Conditional Conservatism and Disaggregated Bad News Indicators in Accrual Models
51 Pages Posted: 6 Apr 2015 Last revised: 19 May 2016
Date Written: May 17, 2016
Conditional conservatism is an integral but often unmodeled part of the normal accrual process. The standard economic determinants of accruals contain information about unrealized losses. We argue that accountants recognize these unrealized losses as disaggregated write-downs for small asset pools. Modeling disaggregated impairments yields new economic insights about accruals and improved accrual models. We predict that accrual conservatism manifests as a sum of asymmetries for a vector of news indicators, rather than as an asymmetry for a scalar aggregate news proxy. We argue that more detailed segment-level and quarterly indicators have an incremental effect on annual firm-level accruals. We also predict a dynamic effect of successive loss indicators because accountants look for consistent patterns in these variables. Empirical results for U.S. firms support our predictions. The asymmetries in accruals are consistent with conservatism in validation tests. We also document improved statistical power and type I error in earnings management tests.
Keywords: asset impairment, timely loss recognition, lower of cost or market rule, abnormal accruals, materiality
JEL Classification: C5, D8, M41
Suggested Citation: Suggested Citation