Accounting Conservatism and the Temporal Trends in Current Earnings’ Ability to Predict Future Cash Flows Versus Future Earnings: Evidence on the Trade-Off Between Relevance and Reliability

Abstract

This research reports that an increasing level of accounting conservatism over the 1973–2005 period is associated with (1) an increase in the ability of current earnings to predict future cash flows (a measure of relevance, e.g., Kim and Kross, 2005); and (2) a decrease in the ability of current earnings to predict future earnings (a measure of reliability in the Richardson et al. [2005] sense). We also find that usefulness of earnings for explaining stock prices over book values is positively related to reliability but not to relevance. Our results hold for the constant and full samples and in both in-sample and out-of-sample analyses and are also robust to the use of different measures for relevance, reliability, earnings usefulness, and conservatism. Our findings about the relations between conservatism, relevance, reliability, and usefulness suggest a trade-off between relevance and reliability and seem to indicate that the adoption of an increasing number of conservative accounting standards possibly has an adverse impact on earnings usefulness through their negative effects on reliability.

Keywords: accounting conservatism, relevance, reliability, earnings predictability, cash flow predictability

JEL Classification: M41, C23, D21, G38, N20