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Accounting Conservatism, the Quality of Earnings, and Stock Returns

39 Pages Posted: 23 Jan 2000  

Stephen H. Penman

Columbia Business School - Department of Accounting

Xiao-Jun Zhang

University of California, Berkeley; China Academy of Financial Research (CAFR)

Date Written: December 1999

Abstract

Quality of earnings questions arise when firms that practice conservative accounting change the level of their investment in net operating assets: increases in net operating assets create "hidden reserves," depressing earnings, and decreases in investment release hidden reserves into earnings. This paper develops diagnostics that capture this joint effect of investment and conservative accounting and finds that the diagnostics forecast differences in future return on net operating assets from the current return on net operating assets. Moreover, the diagnostics forecast stock returns, indicating that the stock market does not appreciate how conservatism and investment combine to raise quality questions about reported earnings.

JEL Classification: M41, G12, G14

Suggested Citation

Penman, Stephen H. and Zhang, Xiao-Jun, Accounting Conservatism, the Quality of Earnings, and Stock Returns (December 1999). Available at SSRN: https://ssrn.com/abstract=201048 or http://dx.doi.org/10.2139/ssrn.201048

Stephen H. Penman (Contact Author)

Columbia Business School - Department of Accounting ( email )

3022 Broadway
New York, NY 10027
United States
212-854-9151 (Phone)
212-316-9219 (Fax)

Xiao-Jun Zhang

University of California, Berkeley ( email )

545 Student Services Building
SPC 1900
Berkeley, CA 94720
United States
(510) 642-4789 (Phone)
(510) 642-4700 (Fax)

China Academy of Financial Research (CAFR)

1954 Huashan Road
Shanghai P.R.China, 200030
China

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