We investigate the role of accrual accounting in the asymmetrically timely recognition (incorporation in reported earnings) of gains and losses. Timely recognition requires accruals when it precedes complete realization of the gains and losses in cash. We show that nonlinear accruals models incorporating the asymmetry in gain and loss recognition (timelier loss recognition, or conditional conservatism) offer a substantial specification improvement, explaining substantially more variation in accruals than equivalent linear specifications. Conversely, conventional linear accruals models, by omitting the loss recognition asymmetry, exhibit substantial attenuation bias and offer a comparatively poor specification of the accounting accrual process. Linear specifications also understate the ability of current earnings to predict future cash flows. These findings have implications for our understanding of accrual accounting and conservatism, as well as for researchers estimating discretionary accruals, earnings management, and earnings quality.

Value relevance, Accounting, Earnings announcements, Usefulness of Accounting

Do accruals-based earnings provide better information about future operating cash flows than do operating cash flows themselves, as predicted by the Financial Accounting Standards Board's conceptual framework (FASB, 1978)? While this is a foundational issue in accounting, because it addresses the information added by accrual accounting methods, testing it remains unsettled. We show that when comparing the predictive ability of operating cash flows with that of an equivalent earnings measure calculated on an accrual basis, earnings outperform operating cash flows. The result becomes more pronounced when allowance is made for cross-sectional differences in the relation between firms' earnings and future cash flows. In fact, even “bottom line” earnings then have similar explanatory power as operating cash flows.

The East Asian countries Hong Kong, Malaysia, Singapore and Thailand provide rare insight into the interaction between accounting standards and the incentives of managers and auditors. Their standards derive from common law sources (UK, US, and IAS) that are widely viewed as higher quality than code law standards. However, their preparers’ incentives imply low quality. We show their financial reporting quality is not higher than under code law, with quality operationalized as timely recognition of economic income (particularly losses). It is misleading to classify countries by standards, ignoring incentives, as is common in international accounting texts, transparency indexes, and IAS advocacy.

Income variation, Balance sheet, Common size statements method, Financial analysts