An International Investigation Of Conservative Bias And Accounting Practices

Abstract

This paper investigates the relationship between conservatism of accrual accounting and the relationship described by Ohlson (1995) and Feltham and Ohlson (1995) between future profitability and both current profitability and the growth in net operating assets. To evaluate the conservatism of accounting practices, we construct an annual index for six countries based on the relationship of depreciation and amortization expense and research and development costs expensed to the underlying long-term operating assets. As in Fairfield, Whisenant, and Yohn (2003, hereafter FWY), the growth in net operating assets is disaggregated into growth in long-term net operating assets and accruals. We focus on the accrual practices used by companies listed on the primary exchanges in six countries, to assess whether there are country-specific accounting differences that affect the profitability relationship, and whether such differences are related to the negative earnings persistence of the components of growth in net operating assets documented by FWY for the US. Following FWY, we also disaggregate growth in net operating assets into growth in net long-term operating assets and growth in net short-term operating assets to assess their relative persistence. Our findings suggest that variation in the conservative bias in accounting practices affects the impact of the growth in short-term and long-term net operating assets differently, providing evidence that the accrual anomaly is not just another representation of the growth anomaly. Finally, we employ the Mishkin (1983) model to extend internationally the FWY findings of market inefficiency with regards to the impounding in stock prices information conveyed by investments in short-term and long-term net operating assets.