Accounting Conservatism, the Quality of Earnings, and Stock Returns
Stephen H. Penman
Columbia Business School - Department of Accounting
University of California, Berkeley; China Academy of Financial Research (CAFR)
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.
Number of Pages in PDF File: 39
JEL Classification: M41, G12, G14
Date posted: January 23, 2000