Using Product Market Output Changes to Capture Business Fundamentals

We use changes in aggregate product market output as instruments for changes in the business fundamentals of the firms operating in those markets. These output changes are remote from individual firms’ economic and accounting choices while still capturing key fluctuations in their relevant business conditions. For many industries, public sources provide machine-readable output time-series data, sometimes disaggregated cross-sectionally (e.g., by geography). To provide evidence of the usefulness of this approach for empirical accounting research, we obtain output changes for five-digit NAICS code industries from the Census Bureau and county-level output changes for skilled nursing facilities from the Centers for Medicare & Medicaid Services. Estimating piecewise linear regressions similar to those in extensive prior accounting research on conditional conservatism, we find that accruals are more strongly correlated with decreases in industry output than with increases in industry output, but operating cash flow does not exhibit such an asymmetric response. Consistent with theory, we find that economic factors (e.g., market competition and global diversification) and accounting factors (e.g., debt covenants) influence the strength of the asymmetric relation between accruals and industry output changes. Overall, our method offers researchers a viable alternative to the use of firm-level proxies for changes in firms’ business fundamentals (e.g., stock returns, less discretionary accounting line items, or non-financial measures) that yields interpretable empirical results consistent with theory