The Effect of Conditional Accounting Conservatism on the Predictive Ability of Accruals Components with Respect to Future Cash Flows

47 Pages Posted: 26 Jun 2017 Last revised: 30 Sep 2022

See all articles by Wei Chen

Wei Chen

University of Connecticut

Daniel W. Collins

University of Iowa - Department of Accounting

Sam Melessa

University of Iowa - Department of Accounting

Date Written: September 28, 2022

Abstract

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.

Suggested Citation

Chen, Wei and Collins, Daniel W. and Melessa, Sam, The Effect of Conditional Accounting Conservatism on the Predictive Ability of Accruals Components with Respect to Future Cash Flows (September 28, 2022). Available at SSRN: https://ssrn.com/abstract=2992150 or http://dx.doi.org/10.2139/ssrn.2992150

Wei Chen

University of Connecticut ( email )

Department of Accounting
Storrs, CT 06269
United States

Daniel W. Collins (Contact Author)

University of Iowa - Department of Accounting ( email )

108 Pappajohn Business Building
Iowa City, IA 52242-1000
United States
319-335-0912 (Phone)
319-335-1956 (Fax)

Sam Melessa

University of Iowa - Department of Accounting ( email )

108 Pappajohn Business Building
Iowa City, IA 52242-1000
United States

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