The Unique Effect of Depreciation on Earnings Properties: Persistence and Value Relevance of Earnings

Abstract

Prior studies document high persistence of earnings is a desirable earnings’ attribute and associated with high value relevance of earnings. Nevertheless, other studies indicate negative earnings components depress persistence of earnings. Depreciation expense constitutes a major negative earnings component for most firms. Larger depreciation could represent higher cost of utilizing resources; however, it could also represent a higher level of capital improvements and conservative accounting choice. We find firms reporting higher depreciation and amortization expense (High DP) outperform other firms (Low DP) in terms of future operating cash flows. Though the persistence of earnings is lower for High DP firms, the stock markets actually place higher valuation weight of their earnings. Our study contributes to research on earnings attributes and the role of accounting information in the stock markets. We identify potential biases of overly reliance on the persistence of earnings to evaluate a firm’s performance and to predict the stock market reactions.