See discussions, stats, and author profiles for this publication at: https://www.researchgate.

net/publication/228913534

The Association Between Inter-Segment Profit Smoothing and the

Conservatism of Accounting Earnings

Article · January 2009

CITATIONS READS

2 279

3 authors, including:

Daniel A. Bens Steven J. Monahan

INSEAD INSEAD
20 PUBLICATIONS   687 CITATIONS    23 PUBLICATIONS   679 CITATIONS   

SEE PROFILE SEE PROFILE

Some of the authors of this publication are also working on these related projects:

Financial Statemen Analysis and Earnings Forecasting View project

All content following this page was uploaded by Steven J. Monahan on 05 June 2014.

The user has requested enhancement of the downloaded file.

 The Association Between Inter-Segment Profit Smoothing and the
Conservatism of Accounting Earnings

Daniel A. Bens†
dbens@email.arizona.edu
University of Arizona
Eller College of Management
1130 E. Helen Street, P.O. Box 210108
Tucson, AZ 85721

Steven J. Monahan
steven.monahan@insead.edu
INSEAD – Accounting and Control Area
Boulevard de Constance
PMLS No. 1.24
F-7705 Fontainebleau Cedex, 77305
France

Logan Steele
logans@email.arizona.edu
University of Arizona
Eller College of Management
1130 E. Helen Street, P.O. Box 210108
Tucson, AZ 85721

Latest Draft as of:

December 26, 2008

Preliminary and Incomplete – Please do not Cite or quote without the Authors’ permission

†
Corresponding author.

The authors gratefully acknowledge financial support from the Ratoff Family Fellowship at the University of
Arizona and the INSEAD Alumni fund. The authors are solely responsible for any errors.
 The Association Between Inter-Segment Profit Smoothing and the
Conservatism of Accounting Earnings

Abstract

We devise a measure of inter-segment profit smoothing for multi-segment firms. This measure
equals the ratio of the variance of profits for a portfolio of single segment firms to the variance of
profits across a firm’s multiple business units. The single segment firms are matched to the
firm’s segments by industry and size. We interpret increases in this ratio as capturing the
smoothing of inter-segment profit. Specifically, as the ratio increases the underlying profit
volatility (as captured by the control group) has increased while reported volatility stays
constant.

We find that our inter-segment profit smoothing measure is positively correlated with the level of
information asymmetry at the firm (as measured by the bid-ask spread and the probability of an
informed equity trade). As our main contribution, we document that increased inter-segment
profit smoothing reduces the asymmetric timeliness (or conservatism) in firm level accounting
earnings by as much as 24%. We use a Basu [1997] reverse regression framework for this
analysis. We also demonstrate that inter-segment profit smoothing reduces the likelihood that
the firm records a non-recurring negative accrual, namely an asset impairment. These accruals
are generally used to communicate bad economic news, and thus our evidence suggests they are
less likely to be recorded when inter-segment smoothing is high.
I. Introduction

In this paper we examine whether multi-segment firms that publicly report relatively

smooth operating performance across their segments exhibit a low association between bad

economic news and its recognition in accounting earnings. That is, we test for a negative

association between inter-segment profit smoothing and accounting conservatism1.

We measure inter-segment profit smoothing for publicly traded U.S. firms that report

more than one business segment in their annual financial reports. Our measure is a decile rank

variable within the population of multi-segment firms; the higher the rank within the sample, the

higher the classification of smoothing. We first measure the variance of profit margins across a

portfolio of single segment firms that are matched on size and industry to the multi-segment

firm’s business segments; this serves as the numerator of our ranked smoothing variable. We

then measure the variance of profit margins across the firm’s segments; this serves as the

denominator of our ranked smoothing variable. The higher this ratio, the more the firm is using

either industry aggregation schemes or cost allocation strategies to make their underlying income

appear less volatile across business units than the underlying fundamentals (as captured by the

single segment firms) suggest.

Our proxy for conservatism is the measure of the asymmetric timeliness of accounting

earnings first used by Basu [1997]. Basu’s intuition, also articulated by Ball [1998] and Watts

[2003] among others, is that U.S. generally accepted accounting principles (GAAP) exhibit an

asymmetric bias towards reporting bad news on a more timely basis than good news. These

standards restrict the recognition of good news in accounting earnings while encouraging the

1
As we discuss later in this section, our definition of conservatism follows Basu [1997], which is often referred to as
“conditional conservatism.” Watts [2003] and Ryan [2006], among others differentiate this from “unconditional
conservatism,” which consists of an understatement of all assets irrespective of the economic condition of the
company. For simplicity, we use the term “conservatism” to mean “conditional conservatism” and the “asymmetric
timeliness of earnings”

1
recognition of bad news. Further, in the judgmental application of GAAP accountants generally

require less verification for the recognition of bad news vis-à-vis good news. Basu uses a

reverse regression specification where accounting earnings are the dependent variable and stock

returns the independent variable; the coefficient on stock returns is then allowed to vary by

whether the measure for the year is positive (i.e., good economic news) or negative (i.e., bad

economic news). Basu documents that the coefficient on the bad news is larger than that on

good news, in both statistical and economic terms. This evidence confirms, empirically, the

presence of an asymmetric bias towards accelerated bad news recognition in applied GAAP.

We conjecture that the smoothing of income across segments is a form of information

asymmetry in the capital markets. We estimate univariate correlations between our smoothing

measure and other publicly available measures of information asymmetry to confirm this

prediction. We document that the level of inter-segment smoothing is positively associated with

the bid-ask spread and the probability of an informed trade (PIN), both of which have been

interpreted in the literature as capturing information asymmetry.

We next examine whether inter-segment smoothing is associated with a lower level of

conservatism. Given our initial results that inter-segment smoothing is associated with greater

information asymmetry, we conjecture that this smoothing obscures the underlying value of firm

assets. This obfuscation complicates the task of identifying unrecognized losses (such as asset

impairments) and creates uncertainty as to the extent of these losses. Therefore, we expect that

inter-segment smoothing reduces the ability of the accounting system to communicate bad news

in a timely fashion. Our empirical approach for testing this conjecture is based on the

multivariate regression specified by Basu [1997]. In a pooled time-series cross-sectional

regression, the dependent variable is annual earnings per share divided by beginning stock price.

2
The proxy for “economic news” is the concurrent stock return. A dummy variable that equals

one whenever returns are negative for the year is then interacted with the returns variable,

allowing for a differential coefficient for “bad news.” Our hypothesis variable is an additional

interaction term with the negative stock returns variable. This hypothesis variable is the decile

ranking of the ratio of the variance of matched single-segment firm profits to the variance of the

firm’s profits across its multiple segments. We interpret the higher ranked decile as containing

firms that are engaging in relatively more inter-segment profit smoothing.

Our main regression results are consistent with our prediction that when the smoothing

variable is high then the sensitivity of accounting earnings to bad economic news is reduced.

We conclude that inter-segment smoothing results in a reduction of the informativeness of

earnings, and that this manifests itself via the delayed accounting recognition of economic losses.

This is the main contribution of our study. Our results are strengthened by the inclusion of other

cross-sectional determinants of asymmetric timeliness identified by Khan and Watts [2007]:

firm size, book-to-market, and leverage.

We also examine a set of specific accounting accruals designed to communicate bad

news and test whether a higher level of inter-segment smoothing reduces their use. We focus on

asset write-downs (both tangible and intangible). In a probit regression, we find that the

smoothing variable is negatively associated with the likelihood of recording one of these charges,

after conditioning on several market and accounting return variables. This provides further

evidence that inter-segment smoothing reduces the timely recognition of bad news via firm-level

accounting earnings.

Our paper contributes to the growing body of literature on the conservatism of accounting

earnings. Ball [1998] and Watts [2003] posit that the contracting and governance demands on

3
accounting logically lead to the asymmetric timeliness of accounting earnings documented by

Basu [1997]. We examine how the combination of organizational structure (i.e., the

diversification into multiple business segments) and financial reporting choice (i.e., the

smoothing of accounting profits across segments) can reduce the accounting system’s ability to

fulfill this contracting and governance role.

The next section of this paper reviews the existing smoothing and conservatism

literatures while placing our hypotheses in this context. The third section describes our inter-

segment smoothing variable in more detail. The fourth section describes our sample selection

process and presents descriptive statistics. The fifth section empirically documents results

related to our hypothesis that the inter-segment smoothing variable is associated with

information asymmetry. The sixth section presents empirical results related to our main

contribution that inter-segment smoothing reduces accounting conservatism. The seventh

section presents additional findings that certain non-recurring negative accruals used to

communicate bad news are less likely when inter-segment smoothing is high. The final section

summarizes the paper.

II. Literature Review and Hypothesis Development

Income smoothing has been the subject of a number of accounting research studies, both

analytical and empirical, over the past three decades. A comprehensive review of that literature

is beyond the scope of this study, but others have periodically reviewed this research (see Ronen

and Saden [1981]; Schipper [1989]; and Dechow and Skinner [2000], for examples). The

traditional income smoothing study examines the inter-temporal recognition of firm-level profit

figures. These models or empirical specifications seek to identify situations where revenues or

4
expenses are shifted by the firm from one period to another in an attempt to present a time-series

of earnings with a lower variance. Yet this definition is problematic because GAAP, when

neutrally applied, requires firms to “smooth” cash flows via the accrual process. Dechow and

Skinner [2000] discuss the problems a researcher faces when trying to determine whether there is

“too much” smoothing and thus “earnings management.”

With any earnings management study, the challenge for the researcher is in identifying

what the “unmanaged” portion of earnings is before testing whether the “managed” piece

corresponds to the economic forces of their hypothesis. In the smoothing literature, for example,

DeFond and Park [1997] study the descriptive validity of Fudenberg and Tirole’s [1995] theory

that managers smooth income across time to prevent the “intervention” of the principal/owner in

the manager’s division (e.g., by sacking him). DeFond and Park interpret their empirical

evidence as consistent with the theory. But in a follow up paper, Elgers, Pfeiffer and Porter

[2003] point to methodological problems in measuring expected accruals via the modified-Jones

model, and how this biases the DeFond and Park conclusions in favor of the smoothing

hypothesis being tested.

In our study, we take a different tack from much of the prior literature and focus on inter-

segment income smoothing by the firm across segments as opposed to across time. The

smoothing of income across segments can take two forms. The first approach is to aggregate

different business activities into segments such that the variance of the underlying profits across

units is reduced. This is the form of smoothing described analytically by Hayes and Lundholm

[1996]. In their setting, firms choose to aggregate business segments with dissimilar profitability

so as to hide information from competitors. The second approach to smoothing income involves

the manipulation of the cost allocation of expenses that are components of segment profits.

5
Hann and Lu [2008] find that the incidence of segment losses appears to be unusually low, and

they attribute this result to strategic cost allocation decisions by managers.

With the exception of Hann and Lu [2008], most past research that examines

management’s distortion of segment information focuses on the aggregation of dissimilar

segments into a common segment(s). The early literature in this area focused on the proprietary

cost incentive as the source of demand for this behavior. For example, Harris [1998] finds that

firms with segments in highly concentrated industries tend to aggregate those segments with

others in external reports; she also finds that segments in industries where abnormal profits tend

to persist are aggregated by firms. She concludes that these managers engage in this behavior to

hide information from competitors, as predicted by the Hayes and Lundholm [1996] model.

More recent work in this area focuses on agency cost incentives to withhold information on

disparate segments. Berger and Hann [2007] examine the revelation of previously hidden

segments that was mandated by a change in accounting rules effective in 1998.2 They conclude

that the newly revealed segments were previously withheld for agency cost reasons; managers

were attempting to prevent shareholders and other stakeholders from pressuring the firm to

divest unprofitable segments by hiding the information about these segments

In this paper, we examine the smoothing of internal profits across segments via either

aggregation or cost allocation.3 Our measure, which will be more fully described in the next

section, captures the variance of profits reported across a firm’s multiple segments and compares

this to a benchmark of the variance of profits reported across a sample of single segment firms

2
The Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standard (SFAS)
No. 131, Disclosures about Segments of an Enterprise and Related Information effective for fiscal years beginning
after December 15, 1997.
3
It is beyond the scope of this project to determine exactly how the profits are smoothed across the segments.
However, we present evidence in Section VI that the autocorrelation in our smoothing measures is 0.394. This
suggests that the smoothing measure we use is fairly consistent through time, and thus likely due to business
aggregation or cost allocation decisions that cannot be easily changed from year to year.

6
matched by size and industry to the segments. Our interpretation is that when the benchmark

matched sample has a high variance, but the treatment firm has a low variance, then the

treatment firm is engaging in income smoothing across its segments. The advantage to capturing

smoothing this way, as opposed to the traditional inter-temporal smoothing measures, is that it

alleviates our need to specify a level of expected earnings (or accruals) in a time-series for a

sample firm. This is the methodological problem that DeFond and Park [1997] face per the

analysis of Elgers et al. [2003]. In a sense, our smoothing measure is akin to Beaver’s [1968]

research design of examining the information content of earnings not by modeling the first

moment expectations of the stock market, but rather the historical pattern in the second moment

of variance in stock returns, and how that variance changes around earnings announcements.

Our goal in this paper is to examine how inter-segment profit smoothing affects the

ability of the overall firm earnings figure to communicate timely information. Our first

hypothesis is that inter-segment smoothing suppresses the information in the components of firm

earnings because investors are now less aware of the underlying source of firm profits. We

predict that inter-segment smoothing will thus be positively associated with other measures of

information asymmetry that are publicly observable, namely, bid-ask spreads and the probability

of informed (PIN) trading as defined by Easley, Kiefer and O’Hara [1997].

Conditional on inter-segment smoothing increasing information asymmetry, we focus on

a specific manifestation of how accounting information may be garbled with this smoothing. We

focus on the conservatism inherent in GAAP, and how inter-segment smoothing might affect the

application of this principle.

Basu [1997] defines conservatism as “accountants’ tendency to require a higher degree of

verification for recognizing good news than bad news in financial statements” (p. 4). This

7
definition leads to the natural prediction that bad news will be reported on a more timely basis

than good news, since the accountant will require less corroborating evidence to recognize a loss

than a gain. Basu empirically documents the application of this principle in the U.S. over a

period of roughly four decades (1963-1990); he also cites sources that claim it had been applied

in Europe over the past six centuries. Ball [2001] and Watts [2003] explain the demand for

conservatism as coming from the contracting process where, largely due to governance needs

and lending arrangements, conservatism arises endogenously.

An exogenous force that has been studied as a source of conservatism is the legal nature

of a corporation’s national environment. Ball, Kothari and Robin [2000] find that firms in

common-law countries, where accounting standards are more likely to arise from the “bottom-

up” via commercial transactions, contracts and court precedent, are likely to exhibit more

conservative earnings numbers than those in code-law countries, where accounting standards

come from the “top-down” via government action. Bushman and Piotroski [2006] examine

additional macro factors in a cross-country study, including legal origin, securities laws and

other political economy measures.

Less research has examined conservatism at the firm level within the U.S. to determine

forces that might lead to cross-sectional variation in its application. Ryan [2006] identifies many

of the problems associated with applying the Basu framework generally (see especially pp. 515-

516), as does Givoly, Hayn and Natarajan [2006]. Khan and Watts [2007] suggest that three

firm fundamentals are natural determinants of a firm’s conservatism measure: the market-to-

book ratio, firm size, and firm leverage. They use these variables to form a “C_Score” that they

validate with tests that are direct (e.g., higher C_Score firms exhibit more asymmetric timeliness

as defined by Basu) and indirect (e.g., higher C_Score firms tend to experience underlying

8
fundamentals that lead to a higher demand for conservatism, such as greater information

asymmetry).

Our focus is whether a discretionary reporting decision, the smoothing of profits across

the segments of a firm, impairs the ability of the accounting system to fulfill an important

objective, the communication of bad news in a relatively timely manner. Our maintained

assumption is that bad news events, such as revenue or cost shocks that reduce profits, increase

the underlying volatility of the income stream. Yet a reporting system that smoothes these

shocks across the business units of a firm will obscure theses shocks and cause firm level

accounting numbers to be less responsive to bad economic news. Thus, our second hypothesis

predicts that firm-years classified as higher smoothers will exhibit less conservatism. That is, the

incremental “bad news” coefficient in the Basu regression will be attenuated in firm-years that

are classified as having high levels of smoothing of their internal profits.

One of the ways in which bad news is recognized in accounting earnings is through the

use of negative, non-recurring accruals. Compustat uses the non-GAAP term “special items” to

describe these accruals. We believe that either asset write-downs or restructuring charges are

the accounting technology frequently used to actually record the bad news. We refer to these

items as negative non-recurring accruals.

Our third hypothesis is that these negative non-recurring accruals will be recorded with a

lower frequency for smoothing firms. Although this prediction may seem trivial in light of our

second hypothesis, the role of these accruals in the application of conservatism is unclear.

Callen, Hope and Segal [2009] conclude that “special items” per Compustat are a noisy

manifestation of asymmetric timeliness. Further, Frankel and Roychowdhury [2007] find that

restructuring charges appear to be particularly abused. Specifically, Frankel and Roychowdhury

9
[2007] find that restructuring charges are frequently more persistent (i.e., not as non-recurring as

they are purported to be) for firms that score low on the Khan and Watts [2007] C_Score. As

such, these charges may reflect big bath or cookie jar reserve behavior more than they do the

asymmetric timeliness feature of earnings. Accordingly, there is tension regarding whether we

can observe an effect of inter-segment smoothing on the likelihood of negative non-recurring

accrual recognition.

III. Measurement of Inter-Segment Smoothing

Our main hypothesis variable in this study is a within sample decile ranking of a ratio of

variances, denoted RVR (for ranked variance ratio). In the denominator of this ratio is the

variance of profits across a firm’s segments.4 In the numerator is the variance of profits across a

sample of single segment firms that are matched by size and industry to the multi-segment firm’s

business segments. The higher the ratio, the more smoothing that can be inferred. We assume

that the variance in profit across the matched single segment firms represents the expected level

of variation in profits within a multi-segment firm. As RVR increases above one, the more the

expected performance variance exceeds the reported performance variance. We interpret this as

inter-segment profit smoothing. We use ranks as opposed to a continuous measure of the ratio to

control for extreme values that can result when measuring a variance across a small number of

data points.

Both profit figures in the raw variance ratio are deflated by the respective sales of the unit

of analysis (i.e., segment sales for the multi-segment firms and firm sales for the single segment

group). We match on industry at the most precise level possible using SIC classification,

limiting ourselves to the two digit level. That is, where possible, we match first on the four-digit
4
Only multi-segment firms are included in our sample. We elaborate on the sample selection in Section IV.

10
level, second on the three-digit level if a four-digit match is not possible, and third on the two-

digit level if no match occurs in the first two attempts. After matching at the industry level, we

then choose the single segment firm with the value of sales closest to the business segment’s.

Because the definition of “profit” at the segment level may vary across the sample firms,

we use an algorithm to infer how the firms are measuring this figure at the segment. This is

necessary because we wish to remain consistent in our definition of “profit” with our benchmark

single-segment firms. We sum the profit figures across the segments, and then compare it to

several likely firm level earnings figures. We identify the minimum difference between the sum

of segment profit and the firm level measures. We then use that firm level measure for our

single segment firms when calculating the variance of profit for this matched portfolio. Our

candidates for firm level earnings in this process include (all identifying numbers refer to

Compustat fields):

• net income before extraordinary items (#18);

• net income before extraordinary items plus depreciation expense (#18 + #14);

• net income before extraordinary items plus interest expense (#18 + #15);

• net income before extraordinary items plus tax expense (#18 + #16);

• net income before extraordinary items plus depreciation expense plus interest expense

(#18 + #14 + #15);

• net income before extraordinary items plus depreciation expense plus tax expense

(#18 + #14 + #16);

• net income before extraordinary items plus interest expense plus tax expense (#18 +

#15 + #16);

11
 • and, net income before extraordinary items plus depreciation expense plus tax

expense plus interest expense (#18 + #14 + #16 + #15).

Our measure of smoothing is similar to one used by Ettredge, Kwon, Smith and Stone

[2006], however there are significant differences. Ettredge et al. use the range of return on sales

(ROS) across a firm’s segments as the measure of variability.5 This serves as a dependent

variable in their analyses. The primary research question they ask is whether this variability

increased following SFAS 131. They construct a benchmark inherent variability measure by

looking at the range of mean profits of the single segment firms operating in the same industries

as the multi-segment firms various segments. This inherent variability is then used as a control

in an OLS regression where the aforementioned range of ROS across firm segments serves as the

dependent variable.

While our ranked variance ratio (RVR) measure differs significantly from the Ettredge et

al. approach, the variables are similar. But more importantly, the research question we ask is

considerably different from this other study. Ettredge et al. are concerned with how a new

accounting standard, SFAS 131, affected the inter-segment smoothing behavior of multi-segment

firms. Our research question is whether the inter-segment smoothing behavior of multi-segment

firms can affect the asymmetric timeliness of earnings. Thus our contribution is to assess

whether the accounting system’s role of communicating bad news on a timely basis is

compromised via inter-segment profit smoothing; this is a fundamentally different research

question than Ettredge et al. address.6

5
In footnote 11 (p. 98) they report that their results are robust to using the standard deviation of ROS rather than the
range.
6
We do explore the role of SFAS 131 in our tests in Section VI.

12
IV. Sample Selection, Variable Definitions and Descriptive Statistics

Firm-level data is gathered from the Compustat Annual Industrial Files. Firms must have

data on sales (#12), diluted EPS including extraordinary items (#169), net income before

extraordinary items (#18), the current and lagged fiscal year-end stock price (#199), the current

and lagged fiscal year-end shares outstanding (#25), the book value of equity (#60), the book

value of long-term debt including the current portion (#9 + #34), and assets (#6) to be included in

our sample. Firms must also have a continuous string of stock returns on the Center for Research

in Security Pricing (CRSP) database from April of the sample year to March after the sample

year-end.

We gather segment information from the Compustat Segment database requiring segment

sales (SALE), an income variable (OPS, OIBD, or NI), and an SIC code (SSIC1 or SSIBC1).

Segments are deleted if segment sales are equal to or less than zero. Compustat includes single-

segment firms as segments in the segment database, therefore segments are also deleted if

“segment” sales are equal to or greater than aggregate firm sales.

We identify multi-segment firms as those firms that are successfully matched to at-least

two segments on SPC Permanent Number and year-end date. Multi-segment firms are deleted

from the sample if the sum of segment sales for segments successfully matched to the multi-

segment firm is not within 1% of aggregate firm sales. We identify single-segment firms as

those firms that are successfully matched to zero or one segments on SPC Permanent Number

and year-end date. We do this matching before any segments are deleted from the segment file

to reduce the likelihood that multi-segment firms are mistakenly identified as single-segment

firms.

13
 Table 1 presents two panels of descriptive statistics. Panel A includes all of the

observations (17,367) that will be included in our main Basu regression tests. That panel

presents the descriptive statistics regarding the distributional characteristics of the variables that

will be used in the regressions. This sample is truncated by deleting observations in the top and

bottom 1% of deflated earnings per share (DEPS), annual returns (R), book-to-market (BTM),

and the top 1% of leverage (LEV). The variables are defined as follows:

DEPS: Diluted earnings per share including extraordinary items (#169) divided by the

stock price at the beginning of the period (#199).

RVR: A ranking of the firm’s variance ratio into deciles, higher deciles indicate higher

levels of segment performance variance suppression.

Neg: A dummy variable equal to one if returns for the 12 month period beginning in

April of the sample year are less than zero; else the dummy variable takes on a

value of zero.

SIZE: The natural log of total firm assets (#6)

BTM: The book value of equity (#60) divided by the market value of equity (#199 *

#25)

LEV: The book value of long-term debt including the current portion (#9 + #34) divided

by the market value of equity (#199 * #25)

Panel B of Table 1 presents the univariate correlations for all of the variables above. Pearson

correlations are presented above the diagonal, with Spearman below.

14
V. Correlations between Inter-Segment Profit Smoothing and Information Asymmetry
Measures

In our first set of analyses we examine the univariate correlations between RVR and other

publicly observed measures of information asymmetry. Our objective is to gain comfort that the

smoothing RVR measure does indeed measure a phenomenon that is associated with information

asymmetry. We focus on univariate correlations between RVR and both the bid-ask spread

(BA_S) and the probability of informed trading (PIN).

The bid-ask spread is a common measure of information asymmetry in the equity market.

Moreover, it is one that more transparent disclosure or accounting policies are thought to reduce.

For example, Healy, Hutton and Palepu [1999] find that sustained increases to voluntary

disclosure (as measured by a qualitative rating of disclosure quality by sell-side equity analysts)

are associated with a decline in the spread. Leuz and Verrecchia [2000] document that German

companies that voluntarily commit to a more transparent accounting system (as measured by a

switch from German GAAP to the more transparent IFRS or U.S. GAAP in the mid-1990s)

experience a decline in the spread.

The PIN measure, as developed by Easley, Kiefer and O’Hara [1997] is another variable

used to capture information asymmetry. It is an estimate of the probability that a trade in an

equity security has been initiated by an informed trader. Hence, it is increasing in the

information asymmetry between informed and uninformed investors. Like Healy et al.’s [1999]

analysis of disclosure and bid-ask spreads, Brown and Hillegeist [2007] find that voluntary

disclosure quality is also inversely related to the PIN, the implication being that a firm’s

reporting strategy can reduce this information asymmetry measure that raises the cost of capital

for a firm.

15
 We predict with our first hypothesis that the smoothing measure RVR is positively

associated with both BA_S and PIN. Our logic is that when firms smooth profits across their

segments, this increases the level of information asymmetry as captured by these proxies. This

prediction is similar to the conjectures of Healy et al. [1999] and Brown and Hillegeist [2007].

BA_S is calculated as the average closing bid-ask spread per CRSP throughout the year

that RVR is measured. We use calendar year PIN scores calculated by Assistant Professor

Soeren Hvidkjaer for the years 1983 to 2001, posted on his webpage;

http://www.smith.umd.edu/faculty/hvidkjaer/index.htm to proxy for information asymmetry. The

PIN score measures abnormal trading activity by inferring imbalances in the volume of buy

versus sell orders in a given stock. The PIN score employs the assumption that the market maker

should incorporate new public information directly into prices for subsequent trades of a given

stock, thus creating no systematic order imbalance. In contrast, the market maker is not capable

of incorporating private information into stock prices for subsequent trades. Thus, an order

imbalance will exist whereby “bad” private information generates an excess of sell-orders and

“good” private information generates an excess of buy orders. Firms with relatively greater

abnormal trading volume (a higher PIN score) likely have more information asymmetry between

outside investors and insiders. Easley & O’Hara (1992), Easley, Hvidkjaer, & O’Hara (2002 &

2004) provide an extensive treatment of the PIN score and its relation to information asymmetry.

We limit our analysis for our first hypothesis to univariate correlations because the

ultimate goal of this analysis is to gain comfort that RVR actually captures a measure of

information asymmetry. This provides us with a cleaner interpretation of our primary analyses

in the next section where we examine whether RVR inhibits the asymmetric timeliness of

earnings.

16
 Panels A and B of Table 2 present all of the regression variables defined in Section IV for

smaller sub-samples where the BA_S and PIN are available. We have only 11,785 observations

with a usable bid-ask spread, and 3,801 with a PIN. The use of the PIN score imposes several

sample size limitations on our study, which account for the dramatic drop in the number of

viable observations. The PIN score is calculated on a calendar year basis only, so firms that

don’t have a December fiscal year-end are lost. Further, the PIN score is only available for firms

on the NYSE/AMEX stock exchange for the years 1983 through 2001.

In Panel C of Table 2 we present the correlations between our smoothing measure RVR,

and BA_S and PIN. Pearson correlations are presented in the upper diagonal, Spearman in the

lower. The correlations across all variables are positive and significant, as predicted. The

magnitudes of the correlations between PIN and BA_S are quite high, which is to not surprising

as they are both designed to capture the primitive information asymmetry construct. Our

variable of interest, RVR, is positively correlated with each of the other measures, but the

magnitudes of the correlations are modest. This is to be expected, however, as the primitive

measures should encompass all of the features that lead to information asymmetry (e.g.,

disclosure policy, organizational structure, other accounting choices, etc.) whereas RVR captures

a single aspect.

VI. Methodology and Results of Testing Main Hypothesis

The basic Basu regression uses earnings as the dependent variable, with

contemporaneous stock returns as an explanatory variable that proxies for “economic news.”

Returns are interacted with a dummy variable that takes on a value of one if the return is

17
negative, zero otherwise. In equation form, the model is presented below (all variables are

defined in Section IV):

DEPSit = β0 + β1 Negit + β2 Rit + β3 Negit * Rit [1]

The evidence of conservatism, or asymmetric timeliness, is provided by a positive coefficient β3.

We augment the basic Basu model by including our proxy for inter-segment profit

smoothing RVR as an additional interactive variable per model [2] below:

DEPSit = β0 + β1 Negit + β2 Rit + β3 Negit * Rit + β4 RVRit + β5 Negit * RVRit + β6 RVRit * Rit

+ β7 Negit * RVRit * Rit [2]

Our prediction for our second hypothesis is that the β7 coefficient is negative. This

would suggest that inter-segment smoothing reduces the ability of the accounting system to

communicate bad news in a timely manner.

Table 3 presents estimates of several variants of model [2]. In the first column of results,

the model above is estimated for the entire pool of 17,367 observations. The results of this

estimation support our second hypothesis. The β7 coefficient is negative and statistically

significant at the 1% level. The magnitude of the coefficient is -0.0081. Thus, if a firm moved

from the lowest decile to the highest decile of smoothing, then that would suggest the Basu

asymmetric timeliness coefficient would fall by 0.0729 (or nine multiplied by 0.0081); this

reflects a decline of 24.0% of the baseline estimated β3 coefficient of 0.3036. Even a more

conservative change of a one standard deviation increase in RVR of would suggest a decline in

the asymmetric timeliness coefficient of 0.0232 (or 2.861 multiplied by 0.0081); a decline of

7.6% in the magnitude of the coefficient.

As an extension of model [2], we use the lagged value of RVR. We expect that

smoothing should represent a fairly static decision by the firm, especially if it is driven by the

18
choice in how business activities are aggregated into reportable segments; we do not expect this

decision to change much from year to year. Indeed, when we estimate a univariate regression

where current RVR is the dependent variable and lagged RVR the explanatory variable, the

adjusted R2 of the model is 0.156 and the estimated coefficient for the lagged value is 0.394,

which is highly statistically significant. Thus, inter-segment profit smoothing is a persistent

phenomenon. In the third column of Table 3 we replace the contemporaneous RVR with its

lagged values. The statistical significance and economic magnitude of the coefficient do not

change in this specification.

In the second and fourth columns of Table 3 we estimate model [2] annually, using either

the contemporaneous (second column) or lagged (fourth column) RVR as our main variable of

interest. Then, we take the average β7 coefficient across the 24 or 23 years and test for its

statistical significance using the Fama-MacBeth method. This approach controls for cross-

sectional dependence in the financial data that likely exists. The results presented in columns

two and four of Table 3 suggest that the β7 coefficient is statistically insignificant when using the

Fama-MacBeth approach.

To examine this result further, we examined the time series of the β7 coefficient from the

annual model [2] estimations using the contemporaneous RVR value interacted with R and Neg.

We noticed that it was after the application of SFAS 131 in 1998 that the stability of the β7

coefficient began to deteriorate. Recall that SFAS 131 was designed to improve segment

footnotes by aligning the external reporting with internal management tracking of business units.

Ettredge et al. [2006] find that following the mandatory adoption of this standard the range of

reported profits across business segments increases, on average; they conclude that this implies

that SFAS 131 reduced the smoothing by management of profits across their segments. In our

19
sample, there appears to be some evidence that the higher pre-SFAS 131 smoothing levels were

accompanied by a greater reduction in the asymmetric timeliness of earnings. Specifically, the

average value of β7 over the 15 years from 1983-1997 was -0.0170; the Fama-MacBeth t-statistic

for this average coefficient is -2.0358. Moreover, the estimated coefficient is negative in 11 of

the 15 years. Yet in the 9 years from 1998-2006, the average β7 value is 0.0097; the Fama-

MacBeth t-statistic for this is 0.6927 and the estimated coefficient is negative in 4 years.7 We

examine the effects of this accounting regime change further in our next set of analyses that

incorporates more controls in the base model.

We augment model [2] by adding the variables identified by Khan and Watts [2007] as

cross-sectional determinants of asymmetric timeliness. These variables are as follows:

SIZE: The natural log of total firm assets (#6)

BTM: The book value of equity (#60) divided by the market value of equity (#199 *

#25)

LEV: The book value of long-term debt including the current portion (#9 + #34) divided

by the market value of equity (#199 * #25)

Including the asymmetric timeliness measure interactions with these firm fundamentals will

insure that our smoothing measure is not driven by these other forces. The resulting model is

presented below:

DEPSit = β0 + β1 Negit + β2 Rit + β3 SIZEit * Rit + β4 BTMit *Rit + β5 LEVit * Rit + β6 RVRit * Rit

+ β7 Negit * Rit + β8 SIZEit *Negit * Rit+ β9 BTMit *Negit * Rit + β10 LEVit *Negit * Rit

+ β11 RVRit *Negit * Rit [3]

7
One year in particular drives up the average in the post-SFAS 131 era: in 2003 the estimated coefficient is 0.0987.
Excluding that year the post-SFAS 131 coefficient is essentially zero: -0.0014.

20
 We present the results of estimating model [3] in Table 4. We specified model [3] with

minimal intercept terms to reduce multi-colinearity problems consistent with Khan and Watts

[2007]. Our results are quantitatively and quantitatively similar with and without the control

variables, although SAS diagnostic output suggests that strong multi-colinearity problems exist

when the full set of intercept terms is included. The unconditional asymmetric timeliness

coefficient (β7) is positive and significant, as expected. The Khan and Watts conditional

variables also take on their expected signs. Our variable of interest is β11, which conditions the

asymmetric timeliness on the degree of inter-segment smoothing. Consistent with our earlier

analyses, this estimated coefficient is negative and statistically significant in column one where

the pooled regression model is presented. Thus, the results continue to suggest that inter-

segment smoothing reduces the asymmetric timeliness of earnings. The second column of the

table presents the Fama-MacBeth coefficients and t-statistics. In this specification, the β11

smoothing coefficient is also negative and statistically significant.

As previously noted, we detect an attenuated effect of smoothing on the asymmetric

timeliness of earnings in the years following the enactment of SFAS 131 (1998-2006). If we try

to control for this temporal effect via an additional dummy variable for the change in accounting

regime, we end up with a model that suffers collinearity problems per the SAS diagnostic output.

This is not surprising given the various interactions involved with such a model. That is, we

have dummy variables for both time and negative returns, as well as our smoothing measure

RVR. With all combinations of these variables interacted with the economic income proxy (i.e.,

stock returns, R), the model is difficult to interpret.

In lieu of that approach, we present a simpler model in Table 5. In the first column of

results, we present model [3] which includes the Khan and Watts determinants of asymmetric

21
timeliness, for the pre-SFAS 131 period only. In this model, our smoothing interaction,

coefficient β11 is still negative and significant with a magnitude of -0.0195. In the post-SFAS

131 era presented in the second column, we see that the magnitude of the coefficient has fallen

by roughly 25% to -0.0147, although it is still statistically significant. While this suggests that

SFAS 131 has reduced the ability of inter-segment smoothing to compromise the asymmetric

timeliness of earnings, the standard has not eliminated the effect.

Overall, the results from Tables 3-5 suggest that inter-segment smoothing reduces the

asymmetric timeliness of earnings, consistent with our second hypothesis. Additional analyses

suggest that this effect has attenuated post-SFAS 131, but is still present.

VII. Inter-Segment Smoothing and the Likelihood of Asset Impairments

The results above suggest that inter-segment profit smoothing reduces accounting

conservatism as measured by Basu’s asymmetric timeliness specification. In this section, we

analyze a specific method in which conservatism is applied in order to re-enforce this

conclusion. We analyze whether smoothing reduces the likelihood of accounting accruals that

are used to communicate “bad news,” namely asset impairments or restructuring charges.

If inter-segment smoothing allows firms to avoid undertaking real actions to address

fundamental operational problems, then we expect a negative association between the measure

RVR and the likelihood of an asset impairment or restructuring charge after conditioning on

economic fundamentals. This is the third hypothesis of our paper.

We examine only the time period 2001-2006 as this is when Compustat fields for specific

impairment and restructuring charges are more complete. Compustat has presented the annual

data field “Special Items” (#17) as a record of impairment and restructuring charges since 1950.

22
However, that field contains a myriad of other charges that are not impairments or restructurings.

After reading detailed earnings announcements, Bens and Johnston [2008] screen out a number

of special item charges that are unrelated to restructuring charges or asset impairments for their

study of earnings management via these accruals (see their Table 1). Since 2001 Compustat has

been recording specific charges that are either tangible asset impairments (#380), intangible asset

impairments (#368) or restructuring charges (#376).8 Frankel and Roychowdhury [2007] find

that restructuring charges may reflect opportunistic behavior more than they do the asymmetric

timeliness feature of earnings. Therefore, our primary test focuses on asset impairments alone.

We code our dependent variable D_Spec as one if the firm has recorded an impairment charge to

either tangible or intangible assets. In untabulated results we examine a dependent variable

taking on a value of one if a charge is recorded in any of the three fields for the year, zero

otherwise.

We base most of our control variables on the study by Francis, Hanna and Vincent

[1996], which identified several firm and industry level economic determinants of asset write-

offs and restructuring charges. We also include the change in GDP as a macro variable that is

correlated with restructuring charges (Bens and Johnston [2008]). Finally, we include the three

determinants of asymmetric timeliness identified by Khan and Watts: size, book-to-market, and

leverage. Our variable of interest remains our ranked inter-segment profit smoothing variable,

RVR, which we predict will be negatively associated with the likelihood of recording a write-off.

We present our probit model below, and the specific definitions of the variables follow:

8
While some of these fields appear with non-zero values in 2000, the Compustat dataset appears to be incomplete
for this year. Lee [2008] reaches the same conclusion and ignores this year (see footnote 15).

23
D_Specit = ß0 + ß1Rit + ß2∆Saleit + ß3∆IND_Saleit + ß4∆(∆Sale) it + ß5∆(∆IND_Sale) it + ß6ROAit

+ ß7IND_ROAit + ß8CH_ROAit + ß9CH_IND_ROAit + ß10∆GDPit + ß11RVRit

+ ß12BTMit + ß13LVEit +ß14SIZEit [4]

Consistent with Francis, Hanna and Vincent [1996] we include a variety of variables

intended to control for the economic characteristics of the firm that likely impact the probability

of an asset impairment. We remove special items (of which our dependent variable is a

component) when determining firm financial performance so as to remove the possibility that the

explanatory power of our variable of interest, RVR, is unduly sapped. These variables are

defined as follows:

ROA: Return on assets is calculated as (NIBE – Special Items)/Lagged Total Assets or

(#18 – #17)/#6.

IND_ROA: The average return on assets for the firm’s 2-digit SIC code industry.

∆ROA: The firm’s change in return on assets from the previous year.

∆IND_ROA: The average change in return on assets from the previous year for the firm’s 2-

digit SIC code industry.

∆Sales: The firm’s change in sales (#12) from the previous year.

∆GDP: The year’s change in chained GDP from the Federal Reserve Bank of St. Louis

web-site: http://research.stlouisfed.org/fred2/.

∆IND_Sales: The average change in sales from the previous year for the firm’s 2-digit SIC code

industry.

∆(∆Sales): The change in the firm’s change in sales from the previous year.

∆(∆IND_Sales): The average change in the industry’s change in sales from the previous year for

the firm’s 2-digit SIC code industry.

24
 We present the results of estimating model [4] in Table 6. The first column of results

used independent variables that are raw values, with the exception of RVR which is a ranked

variable by definition. In the second column, all explanatory variables are decile ranked, except

for ∆GDP which is ranked from one to six, corresponding to the number of years in the panel.

Firm specific data is ranked within 2-digit SIC code, whereas industry level data is ranked across

industries.

In both columns, we see a negative and significant [ß11] association between the

likelihood of impairments and inter-segment profit smoothing by multi-segment companies. The

marginal effect from the probit model evaluated at sample means is -0.0067. Thus if a firm

moved from lowest decile to the highest decile of smoothing, then that would suggest the

probability of recording an asset impairment is 6.05% lower (or nine multiplied by .0067).

Moving from one standard deviation below the average RVR to one standard deviation above

decreases the probability of an asset impairment by 3.85%. In untabulated results we find that

when the dependent variable D_Spec is formed using both asset impairments and restructuring

charges the coefficient on our variable of interest, RVR, becomes insignificant but still negative.

This is consistent with evidence in Frankel and Roychowdhury [2007] indicating that

restructuring charges may reflect opportunistic behavior more than they do the asymmetric

timeliness feature of earnings.

This analysis provides complimentary evidence that inter-segment profit smoothing

reduces the conservatism applied in accounting reports. Our analysis in Section VI demonstrates

that the asymmetric timeliness coefficient declines as smoothing increases – suggesting that

recognition of bad economic news is delayed when smoothing is high. In this section we

25
analyzed how a specific set of “bad news” accruals are used with less frequency when smoothing

increases.

VIII. Conclusion

In this paper we create a measure of inter-segment profit smoothing. We conjecture that

this smoothing is positively associated with the information asymmetry between informed and

uninformed shareholders. The intuition is that smoothing profits across segments obfuscates the

actual underlying performance of each segment. We empirically document a positive association

between our inter-segment profit smoothing measure and two common proxies for information

asymmetry: the bid-ask spread and the probability of an informed equity trade.

Past research has demonstrated that U.S. GAAP are applied with a conservative or

asymmetric bias: bad economic news is communicated faster than good economic news. This

“conservatism” in U.S. GAAP is thought to be a strength of financial reporting. We predict that

inter-segment profit smoothing reduces the ability of the accounting system to communicate bad

news in a timely manner. Our empirical results support our prediction. We estimate a regression

of earnings on stock returns, where the returns are separated into good news (i.e., greater than

zero) and bad news (i.e., less than zero), similar to Basu [1997]. We find that the estimated

coefficient relating bad economic news to earnings is reduced by up to 24% as inter-segment

profit smoothing increases.

Finally, we examine a particular manner in which bad economic news is communicated

via the accounting system: through the use of negative non-recurring accruals, specifically asset

impairments and restructuring charges. We predict that the probability of a firm recording such

26
charges will be reduced as they increase the level of inter-segment smoothing. Our results

support this hypothesis.

Our paper examines how firm structure and external reporting choices influence an

important role of financial accounting: the communication of bad news in a timely manner. The

structure we study is the segment reporting choice of the firm. We find that when discretion is

used to reduce the variation across segment profits, the ability of firm level earnings to

communicate bad news on a timely basis is reduced.

27
References

Ball, R. “Infrastructure Requirements for an Economically Efficient System of Public Financial

Reporting and Disclosure.” Brookings-Wharton Papers on Financial Services (2001):
127-182.

Ball, R., S. P. Kothari and A. Robin. “The Effect of International Institutional Factors on
Properties of Accounting Earnings.” Journal of Accounting and Economics 29 (2000):
1-51.

Basu, S. “The Conservatism Principle and the Asymmetric Timeliness of Earnings.” Journal of
Accounting and Economics 24 (1997): 3-37.

Beaver, W. “The Information Content of Annual Earnings Announcements.” Journal of

Accounting Research (1968 – Supplement): 67-92.

Bens, D. A. and R. Johnston. “Accounting Discretion: Use or Abuse? An Analysis of

Restructuring Charges Surrounding Regulator Action.” University of Arizona and Ohio
State University. Working paper (2008).

Berger, P. G. and R. N. Hann. “Segment Profitability and the Proprietary and Agency Costs of
Disclosure.” The Accounting Review 82 (2007): 869-906.

Brown, S. and S. A. Hillegeist. “How Disclosure Quality Affects the Level of Information
Asymmetry.” Review of Accounting Studies 12 (2007): 443-477.

Burgstahler, D. and I. Dichev. “Earnings Management to Avoid Earnings Decreases and

Losses.” Journal of Accounting and Economics 24 (1997): 99-126.

Bushman, R. M. and J. D. Piotroski. “Financial Reporting Incentives for Conservative

Accounting: The Influence of Legal and Political Institutions.” Journal of Accounting
and Economics 42 (2006): 107-148.

Callen, J. O. Hope and B. Segal. “The Pricing of Conservative Accounting and the Measurement
of Conservatism at the Firm-Year Level.” Review of Accounting Studies forthcoming
(2009).

Dechow, P.M. and D.J. Skinner. “Earnings Management: Reconciling the Views of Accounting
Academics, Practitioners and Regulators.” Accounting Horizons 14 (2000): 235-250.

DeFond, M. L. and C. W. Park. “Smoothing Income in Anticipation of Future Earnings.”

Journal of Accounting and Economics 23 (1997): 115-139.

Easley, D., N. M. Kiefer and M. O’Hara. “One Day in the Life of a Very Common Stock.”
The Review of Financial Studies 10 (1997): 805-835.

28
Elgers, P. T., R. J. Pfeiffer and S. L. Porter. “Anticipatory Income Smoothing: A
Re-examination.” Journal of Accounting and Economics 35 (2003): 405-422.

Ettredge, M. L., S. K. Kwon, D. B. Smith and M. S. Stone. “The Effect of SFAS No. 131 on the
Cross-segment Variability of Profits Reported by Multiple Segment Firms.” Review of
Accounting Studies 17 (2006): 91-117.

Financial Accounting Standards Board (FASB). Disclosures about Segments of an Enterprise

and Related Information. Statement of Financial Accounting Standards No. 131 (1997).
Norwalk, CT.

Francis, J., J. D. Hanna and L. Vincent. “Causes and Effects of Discretionary Asset Write-
Offs.” Journal of Accounting Research 34 Supplement (1996): 117-134.

Frankel, R. and S. Roychowdhury. “Predicted Asymmetric Timeliness and the Persistence of

Special Items.” Washington University and MIT. Working paper (2007).

Fudenberg, D. and J. Tirole. “A Theory of Income and Dividend Smoothing Based on

Incumbency Rents.” Journal of Political Economy 103 (1995): 75-93.

Givoly, D., C. K. Hayn and A. Natarajan. “Measuring Reporting Conservatism.” The

Accounting Review 82 (2007): 65-106.

Hann, R. N. and Y. Y. Lu. “Earnings Management at the Segment Level.” University of

Southern California. Working paper (2008).

Harris, M. “The Association between Competition and Managers’ Business Segment Reporting
Decisions.” Journal of Accounting Research 36 (1998): 111-128.

Hayes, R. M. and R. Lundholm. “Segment Reporting to the Capital Market in the Presences of
a Competitor.” Journal of Accounting Research 34 (1996): 261-279.

Healy, P. M., A. P. Hutton and K. G. Palepu. “Stock Performance and Intermediation Changes
Surrounding Sustained Increases in Disclosure.” Contemporary Accounting Research 16
(1999): 485-520.

Khan, M. and R. L. Watts. “Estimation and Validation of a Firm-Year Measure of

Conservatism.” MIT. Working paper (2007).

Lee, Y. G. “An Examination of SFAS 146 Restructuring Charges.” Columbia University.

Working paper (2008).

Leuz, C. and R. E. Verrecchia. “The Economic Consequences of Increased Disclosure.”

Journal of Accounting Research 38 Supplement (2000): 91-124.

29
Ronen, J. and S. Sadan. Smoothing Income Numbers: Objectives, Means and Implications.
Addison-Wesley Publishing Company, Reading, MA (1981).

Ryan, S. G. “Identifying Conditional Conservatism.” European Accounting Review 15 (2006):

511-525.

Schipper, K. “Commentary on Earnings Management.” Accounting Horizons 3 (1989): 91-102.

Watts, R. L. “Conservatism in Accounting Part I: Explanations and Implications.” Accounting

Horizons 17 (2003): 207-221.

30
Table 1
Panel A: Descriptive statistics for variables used in the conservatism tests (n=17,367)
Variable Mean Median Std Deviation Min Max
DEPSit 0.025 0.055 0.145 -1.953 0.781
Rit 0.125 0.076 0.498 -0.968 8.383
RVRit 5.642 6.000 2.861 1 10
Negit 0.411 0.000 0.492 0 1
SIZEit 6.333 6.359 2.088 -0.650 13.112
BTMit 0.670 0.571 0.547 -1.837 11.194
LEVit 0.653 0.341 1.113 0.000 20.238

Panel B: Correlation table for variables used in the conservatism tests (n=17,367)
Pearson Correlation Coefficients Top Right / Spearman Correlation Coefficients Bottom Left
Prob > |r| under H0: Rho=0
DEPSt Rt RVRt Negt SIZEt MTBt LEVt
DEPSit 1 0.1930 0.0403 -0.2435 0.1675 -0.1185 -0.2613
<.0001 <.0001 <.0001 <.0001 <.0001 <.0001
Rit 0.3566 1.0000 0.0087 -0.6465 0.0747 -0.2208 -0.1618
<.0001 0.2499 <.0001 <.0001 <.0001 <.0001
RVRit 0.0282 0.0015 1.0000 -0.0007 -0.1019 0.0155 -0.0149
0.0002 0.8399 0.929 <.0001 0.0406 0.0503
Negit -0.3337 -0.8522 0.0003 1.0000 -0.1696 0.1949 0.1533
<.0001 <.0001 0.973 <.0001 <.0001 <.0001
SIZEit 0.1585 0.1438 -0.1037 -0.1684 1.0000 -0.1399 0.0652
<.0001 <.0001 <.0001 <.0001 <.0001 <.0001
MTBit 0.0582 -0.2307 0.0195 0.1829 -0.1538 1.0000 0.3985
<.0001 <.0001 0.0102 <.0001 <.0001 <.0001
LEVit -0.0242 -0.1499 -0.0188 0.1165 0.1754 0.4040 1.0000
0.0014 <.0001 0.0131 <.0001 <.0001 <.0001

31
Table 2
Panel A: Descriptive statistics for observations with a caclulable B/A Spread (n=11,785)

Variable Mean Median Std Deviation Min Max

DEPSit 0.021 0.050 0.138 -1.843 0.613
Rit 0.133 0.072 0.537 -0.968 8.383
RVRit 5.682 6.000 2.866 1 10
Negit 0.419 0.000 0.493 0 1
SIZEit 6.373 6.334 2.080 0.828 13.112
BTMit 0.637 0.524 0.559 -1.837 11.194
LEVit 0.585 0.299 1.035 0.000 19.353
BA_Sit 2.428 1.492 2.837 0.001 39.820

Panel B: Descriptive statistics for observations with B/A Spread and PIN (n=3,801)

Variable Mean Median Std Deviation Min Max

DEPSit 0.043 0.060 0.107 -1.277 0.613
Rit 0.121 0.091 0.395 -0.951 3.795
RVRit 5.584 6.000 2.760 1 10
Negit 0.386 0.000 0.487 0 1
SIZEit 6.973 7.090 1.726 1.052 12.288
BTMit 0.608 0.519 0.526 -0.825 11.194
LEVit 0.652 0.381 1.030 0.000 19.353
BA_Sit 2.289 1.576 2.165 0.256 19.886
PINit 0.175 0.155 0.080 0.033 0.849

Panel C: Correlation table for information asymmetry related variables

Pearson Correlation Coefficients Top Right / Spearman Correlation
Prob > |r| under H0: Rho=0
RVRit PINit BA_Sit
RVRit 0.0480 0.0792
0.0031 <.0001
PINit 0.0666 0.5048
<.0001 <.0001
BA_Sit 0.0666 0.5548
<.0001 <.0001

32
Table 3
Primary accounting conservatism regressions

DEPSit = ß0 + ß1Negit + ß2Rit + ß3Negit*Rit + ß4RVRit + ß5Negit*RVRit + ß6RVRit*Rit + ß7Negit*RVRit*Rit

Prediction Basic Fama & MacBeth Lagged RVR Fama & MacBeth
Intercept ß0 ? 0.0591 *** 0.0515 *** 0.0574 *** 0.0510 ***
(0.0040) (0.0059) (0.0042) (0.0058)
Negit ß1 ? -0.0255 *** -0.0132 -0.0050 -0.0041
(0.0069) (0.0107) (0.0077) (0.0109)
Rit ß2 ? -0.0254 *** 0.0066 -0.0061 0.0147
(0.0065) (0.0223) (0.0071) (0.0161)
Negit*Rit ß3 ? 0.3036 *** 0.3056 *** 0.3054 *** 0.2602 ***
(0.0179) (0.0538) (0.0216) (0.0576)
RVRit ß4 ? 0.0001 0.0004
(0.0006) (0.0008)
Negt*RVRit ß5 + 0.0021 * 0.0011
(0.0011) (0.0015)
RVRit*Rit ß6 ? 0.0020 ** 0.0008
(0.0010) (0.0024)
Negit*RVRit*Rit ß7 - -0.0081 *** -0.0072
(0.0028) (0.0078)
RVRit-1 ß4 ? 0.0001 0.0004
(0.0007) (0.0005)
Negit*RVRit-1 ß5 ? -0.0010 -0.0008
(0.0012) (0.0015)
RVRit-1*Rit ß6 ? -0.0007 -0.0019
(0.0011) (0.0022)
Negit*RVRit-1*Rit ß7 - -0.0081 ** 0.0015
(0.0034) (0.0079)

Number of Observations 17,367 24 Years 13,710 23 Years

Explanatory 0.1130 0.1589 0.1009 0.1428
Power
Adjusted 0.1127 0.1502 0.1005 0.1318
Explanatory
Power
*** Significant at the 1% level
** Significant at the 5% level
* Significant at the 10% level

33
Table 4
Accounting conservatism regressions using the Watts & Khan C_Score specification

DEPSit = ß0 + ß1Negit + ß2Rit + ß3SIZEit*Rit + ß4BTMit*Rit + ß5LEVit*Rit + ß6RVRit*Rit + ß7Negit*Rit +

ß8SIZEit*Negit*Rit + ß9BTMit*Negit*Rit + ß10LEVit*Negit*Rit + ß11RVRit*Negit*Rit

Prediction Basic Fama Macbeth

Intercept ß0 ? 0.0564 *** 0.0479 ***
(0.0018) (0.0042)
Negit ß1 ? -0.0225 *** -0.0178 ***
(0.0031) (0.0053)
Rit ß2 ? -0.0844 *** -0.1052 ***
(0.0089) (0.0166)
SIZEit*Rit ß3 ? 0.0091 *** 0.0116 ***
(0.0012) (0.0023)
BTMit*Rit ß4 ? 0.0627 *** 0.1073 ***
(0.0065) (0.0241)
LEVit*Rit ß5 ? -0.0559 *** -0.0554 ***
(0.0036) (0.0098)
RVRit*Rit ß6 ? 0.0026 *** 0.0035 **
(0.0007) (0.0014)
Negit*Rit ß7 + 0.5436 *** 0.5658 ***
(0.0196) (0.0421)
SIZEit*Negit*Rit ß8 - -0.0526 *** -0.0652 ***
(0.0026) (0.0071)
BTMit*Negit*Rit ß9 + -0.0711 *** -0.1224 ***
(0.0083) (0.0361)
LEVit*Negit*Rit ß10 + 0.1136 *** 0.1876 ***
(0.0043) (0.0209)
RVRit*Negit*Rit ß11 - -0.0159 *** -0.0147 ***
(0.0017) (0.0030)

Number of Observations 17,367 24 Years

Explanatory Power 0.1650 0.2496
Adjusted Explanatory Power 0.1644 0.2373
*** Significant at the 1% level
** Significant at the 5% level
* Significant at the 10% level

34
Table 5
Conservatism regressions using the Watts & Khan C_Score specification before and after FAS 131

DEPSit = ß0 + ß1Negit + ß2Rit + ß3SIZEit*Rit + ß4MTBit*Rit + ß5LEVit*Rit + ß6RVRit*Rit + ß7Negit*Rit +

ß8SIZEit*Negit*Rit + ß9MTBit*Negit*Rit + ß10LEVit*Negit*Rit + ß11RVRit*Negit*Rit

Prediction Before FAS 131 After FAS 131

Intercept ß0 ? 0.0547 *** 0.0403 ***
(0.0024) (0.0031)
Negit ß1 ? -0.0192 *** -0.0120 **
(0.0041) (0.0053)
Rit ß2 ? -0.0652 *** -0.1108 ***
(0.0133) (0.0124)
SIZEit*Rit ß3 ? 0.0091 *** 0.0142 ***
(0.0018) (0.0017)
BTMit*Rit ß4 ? 0.1018 *** 0.0299 ***
(0.0100) (0.0091)
LEVit*Rit ß5 ? -0.0463 *** -0.0728 ***
(0.0050) (0.0052)
RVRit*Rit ß6 ? 0.0020 * 0.0036 ***
(0.0012) (0.0010)
Negit*Rit ß7 + 0.5135 *** 0.6017 ***
(0.0274) (0.0296)
SIZEit*Negit*Rit ß8 - -0.0511 *** -0.0639 ***
(0.0043) (0.0038)
BTMit*Negit*Rit ß9 + -0.1445 *** -0.0321 ***
(0.0147) (0.0110)
LEVit*Negit*Rit ß10 + 0.1495 *** 0.1182 ***
(0.0066) (0.0060)
RVRit*Negit*Rit ß11 - -0.0195 *** -0.0147 ***
(0.0026) (0.0024)

Number of Observations 10,191 7,173

Explanatory Power 0.1922 0.1633
Adjusted Explanatory Power 0.1913 0.1620
*** Significant at the 1% level
** Significant at the 5% level
* Significant at the 10% level

35
 Table 6
Probability of Writedown

D_Specit = ß0 + ß1Rit + ß2∆Saleit + ß3∆IND_Saleit + ß4∆(∆Sale)it + ß5∆(∆IND_Sale)it + ß6ROAit +

ß7IND_ROAit + ß8CH_ROAit + ß9CH_IND_ROAit + ß10∆GDPit + ß11RVRt + ß12BTMit +
ß13LEVit +ß14SIZEit

Prediction Continuous Ranks

Intercept ß0 ? -1.4116 *** -0.5651 ***
(0.1331) (0.1786)
Rit ß1 - -0.1808 *** -0.1703 ***
(0.0473) (0.0474)
∆Saleit ß2 - -0.2075 *** -0.0465 ***
(0.0803) (0.0111)
∆IND_Saleit ß3 - -0.0612 -0.0301 **
(0.0416) (0.0119)
∆(∆Saleit) ß4 - 0.0079 0.0096
(0.0148) (0.0103)
∆(∆IND_Saleit) ß5 - -0.0951 -0.0204 *
(0.0609) (0.0111)
ROAit ß6 - -1.8541 *** -0.0626 ***
(0.2475) (0.0116)
IND_ROAit ß7 - -0.0175 -0.0373 ***
(0.0312) (0.0134)
CH_ROAit ß8 - -0.0004 0.0063
(0.0011) (0.0089)
CH_IND_ROAit ß9 - 0.0023 -0.0111
(0.0217) (0.0098)
∆GDPit ß10 - 1.2427 0.0071
(2.4669) (0.0137)
RVRit ß11 - -0.0233 *** -0.0238 ***
(0.0084) (0.0084)
BTMit ß12 ? 0.0893 * 0.0322
(0.0485) (0.0513)
LEVit ß13 ? (0.1245) (0.1591)
(0.1412) (0.1438)
SIZEit ß14 + 0.1248 *** 0.1185 ***
(0.0136) (0.0135)

Number of Observations 3,564 3,564

Number with Writedowns (Tangible and/or Intangible) 822 820
Model Log Likelihood -1,828 -1,824
*** Significant at the 1% level
** Significant at the 5% level

36

View publication stats