Givoly2000 PDF

Journal of Accounting and Economics 29 (2000) 287}320
The changing time-series properties of

earnings, cash #ows and accruals:
Has "nancial reporting become
more conservative?夽
Dan Givoly , Carla Hayn*
Graduate School of Management, University of California at Irvine, Irvine, CA 92717-3125, USA
Anderson Graduate School of Management, University of California at Los Angeles, Los Angeles,
CA 90095-1481, USA
Received 9 June 1998; received in revised form 22 August 2000
Abstract
This paper documents changes in the patterns of earnings, cash #ows and accruals over
the last four decades. In the absence of a generally accepted de"nition of conservatism,
a number of measures of reporting conservatism are identi"ed and examined. These
measures rely on the accumulation of nonoperating accruals, the timeliness of earnings
with respect to bad and good news, characteristics of the earnings distribution and the
market-to-book ratio. The patterns are consistent with an increase in conservative
"nancial reporting over time. The "ndings have implications for accounting standard
setting, regulation of "nancial information and "nancial statement analysis. 2000
Elsevier Science B.V. All rights reserved.
JEL classixcation: M41; C23; D21; G38; N20

Keywords: Earnings; Losses; Cash #ows; Accruals; Conservatism; Market-to-book ratio;
Earnings variability; Skewness
夽
We thank Jerry Zimmerman (the editor), Ray Ball, Jack Hughes, Katherine Schipper, and
participants in the accounting workshops at the University of California at Berkeley, Duke
University, University of Michigan, New York University, Tulane University and Tel Aviv Univer-
sity for their helpful comments on this paper.
* Corresponding author. Tel.: #1-310-206-9225; fax: #1-310-825-3165.
E-mail address: chayn@agsm.ucla.edu (C. Hayn).
0165-4101/00/$ - see front matter 2000 Elsevier Science B.V. All rights reserved.
PII: S 0 1 6 5 - 4 1 0 1 ( 0 0 ) 0 0 0 2 4 - 0
288 D. Givoly, C. Hayn / Journal of Accounting and Economics 29 (2000) 287}320
1. Introduction
In a steady state and over a su$ciently long period, accounting-based

measures of performance of the "rm are expected to converge to the &true'
economic performance as measured by the cash #ows from operations. In
particular, any departure of accounting earnings from cash #ows from opera-
tions is temporary and mean reverting. This expectation, which underlies the
interpretation and analysis of "nancial statements (see, for example, Carslaw
and Mills, 1991), has been conceptually articulated in a valuation framework by
Ohlson (1995) and Feltham and Ohlson (1995).
Recent studies provide indications that certain shifts in the economics-
accounting mapping do, however, occur over time. For example, the earnings
response coe$cient (ERC) has been found to decline over recent years (see, for
example, Barth et al., 1998; Collins and Kothari, 1989; Collins et al., 1997;
Easton and Harris, 1991; Francis and Schipper, 1999; Hayn, 1995; Lev and
Zarowin, 1998; Rayburn, 1986). Further, a continuous shift in emphasis from
earnings to the book value of equity has been documented (see Barth et al., 1998;
Collins et al., 1997).
This study extends this body of research by analyzing the relation between
earnings and cash #ows to identify structural changes in the accounting report-
ing system. In particular, we examine whether the changes in the time-series
properties of earnings, cash #ows and accruals are consistent with increased
reporting conservatism.
Anecdotal evidence suggests that "nancial reporting has become more conser-
vative in recent years. This evidence includes the numerous FASB pronouncements
that have the e!ect of an earlier recognition of expenses and losses, or a deferral of
revenue recognition. It also includes the increasingly litigious environment
that has led management to adopt a more conservative reporting stance, and
Many FASB statements result in an earlier recognition of expenses or losses. These include
SFAS 106, Employer's Accounting for Postretirement Bene"ts Other Than Pensions (1992), SFAS
114, Accounting by Creditors for Impairment of a Loan (1993), SFAS 68, Research and Develop-
ment Arrangements (1982), SFAS 123, Accounting for Stock-Based Compensation (1995) and SFAS
121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed
Of (1995). More conservative rules by the AICPA include AICPA SOP 97-2 (1997) and SOP 98-5
(1998) on software revenue recognition and the costs of start-up activities.
See, for example, Berton (1992), Kothari et al. (1988), Minow (1984) and Walters (1992).
Examples include managers' tendency to write o! acquired in-process R&D, as well as the
election by most "rms to report the full impact of SFAS 106 in the year of adoption rather than
amortize it over future years. Patterns of management response to the litigious environment are
modeled by Hughes and Sankar (1998) and documented by Kasznik and Lev (1995) and Skinner
(1994, 1997), among others.
D. Givoly, C. Hayn / Journal of Accounting and Economics 29 (2000) 287}320 289
auditors to be more careful in client selection and less willing to accommodate

management reporting objectives.
The issue of whether the time-series properties of accounting numbers have
changed over time and, in particular, whether accounting in the U.S. has become
more conservative is important for investors, researchers and regulatory bodies.
If a change in the structural relation between earnings, cash #ows and accruals
has occurred, "nancial statement analysis should recognize it. For example, if
the degree of reporting conservatism has increased over time, a time-series
analysis of the "nancial statements is not meaningful unless there is an adjust-
ment for the varying levels of conservatism. Indeed, the need for such an
adjustment to account for cross-country di!erences in the degree of conserva-
tism is suggested by researchers of international accounting (Gray, 1980; Joos
and Lang, 1994; Harris et al., 1994; Ball et al., 1999; Pope and Walker, 1999).
Further, it appears that "nancial analysts are already making this type of
adjustment when comparing "nancial statements of companies in di!erent
countries (French and Poterba, 1991; Speidel and Bavishi, 1992).
The issue of conservatism is tied to the debate about whether the current
level of stock prices represents a &bubble'. Those who contend that the U.S.
stock markets today are arti"cially in#ated often support their claim citing
as evidence the historically high earnings multiples and market-to-book
values. However, if "nancial reporting by U.S. companies is indeed more
conservative, the time-series comparison of these valuation measures may be
misleading.
From a research perspective, a "nding of increased conservatism will add
another dimension to the research examining managers' opportunistic behavior
in "nancial reporting. Speci"cally, such a "nding would suggest that the relative
weight of reporting considerations such as political costs, compensation incen-
tives and the capital market response vary over time (Watts and Zimmerman,
1986).
Despite the fact that the conservatism phenomenon is important and
has, indeed, attracted some attention from analysts, accounting standard
Krishnan and Krishnan (1997) and Stice (1991) suggest that client characteristics signi"cantly
a!ect auditors' litigation risk. The former study "nds that auditors are more likely to resign from
jobs that have a higher probability of resulting in litigation. Anecdotal evidence is provided in &More
accounting "rms are dumping risky clients', (The Wall Street Journal, 23 April 1997). Some studies
even suggest that the increased legal liability of auditors inhibits reporting innovation and dis-
closures (Minow, 1984; Kothari et al., 1988).
See, for example, Cole et al. (1996), Dreman (1998) and Wyatt (1996).
See, for example, &On the books, more facts and less "ction', The New York Times, 16 February
1997.
setters and regulators, the empirical "ndings regarding the extent of, and, in
particular, the trend in, conservatism are scant. Stober (1996), using the market-
to-book ratio as a proxy for the degree of conservatism, "nds a conservative bias
in accounting book values relative to market values. Leftwich (1995) examines
the content of the history of the FASB pronouncements and agenda decisions.
He concludes that they manifest a conservative tilt and a predominant concern
by the FASB that management is more likely to use its measurement discretion
and disclosure options to report higher earnings and net worth over some
horizon.
Basu (1997) devises several empirical measures of conservatism, among them
a stronger association of stock price movements and earnings in periods of bad
news. His results are consistent with the presence of reporting conservatism and
with the level of conservatism varying with changes in auditors' legal liability
exposure. Holthausen and Watts (2000), employing Basu's methodology, pro-
vide indications of conservative accounting even in the pre-standard setting era
and an increase in its degree during the FASB's regime. Similar market-based
measures are used by Ball et al. (1999) and by Pope and Walker (1999) to assess
cross-country di!erences in conservatism. Results that could be interpreted as
indicating reporting conservatism are also reported by McNichols (1988). She
"nds that returns during earnings announcement periods are skewed more
negatively than non-announcement returns, which is consistent with earnings
re#ecting bad news in a more timely manner than good news.
The studies cited above, with the exception of Holthausen and Watts (2000),
have not focused on the intertemporal variations in the degree of conservatism.
This study extends this line of research by addressing the variation in conserva-
tism over time. Further, rather than relying primarily on market-based
measures of conservatism (such as the market-to-book ratio), this paper recog-
nizes that conservatism is essentially an issue of the timing and sequencing of
revenues and expenses relative to the associated cash #ows. Therefore, both
time-series and distributional properties of earnings, cash #ows and accruals are
examined.
The "ndings show persistent, non-trivial changes in the relation between
earnings, cash #ows and accruals. In line with the results of previous studies (e.g.,
Hayn, 1995; Jan and Ou, 1994; Collins et al., 1997), we "nd that reported
See, for instance, EITF 94/3 (FASB, 1994) which attempts to limit the amounts written o! as
restructuring charges before actual cost commitments are made.
Arthur Levitt, the SEC Chairman, cited an assortment of accounting practices commonly
used by public corporations to manage earnings. Most of the practices (such as overstatements
of restructuring and loss provisions) are income-decreasing (see www.sec.gov/news/speeches/
spch220.txt).
pro"tability over the last four decades has generally declined. More revealing,
however, is the "nding that this decline is not accompanied by a corresponding
decline in cash #ows. In particular, the evidence points to a massive accumula-
tion of negative nonoperating accruals over this period. In addition, the earnings
distribution has become more dispersed and negatively skewed relative to that
of cash #ows. The evidence also suggests a more timely recognition of &bad news'
relative to &good news'. These results are consistent with an increase over time in
the degree of reporting conservatism.
The "ndings have implications for "nancial statement analysis, accounting
standard setting, securities regulation and research. The changes in the time-
series patterns of earnings and cash #ows suggest that an analysis of "nancial
statements should take into account this trend rather than relying on historical
benchmark ratios. In particular, the indications of a greater conservatism in
"nancial reporting suggest that the higher earnings multiples and market-
to-book ratios of recent years do not necessarily imply equity overpricing.
The results also call into question the assumption, often made by researchers
and regulatory bodies, regarding management's motivation to accelerate
earnings.
The remainder of the paper is organized as follows. Section 2 discusses the
nature of conservatism and introduces measures to assess its extent. The data
and sample are described in Section 3. Section 4 contains the "ndings concern-
ing conservatism, based on the measures introduced in Section 2. Section
5 provides a summary and concluding remarks.
2. De5nition and measurement of reporting conservatism
Conservatism is an important convention of "nancial reporting. It implies the

exercise of caution in the recognition and measurement of income and assets.
However, despite its central role in accounting theory and practice, no authori-
tative de"nition of conservatism exists. The only &o$cial' de"nition is that
o!ered in the glossary of Statement of Concepts No. 2 of the FASB, namely, that
conservatism is &a prudent reaction to uncertainty to try to ensure that uncer-
tainty and risks inherent in business situations are adequately considered'.
However, this de"nition does not specify the nature of the &prudent reaction'
called for by conservatism nor does it explain how such a &reaction' may ensure
that risks are &adequately considered'.
The textbook de"nitions of conservatism are more descriptive. A typical one
is that conservatism is the rule whereby &when there is a genuine doubt concern-
ing which of two or more reporting alternatives should be selected, the alterna-
tive with the least favorable e!ect upon owners' equity should be chosen' (Smith
and Skousen, 1987).
This de"nition, however, is still ambiguous since accounting measurements

under GAAP must preserve certain identities. In particular, the sum of earnings
over the life of the "rm (or over a full business cycle) must be the same regardless
of the accounting choice. Therefore, what constitutes &conservatism' in one
period may lead to &non-conservative' results in subsequent periods. A more
descriptive de"nition of conservatism is that it is a selection criterion between
accounting principles that leads to the minimization of cumulative reported
earnings by slower revenue recognition, faster expense recognition, lower asset
valuation, and higher liability valuation (Wolk et al., 1989; Davidson et al., 1985;
Stickney and Weil, 1994).
This de"nition, which properly recognizes the multi-period dimension of the
accounting choice, suggests several empirical measures that can be used to
gauge the degree of accounting conservatism. One measure is the sign and
magnitude of accumulated accruals over time. Accruals tend to reverse: periods
in which net income exceeds (falls below) cash #ows from operations are
expected to be followed by periods with negative (positive) accruals. For "rms in
a steady state, we expect the cumulative amount of net income before deprecia-
tion and amortization to converge in the long run to cash #ows from operations.
A consistent predominance of negative accruals across "rms over a long period
is, ceteris paribus, an indication of conservatism, while the rate of accumulation
of net negative accruals is an indication of the shift in the degree of conservatism
over time.
In addition to the accrual measures, we also use measures of reporting
conservatism that were developed by previous studies. Our second set of
conservatism measures is based on the notion that conservatism induces asym-
metry in the timeliness of incorporating economic events in reported earnings.
Speci"cally, under conservatism, &bad news' is re#ected in earnings more
promptly than &good news'. As a result, earnings are expected to be more
correlated with stock price movements in periods characterized by bad news
than in periods characterized by good news. The measure of conservatism is
thus the excess of the association of stock price movements with earnings signals
in &bad news' periods over their association with earnings signals in &good news'
periods (Basu, 1997; Ball et al., 1999; Pope and Walker, 1999; Holthausen and
Watts, 2000).
We use this approach to determine whether there has been an increase over
time in the timeliness in which bad news is re#ected in earnings, our next
measure of conservatism. Following Basu, we identify periods of bad and good
news by the sign of the period's stock return. The return then serves as the
independent variable in the following cross-sectional regression:
EPS /P "a #a DR #b R #b R*DR #e , (1)
GR GR\ GR GR GR GR GR
where EPS is the earnings per share of "rm i in "scal year t, P is the price
GR GR\
per share at the beginning of the "scal year, R is the return of "rm i over the 12
GR
months beginning nine months prior to the end of "scal year t, and DR is
GR
a dummy variable set equal to 1 if R is negative and 0 otherwise.
GR
Various measures of conservatism can be developed from the results of
regression (1):
1. The incremental response to bad news relative to good news, captured by b .

Under conservative reporting, b is expected to be positive.

2. The relative sensitivity of earnings to bad news compared with their sen-
sitivity to good news, measured by the ratio (b #b )/b . Under

conservative reporting, this ratio is expected to be greater than one.
3. The relative explanatory power of regression (1) in periods of bad news
(negative returns) and good news (positive returns), assessed by the ratio of
the R in bad news periods to the R in good news periods. Under conserva-
tive reporting, this ratio is expected to be greater than one.
4. The average downward bias in the earnings-to-price ratio due to conserva-
tism.
One of the limitations of the above measures is that they rely on the stock
price movements to identify good and bad news. The fourth measure requires, in
addition, the estimation of the risk-free rate and further assumes that it is
constant over time.
The notion that, under conservative reporting, bad news is reported on
a more timely basis than good news serves as the basis for yet another set of
conservative measures. Note that if conservatism leads to an immediate and
complete recognition of negative events and a delayed and gradual recognition
of positive events, it is likely to result in a negatively skewed earnings distribu-
tion. Second, to the extent that increased conservatism takes the form of either
a more immediate (rather than gradual) recognition of bad news, or a greater
tendency to provide for anticipated future costs or losses, such an increase will
be associated with increased variability of the earnings series. Accordingly, two
additional measures of conservatism are the skewness and variability of the
earnings distribution.
A "nal proxy for conservatism is based on the balance-sheet-oriented de"ni-
tion of conservative accounting suggested by the theoretical framework
As in Basu (1997) and Beaver et al. (1980), the reverse regression is used because the OLS
standard errors and test statistics are better speci"ed when the leading variable is independent and
the lagging variable is dependent.
The average downward bias is shown by Pope and Walker (1999) to equal (under certain
assumptions): (1/k!b ) R Pr(good) } (b #b !1/k) R Pr(bad), where R (R ) is the

mean return over a good news (bad news) period, de"ned as a period with positive (negative) returns
and Pr(good) (Pr(bad)) is the relative frequency of good news (bad news) periods. The parameter 1/k,
the risk-free rate, is estimated by the intercept of regression (1).
developed by Feltham and Ohlson (1995). This de"nition views accounting as

being conservative if the expected value at time t of the excess of the market
value over the book value of the "rm's equity at time t#q is greater than zero as
q approaches in"nity. This notion of conservatism points to the use of the
market-to-book ratio as a proxy for the degree of conservatism. A ratio greater
than one indicates conservative accounting and, other things being equal, an
increase in the ratio over time suggests an increase in the degree of reporting
conservatism. Stober (1996) uses this measure to test for the existence of
conservatism.
To summarize, this study uses four sets of measures to estimate the extent of,
as well as the shift in, reporting conservatism in the U.S. over the last four
decades:
1. the level and rate of accumulation over time of negative nonoperating

accruals;
2. measures based on the earnings-return association (derived from regression
(1)) during periods of good and bad news;
3. measures based on the time-series properties of earnings and cash #ows (i.e.,
the skewness of the earnings distribution relative to the cash #ows distribu-
tion and the variability of earnings relative to cash #ows); and
4. the market-to-book ratio.
It should be emphasized at the outset that the absence of a generally accepted

de"nition of conservatism makes it di$cult to test its level through a single
measure or even a number of measures. The evidence that we provide in this
paper on the various measures stated above should thus be viewed as indicative
of the trends in reporting conservatism.
3. Sample
The sample consists of all "rms on the 1999 Compustat database contained in
the primary, secondary and tertiary, full coverage and research "les. The
resulting sample, referred to as the &full sample', spans the 49-year period from
1950 to 1998. Since this paper addresses patterns in the relation between
accounting numbers and cash #ows over time, regulated "rms (i.e., utilities) for
which this relation is a!ected by unique institutional and regulatory factors were
excluded from the sample. The full sample increases in size from 593 "rms in
Note that the very existence of "rms implies a positive economic rent to creating "rms and
hence a market-to-book ratio that exceeds unity, independent of conservatism. Yet, the ratio is still
meaningful in gauging changes over time in the degree of conservatism.
1950 to about 9,000 in the late 1990s, as new "rms are added to the Compustat
database. To ensure comparability of the results over time, most of the analyses
are conducted on a constant sample of 896 "rms that exist for the period from
1968 to 1998 (hereafter, the &constant sample'). Selection bias issues associated
with both samples are discussed in the following section. Return information
was retrieved from the Center for Research in Security Prices (CRSP) database.
4. Time series properties of earnings, cash 6ows and accruals
In this section, we provide descriptive statistics on the time-series patterns of

earnings and cash #ows over the last 49 years. While not directly bearing on the
issue of conservatism, these statistics are helpful in interpreting some of the
"ndings reported later in the paper. To allow for a cross-sectional aggregation,
we de#ate all of the #ow variables (earnings, cash #ows) for each year by the
total assets at the beginning of that year. Statistics based on alternative de#ators
are also provided.
4.1. Proxtability
The pattern of "rm pro"tability over the last four decades for both the full and
constant samples of "rms is shown in Table 1. In line with previous results
(Hayn, 1995; Jan and Ou, 1995; Collins et al., 1997), the percentage of "rms in
the full sample reporting losses has increased signi"cantly, from 2}3% in the
early years to over 35% in the late 1980s and the 1990s (see Panel A). The
constant sample, shown in Panel B, shows a similar trend.
This increase in the frequency of losses re#ects the drop in reported pro"tabil-
ity over the years. For the full sample, the accounting rate-of-return, de"ned as
the ratio of net income-to-total assets (hereafter, ROA), shows a continuous
decline over the years, falling fairly steadily from a mean of about 7% in the
1950s to !8% in the 1990s. Some portion of this decline is due, undoubtedly,
to the changing composition of "rms on the Compustat database, which
Net income (or net loss) is de"ned throughout this paper as the &bottom line' net income (i.e.,
income after gains or losses from discontinued operations, extraordinary items and the cumulative
e!ect of changes in accounting principle). Very similar results are obtained for all of the analyses in
the paper when income from continuing operations is used instead of &bottom line' net income.
The "nding that earnings performance over the last two decades is rather lackluster runs
contrary to the common belief that vigorous earnings are one of the causes for the surge in the stock
market in recent years. This belief is re#ected in many analyses in the "nancial press such as
Bongiorno, L., &Hot Damn, What a Year!' Business Week, 3414 (March 6, 1995) 98}100; Clark, K.,
&These are the Good Old Days', Fortune, 135 (11) (June 9, 1997) 74}86; and Spiers, J., &The Pro"ts
Flowed', Fortune, 133 (8) (April 29, 1996) 260}261.
Table 1
Frequency of losses and net income-to-total assets, ROA
Freq. of ROA Freq. of ROA
No. of losses losses
Year "rms (%) Mean Median Subperiod (%) Mean Median
Panel A: Full sample

1950 595 1.01 0.103 0.099
1951 606 0.83 0.079 0.076
1952 618 1.94 0.067 0.065 1950}1955 1.67 0.078 0.072
1953 628 1.43 0.068 0.066
1954 648 2.93 0.069 0.067
1955 668 1.80 0.080 0.075
1956 688 2.18 0.081 0.075
1957 705 1.99 0.075 0.069
1958 729 3.57 0.064 0.060 1956}1960 4.64 0.067 0.065
1959 748 2.27 0.074 0.068
1960 1355 9.15 0.055 0.057
1961 1495 9.23 0.055 0.055
1962 1715 6.76 0.060 0.056
1963 1896 7.07 0.059 0.056 1961}1965 6.57 0.063 0.061
1964 2025 6.02 0.067 0.064
1965 2174 4.65 0.073 0.069
1966 2331 4.63 0.076 0.070
1967 2503 5.75 0.069 0.064
1968 3086 6.48 0.061 0.060 1966}1970 9.27 0.054 0.056
1969 3266 10.13 0.049 0.054
1970 3450 16.64 0.028 0.041
1971 3640 14.75 0.031 0.044
1972 3821 9.53 0.046 0.050
1973 4193 9.44 0.051 0.052 1971}1975 15.48 0.035 0.046
1974 5787 19.01 0.027 0.043
1975 5856 20.65 0.025 0.041
1976 5893 16.73 0.035 0.048
1977 5900 16.27 0.036 0.049
1978 5825 14.88 0.042 0.052 1976}1980 16.40 0.035 0.048
1979 5725 15.48 0.038 0.052
1980 5826 18.62 0.023 0.049
1981 5871 21.75 0.010 0.045
1982 6167 28.38 !0.027 0.033
1983 6409 28.57 !0.027 0.034 1981}1985 28.62 !0.035 0.034
1984 6467 29.33 !0.042 0.035
1985 6783 34.14 !0.080 0.026
1986 7047 35.58 !0.089 0.022
1987 7107 35.29 !0.069 0.022
1988 6958 34.72 !0.067 0.023 1986}1990 35.81 !0.074 0.021
1989 6875 36.22 !0.063 0.020
1990 6912 37.30 !0.083 0.017
1991 7057 38.10 !0.071 0.015
1992 7466 36.36 !0.068 0.020
1993 8589 32.70 !0.058 0.016
1994 8964 29.46 !0.065 0.022 1991}1998 33.58 !0.080 0.018
1995 9775 32.00 !0.087 0.020
1996 9930 32.65 !0.081 0.019
1997 9418 34.00 !0.106 0.017
1998 9192 35.32 !0.103 0.015
Table 1 (continued)
Freq. of Freq. of
ROA ROA
No. of losses losses
Year "rms (%) Mean Median Subperiod (%) Mean Median
Panel B: Constant sample

1950 255 0.78 0.107 0.104
1951 258 1.16 0.080 0.077
1952 260 1.15 0.071 0.068 1950}1955 1.31 0.081 0.077
1953 263 0.76 0.072 0.068
1954 277 2.53 0.074 0.071
1955 285 1.40 0.085 0.080
1956 293 1.02 0.086 0.080
1957 300 1.33 0.080 0.074
1958 311 2.25 0.068 0.062 1956}1960 2.55 0.075 0.069
1959 316 1.58 0.079 0.073
1960 468 5.13 0.066 0.064
1961 497 5.43 0.064 0.060
1962 564 2.66 0.069 0.062
1963 625 4.32 0.069 0.064 1961}1965 3.98 0.071 0.066
1964 653 4.44 0.074 0.070
1965 692 3.32 0.078 0.072
1966 735 2.86 0.080 0.071
1967 790 4.30 0.072 0.066
1968 896 3.23 0.070 0.065 1966}1970 5.23 0.066 0.062
1969 896 5.11 0.064 0.060
1970 896 10.11 0.048 0.049
1971 896 9.34 0.046 0.049
1972 896 6.33 0.057 0.054
1973 896 4.44 0.064 0.060 1971}1975 7.68 0.056 0.056
1974 896 8.69 0.059 0.060
1975 896 9.58 0.052 0.058
1976 896 6.56 0.063 0.066
1977 896 7.44 0.063 0.067
1978 896 5.23 0.066 0.068 1976}1980 6.74 0.064 0.067
1979 896 6.67 0.065 0.069
1980 896 7.79 0.064 0.067
1981 896 8.02 0.063 0.064
1982 896 15.38 0.044 0.053
1983 896 14.17 0.046 0.053 1981}1985 13.57 0.049 0.056
1984 896 12.30 0.052 0.058
1985 896 18.01 0.037 0.049
1986 896 18.44 0.033 0.047
1987 896 15.37 0.044 0.052
1988 896 13.90 0.046 0.057 1986}1990 16.54 0.039 0.050
1989 896 15.75 0.043 0.050
1990 896 19.26 0.029 0.042
1991 896 26.09 0.017 0.029
1992 896 30.58 0.017 0.032
1993 896 25.53 0.018 0.034
1994 896 15.81 0.038 0.048 1991}1998 20.29 0.028 0.043
1995 896 16.05 0.035 0.049
1996 896 14.62 0.039 0.053
1997 896 15.44 0.034 0.051
1998 862 17.85 0.030 0.044
The most extreme (0.5%) of the cases at either end of the distribution each year were truncated.
expanded through the addition of smaller, potentially less pro"table, "rms.

Yet, a similar decline is evidenced for the constant sample with a signi"cant
drop in the average ROA from almost 8% in the 1950s to merely 3% in the
1990s.
The results for the constant sample are likely to be a!ected by selection biases
of di!erent types. Note that this sample consists of survivors, that is, "rms that
existed from 1968 to 1998. On the one hand, these "rms are likely to be
"nancially strong since they were present throughout the entire 31-year period.
This survivorship bias is more likely to work against "nding an increase in the
frequency of losses or a drop in the pro"tability rate. On the other hand, these
"rms may have been among the largest and strongest "rms in the early years as
indicated by their inclusion on Compustat. Thus, their subsequent performance
may have declined over time. The robustness of the results to selection biases is
tested in two ways. First, we replicate the results reported in Table 1 (as well as
those of Tables 2}4) for two samples whose results bound the extremes of the
potential selection e!ects. The "rst consists of all "rms on Compustat in 1998,
back to their earliest year of inclusion in the database. This sample has an
increasing number of observations over time. The other sample consists of all
"rms present in 1966 through their last year of inclusion on the database. This
sample results in a declining number of observations over time. The results from
these two samples are very similar to those obtained for the constant sample
examined in the study.
Summary results for four other measures of pro"tability for the constant
sample are presented in Table 2. The measure of income from continuing
operations-to-assets is devoid of the e!ect that &below the line' items (discontinu-
ed operations, extraordinary items and the cumulative e!ect of changes in
accounting principle) might have on "rms' pro"tability. The impact of these
items was primarily to depress pro"tability in the most recent period (as
indicated by a comparison with Table 1, Panel B). Nonetheless, even excluding
these items, pro"tability shows the same declining pattern over time, parti-
cularly from the mid-1970s onward. The next measure, earnings before interest
and taxes (EBIT)-to-assets neutralizes the e!ect of increased leverage on pro"t-
ability. Again, the dramatic decrease over the years is evident even before the
interest expense is considered.
The other two measures examine the e!ect that the de#ator, total assets, has
on the primary pro"tability measure. Net income-to-sales shows a steep decline
To test for signi"cance, nine subperiods (generally "ve years long) are formed as shown in Table
1. T-tests are performed to assess whether the di!erence in the mean ROA between adjacent
subperiods is signi"cant. All t-values indicate a signi"cant decline (at the 1% signi"cance level).
This argument is reinforced by the fact that the mean annual stock return over the 1950}1998
period is much higher for the "rms in the constant sample (9.8%) than for the other "rms (2.0%).
Table 2
Alternative pro"tability measures, by subperiod (constant sample of 896 "rms)
Income from Earnings before

continuing interest and taxes Net income-
operations-to- (EBIT)-to-total Net income- to-book value of
total assets assets to-sales equity
Subperiod Mean Median Mean Median Mean Median Mean Median
1950}1955 0.082 0.077 0.177 0.165 0.067 0.059 0.075 0.072

1956}1960 0.075 0.069 0.154 0.141 0.063 0.055 0.081 0.076
1961}1965 0.070 0.066 0.141 0.127 0.062 0.052 0.130 0.122
1966}1970 0.066 0.062 0.138 0.125 0.057 0.050 0.116 0.121
1971}1975 0.057 0.055 0.126 0.118 0.049 0.043 0.099 0.113
1976}1980 0.066 0.067 0.143 0.140 0.055 0.049 0.125 0.142
1981}1985 0.049 0.054 0.114 0.118 0.039 0.042 0.072 0.121
1986}1990 0.038 0.047 0.097 0.102 0.033 0.040 0.060 0.117
1991}1998 0.032 0.043 0.082 0.091 0.023 0.037 0.067 0.110
The most extreme (0.5%) of the cases at either end of the distribution each year were
truncated.
The ratio of net income-to-book value of equity is computed only for cases with positive book
values. The percentage of "rms with negative book values is negligible in the "rst four subperiods. It
rises steadily in the last "ve subperiods, with about 5% of the "rms having negative book values by
the latest subperiod.
in pro"tability, mirroring the ROA measure. So too in recent years does net
income-to-equity, a measure that re#ects the e!ect of leverage on the return to
shareholders. However, the results pertaining to this measure are less clear due
to the increasing presence of "rms with negative book values of equity. In
summary, all four measures show a signi"cant decline over time similar to that
exhibited by ROA. Since the main "ndings of the paper hold for all of these
measures and for both the full and constant samples, for the sake of brevity we
discuss primarily the results based on ROA.
4.1.1. Firm-size and industry ewects

The pattern of reduced pro"tability appears to be present in all "rm-size
groups and prevalent across industries. To examine the e!ect of "rm size on the
Very few "rms had negative book values in the early years; by the 1991}1998 subperiod, over
5% of the "rms had negative book values.
See footnote 14 for a description of the signi"cance tests by subperiod. All comparisons are
signi"cant at the 1% signi"cance level except for the di!erence in the mean income-to-sales between
the "rst two subperiods and the di!erence in the mean of the tested variables between the 1971}1975
and 1976}1980 subperiods. When signi"cance tests are performed on the di!erences between
decades, all comparisons are signi"cant at the 1% level.
results, the constant sample of "rms is partitioned each year into "ve "rm-size
portfolios based on total assets. The results (not tabulated here) show that while
the decline in pro"tability and the increase in losses are somewhat more
pronounced for smaller "rms, the patterns observed in the earnings data hold
for all "rm-size portfolios. Similar results (not reported) are obtained for the full
sample.
To determine whether these trends are limited to only a few industries, we
divide the constant sample into 272 industry groups based on their 4-digit SIC
codes. The results of this analysis (not shown) indicate that the decline in
pro"tability of the accounting return measure occurred in almost all of the
industries. Between the early years and the later years, the ROA dropped in over
two-thirds (66.2%) of the 272 industries examined and the cross-sectional
average of the within-industry percentage of losses increased from 5.1% in
1950}1960 to 14.8% in 1991}1998. Similar results are obtained when, instead of
breaking down the sample by SIC codes, we partition the "rms into two groups:
those in &high technology' and those in &low technology' industries.
The fact that the patterns of reduced pro"tability, increased incidence of
losses and the drop in reported pro"tability are observed across "rm size groups
and industries suggests that these phenomena are widespread, a!ecting the
majority of U.S. "rms.
4.2. Cash yows and accruals
An intriguing question regarding the increase in the frequency of losses and

the deterioration in the reported earnings is whether they are a re#ection of
a real drop in the economic performance of the companies or accounting-driven.
A measure of individual company performance that is una!ected by accrual
accounting is the cash #ows from operations (CFO). We use the ratio of
CFO-to-assets to assess "rms' economic performance.
This measure has been used by other studies to gauge "rm performance (see,
for example, Healy et al., 1992). Changes in the ratio of CFO-to-assets over the
This classi"cation, used by Francis and Schipper (1999), is based on the likelihood that "rms in
an industry will have substantial unrecorded intangible assets.
Data for CFO in 1987}1998 are obtained from Compustat item 308. For earlier years, we derive
CFO from funds from operations (FFO), Compustat item 110, as follows: CFO " FFO ! (*Cur-
rent Assets #*Debt in Current Liabilities ! *Current Liabilities !*Cash). Because it is based
on balance sheet changes, our derivation of the CFO for the earlier years is subject to measurement
error (Collins and Hriber, 1999). However, this measurement error is related to the incidence of
mergers and acquisitions as well as discontinued operations. As explained later in the paper, our
conclusions do not change when net income before discontinued operations is considered or when
"rms engaging in mergers and acquisitions are excluded from the analysis. Therefore, measurement
errors are unlikely to a!ect our results.
period are presented in Table 3. Note that there is no particular trend in

the ratio over time, with the average in most subperiods being around 9%.
In contrast to earnings, there is no increase in the incidence of negative cash
#ows nor is there a decrease in the CFO-to-assets ratio over the 48-year
period.
These results strongly suggest that the decline in pro"tability is not a result of
a change in the distribution of the underlying cash #ows but rather stems from
a change in the relation between cash #ows and earnings, that is, a change in
accounting accruals. This relation is explored in the next section.
4.2.1. Results on the accumulation of accruals

As indicated earlier, in a steady state, one would expect the cumulative
amount of net income before depreciation and amortization to converge in the
long run to cash #ows from operations. Line 1 of Fig. 1 provides evidence on the
actual reversal of accruals for our constant sample of "rms. At the end of each of
the years 1966}1998, the di!erence between cumulative net income before
depreciation and amortization (hereafter referred to collectively as &deprecia-
tion') and the cumulative cash #ows from operations, aggregated over the
constant sample, is plotted. Line 1, which plots this di!erence, shows that
accruals (excluding depreciation) across the entire sample do not cancel out
(i.e., do not sum to zero) over time. Instead, two distinct subperiods emerge, from
1966 to the early 1980s and from the early 1980s to 1998. In the earlier
subperiod, the aggregate cumulative net income (adjusted for depreciation)
slightly exceeds the aggregate cumulative cash #ows from operations. In other
words, excluding depreciation, the sample "rms generated net positive accruals
up until about 1982 when they began to be slightly negative. In contrast, the
second subperiod shows an almost continuous accumulation of negative ac-
cruals. That is, net income before depreciation in the later subperiod is system-
atically and consistently below cash #ows from operations.
The magnitude of the signed accumulation of total accruals (before deprecia-
tion) is nontrivial. For the constant sample, this accumulation over the years
1965}1998 represents over 16% of the cumulative net income over the same
period.
The de#ator of the cash #ow measure, total assets, depends to some extent on accounting
procedures. However, since it also serves as the de#ator for ROA, the earnings measure, any
di!erence between the cash #ow ratio and the earnings measure is unlikely to be a!ected by
accounting practices. To further ascertain that the de#ator does not a!ect the conclusions, we
conducted the analysis using total sales as the de#ator, with essentially the same results.
Extending the period to earlier years reduces the sample size considerably due to missing data.
Depreciation accruals are excluded because their reversal is not captured by cash #ows from
operations. The related cash out#ows (arising from the acquisition of long-lived assets) are reported
as cash #ows from investing activities.
Table 3
Cash #ow from operations-to-total assets, CFOA (constant sample of 896 "rms)
Freq. of CFOA Freq. of CFOA
negative negative
Year cases (%) Mean Median Subperiod cases (%) Mean Median
1951 19.91 0.085 0.099

1952 12.82 0.083 0.086
1953 3.81 0.112 0.111 1951}1955 11.02 0.097 0.101
1954 7.82 0.103 0.110
1955 11.02 0.102 0.102
1956 16.23 0.081 0.090
1957 6.99 0.100 0.103
1958 7.39 0.094 0.098 1956}1960 10.57 0.090 0.095
1959 11.07 0.093 0.104
1960 11.33 0.082 0.086
1961 12.50 0.081 0.085
1962 13.71 0.080 0.088
1963 10.91 0.089 0.094 1961}1965 12.41 0.085 0.090
1964 11.69 0.091 0.093
1965 13.35 0.083 0.085
1966 16.17 0.075 0.079
1967 15.67 0.070 0.075
1968 17.54 0.072 0.078 1966}1970 17.54 0.066 0.072
1969 19.50 0.054 0.065
1970 18.14 0.063 0.066
1971 11.84 0.082 0.087
1972 13.77 0.076 0.080
1973 18.39 0.070 0.073 1971}1975 13.60 0.083 0.084
1974 19.77 0.064 0.063
1975 4.22 0.120 0.115
1976 9.49 0.103 0.104
1977 11.30 0.087 0.090
1978 11.78 0.090 0.091 1976}1980 10.67 0.094 0.095
1979 11.21 0.087 0.089
1980 9.56 0.102 0.100
1981 8.21 0.107 0.109
1982 8.05 0.116 0.114
1983 9.92 0.103 0.108 1981}1985 10.09 0.104 0.107
1984 12.30 0.096 0.104
1985 12.00 0.099 0.103
1986 12.26 0.094 0.099
1987 12.17 0.095 0.095
1988 7.35 0.088 0.088 1986}1990 8.19 0.093 0.092
1989 3.90 0.095 0.090
1990 5.50 0.096 0.087
1991 5.45 0.090 0.088
1992 6.11 0.087 0.089
1993 5.76 0.085 0.083
1994 7.46 0.083 0.084 1991}1998 6.57 0.088 0.089
1995 7.70 0.083 0.088
1996 5.71 0.095 0.095
1997 7.59 0.095 0.095
1998 6.83 0.087 0.090
Fig. 1. Cumulative accruals by type, 1965}1998 (constant sample of 896 "rms). Total Accruals
(before depreciation): (Net Income#Depreciation)! Cash Flow from Operations. Operating
Accruals: *Accounts Receivable#*Inventories#*Prepaid Expenses!*Accounts Payable!
*Taxes Payable. Nonoperating Accruals: Total Accruals (before depreciation) minus Operating
Accruals.
4.2.2. Components of accruals

Further insight into the nature of the accrual accumulation is provided by
lines 2 and 3 of Fig. 1. These lines depict the behavior over time of components
of total accruals (other than depreciation), speci"cally &operating' (or &working
capital') accruals and &nonoperating' accruals. Operating accruals are those
arising from the basic day-to-day business of the "rm. They are de"ned as:
Operating accruals"* Accounts Receivable#* Inventories
#* Prepaid Expenses!* Accounts Payable
!* Taxes Payable. (2)
While total accruals (excluding depreciation) exhibit a negative accumulation
over time as indicated by line 1, operating accruals have a very di!erent pattern.
Consistent with the growth of the sample "rms, operating accruals depicted by
line 2 increase over time reaching a total aggregate accumulation of almost $1.5
trillion for the constant sample by the end of 1998. The pace of accumulation of
the operating accruals was relatively slow in the early years, accelerating from
the late 1970s onward.
Extracting depreciation, amortization and operating accruals components
from total accruals results in accruals consisting primarily of such items as loss
and bad debt provisions (or their reversal), restructuring charges, the e!ect of
changes in estimates, gains or losses on the sale of assets, asset write-downs, the
accrual and capitalization of expenses, and the deferral of revenues and their
subsequent recognition.
To distinguish these accruals from the operating accruals, we refer to these
remaining accruals as &nonoperating' accruals. Note that although some of these
accruals are dictated by GAAP, the timing or amount of most of them are
subject to management discretion.
The accumulation of these nonoperating accruals over time, our "rst measure
of conservatism, is illustrated by line 3 of Fig. 1. Note that nonoperating
accruals accumulate fairly steadily over the sample period to a sizable negative
amount. The net negative accumulation is most pronounced in the more recent
years. The total accumulation of these accruals is quite substantial, representing
2.8% of the cumulative sales of the sample "rms for that period and 32.2% of
their total assets as of the end of 1998. The accumulation of negative accruals in
the second half of the period is common to most "rms and industries. The
average annual accumulation of accruals per "rm in the second half of the
period is signi"cantly lower (i.e., more negative) than in the early half of
the period. Further, the negative accumulation of nonoperating accruals
in the second subperiod occurs in 264 of the 272 4-digit industries. The ratio
between this accumulation in the second subperiod and that in the "rst sub-
period is 6.1 for the constant sample, with an inter-quartile range across the 272
industries of between 2.9 and 7.7.
The "nding of a prevalent and signi"cant accumulation of negative
nonoperating accruals is consistent with an increase in reporting conservatism
over the last several decades.
4.2.3. Alternative explanations for the decline in proxtability and accumulation of

negative accruals
Several explanations, other than conservatism, could be o!ered for either the
decline in pro"tability or the increased accumulation of negative accruals. Both
Another manifestation of reporting conservatism is an increased tendency to accrue liabilities

and loss provisions, and a decreased tendency to capitalize costs. While such tendencies cannot be
precisely measured based on Compustat data, a rough approximation is obtained by comparing the
level of &other (nondebt) liabilities' (Compustat items 207 and 75) with the level of &other assets'
(Compustat items 195 and 69) over time. Standardizing this di!erence by total assets, we "nd that
the excess of &other liabilities' over &other assets' has increased monotonically for the constant
sample, from about 4% in 1968 to 14% in 1998.
phenomena could be a re#ection of real economic developments rather than

reporting patterns, or merely an artifact of our measurement. The following is an
examination of alternative explanations to our main "ndings.
Restructuring. One economic development over the last two decades is the
restructuring or re-engineering activity undertaken by many companies. Such
real activities are often associated with charges to income that are not accom-
panied by a contemporaneous cash out#ow. These charges, while resulting in
a decline in immediate pro"tability and an accumulation of negative nonoperat-
ing accruals, do not necessarily imply a greater reporting conservatism.
To examine the validity of this explanation, we recomputed the nonoperating
accruals (as de"ned in Section 4.2.2) excluding two components that are most
likely to capture the e!ect of restructuring activities } special items and gains or
losses from discontinued operations. The results, presented in line 4 of Fig. 1,
show that while these components do indeed dampen reported earnings, the
extensive accumulation of negative accruals persists even after their exclusion.
The restructuring explanation is also inconsistent with the "nding (presented
earlier) that the drop in pro"tability is prevalent across almost all industries,
a!ecting not only those in which restructuring was common (most notably the
manufacturing sector), but also industries (such as those belonging to the
high-technology group) that were less a!ected by this trend.
Mergers and acquisitions. Another possible explanation for the drop in corporate
pro"tability is the recurring waves of mergers and acquisitions (M&A) during
the "ve decades spanned by our sample. Most of the acquisitions in the last
decade were accounted for by the purchase method (Davis, 1990). The purchase
method tends to dampen pro"tability (and increase negative accruals) due to the
added amount of depreciation and amortization arising from the revaluation of
the acquired tangible assets and the establishment of goodwill. Further, since
most acquisitions are highly leveraged, subsequent pro"ts are also adversely
a!ected by the increased "nancial charges.
To test for the plausibility of the M&A explanation for the decline in
pro"tability, we "rst examine the trend in earnings before depreciation, amorti-
zation and interest. The results (not shown) reveal a pattern of decline similar to
that observed for the other measures of pro"tability such as the ROA or
EBIT/Assets (as shown in Table 2). Second, we form each year a sub-sample of
An indication of the prevalence of corporate restructuring is provided by the frequency with

which the term &restructuring' appears in "rms' "nancial statements. In the National Automated
Annual Reports System (NAARS) database, the term appeared 516 times in 1984, 942 times in 1989,
1,146 times in 1993 and 2,618 times in 1995. See also the documentation provided by Elliott and
Hanna (1996) and Francis et al. (1996).
all "rms that did not engage in an acquisition in any of the preceding "ve years
(identi"ed by a footnote code to Compustat item 12). The "ndings indicate that
the decline in ROA over the years for this sub-sample is statistically indistin-
guishable from that of the full sample. Finally, we reproduced the accrual
accumulation results of Fig. 1 excluding "rms that engaged in M&A activity
during the period. The results (not shown) are again similar to those reported for
the entire sample.
Increased cost of pension and post-retirement benexts. A third potential economic

explanation for the reduced pro"tability is increased pension and post-retire-
ment health bene"ts to employees, which might dampen earnings. Coupled with
the more timely recognition of these expenses (mandated by new accounting
pronouncements), such an increase is expected to result in an increase in the
respective liabilities and a corresponding buildup of negative (nonoperating)
accruals.
To examine this explanation, we compute the accrual accumulation over the
period from 1986 (the "rst year in which disclosures on both pension and
post-retirement bene"ts became available for most "rms) to 1998, excluding the
accruals relating to these expense items. The results (not reported) show that the
rate of accumulation of total and nonoperating accruals as well as the levels are
very similar to those indicated by Fig. 1.
Growth and Inyation. A potential technical explanation for the observed accu-
mulation of negative accruals is the growth of the sample "rms. Growth,
whether real or nominal (due to in#ation), results in an increase in the magni-
tude of earnings and cash #ows and, consequently, of accruals. While we control
for growth by de#ating the accruals by total assets, this de#ator may not fully
capture the scale of operations that gives rise to the accruals. While the constant
sample "rms indeed exhibit impressive growth throughout the examined
period, the growth explanation is not supported by further analyses for several
reasons. First, the average geometric annual growth rate in sales is even higher
in the early part of the period (1950}1980) than in the most recent one
(1981}1998), 13.5% vs. 6.9%. Second, the results remain intact when we use sales
or the change in sales rather than total assets to de#ate the accumulation.
The results for accrual accumulation using alternative de#ators are presented
in Table 4. The table shows the mean (and median) annual cumulative accruals
in the "rst and second subperiods. Note that the accumulation of both total and
nonoperating accruals is signi"cantly more negative in the later subperiod even
The average (geometric) annual growth rate in nominal sales of the constant sample "rms
during the 49-year period from 1950 to 1998 is 9.6%.
Table 4
Accumulation of de#ated accruals, by subperiod (constant sample of 896 "rms)
Total accruals Nonoperating Cash #ow from

(before depreciation) accruals operations
De#ator Subperiod Mean Median Mean Median Mean Median
Assets 1951}1980 !0.063 !0.024 !0.016 !0.003 0.086 0.090

1981}1998 !0.219 !0.047 !0.037 !0.012 0.094 0.095
(6.28) (3.32) (1.64)
Sales 1951}1980 !0.128 !0.016 !0.016 !0.002 0.061 0.063
1981}1998 !0.546 !0.038 !0.512 !0.009 0.074 0.077
(2.95) (2.41) (1.47)
*Sales 1951}1980 !0.658 !0.098 !0.222 !0.015 1.105 0.372
1981}1998 !2.282 !0.321 !0.492 !0.047 1.532 0.450
(3.66) (2.12) (1.51)
Total Accruals (before depreciation): (Net Income # Depreciation) !Cash Flows from Opera-
tions. Nonoperating Accruals: Total Accruals (before depreciation) ! Operating Accruals,
where Operating Accruals equal *Accounts Receivable#*Inventories # *Prepaid Expenses
} *Accounts Payable ! *Taxes Payable.
t-values for the di!erence in means in the two subperiods are shown in parentheses.
Observations where sales declined were excluded from the analysis.
after controlling for growth through several alternative de#ators. The table also
shows that, in contrast to the pattern of accruals, de#ated operating cash #ows
remain fairly constant over the entire period.
Further, the accumulation of negative accruals could not be due to in#ation.
Note that there is no discernible accumulation of negative accruals in the 1960s
or the 1970s. Yet, the mean annual in#ation rate in these years (4.9%) was even
higher than in the later period from 1981}1998 (4.1%) where the major accumu-
lation is observed.
In summary, the above tests are inconsistent with several alternative explana-
tions for the decline in the reported pro"tability and the increase in the
accumulation of negative accruals over the last two decades, making it more
likely that increased reporting conservatism is the explanation for these
phenomena.
4.3. The earnings}return association
Table 5 shows the average annual values of each of the four measures based
on the earnings}return association obtained from regression (1) over "ve-year
Table 5
The di!erential earnings}return association in good and bad news periods: 308
Results by subperiod for Regression (1): (EPS /P "a #a DR # b R #b R* DR ) (constant sample of 896 "rms)
GR GR\ GR GR GR GR
Total bias
in earnings
(de#ated by
Subperiod N a a b b Adj R (b #b )/b R /R lagged price)

Overall period 23,612 0.077 0.002 0.048 0.133 7.54 3.77 3.92 0.011
(58.51) (1.01) (17.77) (15.05)
1950}1955 544 0.095 0.005 0.026 0.019 7.56 1.73 0.71 0.002
(25.13) (0.60) (4.88) (1.85)
1956}1960 612 0.065 0.012 0.034 0.057 8.01 2.68 1.61 0.010
(23.87) (2.14) (6.45) (2.24)
1961}1965 1,080 0.080 0.006 0.023 0.074 13.63 4.22 1.95 0.011
(38.93) (1.78) (5.18) (3.65)
1966}1970 1,978 0.063 0.005 0.025 0.085 12.58 4.28 2.22 0.013
(30.70) (1.86) (8.73) (5.86)
1971}1975 2,930 0.092 0.006 0.052 0.199 10.83 4.83 2.89 0.012
(20.20) (1.85) (9.43) (6.28)
1976}1980 3,616 0.142 0.005 0.043 0.292 10.95 7.79 2.73 0.025
(43.08) (1.81) (6.63) (8.90)
1981}1985 3,658 0.082 0.015 0.020 0.346 9.64 18.30 8.10 0.023
(22.84) (2.14) (3.75) (7.19)
1986}1990 3,705 0.068 0.005 0.025 0.449 12.09 18.96 18.25 0.026
(19.36) (1.79) (2.83) (12.02)
1991}1998 5,481 0.047 0.005 0.021 0.521 9.41 25.81 22.17 0.031
(16.73) (1.96) (3.82) (12.87)
EPS is the earnings per share of "rm i in "scal year t, P is the price per share at the beginning of the "scal year, R is the return of "rm i from nine
D. Givoly, C. Hayn / Journal of Accounting and Economics 29 (2000) 287}320
GR GR\ GR
months before "scal year-end t to three months after "scal year-end t, DR is a dummy variable that is equal to 1 if R is negative and 0 otherwise. `Total
GR GR
biasa is measured as (1/k!b ) R Pr (good)!(b #b !1/k) R Pr (bad), R (R ) where R (R ) is the mean return over a good (bad) news

period, de"ned as a period with a positive (negative) return and Pr (bad) (Pr (good)) is the relative frequency of good (bad) news periods. The parameter
k was estimated by the reciprocal of the intercept of regression (1).
The most extreme 1% EPS/P values are truncated each year.
t-values are shown in parentheses.
intervals. The results indicate that "nancial reporting is, in general, conservative
in that it defers recognition of good news and accelerates the recognition of bad
news. More importantly, there is a considerable and signi"cant increase over
time in the degree of conservatism as captured by these measures.
The "rst measure, b , the incremental response to bad news relative to good

news, is positive and signi"cant in the subperiods spanning 1950}1998, sugges-
ting a di!erential stock price response in periods of bad and good news. Further,
there is a marked increase in b over time. The coe$cient's value increases

steadily from the range of 0.02 to 0.08 in the early years through 1975 to 0.449 in
the subperiod 1986}1990 and to 0.521 in the last subperiod, 1991}1998. The
hypothesis that the value of the annual b is the same in the later years as in the

earlier years is rejected at the 1% signi"cance level. These results suggest that,
consistent with accounting conservatism, earnings re#ect bad news more
promptly than good news. Further, consistent with an increased level of conser-
vatism, the di!erential response time to bad news relative to good news has
become more pronounced in recent years.
The second measure, (b #b )/b , which assesses the sensitivity of earnings

to bad news relative to their sensitivity to good news, shows a similar pattern.
Speci"cally, the ratio is always above one, indicating the greater propensity to
recognize bad news in a more timely manner than good news. Further, the &over-
recognition' of bad news is more pronounced in later years than in early years.
The ratio averages 1.73 in the earliest subperiod and increases almost monotoni-
cally to 4.83 in the years 1971}1975 and to over 25 in the more recent years.
In a similar vein, the third measure based on regression (1), the ratio of R
in bad news periods to R in good news periods, increases considerably over
the 49-year period, from 0.71 in the earliest subperiod to over 20 in the
1990s.
The &total bias' measure, which expresses the net downward e!ect on earnings
due to the over-recognition of bad news and the under-recognition of good news
as a fraction of the true earnings, is shown in the last column of Table 5. The
total (downward) bias in the earnings-to-price ratio is on average 0.011. Given
that the average earning-to-price ratio across "rms and years in our sample is
0.09, an average bias of 0.011 suggests an average understatement of about 12%
in earnings (0.011/0.09). The bias, however, increases over time. In the earliest
subperiod the bias is only 0.002 (or about 2% of earnings) but it increases fairly
steadily to 0.031 (or about 30% of earnings) in the latest subperiod. These bias
results are in line with the "ndings regarding the accumulation of negative
accruals. They also con"rm previous studies' "ndings on accounting conserva-
tism (Ball et al., 1999, Basu, 1997; Holthausen and Watts, 2000; Pope and
Walker, 1999; Stober, 1996).
In summary, the four measures based on regression (1), which capture various
aspects of the timeliness with which bad news is reported relative to good news,
consistently point to an increase in reporting conservatism over time.
4.4. Skewness of earnings
As explained earlier, a basic feature of a conservative reporting system is the

early and full recognition of unfavorable events in the "nancial statements and
the delayed and gradual recognition of favorable events. If such propensities
exist, the earnings distribution would be negatively skewed. Fig. 2 depicts the
change in the skewness of the ROA distribution over time. The skewness
measure in each analysis is de"ned as E(x!k)]/p where x is the ROA (or
CFO/Assets), and k and p are estimated by the mean and standard deviation of
the ROA (or CFO/Assets) distribution. The "gure shows the skewness measure
derived alternately from the time-series of individual "rms and the cross section
of "rm-years. Both sets of results indicate that the earnings distribution is indeed
negatively skewed in most of the periods examined. More important, it has
become increasingly negatively skewed over time. This trend is monotonic, with
the increase in skewness occurring in the mid- to late 1970s and accelerating in
the 1980s. The distributions of other measures of earnings (not reported),
including those based on income from continuing operations and on income
excluding special items, reveal a similar pattern. No such trend is observed in the
cash #ows series. The negative skewness of the earnings distribution is consistent
with conservative reporting and the increase in the negative skewness is consis-
tent with an increase in conservatism.
4.5. Variability of earnings
4.5.1. Results
Table 6 provides results on the variability of the earnings distribution, our
next measure of conservatism. Earnings have become increasingly dispersed,
with the standard deviation of ROA rising from an average of about 0.060 in the
years prior to 1971 to an average of 0.517 (0.287) in the 1990s for the full
(constant) sample.
A similar result (not shown) is obtained when the time series of earnings of
individual "rms are considered. The mean ratio of the standard deviation of
ROA during the later subperiod (1981}1998) to the standard deviation of ROA
during the early subperiod (1951}1980) for the constant sample of "rms is 3.07,
signi"cantly (at the 1% level) above 1.0. Further, about 75% of the "rms
As in the earlier tests, the test of increased variability is based on the comparison of each of the
nine subperiods with the subperiod that preceded it. The F-statistics are signi"cant across all paired
comparisons for the full and constant samples at the 1% signi"cance level, except for the comparison
between the subperiods 1961}1965 and 1966}1970 for the constant sample.
Fig. 2. Time-series and cross-sectional skewness measures of earnings and cash #ows (constant
sample of 896 "rms). Skewness is de"ned as y"[E(x!k)/p where k and p are the mean and
standard deviation of the x distribution. All variables are de#ated by Total Assets. Values shown for
each year are the "ve-year moving average of the skewness measure, centered on that year. The
cross-sectional value shown for each year is the average value of the skewness measure computed
across the sample "rms. The time-series value shown for each year is the average sample value of the
skewness measure computed for each "rm. The skewness measure for each "rm in any given year is
based on the time series consisting of eleven annual observations centered on that year.
experienced an increase in the standard deviation of their ROA measure be-

tween the two subperiods.
The results also show that the increase in the dispersion of earnings distribu-
tion is common to all "rm-size groups and industries. To illustrate, the mean
standard deviation of ROA of the smallest 20% of the "rms grew from 0.085 to
0.732 between the early subperiod (1951}1980) and the later subperiod
(1981}1998). The largest 20% of the "rms show a less dramatic trend, yet the
mean standard deviation of their ROA still doubled over this period, from 0.033
to 0.067.
The mean annual cross-sectional standard deviation of ROA of the 272
industries increased from 0.046 in the early subperiod to 0.075 in the later
subperiod, with 78% of the industries showing an increased dispersion in ROA.
Similar results are obtained when, instead of breaking down the sample by SIC
codes, we partition the "rms into &high technology' and &low technology' indus-
try groups.
In contrast to the pattern of an increased earnings dispersion over time, the
last column of Table 6 shows that the standard deviation of cash #ows from
Table 6
Standard deviation of net income-to-total assets (ROA) and cash #ows from operations-to-total
assets (CFOA), by subperiod
Standard deviation of ROA Standard deviation of CFOA
Subperiod Full sample Constant sample Constant sample
1951}1955 0.043 0.039 0.084

1956}1960 0.052 0.044 0.073
1961}1965 0.060 0.051 0.085
1966}1970 0.081 0.058 0.088
1971}1975 0.119 0.065 0.084
1976}1980 0.165 0.090 0.083
1981}1985 0.337 0.145 0.092
1986}1990 0.437 0.198 0.093
1991}1998 0.517 0.287 0.086
operations-to-assets remained fairly stable, hovering around 0.08 throughout

the examined period. This stability in the cash #ow skewness is evident also in all
"rm-size groups and industries.
4.5.2. Causes and ewects of earnings variability

To identify the contributors to the increased earnings variability and to more
closely relate it to the behavior of accounting accruals, the variance of ROA was
decomposed each year as follows:
Variance(ROA)"Variance(CFO/Assets)#Variance(Accruals/Assets)
#2 Covariance(CFO/Assets, Accruals/Assets). (3)
The results of this decomposition are summarized in Fig. 3. As the "gure

shows, accounting accruals contributed to the increased volatility of earnings
over time in two ways. First, the variance of the accruals component of ROA
(line 3) has more than doubled from the 1960s to the 1990s. Second, the
covariance between cash #ows and accruals (line 4), whose negative sign has
served to moderate earnings volatility, has declined considerably in the last 15
years to the point where the earnings series is no longer smoother than that of
The tests based on the standard deviation of the level variable were replicated using the
standard deviation of the changes with essentially similar "ndings.
Fig. 3. Decomposition of the variance of net income into cash #ow and accrual components
(constant sample of 896 "rms). All variables are de#ated by Total Assets. Values shown for each year
are the "ve-year moving average of the variable, centered on that year.
cash #ows. Note that in more recent years, the variance of the earnings measure
exceeds that of the cash #ows measure.
A closer look at the contributors to the increased earnings variability is
possible by representing the variance of total accruals as the variance of the sum
of nonoperating accruals and all other accruals (see Section 4.2.2 for the
de"nition and discussion of nonoperating accruals). An examination of
the behavior of these components over time (not shown here) reveals that the
variance of the nonoperating accruals is the greatest contributor to the increase
in earnings variability in recent decades. The results from further analysis (not
reported) indicate that the greater earnings and accrual variability is due
primarily to the rising incidence of one-time large nonoperating accruals (as
documented by Elliot and Shaw (1988), Collins et al. (1997) and Givoly and
Hayn (1994)) and the evidence noted in footnote 24).
The results are essentially the same when this analysis is conducted using income from
continuing operations (before discontinued operations, extraordinary items and the cumulative
e!ect of accounting changes) instead of net income. In this case, total accruals (and nonoperating
accruals) exclude these &below-the-line' items.
Fig. 4. Aggregate market-to-book ratios (constant sample of 896 "rms). The aggregate market-to-
book ratio is the aggregate market value of the constant sample "rms divided by their aggregate
book value at year end. The aggregate adjusted market-to-book ratio re#ects the adding-back of the
nonoperating accruals in the denominator.
4.6. Market-to-book ratio
Our "nal measure of the degree of reporting conservatism relies on the

relation between the market value and the book value of "rms' equity (Feltham
and Ohlson, 1995; Stober, 1996; Ohlson and Zhang, 1998). To the extent that
equity valuation by investors is based on the present value of future cash #ows,
the market-to-book ratio as well as earnings multiples would tend to be higher
when accounting measurement is more conservative.
The solid line in Fig. 4 shows the behavior of the ratio of the aggregate
market value of the constant sample "rms to their aggregate book value
(hereafter, the aggregate M/B ratio) over time. The "ndings indicate a
The use of the sample aggregate M/B ratio rather than the simple average ratio across
individual companies has the advantage of being independent of the cross-sectional variance in this
ratio (which a!ects the mean ratio). Nonetheless, results based on the simple mean (equally
weighted) M/B ratio show a similar pattern.
U-shaped curve, with the ratio declining from a level of about 2.0 in the years
through the early 1970s, falling to slightly above 1.0 during the remaining 1970s,
rising again to 2.0 by the end of the 1980s, and increasing to over 3.0 in the
1990s. These "ndings, which are consistent with those of Basu (1997) and
Stober (1996), support the hypothesized increase in conservatism.
As a further indication of the extent to which the increase in the M/B ratio in
the second subperiod is related to reporting conservatism, we re-estimated the
ratio using as the denominator an estimate of the book values that would have
been reported had there been no accumulation of negative nonoperating ac-
cruals. This adjusted book value was computed as the reported book value plus
the accumulated nonoperating accruals as of the end of the period. The resulting
aggregate adjusted M/B ratio, appearing as the dotted line in Fig. 4, shows
relatively little change in its level from the mid-1970s to 1998.
The observed variations in the M/B ratio over time might, however, re#ect
changes in the market expectations of growth rather than a change in the degree
of reporting conservatism. To control for growth expectations, we ranked all
"rm-years by expected growth rates and measured the median M/B ratio in each
portfolio for each of the two subperiods 1968}1980 and 1981}1998. Two
alternative proxies were used for the expected growth. One was the annual
geometric growth rate in sales of the "rm over the succeeding "ve years (years
t#1 to t#5) and the other was the actual annual geometric growth rate in the
preceding "ve years (years t!5 to t).
Table 7 shows that, as expected, the M/B ratio is higher in the second
subperiod relative to the "rst subperiod (a median ratio of 1.67 vs. 1.30). Further,
the ratio within each subperiod increases with expected growth. More relevant
to our examination, the M/B ratio for any growth portfolio is greater in the
second subperiod than in the "rst subperiod. Except for the highest growth
portfolio, all di!erences are statistically signi"cant at the 1% level.
We replicated these results using the adjusted book value in the computation
of the market-to-book ratio. The "ndings, reported in the last two columns of
Table 7, reveal that after controlling for growth, the median adjusted M/B ratio
in the early subperiod is not discernibly di!erent from the median adjusted M/B
Basu (1997) "nds a drop in the M/B ratio in the mid-years and an increase in this ratio in the
later years, consistent with changes in the audit liability environment.
Underlying the forward-looking approach is the assumption that investors project future
growth without bias. The backward-looking estimate assumes that investors project future growth
based on past growth rates.
The results in Table 7 are based on growth expectations estimated each year from the preceding
"ve-year growth rate. Use of subsequent years to estimate the expected growth rate led to essentially
the same conclusions.
316
Table 7
Market-to-book ratios (constant sample of 896 "rms)
Median growth rate (%) Median market-to-book ratio Median adjusted market-to-book ratio
First subperiod Second subperiod First subperiod Second subperiod First subperiod Second subperiod
Growth portfolio 1968}1980 1981}1998 1968}1980 1981}1998 1968}1980 1981}1998
All Portfolios 13.5 6.9 1.30 1.67 1.24 1.26

(n"21,320)
By growth portfolio:
1: lowest growth 0.4 !1.3 0.92 1.29H 0.98 1.05
2 5.6 5.2 1.09 1.59H 1.10 1.24
3 9.5 9.2 1.26 1.68H 1.23 1.37
4 13.3 12.3 1.48 1.78H 1.42 1.59HH
5: highest growth 21.2 20.2 1.84 1.95 1.73 1.71
HThe means of the two subperiods are signi"cantly di!erent at the 1% con"dence level.
HHThe means of the two subperiods are signi"cantly di!erent at the 5% con"dence level.
Estimated as the geometric mean annual growth rate in sales over the preceding "ve-year period.
The adjusted book value is computed as the reported book value less the accumulated nonoperating accruals through the end of the period. Since these
accruals are generally negative, the adjusted book values are typically larger than the reported ones.
D. Givoly, C. Hayn / Journal of Accounting and Economics 29 (2000) 287}320
in the second subperiod (1.24 vs. 1.26). Thus, the higher M/B ratios observed in
recent years may be driven by depressed book values.
The adjusted M/B test may overstate the contribution of increased reporting
conservatism to the increase in the M/B ratio over time. Note that the &true'
adjusted book value at the end of the period is likely to be lower than our
estimate (which is the reported book value plus the accumulated negative
nonoperating accruals at that time). This overstatement is due to the potential
substitution between certain nonoperating accruals and future operating ex-
penses. For example, a write-o! of a depreciable asset in the current period leads
to lower depreciation charges in subsequent periods unless the written o! asset
is replaced. Likewise, the establishment of a provision for future costs (another
negative discretionary accrual) in one period results in lower recorded expenses
in subsequent periods. It is di$cult to assess the extent of the upward bias in our
adjusted book values, yet it may be small. New depreciable assets that tend to at
least maintain the previous level of depreciation are likely to replace most of the
assets written o!. Furthermore, because many of the provisions for future
expenses are &settled' only over a long period (e.g., post-retirement bene"ts), this
bias may not be very pronounced.
To further assess the role of accruals in the observed increase in the M/B ratio,
we examine whether the extent of the increase in each "rm's M/B ratio between
the two subperiods is associated with the acceleration in the accumulation of the
"rm's (negative) nonoperating accruals in the second subperiod. The results (not
shown) indicate that the "rms with the greatest accumulation of negative
nonoperating accruals in the second subperiod relative to the "rst subperiod
(portfolio 1) are also those with the highest M/B ratios in the second subperiod
and the greatest increase in the M/B ratio between the two subperiods.
5. Summary and conclusions
The paper provides evidence on the change in the time-series properties of

earnings, cash #ows and accruals, suggesting that the relation between ac-
counting earnings and the economic performance of "rms is not stable over
time. In particular, the results of a series of tests are consistent with a trend of
increased reporting conservatism. While each of these tests has limitations, when
considered as a whole the results suggest more conservative "nancial reporting
in the last two decades. The fact that generally accepted accounting principles
have a built-in conservative bias is widely recognized. However, the trend
towards an even greater conservatism has not been systematically documented
and, with a few exceptions (most notably Basu (1997) and Pope and Walker
(1999)), has received little attention from researchers.
The evidence on conservatism is primarily &circumstantial'. Although
we examine several other explanations for the main "ndings and "nd them
inconsistent with the data, it is possible that other factors contribute to the
results. The absence of an acceptable de"nition of conservatism and proven
measures to gauge its level make it di$cult to make more de"nitive statements.
Nonetheless, more conservative accounting would suggest that the high earn-
ings and book value multiples in today's stock market and the prevalence of
losses do not necessarily indicate overpricing.
It has often been suggested that the increase in the M/B ratios over time is due
to the failure of conventional accounting to properly measure major value
drivers, such as investment in intangibles like R&D, human resources or
information technology (Amir and Lev, 1996). The e!ect of these o!-balance-
sheet intangibles on the M/B ratios is, however, quite distinct from the phenom-
enon of conservatism as measured in this paper. While the immediate expensing
of the investment in intangibles re#ects conservatism, it does not generate any
accruals. Therefore, neither the level of these investments nor their increased
prominence in recent years can explain the signi"cant accumulation of negative
accruals. Thus, the manifestations of increased conservatism documented by this
study are in addition to the conservative e!ect on the "nancial statements
stemming from the omission from the books of "rms' increasingly prominent
investment in intangibles.
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Journal of Accounting and Economics 29 (2000) 287}320

The changing time-series properties of

JEL classixcation: M41; C23; D21; G38; N20

In a steady state and over a su$ciently long period, accounting-based

auditors to be more careful in client selection and less willing to accommodate

2. De5nition and measurement of reporting conservatism

Conservatism is an important convention of "nancial reporting. It implies the

This de"nition, however, is still ambiguous since accounting measurements

1. The incremental response to bad news relative to good news, captured by b .

developed by Feltham and Ohlson (1995). This de"nition views accounting as

1. the level and rate of accumulation over time of negative nonoperating

It should be emphasized at the outset that the absence of a generally accepted

4. Time series properties of earnings, cash 6ows and accruals

In this section, we provide descriptive statistics on the time-series patterns of

Panel A: Full sample

Panel B: Constant sample

expanded through the addition of smaller, potentially less pro"table, "rms.

Income from Earnings before

Subperiod Mean Median Mean Median Mean Median Mean Median

1950}1955 0.082 0.077 0.177 0.165 0.067 0.059 0.075 0.072

4.1.1. Firm-size and industry ewects

4.2. Cash yows and accruals

An intriguing question regarding the increase in the frequency of losses and

period are presented in Table 3. Note that there is no particular trend in

4.2.1. Results on the accumulation of accruals

1951 19.91 0.085 0.099

4.2.2. Components of accruals

4.2.3. Alternative explanations for the decline in proxtability and accumulation of

 Another manifestation of reporting conservatism is an increased tendency to accrue liabilities

phenomena could be a re#ection of real economic developments rather than

 An indication of the prevalence of corporate restructuring is provided by the frequency with

Increased cost of pension and post-retirement benexts. A third potential economic

Total accruals Nonoperating Cash #ow from

De#ator Subperiod Mean Median Mean Median Mean Median

Assets 1951}1980 !0.063 !0.024 !0.016 !0.003 0.086 0.090

4.3. The earnings}return association

4.4. Skewness of earnings

As explained earlier, a basic feature of a conservative reporting system is the

4.5. Variability of earnings

experienced an increase in the standard deviation of their ROA measure be-

Standard deviation of ROA Standard deviation of CFOA

Subperiod Full sample Constant sample Constant sample

1951}1955 0.043 0.039 0.084

operations-to-assets remained fairly stable, hovering around 0.08 throughout

4.5.2. Causes and ewects of earnings variability

#2 Covariance(CFO/Assets, Accruals/Assets). (3)

The results of this decomposition are summarized in Fig. 3. As the "gure

4.6. Market-to-book ratio

Our "nal measure of the degree of reporting conservatism relies on the

All Portfolios 13.5 6.9 1.30 1.67 1.24 1.26

5. Summary and conclusions

The paper provides evidence on the change in the time-series properties of

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An indication of the prevalence of corporate restructuring is provided by the frequency with