Accounting Conservatism, Going-Concern Horizon, and Earnings Informativeness

In the paper, Accounting Conservatism, Going-Concern Horizon, and Earnings Informativeness, which was recently made publicly available on SSRN, I examine how accounting conservatism shapes the relation between a firm’s going-concern status and the informativeness of its earnings for firm valuation. I extend earnings-persistence-based valuation theory to develop the study’s key insight that the difference between the earnings informativeness of a firm with a finite going-concern horizon and the earnings informativeness of a firm with an infinite going-concern horizon is a positive function of the proportion of capitalized value that is reflected in the earnings of future periods. Based on this insight, I predict that because of the asymmetric persistence implications of accounting conservatism, negative shocks to a firm’s assessed going-concern horizon diminish the informativeness of good news earnings but have no effect on the informativeness of bad news earnings. Using the setting of intra-industry bankruptcy to capture shocks to the market’s assessment of firms’ going-concern horizons, I provide empirical evidence consistent with my predictions.

This study makes several contributions to extant literature. First, my analysis and results provide additional insights into the dynamics of the going-concern assumption and firm valuation. In particular, I provide evidence that the negative relation between probability of bankruptcy and earnings informativeness is not symmetric across good and bad news realizations, as suggested implicitly by prior literature.

Second, this study extends our understanding of the effects of the asymmetric persistence implications of accounting conservatism for firm valuation. Moreover, because asymmetric earnings persistence and asymmetric earnings timeliness are inherently linked, my findings suggest that the empirical manifestation of asymmetric earnings timeliness may decrease in probability of firm termination. Accordingly, my results invite a more general investigation into how the empirical manifestation of accounting conservatism is affected by changes in firms’ default risk.

Third, because I use the empirical setting of intra-industry bankruptcy to capture shocks to firms’ going concern horizon, my findings extend our understanding of the effects of intra-industry bankruptcy. Despite the evidence that bankruptcy is an event with significant cross-firm consequences, to date there is no evidence on how intra-industry bankruptcy affects the manner in which market participants react to cross-firm information released in the wake of bankruptcy. The results of the study therefore provide evidence that bankruptcy has broader industry-wide consequences than previously documented. Finally, the evidence bears implications for the general corporate disclosure environment by revealing that reported good news is less informative after a shock to a firm’s going-concern horizon.

Overall, this study provides new insights into how two key features of accounting, conservatism and the going-concern assumption, interact to influence the usefulness of accounting earnings for market participants. This evidence should encourage further research into how accounting conventions and practices interact with the economic environment to affect the relation between earnings and firm valuation.

The full paper is available for download here.