Accounting Conservatism and the Effects of Earning Quality on the Return of Assets and Stock Return

Document Type : Research Paper



Decision making in the economic affairs needs information. The shortage of information causes the ambiguity of the decision making process. The financials provide some of the needed information of this process. The perception of the earnings as the most important information source of the company was being supported by empirical studies. The mentioned researches have shown that the decision makers anchor on the accounting earnings more than any other benchmarks. The purpose of the following research is to help investors and other users to be able to assess the degree of the effects of the conservatism on the earning quality and ROI. The results show that the earning quality index presented based on the conservatism index has the ability to describe some of the differences between return on the operational assets and the current stock returns from the current year to the next year. In other word, economic entities that use the conservative procedures are able to change the earning quality with making some changes in the investments of the operational assets.


- Abarbanell, J., and Reuven L. (2000), Biased forecasts or biased earnings: the role of earnings management in explaining apparent optimism and inefficiency in analysts, earnings forecasts, Working Paper, University of North Carolina.
- Badri, A., (1998), defining factors influencing the income smoothing in the companies listed in the Tehran Stock Exchange, Dissertation, Tehran University.
- Ball, R., and Shivakumar, L. (2004), Earnings quality in UK private firms. Working paper, University of Chicago and London Business School.
- Balsam, S., Krishnan, J., and Yang, J.S. (2003), Auditor industry specialization and earnings quality. Auditing, Vol. 22, No. 2, pp. 71-97.
- Basu, S. (1995), Conservatism and the asymmetric timeliness of earnings, PhD thesis, University of Rochester.
-  Basu, S. (1997), The conservatism principle and the asymmetric timeliness of earnings, Journal of Accounting and Economics, Vol. 24, pp. 3-37.
- Beaver, W.H., and Ryan, S.G. (2000), Biases and lags in book value and their effects on the ability of the book-to-market ratio to predict book return on equity. Journal of Accounting Research, Vol.38, pp. 127-148.
- Bernard, V.L., and Jacob K. T. (1989), Post-earnings-announcement drift: Delayed price response or risk premium?, Journal of Accounting Research, Vol.27 (supplement), pp. 1-36.
- Beneish, M.D., and Vargus, M.E. (2002), Insider trading, earnings quality, and accrual mispricing, Accounting Review, Vol. 77, No. 4, pp. 755.
- Bliss, J.H. (1924), Management through Accounts. New York, NY: The Ronald Press Co.
- Dechow, P. (1994), Accounting earnings and cash flows as measures of firm performance: The role of accounting accruals, Journal of Accounting and Economic, p.11
- Dechow, P. and Dechev. I., (2002), The quality of accruals and earning: The role of accrual estimation errors, Accounting Review Vol.77, (Supplement), pp. 35-59.
-  Degeorge, F., Patel, J. and Zeckhauser, R. (1999), Earnings management to exceed thresholds, Journal of Business, Vol. 72.
- Defond, M., Hung, M., and Treezevant, R., (2004), Investor protection and the information evidence. Working Paper, University of Southern California.
- Fama, E., and French, K. (1992), The Cross-section of expected stock returns. Journal of Finance, Vol. 47, pp. 427-465.
- Feltham, G. and Ohlson, J.A. (1995), Valuation and clean surplus accounting for operating and financial activities, Contemporary Accounting Research, Vol. 11, pp. 689- 731.
- Feltham, G. and Ohlson, J.A. (1996), Uncertainty resolution and the theory of depreciation measurement, Journal of Accounting Research, Vol. 34 (autumn), pp. 209-234.
- Guenther, D.A., Maydew, E.L. and Nutter, S.E. (1997), Financial reporting, tax costs, and book-tax conformity, Journal of Accounting and Economics, Vol. 23 (November), pp. 225-248.
- Healy, P., and Wahlen, J., (1999), A Review of the earnings management literature and its implications for standard setting. Accounting Horizens, Vol. 13 (December).
- Hoitash, R. et al, (2002), Earning Quality and Price Quality, working paper, Rutgers University, Online,
- Houge, T., and Loughran, T., (2000), Cash flow is king: Cognitive errors by investors, Journal of Psychology and Financial Markets, Vol. 1, No. 3&4, pp. 161-175.
- Kellogg, R.L., (1984), Accounting activities, security prices, and class action lawsuits. Journal of Accounting and Economics, Vol. 6 (December), pp. 185-204.
- Kurdistani, G., (2003), Defining the relation between earning quality and the market reaction to the changes of cash earnings, Doctoral Dissertation, Tehran University.
- Lang, M., and Lund h., (1996), Corporate disclosure policy and analyst behavior, Accounting Review, Vol. 71, No. 4, pp. 467-492.
- Latane, H.A., and Jones, C.P. (1979), Standardized unexpected earnings (1971-1977), Journal of Finance, Vol. 34, pp.717-724.
- Mikhail, M.B., and Walter, R.B., and Willis, H.R, (2003),” Reactions to dividend changes conditional on earnings quality”, Journal of Accounting ,Auditing and Finance, Vol. 18, No. 1, pp. 130-155.
- Myers, J. (1999), Implementing residual income valuation with linear information dynamics, The Accounting Review, Vol. 74 (January), pp. 1-28.
- Penman, H. and Zhang, X., (2002), Accounting conservatism the quality of earnings, and stock returns, Accounting Review, Vol. 77, No. 2, pp. 237-264.
- Raymond, A. H. and Gunders, H. (1970), Inventory, control, costing and effect upon Income and Taxes, 2nd, Ed., The Ronald Press Company, New York, Chap. 4.
- Revisine, L., Collins, D. and Johnson, B. (2002), Financial Reporting and Analysis. Second edition. Upper Saddle River, NJ: Prentice00 Hall.
- Richardson, S. (2003), Earnings surprises and short selling, Accounting Horizons, Vol. 17 (Supplement), pp. 49-61.
- Ross, W. (2002), Conservatism in accounting, University of Rochester. Online,
- Saghafi, A., Aghaie, M.A., (1993), the accounting earnings behavior, Accounting Review, Vol. 9.
- Shackelford, D.A., and Shevlin, T. (2001), Empirical tax research in accounting. Journal of Accounting and Economics, Vol. 31 (September), pp. 321-387.
- Sloan R. (1996), Do stock prices fully reflect information in accruals and cash flows about future earnings? Accounting Review, Vol. 71, pp. 289-315.
- Sterling, R.R. (1970), The theory of the measurement of enterprise income. Lawrence, KS: University of Kansas Press.
- Sterling, R.R., (1967), Conservatism: The fundamental principle of valuation in traditional accounting”, Abacus, Vol. 3, pp. 109-132.
- Stickney and Weil (2003), Quality of earnings from text book, online,
- Teoh, S. H., Welch, I. and Wong, T. J. (1998), Earnings management and the long-run performance of initial public offering, Journal of Finance, Vol. 53, pp. 1935-1974.
- Teoh, S.H., (1998), Earnings management and the underperformance of seasoned equity offerings, Journal of Financial Economics, Vol. 50, pp. 63-99.
- Walker, R.G. (1992), The SEC’s ban on upward asset revaluations and the disclosure of current values, Abacus, Vol. 28, pp. 3-35.
- Watts, R.L. (1977), Corporate financial statements, a product of the market and political processes. Australian Journal of Management, Vol. 2 (April), pp. 53-75.
- Watts, R.L., and Zimmerman, J.L. (1979), The demand for and supply of accounting theories: The market for excuses, Accounting Review, Vol. 54 (April), pp. 273-305.
- Watts, R.L., and Zimmerman, J.L. (1986) Positive Accounting Theory, Englewood Cliffs, NJ: Prentice-Hall.
- Watts, R.L. (1993), A proposal for research on conservatism. Working paper, University of Rochester (presented at American Accounting Association national meeting, San Francisco, CA).
- Zeff, S.A. (1972), Forging accounting principles in five countries: a history and analysis of trends, Arthur Andersen Lecture Series. Champaign, IL: Stipes Publishing Company.
- Zhang, X. (2000), Conservative accounting and equity valuation, Journal of Accounting and Economics, Vol. 29, pp. 125-149.
- Zhang, X., (2001), Accounting conservatism and the analysis of line items in earnings forecasting and valuation. Working Paper, University of California Berkeley.