Conservative Accounting and Earnings Quality

Abstract

This paper uses a model that compares two accounting systems to analyze the earnings quality score devised by Penman and Zhang (2002). First, the quality score is interpreted as a factor that links the accounting rates of return of two accounting systems, conservative accounting (CA) and less conservative accounting (LCA). Second, and more closely related to Penman and Zhang's argument, the quality score is viewed as an estimate of the temporary difference between the current accounting rate of return and permanent earnings under a CA system. These interpretations of the quality score provide a framework for reinterpreting Penman and Zhang's conclusion that the quality score forecasts how future accounting rates of return are likely to change. The three definitions of the quality of earnings that are embedded in the analysis also are discussed and the centrality of the concept of predictive ability is commented on.