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

55 Pages Posted: 12 Jan 2008 Last revised: 14 Feb 2010

See all articles by Sati P. Bandyopadhyay

Sati P. Bandyopadhyay

University of Waterloo

Changling Chen

University of Waterloo - School of Accounting and Finance

Alan Guoming Huang

University of Waterloo

Ranjini Jha

University of Waterloo - School of Accounting and Finance

Date Written: July 1, 2009

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

Suggested Citation

Bandyopadhyay, Sati P. and Chen, Changling and Huang, Alan G. and Jha, Ranjini, 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 (July 1, 2009). Contemporary Accounting Research, Forthcoming. Available at SSRN: https://ssrn.com/abstract=1082916 or http://dx.doi.org/10.2139/ssrn.1082916

Sati P. Bandyopadhyay

University of Waterloo ( email )

School of Accountancy
Waterloo, Ontario N2L 3G1
Canada
519-888-4567, ext. 2533 (Phone)
519-888-7562 (Fax)

Changling Chen (Contact Author)

University of Waterloo - School of Accounting and Finance ( email )

200 University Avenue West
Waterloo, Ontario N2L 3G1 N2L 3G1
Canada

Alan G. Huang

University of Waterloo ( email )

School of Accounting and Finance
Waterloo, Ontario N2L 3G1
Canada
519-888 4567 ext. 36770 (Phone)

Ranjini Jha

University of Waterloo - School of Accounting and Finance ( email )

200 University Avenue West
Waterloo, Ontario N2L 3G1 N2L 3G1
Canada

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