Financial Distress and the Earnings-Sensitivity-Difference Measure of Conservatism

Abstract

Following Basu (1997), the difference between the sensitivity of accounting earnings to negative equity return (proxy for bad news) and its sensitivity to positive equity return (proxy for good news) is interpreted as an indicator of conditional accounting conservatism. However, there is concern that the earnings-sensitivity difference (ESD) may be affected by factors other than conditional conservatism, and that this may impair its reliability as an indicator of conditional conservatism. Motivated by such concerns and by recognition that financial distress could contribute to an ESD through a conditional-conservatism route and/or through a non-conditional-conservatism route, we examine the association between financial distress and the ESD for U.S. non-financial firms. By decomposing the association into an element arising from accruals, which can reflect conditional conservatism, and an element arising from cash flow from operating activities (CFO), which cannot directly reflect conditional conservatism, we seek evidence as to whether such association arises through a conditional-conservatism route or through a non-conditional-conservatism route. We find that positive association between financial distress and the ESD arises predominantly through the accruals component of earnings rather than the CFO component, consistent with it arising primarily because of a higher degree of conditional conservatism in relatively financially distressed firms. The inference that there is a positive association between financial distress and conditional conservatism is supported by other non-equity-return-based measures of conditional conservatism. The evidence in this paper suggests that the effect of financial distress does not significantly impair the reliability of the ESD as an indicator of conditional conservatism.

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