The Role of Accruals in Asymmetrically Timely Gain and Loss Recognition

Abstract

We investigate the role of accrual accounting in the asymmetrically timely recognition of unrealized gains and losses (i.e., prior to the actual realization of those losses in cash). This role of accrual accounting has not been directly recognized in the literature. We show that non-linear accruals models are a substantial specification improvement, explaining up to three times the amount of variation in accruals as conventional linear specifications such as Jones (1991). Conversely, we conclude that conventional linear accruals models, by omitting the role of accruals in asymmetrically timely loss recognition, offer a comparatively poor specification of the accounting accrual process. We also conclude that linear specifications of the relation between earnings and future cash flows, ignoring the implications of asymmetrically timely loss recognition (conditional conservatism), substantially understate the ability of current earnings to predict future cash flows. These findings have important implications for our understanding of accrual accounting, and for researchers using estimates of discretionary accruals, earnings management and earnings quality from misspecified linear accruals models.