Divergence in Accounting Profitability: Accounting Conservatism, New Firms, and Industry Attributes

Abstract

Recent empirical research has documented a substantial decrease in average accounting profitability. The phenomenon appears inconsistent with the observation that corporate profit as a fraction of national income as remained stable. This paper shows that the downward trend is fully explicable by a growing profitability gap between large and small firms within many industries, especially those with high R&D intensity. We examine the extent to which the divergence is caused by the entry of new firms to the Compustat database and increasing accounting conservatism, such as R&D expensing and accounting accruals. These effects, however, explain the divergence only partially. We further analyze how the rate of divergence is related to several industry attributes, including the industry average R&D intensity, capital intensity, concentration, and growth. The results have significant implications to understanding accounting conservatism, financial statement analysis, and the economics of industrial organizations.