The Nonlinear Relationship between Accruals Persistence and Accounting Conservatism

Earnings Persistence impacts pricing of the firms and past studies find that conservatism is negatively related to earnings persistence. Extending these prior studies, we examine how earnings persistence varies when the level of conservatism changes. The results show that, when the level of conservatism increases, earnings persistence coefficient first increases and then decreases afterwards. Sample firms with conservatism index near zero (i.e., when the firms’ accounting is neutral) have the most persistent earnings. The relationship between earnings and conservatism is a kinked nonlinear function. Decomposing earnings into the accrual component and the operating cash flow component, we also find that the kinked nonlinear relationship only exists between persistence of the accruals component and conservatism. Based on this result, we further decompose the accrual component into the discretionary component and the non-discretionary component and document that the effect of conservatism on the discretionary component is the sole cause of kinked nonlinear relationship. To address the inconsistency between conservatism and neutrality, the IASB excludes conservatism from the notion of faithful presentation. The empirical results, that earnings are more persistent when accounting is neutral, in this paper are consistent with the IASB decision.