be relatively integrated (e.g., as in the Eurozone member states after 2000). It is also shown that, consistent with these findings, country effects in the forward earnings multiple, that is the ratio of one year ahead forecasted earnings to current market value, persist at all times, even under integrated markets. However,
by examining country versus sector effects in earnings pricing indicators which
incorporate information on the reversal of conservatism beyond one year ahead, it is shown that the importance of country effects dissipates as financial markets become more integrated, despite accounting diversity. Following this, the contribution of Chapter 6 is to go beyond a purely empirical analysis and to build upon the framework that is developed in this thesis in order to explain how various earnings pricing indicators, widely used by finance professionals, reflect the process of unravelling conservatism so that ultimately such indicators will capture the underlying economics of the firm.
Chapter 7 provides a synthesis of the theory and empirical findings, and builds upon the estimates in Chapter 5 to construct an index of the speed of positive value recognition. Also, country effects are tested again based on this index. Consistent with the predictions, country effects persist in earnings pricing even within integrated markets when accounting practices are "slow" at capturing positive value shocks. Admittedly, these final inferences must be seen as a rough approximation; however, in terms of the policy implications, this thesis provides evidence that is in line with the current endeavours of standard setters towards harmonisation, particularly the expressed intention within the common FASB-IASB project to de-emphasise conservatism in favour of neutrality within the conceptual framework. In particular, the introduction in IFRS of notions such as "fair value" would accelerate the speed at which accounting systems capture positive value shocks, thus making it less likely for country effects to be present in accounting numbers. Chapter 7 concludes therefore that, based on the empirical evidence that is reported, the current regulatory initiatives are likely to diminish the impact of accounting diversity as an information barrier.

Details

Original languageEnglish
Awarding Institution
  • University of Wales, Bangor
Supervisors/Advisors
  • Stuart Mcleay (Supervisor)
Award dateFeb 2006