The Effect of Conditional Accounting Conservatism on the Predictive Ability of Accruals Components with Respect to Future Cash Flows
55 Pages Posted: 26 Jun 2017 Last revised: 14 Sep 2022
Date Written: Sep 12, 2022
We investigate the impact of conditional conservatism (timely loss recognition) on the ability of accruals and its components to predict future cash flows. Prior studies claim that conditional conservatism detracts from the valuation role of earnings. We argue that if timely loss recognition improves contracting efficiency by providing early warnings of declines in future cash flows, then these accruals should provide better predictions of future cash flows for valuation purposes. Consistent with this conjecture, we find a positive association between timely loss recognition and the ability of accrual components to predict future cash flows in bad news periods. Moreover, we find the effect is concentrated in income-reducing asset accruals that are more likely to reflect timely loss recognition (e.g., impairments and write-downs) than are liability accruals. We conduct additional analyses to strengthen the validity of our results. Our findings stand in contrast to claims that conditional conservatism impairs the valuation role of earnings.
Keywords: conditional conservatism; timely loss recognition; accruals; cash flow predictability.
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