Journal of Business Finance & Accounting

Journal of Business Finance & Accounting, 36(9) & (10), 1041–1058, November/December 2009, 0306-686X
doi: 10.1111/j.1468-5957.2009.02164.x

Earnings Conservatism and Value

Relevance Across the Business Cycle

David S. Jenkins, Gregory D. Kane and Uma Velury*

Abstract: Prior research has demonstrated higher value relevance of current earnings during
economic expansions relative to contractions. We largely attribute such a result to expected
growth prospects being captured in the current earnings coefficient when a direct proxy for
expected future earnings is omitted from the returns-earnings model. We demonstrate that
the conservatism and value relevance of current earnings is actually higher during economic
contractions when including a proxy for future earnings expectations. We further demonstrate
that the value-relevance of expected future earnings is higher during expansions, when the
association between historical accounting information and future growth opportunities likely
weakens.
Keywords: value relevance, conservatism, business cycle

1. INTRODUCTION
Prior research documents that the relation between stock returns and earnings is
sensitive to the business cycle. In particular, the Earnings Response Coefficient (ERC)
has been shown to be higher during economic expansions than during contractions
( Johnson, 1999). This result can be largely explained by the defining characteristic of
macroeconomic expansion – broad-based economic growth. Furthermore, expansions
are typically longer and thus more persistent than contractions. The higher growth
and persistence associated with macroeconomic expansions alter the contextual
expectations related to reported corporate earnings, resulting in a higher ERC. 1
Recent history, however, suggests that the value relevance of earnings 2 across
the business cycle may be driven by more complex factors that economic growth

∗ The authors are from the Department of Accounting and Management Information Systems, University
of Delaware. They would like to thank Peter Pope (editor) and an anonymous referee for their helpful
comments and suggestions. Data used in this study were obtained from public sources. (Paper received
February 2006, revised version accepted June 2009, Online publication September 2009)

Address for correspondence: David S. Jenkins, Associate Professor, Department of Accounting and
Management Information Systems, University of Delaware, Newark, Delaware 19716, USA.
e-mail: jenkinsd@lerner.udel.edu

1 Prior research has demonstrated a positive relation between ERC and persistence/growth (Collins and
Kothari, 1989).
2 We define value relevance of earnings as the degree of contemporaneous association between earnings
and stock returns. Therefore, we measure value relevance by the magnitude of the ERC.

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and earnings persistence do not fully explain. For example, significant financial
reporting problems manifested during the recent expansion phase of the business
cycle (e.g., 1992–2000). The discovery of and the remedies for many of the financial
reporting problems (e.g., the Sarbanes-Oxley Act of 2002), however, appeared only
after economic contraction began, when there was greater focus on downside risk
by regulators and investors. We posit that increased focus on downside risk during
periods of economic downturns motivates both management and auditors to report
more conservative earnings during contractions. 3 Our reasoning is as follows.
First, the risk of litigation is likely higher during periods of recession, when equity
markets are more likely to experience sharp drops in stock prices. 4 As a result,
periods of economic decline are associated with increased litigation risk. 5 One way to
reduce litigation risk is by reporting conservative numbers (Watts, 1993). Conservatism
increases the contracting efficiency by making bad news available quickly to all parties
and reducing shareholder litigation (Watts, 2003; Ball and Shivakumar, 2005; and Lara
et al., 2009).
Second, the demand for more conservative accounting by investors likely increases
during economic declines due to heightened uncertainty about future outcomes.
Because negative outcomes become more likely during economic decline, investors
demand conservative earnings that provide timely signals for investigating the existence
of negative net present value projects.
Third, firms normally prefer internal sources of funding to external sources, and of
the external sources, debt over equity financing (Myers, 1984). In recession, however,
internal funding may be more constrained as profitability in many firms declines.
Firms will respond by seeking more outside funding. To reduce the information costs
associated with asymmetric information on the part of managers and new outside
stakeholders, more conservative accounting would be demanded during recessions.
In summary, we posit that earnings conservatism is likely to vary across business
cycles. Our findings support our assertion and we document that earnings are more
conservative during recession than during expansions.
Given that there is variation in earnings conservatism across the business cycles,
it follows that the value relevance of earnings varies as well (Watts, 2003; Ball and
Shivakumar, 2005; Choi, 2007; and Brown et al., 2006) When earnings are more
conservative it implies that bad news is reflected in earnings in a more timely manner
relative to good news. As stated earlier, the aforementioned market forces should
result in greater demand for conservatism in accounting numbers during economic
contraction. To the extent that reporting firms respond to the increased demand
for conservative earnings during contractions by reporting more conservatively, there
should be a positive effect on the value relevance of current earnings.

3 Conversely, the incentive to report conservative earnings information is less during expansions. Jenkins
et al. (2007) document a decline in conservatism by clients of Big Six auditors in the United States in late
1990s.
4 For instance, in a testimony to the United States house of Representatives, Michael Perino of Stanford
Law School notes that a significant stock price decline over a short period of time to be a necessary
condition leading to class action securities fraud litigation (see http://securities.stanford.edu/research/
reports/19971021.html).
5 Anecdotal evidence indicates that recessions are marked by increased litigation risk. For instance, according
to the Stanford Law School Securities Class Action Clearinghouse, the number of federal securities fraud
class action lawsuits dramatically increased from 188 in the year 1995 to 497 in 2001 (i.e., recessionary period)
and dropped to 116 in 2006 (http://securities.stanford.edu/index.html).

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Conversely, market forces likely exhibit relatively less demand for conservative
accounting numbers during economic expansions. In addition, growth opportunities
are relatively higher during expansions and since accounting numbers are historical
measures of performance, there is a greater disconnect between historical earnings
and future growth opportunities. As a result, investors presumably will rely more on
non-historical accounting sources of information to derive expectations about future
performance and value. As such, it is likely that the value relevance of current earnings
will decrease during expansions as investors rely less on conservatively reported
historical earnings and more on expectations about future earnings.
To detect the variation in value relevance across economic cycles, a means of directly
modeling information contained in current earnings about expected future earnings
is necessary. Recent research (Warfield and Wild, 1992; and Lundholm and Myers,
2002) indicates that when a proxy for future earnings expectations is omitted from
the returns-earnings model, the coefficient of current earnings captures expectations
about future earnings, which could yield higher ERCs. Consequently, the higher ERC
during expansions demonstrated in Johnson (1999) may not represent higher value
relevance during expansions, but instead may be the result of expectations about future
earnings being captured by current reported earnings. Consistent with Lundholm
and Myers (2002), modeling value relevance by including a direct proxy for expected
future earnings yields a more direct measure of the contemporaneous relation between
earnings and stock returns across business cycles and represents an extension to existing
research.
To summarize, we first investigate whether conservatism varies across business cycles.
Our findings indicate that earnings are more conservative during contractions than
during expansions. These results indicate that the incentives to report conservative
earnings vary across business cycles, with greater demand for the reporting of
conservative earnings during contractions. Next, using Lundholm and Myers (1992),
we investigate the value relevance of earnings across business cycles. We find that the
value relevance of current earnings is higher during contraction relative to expansion.
These findings imply that when business cycles are marked by the reporting of
conservative earnings, investors find information in current earnings more useful for
firm valuation purposes. We also examine the relative value relevance of expected future
earnings across business cycles and show that the value relevance of future earnings
expectations is significantly higher during expansion relative to that of contraction.
These results indicate that during expansions investors rely more on non-historical
earnings information to form expectations about future earnings.
The findings of this research have potential implications for investors, auditors and
regulators. For investors, the business cycle is a relevant factor in determining equity
value using earnings information, as current reported earnings and expected future
earnings relate to value differently during different phases of the business cycle. For
auditors and regulators, the disparity in accounting conservatism across the business
cycle implies that accounting principles may not be consistently applied across varying
economic conditions and that financial reporting may be generally more aggressive
during periods of economic growth.
The remainder of this paper is organized as follows. In Section 2 we provide
background and theoretical development of our hypotheses. The research design
is discussed in Section 3 and the empirical results are discussed in Section 4. The
conclusions are presented in Section 5.


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2. BACKGROUND AND HYPOTHESIS DEVELOPMENT

(i) Business Cycles and Accounting Information

Because accounting information reflects the effects of both firm-specific activities
and general macroeconomic conditions, the information content of accounting
information arguably varies across the business cycle. Supporting this, Richardson
et al. (1998) find that the accounting-based models used to predict corporate failure
are sensitive to the occurrence of a recession. They find the usefulness of accounting
variables in predicting failure to be a function of whether the business cycle is
recessionary. Similarly, Kane et al. (1996) find that controlling for recessions improves
the explanatory power of failure prediction models. These studies together suggest that
accounting numbers are likely to convey different information during different stages
of the business cycle.

(ii) Accounting Conservatism

The accounting literature discusses two types of conservatism: unconditional conser-
vatism and conditional conservatism (e.g., Beaver and Ryan, 2005). Unconditional
conservatism refers to the reporting of conservative accounting numbers not condi-
tioned on the economic reality. For instance, depreciating the cost of an asset over five
years instead of 10 years is likely to lower current earnings. However, such a write-off
might not correspond to economic reality as measured by the life of the asset.
Conditional conservatism, on the other hand, is the reporting of accounting
numbers conditional on the firm experiencing contemporaneous economic loss. This
definition of conservatism captures the timely reporting of economic loss. From a
contracting perspective unconditional conservatism provides numbers that are biased.
If the bias is known, investors can make adjustments for the known bias in their
decision models. If the bias is not known, however, investors can make erroneous
decisions by using biased numbers. Ball and Shivakumar (2005, p. 91) note that
‘while unconditional conservatism seems inefficient or at best neutral in contracting,
conditional conservatism (timely loss recognition) can enhance contracting efficiency.’
In this study, we focus on conditional conservatism, which involves timely recognition
of economic losses.

(iii) Conservatism and Business Cycles

There are a number of reasons to believe that conditional earnings conservatism is
higher during periods of economic recession. First, securities litigation typically occurs
following economic declines, when events such as sharp declines in stock prices are
more likely. To address the heightened litigation risk during economic contractions,
firms generally report more conservatively. Several studies in auditing provide evidence
in support of this argument, showing that auditors respond to litigation risk by
encouraging the reporting of conservative earnings. For instance, Huijgen and
Lubberink (2001) document evidence that firms report more conservatively in high
legal liability regimes. Presumably due to increased litigation risk, client firms of Big-4
auditors have also been documented to report more conservatively in the post-Enron
climate (Willekens and Bauwhede, 2003; and Krishnan, 2006).
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Second, the threat of increased regulatory scrutiny, resultant from more public
uncertainty about the existence and impact of hidden bad news, arguably motivates
the reporting of conservative accounting numbers. During such periods of uncertainty
and heightened interest in information about bad news, regulators tend to respond with
increased scrutiny. Such scrutiny potentially increases the risk to investors of possible
earnings restatement and the attendant investment losses that would manifest. The
reporting of conservative earnings mitigates this risk.
Third, firms normally prefer internal sources of funding to external sources, and
of the external sources, debt over equity financing. This is the result of adverse
selection and increased information costs associated with obtaining external financing,
especially as it relates to equity financing (Myers, 1984). In recession, however, reduced
profitability generally points to the possibility that internal funding may be more
constrained. As a result, more firms will seek external financing. Suppliers of debt
financing should demand more conservative accounting because it better informs
about the risk of default. The cost of equity capital would also be sensitive to earnings
conservatism, particularly during recession when bad news events are more likely.
Supporting the above assertions, empirical studies have documented the benefits
of conservative reporting by showing that conservatism is associated with relatively
lower cost of equity (Francis et al., 2004) and lower cost of debt (Zhang, 2004).
In sum, the shift from internal to external sources of financing that might occur
during recession should affect an increase in demand for more conservative accounting
information.
Thus, consistent with all of the arguments presented above, we posit that firms
will exhibit more conservative financial reporting during economic contraction. We
formally state this hypothesis (in alternative form) as follows:

H 1 : Earnings are relatively more conservative during contractionary economic

cycles than during expansionary cycles.

(iv) Business Cycles and the Value Relevance of Current and Expected Future Earnings
Assuming earnings conservatism is found to be sensitive to the business cycle, it
follows that there may be implications for value relevance research, in particular
the very large literature concerning earnings response coefficients (ERCs). There is
prior research evidence that ERCs vary across the business cycle. Johnson (1999), in
particular, finds that ERCs are higher during periods of expansion than those during
recession.
Johnson’s model, however, does not discriminate between current and expected
future earnings. As mentioned earlier, without a direct proxy for expected future
earnings, the ERC includes the effects of future earnings expectations and can mask the
true contemporaneous returns-earnings relation. Therefore, similar to Lundholm and
Myers (2002), we include a proxy for expected future earnings in the value relevance
models, thus allowing the relation between returns and current and expected future
earnings to be measured separately.
We suggest that the value relevance of contemporaneous earnings, after control-
ling for expected future earnings, will increase during economic contraction. Our
explanation for this expectation is as follows. First, bad news scenarios likely have
greater uncertainty with respect to magnitude, duration and eventual emergence

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during contraction relative to those during economic prosperity. Bad news that occurs
during recession implies that the negative events may be sensitive to the adverse
macroeconomic conditions. Although economic recessions have historically been
transitory in nature, the economic impact of recession on many firms, particularly
those experiencing bad news scenarios, may persist well beyond the macroeconomic
turnaround. 6 As a result, expectations of future earnings are thus more speculative
during such periods and investors likely rely more on current earnings information
to form expectations. Furthermore, given the uncertainty that typically surrounds any
impending economic turnaround, current conditions are likely viewed by the market
as relatively more persistent. Thus, conditionally conservative earnings, because they
better reflect the negative economic conditions are also likely viewed as more persistent,
and hence value relevant, by the market. In summary, although bad news scenarios are
less persistent in the general case (Basu, 1997), we posit that this is often not the
case during economic contractions, when bad news scenarios take on relatively more
persistent characteristics. Hence, greater conditional earnings conservatism implies
that current earnings are more predictive of future earnings, which should result
in larger earnings response coefficients (see Collins and Kothari, 1989) on current
earnings.
Second, conditionally conservative earnings are more informative about bad news
events, thus lowering the information risk investors face (i.e., the possibility of bad
news for which they are unaware). Both of these factors, asymmetric persistence of
conditionally conservative earnings, and the lowered information risk implied by such
conservatism, are arguably amplified during contractions when downside exposure is
greatest and investors are most focused in updating expectations of systematic declines
in profitability and the associated increase in investment risk. The timely reporting of
bad news aids investors in making assessments of the increased downside exposure,
including the potential for mitigating actions by firms and their bearing on expected
future results, thus increasing the value relevance of more conditionally conservative
current earnings.
Prior research provides some support for the notion of a positive relation between
conditional conservatism and value relevance (e.g., Watts, 2003; Ball and Shivakumar,
2005; and Choi, 2007). Specifically, Ball and Shivakumar (2005) states that timely loss
recognition implies higher correlation between accounting information and market
values, which in turn suggests a positive relation between conditional conservatism and
value relevance. In addition, Givoly and Hayn (2000) suggest that greater earnings
conservatism may partially explain higher earnings multiples. Brown et al. (2006)
empirically demonstrates that in countries with high accrual intensity the value
relevance of earnings is positively associated with conditional conservatism.
Based on the conceptual arguments and empirical evidence we cite here, we believe
the value relevance of earnings, after controlling for expected future earnings, should
be higher (as opposed to lower) during periods of economic decline, which would
ostensibly contradict findings from previous research (Johnson, 1999). Formally we
test the following hypothesis:

6 Consider, for example, US blue-chip company General Motors (GM), which experienced significant
adverse effects as a result of the economic recession in 2008. In December 2008 GM needed significant
bailout funds from the US Government to stave off immediate bankruptcy. Months later on June 1, 2009,
GM filed for Chapter 11 bankruptcy protection and significant losses are expected for the foreseeable future.

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H 2 : The value relevance of current earnings, while controlling for future earnings
expectations, is greater during economic contractions as compared to that of
expansions.

Finally, we anticipate that expected future earnings will be positively associated with
expansion, as compared to recessionary environments. First, following the arguments in
Johnson (1999), different stages of the business cycle reflect variation in the aggregate
investing and financing opportunity set, which in turn implies a variation in the manner
in which the market uses earnings information to revise expectations about future cash
flows. Specifically, it is likely that during economic expansion the market will be more
focused on factors affecting future earnings growth and less on factors such as the
degree of conservatism in financial reporting and the risk of litigation and regulatory
scrutiny that mark economic declines.
Second, given a greater disconnect between reported earnings and future growth
opportunities during expansion, investors are likely to rely more on non-historical
earnings information to make assessments of expected future earnings and to place a
greater weight on expected future earnings in determining value. Collectively, these
factors suggest that the value relevance of expected future earnings is expected to be
greater during expansions relative to contractions. Formally, our third hypothesis is
stated (in alternative form) as follows:

H 3 : The value relevance of expected future earnings is greater during expansionary

economic cycles as compared to that of contractionary cycles.

3. RESEARCH DESIGN

(i) Measurement of Conservatism

Our measure of conservatism uses the regression identified by Basu (1997) with annual
earnings as the dependent variable. 7 This measure has been used in several studies (e.g.,
Pope and Walker, 1999; Ball et al., 2000; Huijgen and Lubberink, 2001; and Ball et al.,
2003). The model is based on the premise that stock prices reflect information from
sources other than financial statements and that stock prices lead earnings information
(Ball and Brown, 1968; Beaver et al., 1980; and Kothari and Sloan, 1992). Thus, a
positive association between negative market returns (i.e., bad news) and earnings
suggests timely reporting of bad news relative to that of good news (e.g., earnings
incorporates publicly available information conservatively). We use the following fixed-
effects model 8 to test the level of earnings conservatism:

EARNit = μt + β1 RETit + β2 DRETit + β3 RETit ∗ DRETit + δi + εit (Model 1)

where, for firm i in year t:

7 Basu (1997, p.11) notes that in his model, ‘OLS standard errors and test statistics are better specified when
the leading variable is specified as independent and the lagging variable as dependent.’
8 Because of potential non-stationarity in the model variables, all models include fixed-effects estimators
for time and firm. For convenience of presentation, the coefficients for time and firm are not shown in the
results.


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μ = Time-varying intercept
EARN = Net income deflated by market value of equity at the beginning of the period;
RET = Fiscal year stock return;
DRET = Dichotomous variable set equal to one if RET < 0; else set equal to zero;
δ = Firm fixed-effects estimator;
ε = Error Term.

In the above model, EARN is all inclusive, or ‘bottom line’ net income. That is to
say, it includes both transitory (e.g., discontinued operations and extraordinary items)
and non-transitory items that are reported. The reason we utilize the broadest income
definition is that conditional conservatism may very well be detected within transitory
classifications. For example, a transitory loss associated with recession may be deemed
as unususual and infrequent, thus qualifying for classification as an extraordinary item.
β 1 captures the response of earnings to returns when returns are positive and β 1 +
β 3 capture the response of earnings to returns when returns are negative. If β 1 + β 3 >
β 1 (or β 3 > 0) then earnings are conservative. In other words, a positive and significant
β 3 would indicate that earnings reflect bad news more quickly than good news.
In order to analyze the effect of business cycles on earnings conservatism, we modify
Model 1 as follows:

EARNit = μt + β1 RETit + β2 DRETit + β3 RETit ∗ DRETit + β4 EXPt

+ β5 EXPt ∗ RETit + β6 EXP ∗ DRETit
+ β7 EXPt ∗ RETit ∗ DRETit + δi + εit . (Model 1a)

Where EXP is a dichotomous variable coded one if the economy is expanding, else
zero. β 5 measures the incremental effect of business cycle on the timeliness of good
news recognition and β 5 + β 7 measures the impact of business cycle on the timeliness
of bad news recognition. A negative and significant β 7 would indicate that the earnings
conservatism is less during expansion relative to contraction and would provide support
for Hypothesis H 1 .

(ii) Value Relevance of Earnings

We define value relevance by the following fixed-effects model:

RETit = μt + α1 EARNit + α2 EARNit + δi + εit . (Model 2)

Where RET is annual stock return, EARN is annual earnings before extraordinary items
(deflated by beginning market value of equity), EARN is change in annual earnings
before extraordinary items (deflated by beginning market value of equity), δ is the
fixed-effects estimator and i and t are firm and year subscripts, respectively. It should
be noted here that the value relevance and conservatism models we employ utilize
slightly different measures of earnings. In particular, our measure of EARN is net
income for our conservatism models while the value relevance model uses earnings
before extraordinary items. This is because although inclusion of transitory items is
appropriate for measuring conservatism, the persistent component of earnings is much
more value relevant (see for example, Kormendi and Lipe, 1987). Hence, we exclude
the effect of extraordinary items in our value relevance tests. We should also note that,
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as a practical matter, the effect of the difference between net income and earnings
before extraordinary items on the regression models is quite negligible. There is no
difference between the variables in nearly 90% of the sample observations and the
Pearson correlation coefficient between the two variables is 0.922.
Our specification of value relevance is consistent with the model developed in Easton
and Harris (1991) and used in subsequent studies such as Francis and Schipper (1999),
Lev and Zarowin (1999) and Ely and Waymire (1999). In this specification, the sum of
the coefficients α 1 and α 2 represents the combined ERC (see Ali and Zarowin, 1992,
p. 289; and Lev and Zarowin, 1999, p. 356). This specification also recognizes that
earnings contain both permanent and transitory components. Inclusion of earnings
changes alone assumes that earnings are purely permanent while also including
earnings levels accounts for the presence of transitory components in reported earnings
(see Ali and Zarowin, 1992, for a complete discussion).
We modify the above model by adding a variable to proxy for expectations of future
earnings. Following Beaver et al. (1980), Warfield and Wild (1992) and Lundholm and
Myers (2002), we utilize realized future earnings as a proxy for changes in expected
future earnings. Realized future earnings, however, has both expected and unexpected
components. Consider the following specification:

E (EARN)t+1 = EARNt+1 + UEt+1 . (1)

The above specification states that expectations about earnings in t + 1 equals the
summation of actual earnings in the year t + 1 and measurement error or earnings
surprise. Because the expected and unexpected components of future earnings are
not directly observable, similar to Collins et al. (1994), the unexpected shock to future
earnings, i.e., earnings surprise, is captured by future stock returns in year t + 1. 9
The reason is that the unexpected shock to future earnings is measurement error
when using realized future earnings to proxy for expected future earnings at year t.
Unexpected shocks to future earnings will generate future returns. Thus, future returns
controls for the measurement error associated with the use of future earnings as a proxy
for expected future earnings at year t. Combining equation (1) with Model (2) and
proxying year t + 1 returns for unexpected earnings, Model (2) can be modified as
follows:

RETit = μt + α1 EARNit + α2 EARNit + α3 EARNit+1

+ α4 RETt+1 + δi + εit . (Model 2a)

To test our hypothesis, we modify the above equation and interact all the variables
with a dichotomous variable to denote the business cycle. The following model is

9 One possible alternative for an ex-ante proxy of expected future earnings for year t + 1 would be analysts’
forecasts of earnings at year t. We do not use this proxy because analysts’ forecasts are affected by market
biases towards conservatism, which is a characteristic of interest. As a result, utilizing the forecasts could
misrepresent the information content of current earnings. The value relevance literature (e.g., Francis and
Schipper, 1999; and Lev and Zarowin, 1999), for this reason, uses only past and current earnings to proxy
for unexpected earnings in year t.


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examined to test Hypotheses H 2 and H 3 :

RETit = μt + α1 EARNit + α2 EARNit + α3 EARNit+1 + α4 RETt+1

+ α5 EXPt + α6 EARNit ∗ EXP + α7 EARNit ∗ EXPt
+ α8 EARNit+ ∗ EXPt + α9 RETt+1 ∗ EXPt + δi + εit . (Model 2b)

(iii) Potential Simultaneity Bias

In the above system of equations, the specification indicates that both stock returns
and earnings may be endogenous variables, which gives rise to a potential simultaneity
bias. Consequently, we employ a two-stage least squares approach for our conservatism
and value relevance models as follows. All variables in the system except for RET it and
EARN it are considered exogenous variables. In the first stage regressions, we regress
RET it and EARN it on the exogenous variables. In the second-stage regressions, the fitted
values of RET it and EARN it (hereafter RETHAT it and EARNHAT it ) from the first-stage
regressions are substituted for RET it in models 1 and 1a and for EARN it in Models 2,
2a and 2b, respectively. The subsequent results reflect this two-stage approach.

(iv) Definition of Business Cycle Events

The timing of business cycle changes, and the stock market’s discounting of the
economic impact of those changes, are not typically concurrent. Because the market
is forward-looking, and signals of a greater likelihood of recession (e.g., rising interest
rates) and expansion (e.g., loosening monetary policy) often manifest beforehand,
the stock market’s discounting of business cycle effects typically precedes the onset of
related economic events. Unfortunately, precise identification of starting and ending
points of the discounting mechanism is ultimately arbitrary. For this reason, we are
aware of no currently objective operational definition of a bull and bear stock market
that discounts the business cycle. Perhaps in recognition of this limitation, most prior
research on the business cycle has utilized an economic, as opposed to a market-based,
definition of the business cycle. The reasoning behind the use of this definition is as
follows. First, the National Bureau of Economic Research (NBER) provides an objective
measure of the economic business cycle that is readily available and, using extensive
analysis, identifies ex-post peaks and troughs in economic activity, thus marking the
onset and end of economic contraction and expansion. Second, to the extent that
the magnitude and duration of contraction and expansion are not anticipated, but
discounted concurrently with the economic cycle itself, such an operational definition
will capture the impact of the business cycle on stock market returns. 10 Finally, any
misspecification of the discounting mechanism necessarily results in reducing the
power of our tests to find significant results. Of course, it is possible that the timing of
the discounting mechanism is different in contraction and expansion. Although there
is no reason, a priori, that we can identify to support this notion, it does represent an
alternative explanation for our results, thus representing a limitation in how our results
are to be interpreted.

10 Based on average stock market returns during expansion and recession, much of the business cycle’s
economic effects are apparently not anticipated.

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In summary, lacking a sufficiently objective measure, consistent with prior research

we utilize the well-accepted measure based on the NBER Business Cycle Expansions
and Contractions data. The NBER data is essentially a timeline that defines economic
cycles based on whether the economy is expanding or contracting at a given point in
time based on several macroeconomic factors. Figure 1 illustrates the economic cycle
from 1980 to 2003 based on the NBER criteria in terms of both economic performance
and NBER announcement dates. We test our foregoing hypotheses by categorizing
each year of our sample period as either ‘Expansion’ or ‘Contraction’ (hereafter, EXP
and CON, respectively) based on the predominant NBER classification for the year
(e.g., whichever state prevails for more than six months of a given year). The annual
classifications are presented in Table 2. Not surprisingly, a great majority of the years
in the study are classified as EXP, which is to be expected in a generally expanding
economy such as that of the United States.

Figure 1
National Bureau of Economic Research (NBER) Business Cycle Expansions and
Contactions (1980–2003)
CON EXP CON EXP CON EXP CON EXP

Cycle dates 1/80 7/80 7/81 11/82 7/90 3/91 3/01 11/01
Announcement 6/80 7/81 1/82 7/83 4/91 12/92 11/01 7/03
dates

Source: http://www.nber.org/

(v) Sample Selection

The sample consists of all firm-years listed on COMPUSTAT from 1980 to 2003 that
have the required financial information. To eliminate the effect of outliers, the top
and bottom 1% of all model variables are deleted. These procedures yield 120,070
firm-year observations for the full sample. Dichotomization of the full sample based
on the NBER classification results in 101,219 EXP firm-year observations and 18,851
CON firm-year observations. While there are only five years classified as contractions
in our dichotomization, versus 19 for expansions, we feel that this potential limitation
is somewhat mitigated by the large sample size of contraction observations.

4. EMPIRICAL RESULTS

(i) Descriptive Statistics

NBER business cycle classifications for each year in the study are presented in
Table 1. Descriptive statistics for the full sample are provided in Panel A of Table 2.
Panel B provides descriptive statistics and difference of means analysis for the EXP and
CON groups. From Panel A. mean annual stock returns are approximately 0.08 for
the full sample and 0.09 (0.02) for the EXP (CON) sample. Meanwhile, mean deflated
earnings are 0.028 for the full sample and 0.025 (0.043) for the EXP (CON) sample.
Mean deflated earnings changes are 0.010 for the full sample and 0.013 (−0.008) for the

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Table 1
NBER Annual Business Cycle Classifications
Year Business Cycle Classification

1980 Contraction
1981 Contraction
1982 Contraction
1983 Expansion
1984 Expansion
1985 Expansion
1986 Expansion
1987 Expansion
1988 Expansion
1989 Expansion
1990 Contraction
1991 Expansion
1992 Expansion
1993 Expansion
1994 Expansion
1995 Expansion
1996 Expansion
1997 Expansion
1998 Expansion
1999 Expansion
2000 Expansion
2001 Contraction
2002 Expansion
2003 Expansion
Notes:
Each year of the study is classified as an expansion/contraction year based on the
prevailing NBER business cycle classification for the majority of that year (i.e.
greater than six months).

EXP (CON) sample. As expected, stock returns and earnings changes are significantly
greater for the EXP group. Somewhat surprisingly, mean deflated earnings levels are
significantly greater for the CON group. 11

(ii) Asymmetric Timeliness (Earnings Conservatism) Tests

Results of the Asymmetric Timeliness Models 1 and 1a are presented in Table 3.
Model 1 results are provided to calibrate the sample with the Basu (1997) results.
The coefficients from Model 1 are all significant and are of similar sign and magnitude
to those of Basu (1997). These results show, as expected, that bad news is reflected in
earnings in a more timely manner than good news. Model 1a expands the Basu (1997)
framework to measure the impact of the business cycle on earnings conservatism. Two
key results emerge from Model 1a. First, the positive and significant coefficient on β 5
(RETHAT ∗ EXP) indicates that, consistent with prior research (e.g., Johnson, 1999),
the earnings-return relation is greater during EXP than during CON. Again, as we

11 Further investigation of this surprising result reveals that, although deflated earnings are larger for CON,
mean undeflated earnings are, as one might expect, greater for EXP ($68.1M vs. $45.4M). The primary
reason that deflated earnings are larger for CON is that the deflator (market value of equity) is larger for
EXP ($1,413M vs. $982M).

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Table 2
Descriptive Statistics (N = 120,070)
Panel A: Full Sample
Variable Mean Median Standard Deviation

RET 0.080 0.027 0.457

EARN it 0.028 0.063 0.210
EARN it 0.010 0.009 0.193
DRET it +1 0.469 0.000 0.499
EXP t 0.843 1.000 0.364
Panel B: Difference of Means (Between Business Cycle Groups)
Contraction Expansion
Variable (N = 18,851) (N = 101,219) Difference
RET it 0.020 0.091 0.071∗∗∗
EARN it 0.043 0.025 −0.018∗∗∗
EARN it −0.008 0.013 0.021∗∗∗
Notes:
This table presents descriptive statistics for key variables for the full sample (Panel A) and the sample
disaggregated into the contraction and expansion business cycle groups (Panel B). We also present in
Panel B results of t-tests for differences of means for the between the business cycle groups. ∗∗∗ , ∗∗ , ∗ implies
significance at the 0.01, 0.05 and 0.10 levels, respectively.
RET is annual stock returns, EARN is earnings before extraordinary items, EARN is earnings change from
year t − 1 to year t, DRET is a categorical variable set to 1 if returns are negative and 0 otherwise. EXP is a
categorical variable set equal to 1 if the NBER economic cycle classification is expansion and 0 otherwise.

will show in the subsequent section, this result only holds if expected future earnings
are not included in the model. The second and main result from Model 1a is that
the coefficient on β 7 (RETHAT ∗ DRET ∗ EXP) is negative and significant. Thus, the
asymmetric timeliness coefficient, partitioned on the business cycle, is smaller during
expansions than during contractions. This implies that, consistent with Hypothesis
H 1 , earnings are more conservative for CON as compared to that of EXP. As stated
previously, we posit that the differential earnings conservatism impacts the value
relevance of earnings to investors.

(iii) Value Relevance Tests

The results from our value relevance tests (Models 2, 2a and 2b) are presented in
Table 4. Model 2 is the basic Easton and Harris (1991) framework, in which returns is a
function of both earnings levels and earnings changes. Model 2 is provided to calibrate
the sample with expectations based on prior research. From Model 2 the combined
coefficients α 1 and α 2 (earnings levels and changes) sum to approximately 1.28 and the
model R 2 is approximately 11.6%. Both of these results are reasonable in the context
of the voluminous extant ERC literature.
Model 2a, in the spirit of Warfield and Wild (1992) and Lundholm and Myers (2002),
expands the basic returns-earnings relation to specifically measure expected future
earnings. Again, because inclusion of future returns proxies for future unexpected
earnings, the coefficient on actual future earnings measures the impact of expected
future earnings on year t stock return. In the absence of the inclusion of a proxy for
expected future earnings in the model, the effects of future earnings expectations are
captured by the coefficient on current earnings. Consistent with Lundholm and Myers

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Table 3
Regression Results - Asymmetric Timeliness Model (N = 120,070)
Model 1 : EARNit = μt + β1 RETit + β2 DRETit + β3 RETit ∗ DRETit + δi + εit
Model 1a : EARNit = μt + β1 RETit + β2 DRETit + β3 RETit ∗ DRETit + β4 EXPt
+ β5 RETit ∗ EXPt + β6 DRETit ∗ EXPt
+ β7 RETit ∗ DRETit ∗ EXPt + δi + εit
Expected Sign Model 1 Model 1a

Intercept + Not shown Not shown

RETHAT it + 0.019 0.010
(0.69) (0.64)
DRET −0.028∗∗∗ −0.035∗∗∗
(−11.32) (−7.62)
RETHAT it ∗ DRET it + 0.146∗∗∗ 0.177∗∗∗
(33.64) (16.93)
EXP t −0.393
(17.29)
RETHAT it ∗ EXP t 0.077∗∗∗
(35.85)
DRET it ∗ EXP t 0.038∗∗∗
(8.04)
RETHAT it ∗ DRET it ∗ EXP t − −0.124∗∗∗
(−10.81)
Adjusted R-squared 0.389 0.396
Notes:
This table presents results of two-stage least squares regression with a firm fixed-effects estimator for
the asymmetric timeliness Models 1 and 1a. T -statistics are presented in parenthesis and ∗∗∗ , ∗∗ , ∗ implies
significance at the 0.01, 0.05 and 0.10 levels, respectively.
EARN is net income deflated by beginning market value of equity. RETHAT is the first-stage estimate of
annual stock returns. DRET is a categorical variable set to 1 if returns are negative and 0 otherwise. EXP is
a categorical variable set equal to 1 if the NBER economic cycle classification is expansion and 0 otherwise.

(2002), we show a positive and significant coefficient on actual year-ahead earnings

and a negative and significant coefficient on actual year-ahead returns
With respect to our hypotheses, Model 2b, which expands Model 2a to include the
effect of the business cycle on the returns–earnings (current and future) relation,
provides two primary results. First, α 6 and α 7 , which measures the effect of the EXP
business cycle on the relation between returns and current earnings levels and changes,
respectively, are both negative. This indicates that, when including an explicit estimate
of expected future earnings in the model, the value relevance of current earnings
is actually lower during expansion. From Model 2b it is easily determined that the
combined ERC for CON (EXP) is approximately 1.356 (1.080). Thus, the ERC on
current earnings levels and changes is approximately 0.276 (26%) higher for the CON
group (F = 3.28, p = 0.07), while controlling for expected future earnings. Hypothesis
H 2 is therefore supported.
Second, the coefficient α 8 from Model 2b measures the differential effect of
expected future earnings on current returns for EXP as compared to CON. The
positive and significant coefficient α 8 indicates that expected future earnings are
considerably more value relevant during expansion than during contraction. With
respect to magnitude, the coefficient on expected future earnings is 0.315 and 0.442
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Table 4
Regression Results - Value Relevance of Current and Expected Future Earnings
(N = 120,070)
Model 2 : RETit = μt + α1 EARNHATit + α2 EARNit + δι + εit
Model 2a : RETit = μt + α1 EARNHATit + α2 EARNit + α3 EARNit+1 + α4 RETit+1
+ δι + εit
Model 2b : RETit = μt + α1 EARNHATit + α2 EARNit + α3 EARNit+1 + α4 RETit+1
+ α5 EXPt + α6 EARNHATit ∗ EXPt + α7 EARNit ∗ EXPt
+ α8 EARNit+1 ∗ EXPt + α9 RETit+1 ∗ EXPt + δι + εit

Expected Sign Model 2 Model 2a Model 2b

Intercept Not shown Not shown Not shown

EARNHAT it 0.082∗∗ 0.064∗∗ 0.184∗∗
(1.99) (1.67) (2.67)
EARN it + 1.202∗∗∗ 1.105∗∗∗ 1.172∗∗∗
(32.71) (30.43) (13.12)
EARN it +1 + 0.403∗∗∗ 0.315∗∗∗
(46.84) (14.76)
RET it +1 − −0.177∗∗∗ −0.165∗∗∗
(−54.65) (−18.41)
EXP t −0.026∗∗
(−2.81)
EARNHAT it ∗ EXP t − −0.175∗∗
(−1.97)
EARN it ∗ EXP t − −0.101
(−1.14)
EARN it +1 ∗ EXP t + 0.127∗∗∗
(5.60)
RET it +1 ∗ EXP t −0.014
(−1.41)
Adjusted R-squared 0.116 0.149 0.151
Notes:
This table presents results of two-stage least squares regression with a firm fixed-effects estimator for
the value relevance Models 2, 2a and 2b. T -statistics are presented in parenthesis and ∗∗∗ , ∗∗ , ∗ implies
significance at the 0.01, 0.05 and 0.10 levels, respectively.
RET is annual stock return. EARNHAT is the first-stage estimate of earnings before extraordinary items.
EARN is deflated earnings before extraordinary items. EARN is deflated earnings change from year t − 1
to year t is a categorical variable set to 1 if returns are negative and 0 otherwise. EXP is a categorical variable
set equal to 1 if the NBER economic cycle classification is expansion and 0 otherwise.

(=0.315 + 0.127) for CON and EXP, respectively (this represents a 40% difference).
Again, we posit that lower earnings conservatism and the use of non-earnings informa-
tion to formulate future earnings expectations are significant factors influencing this
finding, which supports Hypothesis H 3 .

(iv) Sensitivity Analysis

An alternative explanation for the variation in ERC across the business cycle is that
anytime there is a turning point in the business cycle (e.g., the state of the business
cycle in the current period differs from that of the previous period) there will be

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a reduction in ERC because historical performance will be less informative about

future performance. We hypothesize that while this is likely true, based on the same
arguments presented previously the effect should be greater when the turning point
is a transition from contraction to expansion than from expansion to contraction.
To test the foregoing arguments, we first identify years in which there is a change
in the state of the business cycle from the preceding year (1983, 1990, 1991, 2001
and 2002) and re-run Model 2b dichotomized on change and non-change years. The
results demonstrate a significant decrease (increase) in current (future) ERC during
‘cycle change’ years (F = 3.22 and t = 4.15, respectively), indicating reduced value
relevance of current earnings following business cycle turning points. Next, we further
dichotomize business cycle changes based on whether the change is from contraction
to expansion (years 1983, 1991, and 2002) or from expansion to contraction (years
1990 and 2001) and re-run Model 2b to test whether the decrease (increase) in current
(future) ERC is uniform across the two types of cycle changes. The results indicate that
there is a significantly larger decrease (increase) in the current (future) ERC for the
contraction to expansion changes (F = 4.57 and F = 16.47, respectively). This result
is consistent with our primary result and demonstrates that a mere change in the state
of the business cycle (without considering the direction of the change) does not fully
explain the change in ERC.

5. CONCLUSION
In this study, we extend prior literature that examines the impact of business cycles on
the value relevance of earnings (e.g., Johnson, 1999), by examining the value relevance
of current and expected future earnings as a function the business cycle. Specifically,
because of factors related to earnings conservatism and the disconnect between
historical earnings reporting and future growth prospects, we posit and find that current
earnings are relatively more value-relevant in contractionary economic periods and that
expected future earnings are relatively more value-relevant in expansionary periods.
These findings indicate that, when directly controlling for the effects of expected future
earnings in a returns-earnings model, the value relevance of current earnings may
actually be lower during periods of high economic growth.

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