The Link Between Earnings Conservatism and the Price to Book Ratio

Abstract

We hypothesize and find: (1) Earnings conservatism, the tendency of firms to recognize bad news in earnings on a more timely basis than good news, is substantially greater in portfolios of firms with lower price-to-book ratios than in portfolios of firms with higher price-to-book ratios;(2) The negative association between earnings conservatism and the price-to-book ratio stems primarily from the accrual component of earnings, not the operating cash flow component of earnings. Our results suggest that studies using earnings-returns associations to investigate cross-sectional or time-series differences in earnings conservatism risk drawing erroneous inferences unless the research designs control for cross-sectional or time-series variation in price-to-book ratios.

Keywords: Accounting conservatism, earnings, accruals, returns, price-to-book

JEL Classification: M41, M44, G12