ARTICLE IN PRESS

Journal of Accounting and Economics 47 (2009) 182–190

Contents lists available at ScienceDirect

Journal of Accounting and Economics

journal homepage: www.elsevier.com/locate/jae

Earnings persistence
Richard Frankel , Lubomir Litov
Washington University in St. Louis, St. Louis, MO 63130-6431, USA

a r t i c l e i n f o abstract

Article history: Dichev and Tang [2009. Earnings volatility and earnings predictability. Journal of
Received 9 September 2008 Accounting and Economics, this issue, doi:10.1016/j.jacceco.2008.09.005] document the
Received in revised form predictive power of past earnings volatility for the persistence of current earnings. We
18 November 2008
revisit their findings to verify the incremental explanatory power of this effect and to
Accepted 18 November 2008
study whether the predictive power of past earnings volatility is priced in stock returns.
Available online 16 December 2008
We also discuss motives for the study of earnings persistence. Our findings indicate that
JEL classification: the relation between past earnings volatility and earnings persistence is robust to the
M 41 additional controls and to a correction for sampling bias, but that earnings volatility
does not predict stock returns.
Keywords:
& 2009 Elsevier B.V. All rights reserved.
Earnings persistence

1. Introduction

Dichev and Tang (2009) examine whether past earnings volatility has incremental explanatory power for the
persistence of current earnings. The paper can be analyzed from two vantage points. First, we can follow the authors’ lead
and view their research as an effort to empirically describe the effectiveness of a factor in differentiating more persistent
from less persistent earnings. Identifying such a factor is of practical importance because the knowledge enhances earnings
prediction—a key step in valuation. If we wish to critique the research on these grounds, four questions about the
explanatory power of the factor arise: (i) Does it result from simple mathematical identity, i.e., is it mechanical? (ii) Is it
incremental to previously identified factors? (iii) Is it induced by the nature of the tests, for example, survivorship bias? (iv)
Are market participants aware of it? We examine each of these questions and find the answers generally confirm that
Dichev and Tang identify an important factor related to earnings persistence.
Second, we can assess Dichev and Tang’s work based on whether it provides insights into the economic determinants of
persistence. This is the vantage point of researchers who read the paper hoping to further their understanding the ‘‘role of
accounting in the firm.’’ If financial-statement characteristics affect the payoffs of the contracting parties that comprise the
firm, we might study this game and thereby predict how accounting characteristics might vary. We discuss the implications
of this view and conclude that the present research adds little to our understanding of economic forces that lead to lower
persistence or that generate the relation between volatility and persistence.
We conclude that Dichev and Tang (2009) identify an interesting empirical relation with potential practical import and
this contribution is sufficient to outweigh the underlying lack of a causal theory. An analogy can be found in Kepler’s three
laws of planetary motion. These laws provided a parsimonious method for predicting the location of planets in the sky, but
they told us nothing about the force that guided the planets. We do not argue that Dichev and Tang’s (2009) findings are of

 Corresponding author.
E-mail addresses: frankel@wustl.edu (R. Frankel), litov@wustl.edu (L. Litov).

0165-4101/$ - see front matter & 2009 Elsevier B.V. All rights reserved.
doi:10.1016/j.jacceco.2008.11.008
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R. Frankel, L. Litov / Journal of Accounting and Economics 47 (2009) 182–190 183

comparable scientific significance to those of Kepler’s, few are. Instead, our point is that documenting salient empirical
features can be of practical use and can spur research into their underlying cause(s).

2. The empirical relation

2.1. Mathematical identities

Dichev and Tang (2009) estimate the following model using a cross-firm regression within each earnings volatility
quintile:
ROAtþ1;i ¼ a þ bROAt;i þ t;i , (1)
where, ROAt,i is earnings before extraordinary items for firm i in year t divided by the average total assets of firm i at the end
of years t and t1. Earnings volatility for firm i in period t is computed as the standard deviation of ROA in periods t4
through t. Dichev and Tang use b as a proxy for earnings persistence and study how b varies across earnings volatility
quintiles.
Algebraic manipulation demonstrates a mathematical relation between the variance of ROA, denoted Var(ROA), and b.
Taking the variance of both sides of Eq. (1) yields
2
VarðROAtþ1;i Þ ¼ bi VarðROAt;i Þ þ Varðt;i Þ. (2)
Noting that ROAt,i is a recursive function of past et;i ’s and assuming that et;i is i.i.d., we drop the t subscript and rewrite Eq.
(2) as
2 4
VarðROAi Þ ¼ Varði Þð1 þ bi þ bi þ   Þ or
2
VarðROAi Þ ¼ Varði Þ=ð1  bi Þ ðif bi o1Þ. (3)
According to Eq. (3) Var(ROAi) is increasing in bi. Therefore, the mathematical relation suggested in these equations is
contrary to Dichev and Tang’s finding that bi is decreasing in Var(ROAi) and indicates their result is not merely an artifact of
the mathematical relation expressed in Eqs. (1)–(3). In these equations ei and bi are parameters. The algebra does not
provide a mathematical connection between these parameters. Such an explanation is province of economic theory as
applied to accounting.
A conference participant raised the possibility that moment generating functions suggests a mathematical relation
between b and Var(ROA). The moment generating function of a random variable implies a mathematical relation between
the mean and variation of the variable. In particular, if, for a random variable x, a moment generating function (E[etx]) exists
in an open interval containing zero, then derivatives of that function with respect to t, evaluated at t ¼ 0, equal the
moments of the random variable.1 In the present context, this implies that E[b2] is mathematically related to E[b]. However,
a mathematical relation between E[b] and Var(b) need not imply a mathematical relation between b and Var(ROA).2

2.2. Controlling for previously identified factors

Dichev and Tang (2009) compare cross-quntile differences in ROA persistence that result from sorting on ROA volatility
to sorts on absolute accruals, earnings level, and cash-flow volatility. The difference in ROA persistence between quintiles
five and one is largest for the ROA volatility sort. Dichev and Tang (2009) use the magnitude of the volatility effect argue for
the import of their findings. However, given the amount of prior research on earnings persistence, a more appropriate
yardstick is the extent to which ROA volatility adds to previously identified factors related to earnings persistence. An
incremental comparison is necessary because such factors are likely to be correlated with earnings volatility. Moreover, as a
practical matter, individuals estimating earnings persistence want to know the explanatory power added by including ROA
volatility in their models rather than the isolated explanatory power of ROA volatility compared with the individual
explanatory power of other factors.
Research suggests large earnings changes are less persistent. Brooks and Buckmaster (1976) find that earnings tend to
revert to levels observed prior to large earnings changes. Freeman et al. (1982) use deviations of return on equity from its
mean to predict future earnings changes, when return on equity deviates significantly from its mean. Freeman and Tse
(1992) and Das and Lev (1994) find that the relation between unexpected earnings and returns is nonlinear. In particular,
the incremental price effect of unexpected earnings declines as the magnitude of unexpected earnings increases.
In sum, large earnings changes are more likely to revert and at least partially reflect this phenomenon. Given the Dichev
and Tang measure of ROA volatility includes the ROA in period t1, their measure will be correlated with the extremeness of
earnings in period t1. Therefore, to discern the contribution of ROA variability that is distinct from the magnitude of the
past earnings changes, we measure ROA volatility between period t2 and t6. Moreover, because more ROA variation in

1
e Denotes the base of the natural logarithm.
2
Neither do the properties of moment generating functions suggest a relation between the sample estimate of b and Var(e), denoted b and s2. Recall
that under the assumptions of the classical linear model one can show that b is distributed independently of s2 (e.g., Johnston, 1984).
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184 R. Frankel, L. Litov / Journal of Accounting and Economics 47 (2009) 182–190

periods t2 to t6 is correlated with the extremeness of the earnings change in period t1, we control for the absolute
value of the ROA change between period t2 and t1.
Loss firms are another source of less persistent earnings. Losses can be less persistent than gains for at least three
reasons. First, a loss can result from the recognition of expected loss transactions (Basu, 1997). By including unrealized
losses in current income the firm converts a series of future loss transactions into a single transitory loss. Losses can also
indicate that the firm is likely to liquidate the assets generating the loss (Hayn, 1995). Third, a realized loss could result
from a negative shock (e.g., a strike, natural disaster, or technological change) accompanied by liquidation of assets or cash
expenditures. If negative shocks are likely to be immediately realized while positive shocks are realized gradually over
time, losses will be tend to be less persistent than gains. Sorting on earnings volatility can inadvertently result in a
profitability sort, because the negative skewness in the ROA distribution (e.g., Deakin, 1976; Frecka and Hopwood, 1983;
Givoly and Hayn, 2000) implies extreme values are more likely to be negative. Given research finds that the performance of
profitable companies reverts more slowly toward the mean (Connolly and Schwartz, 1985), controlling for the presence of
losses is necessary to assess the incremental explanatory power of earnings volatility.
Firm size can also act as a correlated-omitted variable in the relation between volatility and persistence. In the relation
between earnings volatility and persistence, firm size is a long-standing empirical regularity (e.g., Alexander, 1949; Francis
et al., 2004). Why is firm size negatively related to earnings variability? One possibility is that large firms are more
diversified than small firms. Watts and Zimmerman (1978) propose that larger firms will choose less risky investments to
avoid potential government intervention that would accompany higher returns.
Size can also be related to a company’s earnings persistence because it indicates the strength of the company’s
competitive position. Factors related to firm size such as scale economies, capital requirements, and industry
concentration, are positively related to industry-level profitability (Schmalensee, 1989). Interestingly, neither Lev (1983)
nor Baginski et al. (1999) find a significant positive relation between size and earnings persistence. However, these papers
use multivariate estimations that include measures of industry competitiveness, as well as size.
Earnings growth is associated with earnings variability and persistence. Beaver et al. (1970) argue that while new assets
are not necessarily more risky than old assets, growth that results from ‘‘excessive’’ earnings opportunities can attract
competition and leading to reduced profitability over time. To account for growth, we use the price-to-earnings ratio,
which is itself a measure of earnings persistence (Beaver and Morse, 1978; Penman and Zhang, 2004).
The results of our multivariate estimation of the relation between these characteristics and earnings persistence are
shown in Table 1. Our model also includes absolute accruals. Loss firms are excluded from the sample. We rank each
variable to standardize its variance and allow cross-coefficient comparisons. Results in column (1) provide evidence on the
incremental explanatory power of the Dichev and Tang volatility measure relative to other factors. The Dichev and Tang
measure is significant. Moreover, as documented by Dichev and Tang, the volatility effect exceeds the accrual effect. The
coefficient on the interaction between earnings and volatility is 0.0541, while the coefficient on absolute accruals is
0.0251. However, Table 1 shows that other firm characteristics have similar effects on earnings persistence. Mainly,
declines in earnings persistence that accompany increased earnings growth (as proxied by E/P) and the absolute value of

Table 1
Earnings persistence as a function of various firm characteristics.

Variable Coeff. est. (t-stat) (1) Coeff. est. (t-stat) (2)

E(t) 1.4123*** (21.13) 1.4156*** (20.94)

Ranked volatility of E(t) (lagged)  E(t) 0.0312*** (2.86)
Ranked volatility of E(t)  E (t) 0.0541*** (4.32)
Ranked jE(t)–E(t1)j  E(t) 0.0519*** (4.35) 0.0669*** (5.82)
Ranked E/P (t)  E(t) 0.0649*** 4.88) 0.0765*** (5.32)
Ranked total assets (t1)  E(t) 0.0265*** (2.65) 0.0254** (2.52)
Ranked jaccruals (t)j  E (t) 0.0251** (2.31) 0.0274** (2.43)
(Intercepts for interacted term components, except for E(t), not shown for brevity)

N 10,843 9,067
Adj. R2 37.38% 37.38%

This table displays time-series average coefficient estimates and standard errors from annual cross-sectional regressions of future earnings on current
earnings. Sample selection procedures mimics that of Dichev and Tang (2009) (e.g., data are obtained from Compustat between 1984 and 2004, firms with
non-December fiscal-year ends or with average assets less than 100 million US$ are excluded). Firms with earnings less than zero are also excluded from
the sample. Model (1) presents estimates for earnings volatility calculated over t5 through t1. Model (2) presents estimates for earnings volatility
calculated over t4 through t. *, **, and *** indicate significance at 0.10, 0.05, and 0.01 level, respectively, in two-tailed tests; t-statistics are calculated
using robust standard errors correcting for heteroscedasticity and within-firm serial correlation (cluster adjusted at the firm level).
Variable definitions: volatility of E(t) ¼ standard deviation of corporate earnings, computed over the preceding five fiscal years (t5–t1 for model (1) and
t4 to t for model (2)).
E(t) ¼ corporate earnings, defined as income before extraordinary items (#123)/average assets. The average assets are based on the average of the current
and previous fiscal-year total assets (#6).
E/P(t) ¼ income before extraordinary items (#123), divided by equity market capitalization at the end of the current fiscal year (#199 * #25).
Accruals (t) ¼ income before extraordinary items (# 123)—net operating cash flow (#308), scaled by average assets.
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the past earnings change are similar in magnitude to the declines in persistence associated with increased volatility. In fact,
if we exclude the past earnings change from the computation of the volatility measure, thereby allowing the regression to
attribute the entire effect of the lagged earnings change to the lagged earnings-change variable, the coefficients indicate
that the magnitude of the ‘‘volatility effect’’ is about half that of the ‘‘earnings-change effect’’ and the ‘‘growth effect.’’ The
take away from this analysis is that the volatility effect has significant incremental ability to explain cross-sectional
variation in earnings persistence. Its ability to distinguish earnings persistence is similar to size and absolute accruals but is
somewhat less than growth and the prior earnings change.

2.3. Sampling procedure effects

2.3.1. Selection bias

To be included in the Dichev and Tang’s sample requires 6 years of earnings data. A firm that meets this data
requirement, despite higher earnings volatility, is likely to have more inherent negative serial correlation in earnings
changes (i.e., lower persistence) than a firm that does not survive. For example, high-volatility firms that do not bounce
back are likely to get delisted and/or go bankrupt. In contrast, the difference in negative serial correlation between
surviving and non-surviving low-volatility firms will be smaller. Thus, even if high-volatility firms do not have lower
earnings persistence in the population, the sample requirements could induce selection of high-volatility firms with less
persistent earnings.
We cannot measure the negative serial correlation of the earnings of firms that leave the sample, because data on the
‘‘delisting’’ earnings is not available. The differential effects of sample selection across volatility quintiles can be seen by
comparing the number of firms that leave the sample in years t+1 to t+5 in Table 3 of Dichev and Tang (2009). In the highest
earnings volatility quintile, 60.8% (1023/1682) of observations are lost between years t+1 and t+5 compared with 51.4%
(977/1899) for the lowest earnings volatility quintile.
To avert selection-bias arising from the Dichev and Tang data requirements, we estimate earnings volatility using an
industry-based measure. Each year, we compute the average earnings volatility across firms in each four-digit SIC with 5
years of past earnings data. Each firm is then assigned the industry-average earnings volatility of its SIC code. This method
allows us to reduce the number of consecutive years of data required for inclusion in the sample from 6 to 2 years. Results
are reported in Table 2. Sample size more than doubles under the relaxed data requirements and earnings volatility
continues to have significant explanatory power for earnings persistence, but the relative ability of earnings volatility to
distinguish earnings persistence falls dramatically. For example, the incremental effect of accrual magnitude on earnings
persistence is approximately six times larger than the effect of earnings volatility. However, a potential cost of this
industry-based approach it is noisier than the Dichev and Tang method. In moving to the new measure, we turn two dials:
(1) reducing selection bias (2) increasing measurement error. This analysis does not allow us to distinguish between these
effects. Rather, it provides some evidence that that earnings volatility provides incremental explanatory in a test that offers
stronger control for selection bias.

Table 2
Earnings persistence as a function of various firm characteristics and an industry-based volatility measure.

Variable Coeff. (t-stat)

E(t) 1.6572*** (28.92)

Ranked average industry earnings volatility (t)  earnings (t) 0.0167** (2.10)
Ranked jE(t)–E(t1)j  earnings (t) 0.1108*** (11.42)
Ranked E/P (t)  earnings (t) 0.0435*** (4.59)
Ranked total assets (t1)  earnings (t) 0.0143* (1.85)
Ranked jaccruals (t)j  earnings (t) 0.1067*** (12.59)
(Intercepts for interacted term components, except for E(t), not shown for brevity)

N 24,281
Adj. R2 39.21%

This table displays time-series average coefficient estimates and standard errors from annual cross-sectional regressions of future earnings on current
earnings. Data are obtained from Compustat between 1984 and 2004. Firms with non-December fiscal-year ends or with average assets less than 100
million US$**** are excluded. *, **, and *** indicate significance at 0.10, 0.05, and 0.01 level, respectively, in two-tailed tests; t-statistics are calculated using
robust standard errors correcting for heteroscedasticity and within-firm serial correlation (cluster adjusted at the firm level).
Variable definitions: average industry earnings volatility (t) ¼ The average earnings volatility across firms in each four-digit SIC with 5 years of past
earnings data. Each firm is then assigned the industry-average earnings volatility of its SIC code. The firm’s earnings volatility is defined as the standard
deviation of corporate earnings, computed over the preceding five fiscal years (t5–t1).
E(t) ¼ corporate earnings, defined as income before extraordinary items (#123)/average assets. The average assets are based on the average of the current
and previous fiscal-year total assets (#6).
E/P(t) ¼ income before extraordinary items (#123), divided by equity market capitalization at the end of the current fiscal year (#199*#25).
Accruals (t) ¼ income before extraordinary items (# 123)—net operating cash flow (#308), scaled by average assets.
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2.3.2. Selection bias and the economic/accounting cause for relation between volatility and persistence
Of course selection bias remains an issue even when only 2 years of data are required. In effect, the Dichev and Tang
results allow us to say, ‘‘Conditional on the firm surviving another year, earnings will be less persistent as volatility
increases.’’ Because Dichev and Tang provide scant causal explanation linking earnings volatility with persistence, they are
unable to formulate additional tests suggested by a theory and that would allow us to differentiate an economic story from
a selection-bias story.
According to Dichev and Tang, poor matching can add noise to the earnings process reducing earnings persistence while
increasing earnings variability. The model they have in mind is developed in Dichev and Tang (2006) which shows that the
addition of a negatively serially correlated error to ROA can simultaneously increase the variance of the resulting ROA and
reduce its persistence. Assume

ROAet ¼ ROAt þ tt  tt1 , (4)

where t the i.i.d. random variable, uncorrelated with ROAt and et,8t. The intuition for this formulation of t is that managers
misestimate accruals when computing earnings and that these errors are corrected by recording offsetting amounts in the
subsequent period. The resulting ROAe has a higher variance than the original ROA. In particular,

VarðROAe Þ ¼ VarðROAÞ þ 2 VarðtÞ. (5)

Moreover as can be seen with a bit of algebra, the persistence ROAe is lower than the persistence of ROA. To see this begin
by noting that

be ¼ VarðROAet ; ROAetþ1 Þ=VarðROAet Þ.

Substituting Eq. (4) for ROAet gives

be ¼ CovðROAt þ tt  tt1 ; ROAtþ1 þ ttþ1  tt Þ=CovðROAt þ tt  tt1 Þ.

Simplifying gives

be ¼ ½CovðROAt ; ROAtþ1 Þ  VarðtÞ=½VarðROAt þ VarðtÞ. (6)

Given Var(t)4 0, beob. Moreover, the Var(ROAe) (be) is increasing (decreasing) in Var(t) implying that the larger the
potential accrual misestimation, the lower the persistence of ROA and the higher its variance.
If accrual estimation errors drive the relation between variance and persistence of earnings, we should find
a weaker relation between the variance and persistence of cash flows, because accruals are less of a factor in the
determination of cash flows. To examine this possibility, we compare the variation in cash-flow persistence across
cash-flow variance quintiles. Our methods are analogous to those used by Dichev and Tang to estimate earnings
variance and persistence. We estimate cash-flow persistence by regressing future operating cash flow on current
operating cash flow. We estimate cash-flow variance by computing the variance in operating cash flows over the
current and four prior periods. As with earnings measures, cash flows are divided by total assets. Results are shown in
Table 3. Comparing Panels A and B we see that the difference in persistence between high and low variance cash-flow
firm years (0.34) is slightly larger than the difference in persistence between high and low variance earnings firm years
(0.31).
These results provide meaningful insight if we assume earnings and cash-flow capture similar economic phenomenon,
except that earnings are subject to accrual errors. These results suggest that accrual errors are not a significant driver of the
relation between variance and persistence. For example, as suggested by Dichev and Tang, economic shocks might the
critical driver. Another possibility is that selection bias drives both the earnings and the cash-flow results. Given the
uncertain meaning of the term ‘‘economic shocks’’ and the absence of a more detailed causal story, we will have difficulty
establishing that the economic shocks explanation is more plausible than a selection-bias story.

2.4. Are investors aware of the link between volatility and persistence?

By dividing firms with high current earnings into volatility quintiles, Dichev and Tang provide evidence that analysts
only partially incorporate the relation between earnings volatility and persistence in their forecasts. Analysts correctly
anticipate that the earnings performance of high volatility/high earnings firms will revert more quickly that of low
volatility/high earnings firms. But they underestimate this effect by more than 50% (Dichev and Tang, Table 6). Dichev and
Tang take care to perform additional tests controlling for the current forecast error that confirm the result that analysts do
not fully incorporate volatility into their forecasts. While analyst-forecast errors suggest that investors are not fully aware
of the link between volatility and persistence, the tests are subject to the problem that we lack forecast errors for firms that
leave the sample. Returns tests provide a possible remedy.
We adopt the perspective of an investor seeking a profitable trading strategy and examine the ability of an earnings
volatility sort to produce abnormal returns. By using returns rather than future earnings, we are able to control for
selection bias through the use of delisting returns. We employ two-way sort used by Dichev and Tang for their Table 6. First
we sort firms into 20 portfolios based on ROA, we then sort each of these porfolios into quintiles based by past ROA
volatility. The idea is that firms with high (low) ROA and high (low) persistence will be underpriced and that firms with low
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Table 3
Earnings persistence and variance compared with cash-flow persistence and variance.

Panel A: E(t+1) ¼ a+jbE(t)+e(t)

All firms Low Volatility of E(t) High

Q1 Q2 Q3 Q4 Q5

b 0.61 0.81 0.70 0.71 0.63 0.50

Observations 15,594 3,194 3,147 3,135 3,112 3,006

Panel B: CF(t+1) ¼ a+b CF(t)+e(t)

All firms Low Volatility of CF(t) High

Q1 Q2 Q3 Q4 Q5

b 0.65 0.85 0.78 0.75 0.61 0.51

Observations 15,594 3,155 3,169 3,117 3,117 3,036

This table displays time-series average coefficient estimates from annual cross-sectional regressions of future earnings on current earnings, panel A, and
future cash flows on current cash flows, panel B. Quintiles are formed based on annual estimates of past earnings variance, panel A and past cash flow
variance, panel B. Data are obtained from Compustat between 1984 and 2004. Firms with earnings less than zero are excluded from the sample. Firms
with non-December fiscal-year ends or with average assets less than 100 million US$ are excluded. *, **, and *** indicate significance at 0.10, 0.05, and 0.01
level, respectively, in two-tailed tests; t-statistics are calculated using robust standard errors correcting for heteroscedasticity and within-firm serial
correlation (cluster adjusted at the firm level).
Variable definitions: E(t) ¼ corporate earnings, defined as income before extraordinary items (#123)/average assets. The average assets are based on the
average of the current and previous fiscal-year total assets (#6).
CF(t) ¼ operating cashflow (#308)/average assets.
Volatility of E(t) ¼ standard deviation of corporate earnings, computed over the preceding five fiscal years (t5–t1).
Volatility of CF(t) ¼ standard deviation of corporate operating cash flow, computed over the preceding five fiscal years (t5–t1).

Table 4
Return tests of earnings and volatility sorts.

Portfolios Size-adjusted annual returns

Percentile of the distribution

N Mean 10% 25% 50% 75% 90%

Low earnings, low volatility 778 2.17% 23.35% 9.89% 3.26% 11.41% 26.06%
Low earnings, high volatility 946 1.67% 24.07% 12.34% 2.02% 14.57% 27.47%
Difference (expected sign negative) 0.50%
P-value 0.99
High earnings, low volatility 649 0.72% –14.00% 7.24% 0.30% 8.37% 18.70%
High earnings, high volatility 937 3.63% 9.72% 3.76% 4.67% 11.73% 19.12%
Difference (expected sign positive) 2.91%
P-value 0.08

This table shows the average annual raw and size-adjusted returns for portfolios based on dual-dependent sorts across earnings and earnings volatility.
Earnings is defined as income before extraordinary items (#123)/average assets. The average assets are based on the average of the current and previous
fiscal-year total assets (#6). Earnings volatility is computed as the standard deviation of earnings, computed over the preceding five fiscal years
(t5–t1). We start by sorting our sample into 20 groups based on earnings. Within each group we then sort by earnings volatility in five quintiles.
Within each earnings-by-earnings volatility group we then compute the average monthly raw return and the average monthly size-adjusted return, where
the latter is defined and the average monthly raw return minus the corresponding size portfolio monthly return, as computed by Kenneth French
following Fama and French (1992). The annualized raw and size-adjusted returns are then computed as the continuously compounded monthly returns
from t+5 to t+16 months (included) where t is the end of the calendar year that corresponds to the fiscal-year end. We report the average across the so-
computed annual returns within each portfolio. We label earnings ‘‘low’’ if they fall in the bottom 5 (out of 20) groups, and high if they belong to the top 5
(out of 20) groups. We label earnings volatility low if it falls in the bottom quintile, and high if it falls in the top quintile. N is the number of firm in the
corresponding portfolio. We also report the p-values for the Wilcoxon non-parametric test of equality of the means.

(high) ROA and high (low) persistence will be overpriced. We measure the returns of these portfolios over the 12 months
beginning 5 months after the fiscal-year end. Results are shown in Table 4. The evidence does not support our expectations.
High ROA/high-volatility firms significantly out perform high ROA/low-volatility firms. Though the significance is marginal
(8%). We do not find a significant difference in the subsequent returns of low ROA conditional on earnings volatility. These
results suggest that investors do not significantly underestimate the effects of earnings volatility.
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3. Theory and motivation

After hearing a description of Dichev and Tang’s paper, on two separate occasions, theoretically minded researchers
innocently asked, ‘‘Why should we be concerned with earnings persistence?’’ The short answer is that Sloan (1996) showed
an understanding of earnings persistence can be used to predict returns. But a response to these wise researchers must be
more comprehensive.

3.1. Persistence and the valuation role of earnings

The emphasis on earnings persistence stems from a desire to understand the role of current earnings in valuation.
Reported earnings have role if accountants have already done some of the valuation work for investors. We can expect
earnings to have a valuation role if managers already collect information to predict cash flows for internal decision making
purposes and earnings reflects these predictions. A permanent earnings is an extreme example of an earnings number with
a valuation role because permanent earnings can serve as a substitute for cash-flow prediction by outsiders. In a certainty
world, define permanent earnings as follows:
" #
X1
t
E¼r CF t ð1 þ rÞ , (7)
t¼1

where E is the permanent earnings, r is a constant riskless rate, CF are cash flows generated by current equity investment.
This definition, taken from Beaver and Morse (1978), provides a clear example of an earnings number that obviates the
need for cash-flow forecasts.3 To value equity, investors do not need to create a spreadsheet and make cash-flow
predictions. They need only divide E by the risk-free discount rate. Graham and Dodd (1951) refer to permanent earnings as
earnings power and say, ‘‘In the usual case the most important single factor determining value is now held to be indicated
average future earnings power (p. 16)’’.
In Graham and Dodd (1951), we also see the idea that current earnings can be used as a starting point for earnings
prediction. ‘‘In the absence of indications to the contrary we accept the past record as at least the starting basis for judging
the future. But the analysts must be on lookout for any such indications to the contrary (p. 425).’’ To do so, Graham and
Dodd advise analysts to develop a familiarity with the business factors affecting the company to formulate ‘‘his opinion for
the general competitive position and the short- and long-term prospects of the company (p. 415).’’ The idea that earnings
have a bearing on the wealth position of shareholders was reinforced by Ball and Brown (1968). And today, the approach of
Graham and Dodd is echoed by financial-statement analysis books which describe how to use reported numbers for
valuation and suggest that business analysis be used to assess the economic validity of reported numbers (e.g., Palepu and
Healy, 2008; Penman, 2007; Lundholm and Sloan, 2007). Simultaneously, researchers have developed methods and sought
determinants of earnings persistence.4 In sum, the idea that financial statements can be used for valuation if one is wise
enough to make the necessary adjustments has gained wide acceptance. From here, we can begin to see how investors,
looking for a valuation short cut, would seek a better understanding of the relation between, to use current earnings and
permanent earnings.

3.2. The economic link between persistence and earnings variability

The extreme case of permanent earnings brings into stark relief the objections that arise when one views earnings as a
valuation input. An accounting student carrying around his 1348pp. volume of Kieso et al. (2007) might point out that Eq.
(7) is no where to be found in his copy of the 12th edition and that permanent earnings seems far removed from
computations required in the end-of-chapter exercises. A practitioner might say that firms do not compute earnings
according to Eq. (7), and provide a laundry list of discrepancies between the equation and an actual earnings computation
beginning the absence of any reference to historical cost. The esteemed researcher might note that financial reports are
used to limit moral hazard and adverse selection problems that arise among the contracting parties that comprise the firm.
In this context, verifiability, timeliness, and conservatism emerge as equilibrium earnings properties (Ball, 2001). The
accountant’s role is not to covert the economic events that affect a firm in a given period into perpetuity. As we look beyond
the equity-valuation role of earnings we begin to wonder about the economic drivers that lead to a link between earnings
persistence and earnings variability. Could such a link be an outcome of earnings’ contracting role?
Timely loss recognition associated with conservative accounting offers a reason that we might expect to observe a
positive relation between earnings variability and earnings persistence. Ball (2001, p. 153) provides the explanation:

ythe accounting system can incorporate economic losses in one of two ways. One alternative is to incorporate a
capitalized loss in accounting income, either buried among operating expenses or separately captioned to identify its

3
In a world with uncertainty, investors might still wish to forecast cash flows to estimate other properties (e.g., covariances) necessary for valuation.
4
A review of this literature is beyond the scope of this review and certainly this footnote. Instead, I cite Ou and Penman (1989a, b) and Lev and
Thiagarajan (1993) as early examples of papers using financial statement information to predict profitability.
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transitory nature. Provided the economic loss is recognized without a long delay, this method makes accounting
income incorporate economic reality in a timely fashion. It also increases the volatility of accounting income, by
incorporating comparatively large, capitalized, transitory items. The other alternative is to take no action and simply
ignore the loss. This has the effect of incorporating the loss in income over the entire period of the reduced cash
flows, as they eventuate. Taking no action reduces the volatility of accounting income, which becomes a type of
moving average of past economic income.

In other words, timely recognition of losses simultaneously increases the volatility of earnings and reduces its
persistence.
Financial-statement-analysis-based research and contracting-based research are spawned by differing world views. The
former sees the financial statements as a resource for equity valuation. The latter sees them as means of ameliorating the
agency conflicts that arise between the nexus of contracting parties that comprise the firm. Though each literature is built
on a different foundation, knowledge gained in one area can be applied to the other.
We return to the present case for an example. A researcher interested in predicting earnings might note that if a firm’s
accounting is likely to be more conservative its earnings will tend to be more transitory. Frankel and Rowychowdhury
(2008) sort firms based on the predicted asymmetric timeliness of earnings. They find that the large-negative special items
of firms with higher predicted asymmetric timeliness tend to be more timely and less persistent.

4. Conclusion

Dichev and Tang note the importance of earnings prediction for financial-statement analysis and assume that earnings
would be persistent if not for economic shocks and ‘‘problems’’ in determining accounting income. The economic forces
that would cause persistence to be a fundamental earnings property are not discussed. We are sympathetic to the view that
identifying factors that predict earnings persistence is useful for valuation. A technique that aids earnings prediction can be
immediately useful to students and practitioners, especially when results suggest that the method can predict analysts’
forecast errors and returns. However, a framework for understanding the economic drivers of earnings properties would
provide a more systematic method for discovering additional factors, add to the perceived robustness of the present results
and their economic content, and provide insight into the role of accounting in the firm.

Acknowledgements

We thank SP Kothari, Xiumin Martin, Sugata Rowychowdury, and Jerry Zimmerman for helpful discussions. All
remaining errors of course are our own.

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