From micro to macro: Does conditional conservatism aggregate up in the National Income

and Product Accounts?

Henry Laurion
henry_laurion@haas.berkeley.edu

Panos N. Patatoukas
panos@haas.berkeley.edu

University of California at Berkeley

Haas School of Business

This Version: September 16, 2016

We thank the research staff at the Bureau of Economic Analysis and especially Dylan Rassier
for expert advice with NIPA data. We also thank Eric Allen, Michael Crawley, Charlie Gibbons,
Jacquelyn R. Gillette, Yaniv Konchitchki, Richard Lambert (editor), Topseht Nonam, Richard
Sloan, Samuel Tan, Jake Thomas, Annika Wang, Ari Yezegel, Jieyin Zeng, two anonymous
reviewers, and seminars participants at U.C. Berkeley for helpful comments and suggestions.
Panos gratefully acknowledges financial support from the Center for Financial Reporting and
Management at U.C. Berkeley, the Hellman Fellowship, and the Bakar Family Fellowship.
From micro to macro: Does conditional conservatism aggregate up in the National Income
and Product Accounts?

ABSTRACT
We revisit evidence that conditional conservatism aggregates up from the firm level causing
corporate profit estimates in the National Income and Product Accounts (NIPA) to be more
sensitive to negative relative to positive aggregate return news. Our study delivers three main
messages. First, annual estimates of NIPA corporate profits are designed to provide neutral
estimates of income from current production regardless of whether times are good or bad.
Second, we find spurious evidence of asymmetric sensitivity to aggregate return news in placebo
test variables that are void of conditional conservatism, clearly indicating that an alternative
explanation is in order. Third, we find that the variance of aggregate returns decreases with the
level of economic activity. Although this return variance effect is unlikely to be attributed to
accounting, it has the potential to generate spurious evidence of conditional conservatism at the
macro level. Overall, our study highlights the importance of construct validity tests in archival
studies and contributes to research in the properties of NIPA corporate profits.

Keywords: NIPA corporate profits; conditional conservatism; construct validity; placebo tests.

JEL Classifications: M41; G12; E43; E52.

Data Availability: Data are available from the sources identified in the text.

1
 I. INTRODUCTION

Starting with Basu (1997), a long line of accounting research relies on a piecewise linear

regression of earnings or earnings components, such as unexpected earnings (e.g., Ball, Kothari,

and Nikolaev 2013a) and accruals (e.g., Hsu, OHanlon, and Peasnell 2012; Collins, Hribar, and

Tian 2014), on positive and negative unexpected returns to examine asymmetrically timely loss

recognition or conditional conservatism at the firm level. This literature has assumed that the

incremental regression coefficient on negative unexpected returnsalso known as the

asymmetric timeliness (AT) coefficientis a valid measure of conditional conservatism in

financial accounting (e.g., Ball, Kothari, and Nikolaev 2013b).1

Crawley (2015) adopts Basus regression model at the macro level and searches for

evidence of conditional conservatism in measures of economic activity generated by the Bureau

of Economic Analysis (BEA) of the U.S. Department of Commerce. Crawley (2015) documents

that BEAs estimates of corporate profits and gross domestic income in the National Income and

Product Accounts (NIPA) exhibit higher sensitivity to negative relative to positive return news,

and argues that this is evidence consistent with firm-level accounting conservatism aggregating

up to affect measures of macroeconomic activity. In this paper, we revisit evidence of

asymmetric timeliness in NIPA corporate profits and evaluate the construct validity of the AT

coefficient as a measure of conditional conservatism at the macro level.

Our first research objective is to provide an overview of the BEAs source data and

measurement of corporate profits and evaluate whether or not conditional conservatism in firm-

level financial accounting data can aggregate up in NIPA corporate profits. Our second objective
1
A number of studies, however, raise questions about the construct validity of the AT coefficient at the firm level
(e.g., Ryan 2006; Dietrich, Muller, and Riedl 2007; Givoly, Hayn, and Natarajan 2007; Patatoukas and Thomas
2011; Patatoukas and Thomas 2015; Banker, Basu, Byzalov, and Chen 2016; Dutta and Patatoukas 2016).

2
is to evaluate the construct validity of the AT coefficient at the macro level using placebo tests in

settings that are void of conditionally conservative accounting practices. Our final objective is to

shed light on the economic forces that give rise to spurious evidence of conditional conservatism

at the macro level.

With respect to our first objective, we start with the BEAs NIPA Handbook. The NIPA

Handbook clarifies that annual estimates of NIPA corporate profits are designed to reflect

income from current production, defined as receipts arising from current production less

associated expenses. Indeed, the starting point for the derivation of NIPA corporate profits is the

annual IRS tabulation of total receipts less total deductions, henceforth tax corporate profits,

followed by a number of adjustments to conform to the NIPA concept of income from current

production.

Conditional conservatism is embedded in U.S. GAAP earnings through practices such as

lower-of-cost-or-market accounting for inventories (ASC 330, FASB 2009a), goodwill

impairments (ASC 350, FASB 2009b), and asset write-downs (ASC 360, FASB 2009c). NIPA

corporate profits, however, are designed to exclude transactions that merely reflect the

revaluation of assets or liabilities. Therefore, conditionally conservative practices are effectively

eliminated from the NIPA. Our communication with the research staff at the BEA further

clarifies that such practices would actually be inconsistent with the NIPA conceptual framework

for evaluating the usefulness of estimates of economic activity. Indeed, the BEAs objective is to

provide neutral estimates of economic activity regardless of whether times are good or bad.

Turning to our second objective, we begin by confirming spurious evidence of

asymmetric timeliness at the macro level using annual data over the 84-year period from 1929 to

2012. Consistent with Crawley (2015), we find evidence of asymmetric sensitivity to negative

3
relative to positive aggregate return news for NIPA corporate profits and gross domestic income.

Although one might contend that the effects of conditional conservatism aggregate through

BEAs numerous adjustments to tax corporate profits, we propose that tax corporate profits are

void of such effects. This is because for tax purposes conservatism is not an objective and write-

offs of expected losses cannot be recognized until actually realized (e.g., Hanlon 2005).2 Indeed,

studies that examine the book-tax income gap find that financial accounting write-downs and

impairments are significant contributors to book-tax differences (e.g., Seidman 2010; Graham,

Raedy, and Shackelford 2012). Therefore, construct validity would imply that tax corporate

profits do not exhibit evidence of asymmetric timeliness.

Our placebo test results provide evidence against the construct validity of the AT

coefficient as a measure of conditional conservatism at the macro level. Specifically, we find that

tax corporate profits also exhibit evidence of asymmetric timeliness. In fact, the AT coefficient

for tax corporate profits is close to that for NIPA corporate profits, which implies that BEAs

numerous adjustments to tax corporate profits do not have a material effect on evidence of

asymmetric timeliness at the macro level.

Importantly, we also find evidence of asymmetric timeliness in gross domestic income

after excluding NIPA corporate profits, which raises additional construct validity concerns. This

is because conditional conservatism could only flow to gross domestic income through corporate

profits, while all other gross domestic income components (e.g., compensation of employees) are

void of such effects.

2
Internal Revenue Code (IRC) Section 461 (h) and Code of Federal Regulations (CFR) 1.461-1(a)(2)(i) provide
that, under the accrual method of accounting, a liability is incurred, and is generally taken into account for federal
income tax purposes, in the taxable year in which all the events have occurred that establish the fact of the liability,
the amount of the liability can be determined with reasonable accuracy, and economic performance has occurred
with respect to the liability.

4
 As an additional placebo test, we search for evidence of asymmetric timeliness in annual

estimates of the U.S. labor force employment rate available from the Bureau of Labor Statistics

for the post-1948 period and Lebergotts (1964) historical records for the earlier period.

Employment rate estimates are generally based on surveys of the population using a sample of

households that is designed to represent the civilian non-institutional population of the U.S. and,

therefore, there is no reason to believe that financial accounting practices affect the estimation

process. Again, however, we find evidence of asymmetric sensitivity to negative return news for

the U.S. labor force employment rate, which cannot be attributed to accounting practices.

Our placebo tests highlight the fact that evidence of asymmetric timeliness in NIPA

corporate profits cannot be interpreted as evidence of conditional conservatism aggregating up

from firm-level financial accounting data. To shed light on the underlying economic forces

leading to evidence of asymmetric timeliness in NIPA corporate profits, we search for an

alternative, non-accounting explanation. Our efforts zero in on the link between the general

health of the U.S. economy and the variance of return news. Specifically, we find that lower

realizations of NIPA measures of economic activity are associated with larger absolute values of

aggregate return news and, therefore, higher variance of aggregate return news. We refer to this

phenomenon as the return variance effect.

Our evidence of a return variance effect is consistent with evidence of countercyclical

stock market volatility dating back to Officer (1973). Simply put, the link between stock market

volatility and the general health of the U.S. economy implies that periods of lower economic

activity are associated with a greater chance of large positive or large negative aggregate returns.

A long-standing explanation for this phenomenon going back to Schwert (1989a, 1989b) is that

5
economic downturns are characterized by higher uncertainty about future cash flows and

discount rates and, therefore, higher aggregate return variances.

Although the return variance effect is unlikely to be attributed to accounting practices, it

has important implications for the construct validity of the AT coefficient as a measure of

conditional conservatism in NIPA corporate profits. Indeed, a similar return variance effect is

observed at the firm level by Patatoukas and Thomas (2015), who argue that if the first moment

of the distribution of a random variable z is negatively related to the second moment of the

distribution of return news, then the AT coefficient for z is predicted to be positive even in the

absence of conditional conservatism. More specifically, the return variance effect implies that

even if the unconditional relation of z with return news is zero, the conditional relations can be

different from zero for subsamples formed based on the sign of return news: (i) positive for bad

news years, i.e., years with negative return news, and (ii) negative for good news years, i.e.,

years with positive return news.

Consistent with the implications of the return variance effect we observe that although

the unconditional relation of NIPA measures of economic activity with aggregate return news is

indistinguishable from zero, the conditional relations are positive for bad news years and

negative for good news years.3 Our analysis shows that the return variance effect has the

potential to provide a unifying explanation for puzzling facts that cannot be explained based on

conditional conservatism, including spurious evidence of asymmetric timeliness for placebo test

variables that are void of conditional conservatism. Our analysis also shows that evidence of

3
The lack of an unconditional relation between NIPA measures of economic activity and return news is consistent
with well-known evidence of a disconnect between the stock market and macro variables (e.g., Pearce and Roley
1985; Hardouvelis 1987; McQueen and Roley 1993; Flannery and Protopapadakis 2002; Patatoukas 2016).

6
asymmetric timeliness at the macro level disappears after controlling for the negative relation

between the level of economic activity and the variance of aggregate returns.

To be clear, our study does not challenge the existence of conditional conservatism in

financial accounting, which admittedly has been part of accounting practice for centuries (e.g.,

Watts 2003a, 2003b; Basu 2009), nor does it challenge the phenomenon of asymmetric

sensitivity to negative aggregate return news for NIPA corporate profits and gross domestic

income.4 Our study does make the point, however, that annual estimates of NIPA corporate

profits are designed to provide neutral estimates of economic activity regardless of whether times

are good or bad and, therefore, an alternative explanation of asymmetric timeliness at the macro

level is in order. The explanation that we propose and test is based on the link between stock

market return variances and the general health of the U.S. economy rather than conditional

conservatism aggregating up from firm-level financial accounting data.

Our study highlights the importance of placebo tests in archival studies and responds to

Schrands (2014) call for a 360-degree view of construct validity in accounting research on

conditional conservatism. While researchers in other fields routinely replicate analyses for test

variables that should not exhibit predicted patterns, such replications are not commonly

employed by researchers in accounting. Our analyses of placebo test variables show that

evidence of asymmetric timeliness in NIPA corporate profits cannot be interpreted as evidence

of conditional conservatism aggregating up from the firm level.

4
We also acknowledge the possibility that financial accounting conservatism could aggregate up from the firm level
to the aggregate stock market level. In additional analysis, however, we obtain Compustat data for public U.S. firms
and consistent with Crawley (2015) we do not find evidence of asymmetric timeliness in aggregate U.S. GAAP
accounting earnings. Given that Compustat data become available beginning in 1962, this finding could be attributed
to insufficient power combined with an attenuation of the return variance effect post-1960s.

7
 In addition, by shedding light on the economic forces underpinning evidence of

asymmetric timeliness at the macro level, our study contributes to growing research in the

macroeconomic consequences of accounting and the properties of NIPA data (e.g., Mead,

Moulton, and Petrick 2004; Kothari, Lewellen, and Warner 2006; Cready and Gurun 2010;

Hodge 2011; Dichev 2014; Konchitchki and Patatoukas 2014a, 2014b; Patatoukas 2014;

Crawley 2015; Konchitchki and Patatoukas 2016; Patatoukas 2016).

Our study proceeds as follows. Section II provides the background for understanding the

measurement of NIPA corporate profits. Section III provides the empirical results. Section IV

concludes.

II. BACKGROUND

In what follows, we provide an overview of the NIPA. Focusing on annual NIPA

estimates of corporate profits, we describe the underlying data sources and critically evaluate

whether or not conditional conservatism in firm-level financial accounting data can aggregate up

in NIPA corporate profits. Our discussion is primarily based on our review of the NIPA

Handbook available from the BEA website (http://www.bea.gov/methodologies/) and our

extensive communication with the research staff at the BEA.

Overview of the NIPA

The NIPA are a set of economic accounts produced by the BEA of the U.S. Department

of Commerce that provide detailed measures of the value and composition of national output and

the incomes generated in the production of that output. The best known NIPA measure of

economic activity is gross domestic product (GDP), which is defined as the market value of the

final goods and services produced by labor and property located in the United States.

8
 Account 1 of the NIPA illustrates the two methods of measuring U.S. output. The right or

product side of Account 1 measures GDP by summing personal consumption expenditures,

private investment, government spending, and net exports (final expenditures method). The left

or income side of Account 1 features Gross Domestic Income (GDI), which measures GDP by

summing the incomes generated in the production of that output (income method). In concept,

GDP and GDI are equal. In practice, GDP and GDI differ because their components are

estimated using largely independent and less-than-perfect source data as well as a host of

different estimation methods. Nevertheless, the two measures of U.S. output are similar over

time (e.g., Landefeld, Seskin, and Fraumeni 2008).5

NIPA corporate profits

NIPA corporate profits are designed to reflect income from current production, defined as

receipts arising from current production less associated expenses.6 NIPA corporate profits are a

component of national incomethe measure of all incomes earned by U.S. residents regardless

of the location of labor and capital. The domestic portion of NIPA corporate profits, which

excludes profits originating in the rest of the world, is a component of GDI featured in the

income side of Account 1 of the NIPA.

5
Over our sample period, the average percentage deviation of GDP from GDI, also known as statistical discrepancy,
is only 0.48 percent, and the two measures of U.S. output have a correlation coefficient of 99.99 percent.
6
The System of National Accounts is an international set of guidelines for a system of economic accounts, published
by the Commission for the European Communities, the International Monetary Fund, the Organisation for Economic
Cooperation and Development, the United Nations, and the World Bank. The System of National Accounts provides
the general accounting framework for the national economic accounts for the United States and other countries. The
most recent edition of the SNA was published in 2008. For the latest edition of the SNA, see
http://unstats.un.org/unsd/nationalaccount/SNA2008.asp.

9
Source data of NIPA corporate profits

The BEA uses aggregated information from corporate tax returns as the primary source

of information on annual estimates of corporate profits for two reasons. First, tax return data are

based on well-specified, consistent accounting definitions that, in general, more closely parallel

NIPA concepts and definitions. Financial accounting measures, on the other hand, allow more

flexibility in the way definitions are applied by corporations. Second, tax return data are

comprehensive, covering both publicly-traded and privately-held corporations (effectively all

entities required to file federal corporate tax returns), while financial accounting measures cover

only a subset of the corporate universe.

For all but the most recent year, the starting point for the derivation of NIPA profits

before tax (PBT) is tax corporate profits (i.e., total receipts less total deductions) published by

the IRS in the Statistics of Income. The IRS tabulations are based on a stratified sample of

unaudited tax returns that currently includes all active corporations with more than $50 million

of assets and smaller firms on a probability basis. Tax corporate profits differs from taxable

income, as defined on the corporate tax return, in that it includes tax-exempt interest and

excludes special statutory deductions. Tax corporate profits is subject to a number of adjustments

to conform to the NIPA concept of income from current production and arrive at PBT.

The NIPA adjustments include i) an adjustment for the misreporting of corporate income

identified by IRS audit (i.e., an estimate of the additional profits that would be revealed if all

corporate returns were audited); ii) IRS deductions that are not elements of current production

(e.g., depletion on domestic minerals; expensing of expenditure for mining exploration, shafts

and wells; state and local corporate tax accruals; bad debt expense); iii) elements of costs of

current production that are not IRS current deductions (e.g., interest payments of regulated

10
investment companies; costs of trading or issuing corporate securities; taxes paid by domestic

corporations to foreign governments on income earned abroad); iv) elements of domestic income

from current production that are not IRS income (e.g., profits of certain types of financial

institutions); and v) elements of IRS income that are not domestic income from current

production (e.g., gains net of losses from the sale of property; dividends received from domestic

corporations; income on equities in foreign corporations and branches). To arrive at PBT on a

national basis, rest-of-the-world profits derived from the BEAs international transaction

accounts are added.

The BEA supplements the measure of PBT on a national basis with two more

adjustments, namely an inventory valuation adjustment (IVA) and a capital consumption

adjustment (CCadj). The IVA converts the value of inventory withdrawals from a mixture of

historical and current costs used by business in tax accounting to a strict current cost basis by

removing the capital-gain-like or the capital-loss-like element resulting from valuing inventory

withdrawals at the prices of earlier periods. The CCadj converts the measure of depreciation to a

current cost basis by removing from profits the capital-gain-like or the capital-loss-like element

that results from valuing depreciation of fixed assets at the prices of earlier periods.7

The sum of PBT, the IVA, and the CCadj is the featured annual estimate of NIPA

corporate profits. For the most recent year, the first estimate of NIPA corporate profitsalso

7
Over the past several years several economic stimulus acts have become law. These acts have often contained
bonus depreciation provisions and higher ceilings for small business expensing. For example, the Tax Increase and
Prevention Act of 2014 (TIPA) provides for 50 percent bonus depreciation for qualified investments placed in
service during 2014. TIPA also raises the ceiling for small business expensing under Internal Revenue Code Section
179 to $500,000 through 2014. TIPA extended the American Taxpayer Relief Act of 2012, which offered similar
provisions for 2013. The Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010
allowed 100 percent bonus depreciation from September 2010 through December 2011 and 50 percent bonus
depreciation in 2012. NIPA corporate profits are not affected by these tax acts, because profits from current
production do not depend on the depreciation-accounting practices used for Federal income tax purposes but rather
reflect economic accounting practices in which depreciation is based on an estimate of the reduction in the value of
fixed capital used in the production process.

11
known as the first July estimateis prepared by extrapolating the estimate for the preceding

year and it becomes available in the July after the calendar year-end to which it is referred.8 The

second July estimate of NIPA corporate profits is published one year later using the

preliminary IRS tabulations of total receipts less total deductions for the year to which it is

referred. The third July estimate is published two years later using the final IRS tabulations.

Illustrative example

Appendix 1 provides the derivation of annual NIPA corporate profits from IRS total

receipts less total deductions for 2009, 2010, and 2011. Focusing on 2011, we see the

adjustments needed to arrive at profits before tax of $1,806.8 billion from IRS total receipts less

total deductions of $1,242.9 billion, including the adjustment for misreporting on income tax

returns, bad debt expense, as well as the effect of foreign operations, and the exclusion of gains

net of losses from sale of property and of dividends received from domestic corporations. To

arrive at NIPA corporate profits of $1,816.6 billion, the inventory valuation and capital

consumption adjustments are added to profits before tax.9 When measuring output as GDI, only

the domestic portion of NIPA corporate profits is being accounted for, which excludes rest-of-

the-world profits and is equal to $1,394.7 billion for 2011 (subtract $421.9 billion from bottom

line NIPA corporate profits; also available from Line 15 of NIPA Table 1.10).

8
According to the NIPA Handbook, the extrapolations are carried out separately for each of about 75 industries
using indicators that are based on a variety of sources. Two of the principal sources are the Census Bureaus
Quarterly Financial Report and the BEA tabulations of samples of shareholder reports including data drawn from the
Compustat database for all public U.S. corporations that have reported data for the current and prior year on pre-tax
income excluding special charges, such as unusual or non-recurring items, unrealized mark-to-market gains or
losses, asset write-downs, and other valuation gains and losses. We note that quarterly estimates of NIPA corporate
profits are obtained by interpolation between annual estimates and for more recent quarters by extrapolation.
9
Write-downs and impairments that have not yet been realized are generally not deducted from taxable income
when recognized in GAAP earnings. When the losses are subsequently realized, for example through the sale of
impaired property, they are deducted from taxable income. Appendix 1 shows that the BEA eliminates gains, net of
losses, from sale of property to arrive at profits before taxes and bottom-line NIPA corporate profits.

12
Can conditional conservatism aggregate up from firm-level financial accounting data?

Conditional conservatism is embedded in U.S. GAAP earnings through financial

accounting practices such as lower-of-cost-or-market accounting for inventories (ASC 330),

goodwill impairments (ASC 350), and asset write-downs (ASC 360). NIPA corporate profits,

however, are designed to reflect income from current production excluding transactions that

merely reflect the revaluation of assets or liabilities.10

Our communication with the research staff at the BEA further clarifies that conservatism

is not an objective for NIPA estimates of economic activity. In particular, Chapter 1 of the NIPA

Handbook defines four characteristics based on which the usefulness of the NIPA estimates is

determined: i) accuracy, which is described in terms of how close the estimates come to

measuring the concepts they are designed to measure; ii) reliability, which refers to the size and

frequency of revisions to the NIPA estimates; iii) relevance, which refers to the length of time

before the estimates become available and the ability of the accounts to provide estimates that

can be used to answer the questions being asked about the economy; and iv) integrity, which

refers to the confidence on the part of the users that the NIPA estimates represent a truthful

picture of the economy.

Clearly, the BEAs objective is to provide neutral estimates of economic activity

regardless of whether times are good or bad and, therefore, conditional conservatism would

actually compromise the usefulness of NIPA data.

10
Rassier (2012) speculates that quarterly measures of NIPA corporate profits for financial corporations during the
2008 financial crisis are affected by inadequate adjustments required to remove holding losses attributable to fair
value accounting practices in quarterly financial-based source data compiled under U.S. GAAP. However, the
quarterly financial-based source data do not affect the annual tax-based source data.

13
 III. TESTING FOR ASYMMETRIC TIMELINESS AND CONDITIONAL

CONSERVATISM AT THE MACRO LEVEL

In search of evidence of conditional conservatism in NIPA corporate profits, Crawley

(2015) adopts Basus (1997) piecewise linear regression at the macro level and searches for

evidence of asymmetric timeliness in NIPA corporate profits and gross domestic income. In

particular, he estimates the following time-series regression model specification:

Macro Variablet 0 1I (rt 0) 0rt 1I (rt 0) rt t , (1)

where rt is a measure of aggregate return news and I (rt 0) is an indicator variable for negative

return news. The good news timeliness coefficient 0 measures the sensitivity of a test variable

to positive return news, while the AT coefficient 1 measures the incremental sensitivity of the

macroeconomic variable to negative return news. It follows that the bad news timeliness

coefficient is equal to 0 + 1.

Macroeconomic variables

We obtain annual data on the domestic portion of NIPA corporate profits (CPt) from Line

15 of NIPA Table 1.10 and on gross domestic income (GDIt) from Line 1 of NIPA Table 1.10.

Figure 1 reports the time series of the contribution of the domestic portion of NIPA corporate

profits to gross domestic income. The average value of the ratio CPt/GDIt is 8.23 percent with a

standard deviation of 2.33 percent. This ratio turned negative in the midst of the Great

Depression due to negative NIPA corporate profits for 1932 and 1933.

[INSERT FIGURE 1]

We obtain data at the end of year t-1 on the current-cost value of total fixed assets (FAt-1)

and private fixed assets (FAPt-1) from Lines 2 and 3, respectively, of Fixed Assets Accounts

14
(FAA) Table 1.1. The NIPA and FAA tables are available from the BEA website

(http://www.bea.gov/itable/).

We obtain historical data on total receipts less total deductions for corporations reported

to the IRS in year t (TAXt), henceforth tax corporate profits, from Line 1 of NIPA Table 7.16 and

the Statistics of Income Publications available from the IRS website

(http://www.irs.gov/uac/SOI-Tax-Stats-Corporation-Complete-Report).

We obtain historical data on the U.S. labor force employment rate (EMPt), defined as one

minus the unemployment rate (i.e., the number of unemployed as a percent of the U.S. labor

force), from the Bureau of Labor Statistics (BLS) website for the post-1948 period

(http://data.bls.gov/timeseries/LNS14000000) as well as Lebergotts (1964, Table A-3) historical

records for the earlier period. The post-1940 employment data are based on the Current

Population Survey, which is conducted by the Census Bureau for BLS using a sample of

households that is designed to represent the civilian non-institutional population of the U.S. The

pre-1940 data are pieced together from census data, industry records, and various state reports.11

Our full sample period includes 84 years from 1929 to 2012. Our sample starts in 1929

because this is the first year for which we can measure the macro variables needed for our

analysis. Our sample ends in 2012 because this is the last year for which we have the third July

estimate of NIPA corporate profits.

11
Romer (1986, Table 9) raises concerns about estimation error in Lebergotts employment rates and introduces a
revised historical series for the period from 1890 to 1930. To complete our employment rate series, we use Romers
revised estimate for 1929 (for 1930, Romers revised estimate is exactly equal to Lebergotts original estimate).

15
Aggregate return news

We construct two measures of aggregate return news. The first measure is the realized

stock market return in year t (Rt) minus the time-series average return over our sample period or,

1 2012
more formally, rt Rt
T
t 1929 Rt . The realized stock return in year t (Rt) is the annual return
earned from compounding the monthly returns of the CRSP value-weighted index including

distributions.12 Effectively, our first measure of return news (rt) is the abnormal return earned

in year t compared to the average historical return, which is equal to 11.03 percent. The second

measure is based on Crawleys (2015) news measure, which is the residual from a regression of

realized returns in year t on the lagged value of returns (Rt-1), the log dividend yield on the S&P

500 index (Yieldt-1), the spread of BAA-rated corporate bond yields over the AAA-rated

corporate bond yields (DEFt-1), and the small stock value spread (VALUEt-1):

Rt 1Rt 1 2Yieldt 1 3DEFt 1 4VALUEt 1 t . (2)

Our regression results based on equation (2) are consistent with Crawley (2015) and,

therefore, are omitted for brevity. Importantly, we confirm that the models explanatory power is

very low with an adjusted R2 of roughly 2 percent (see also Table 1, Panel B in Crawleys paper).

Given that most of the variation in returns remains unexplained, it follows that the regression

residuals are similar to realized returns adjusted for the time-series average return over the

sample period, i.e., our measure of return news based on abnormal returns. Figure 2 presents the

time series of abnormal returns along with residual returns confirming that the two series

12
Our results are not sensitive when we measure return news for the S&P 500 indexanother commonly used
proxy for the stock market portfolioinstead of the CRSP value-weighted index.

16
commove with a correlation coefficient of 98 percent. To simplify the analysis, we report results

using abnormal returns.

[INSERT FIGURE 2]

Descriptive statistics

Table 1 presents descriptive statistics for key variables. The average ratio of NIPA

corporate profits to lagged private fixed assets (CPt/FAPt-1) is 4.2 percent with a standard

deviation of 1.5 percent and is close to that for tax corporate profits (TAXt/FAPt-1). Indeed, the

average value of NIPA adjustments, i.e., the difference between NIPA corporate profits and tax

corporate profits, is -0.2 percent of the lagged value of private fixed assets. Figure 3 confirms

that NIPA corporate profits and tax corporate profits series are 90 percent correlated. The

average ratio of GDI to lagged total fixed assets is 36.7 percent with a standard deviation of 4.1

percent. The average ratio of GDI excluding NIPA corporate profits to lagged total fixed assets is

33.6 percent with a standard deviation of 3.3 percent. The average value of the employment rate

is 92.8 percent, which implies an average unemployment rate of 7.2 percent. The average value

of return news is zero with a standard deviation of 20.4 percent, while the average value of I(rt <

0) implies that return news is negative for 44 percent of our sample (i.e., 37 out of the 84 years).

[INSERT TABLE 1]

The pairwise correlations show that the scaled values of NIPA corporate profits and GDI

are 86 percent correlated, which is consistent with the fact that corporate profits are a component

of GDI. Scaled NIPA corporate profits are 76 percent correlated with the scaled difference of

GDI minus NIPA corporate profits, which is consistent with prior arguments that corporate

profits are correlated with other components of gross domestic income (e.g., Fischer and Merton

1984). The positive correlation between the employment rate and other measures of economic

17
activity, especially GDI, is consistent with procyclical variation in labor market conditions and

Okuns (1962) law. The pairwise correlations of return news and macro variables are not

significantly different from zero, which is consistent with evidence of a disconnect between

aggregate returns and macro fundamental variables dating back to Pearce and Roley (1985).

Finally, the negative pairwise correlations of stock market volatility (VLTt) and macro variables

are consistent with long-standing evidence of countercyclical stock market volatility.

[INSERT FIGURE 3]

Evidence of asymmetric timeliness in NIPA corporate profits and gross domestic income

Table 2 reports results from regressions of NIPA corporate profits and GDI on aggregate

return news based on the AT model specification described in equation (1). Throughout our

study, we estimate the models using ordinary least squares regressions and base statistical

inferences on Newey and West (1987) heteroskedasticity and autocorrelation consistent standard

errors with a finite sample correction.13

[INSERT TABLE 2]

Starting with NIPA corporate profits, columns 1 and 2 of Table 2 show that even though

the slope coefficient from a simple regression on aggregate returns news is not significantly

13
Crawley (2015) estimates the AT regression model in equation (1) using reverse truncated regressions of return
news on the macro variable considered (i.e., either scaled NIPA corporate profits or scaled gross domestic income).
The truncated regressions are estimated separately for positive and negative return news subsamples using
maximum likelihood. The subsample coefficient estimates from the reverse regressions along with the subsample
squared correlations of return news with fitted return news (a measure of pseudo R 2) are then used to construct
coefficient estimates for the forward piecewise-linear timeliness regressions embedded in equation (1). This
procedure is introduced as a solution to bias from sampling on an endogenous variable in the Basu regression (e.g.,
Hausman and Wise 1977; Dietrich et al. 2007). However, given evidence of a disconnect between return news and
macro variables (see pairwise correlations in Panel B of Table 1), the potential for such bias does not appear to be
relevant at the macro level. In addition, it is not clear whether this procedure introduces other sources of bias since it
seeks to uncover the forward coefficient estimates based on equation (1) as the ratios of the subsample pseudo R 2s
and the corresponding subsample reverse coefficient estimates. As an empirical matter, we continue to find
spurious evidence of conditional conservatism in placebo settings (e.g., tax corporate profits) using this procedure.

18
different from zero, the good news coefficient, i.e., the slope on positive return news, is

significantly negative, while the AT coefficient, i.e., the incremental slope on negative return

news, is significantly positive. Turning to GDI, columns 3 and 4 of Table 2 provide consistent

evidence that even though the simple slope coefficient on aggregate return news is not

significantly different from zero, the good news coefficient is significantly negative, while the

AT coefficient is significantly positive.14

At first blush, evidence of positive AT coefficients for NIPA corporate profits and gross

domestic income would seem to suggest that conditional conservatism aggregates up from the

firm level to the macro level. In what follows, we devise placebo tests of asymmetric timeliness

at the macro level and propose an alternative explanation for the phenomenon.

Placebo tests of asymmetric timeliness at the macro level

To evaluate the construct validity of the AT coefficient as a measure of conditional

conservatism at the macro level, we search for evidence of asymmetric timeliness in placebo test

variables that are void of conditionally conservative accounting practices.

For our first placebo test, we consider tax corporate profits scaled by lagged private fixed

assets (TAXt/FAPt-1). As explained in detail in Section II, NIPA corporate profits are based on tax

corporate profits after a number of adjustments. Although one might contend that the effects of

conditional conservatism may flow through the numerous NIPA adjustments, IRS tabulations of

tax corporate profits should be void of such effects. This is because for tax purposes

14
It should be noted that evidence of negative good news coefficients at the macro level is puzzling because there is
no ex ante reason to believe that even though the unconditional relation of NIPA corporate profits and gross
domestic income with returns news is indistinguishable from zero, the conditional relation for positive return news is
negative because of conditional conservatism. Although inconsistent with conditional conservatism, evidence of
negative good news coefficients at the macro level is consistent with recent firm-level studies, which also find
evidence of negative good news coefficients for U.S. GAAP earnings (e.g., Patatoukas and Thomas 2015).

19
conservatism is not an objective and write-offs of expected losses cannot be recognized until

actually realized (e.g., Hanlon 2005).15 Therefore, construct validity would imply that the AT

coefficient for tax corporate profits is zero.16

For our second placebo test, we focus on gross domestic income after excluding NIPA

corporate profits scaled by lagged total fixed assets or GDIt CPt FAt 1 . The idea is simple. The

effects of conditional conservatism could only flow to gross domestic income through NIPA

corporate profits, while all other gross domestic income components (e.g., compensation of

employees) are void of such effects. Again, construct validity would imply that the AT

coefficient for GDIt CPt FAt 1 is zero.

As an additional placebo test, we search for evidence of asymmetric timeliness in annual

estimates of the U.S. labor force employment rate (EMPt). Employment rate estimates are based

on surveys of the population using a sample of households that is designed to represent the

civilian non-institutional population of the U.S. and, therefore, accounting practices are absent in

the estimation process. Clearly, construct validity would imply that the AT coefficient for the

U.S. labor force employment rate is zero.

Table 3 reports our placebo test results. Starting with the IRS tabulations of tax corporate

profits, we find that the good news coefficient is significantly negative, while the AT coefficient

15
Qiang (2007) also notes that losses due to conditional conservatism are generally not deductible under the Internal
Revenue Code and finds firm-level evidence that taxation does not induce conditional conservatism. Relatedly,
Heltzer (2009) points out that firm-level tax accruals and, therefore, taxable income should be void of conditional
conservatism. When compared to financial accounting earnings, taxable income is aggressive in that it tends to limit
and delay the deductibility of cash outlays and losses.
16
We hasten to note that firms misreporting efforts to reduce taxable income by delaying revenue recognition and
accelerating expense recognition would imply unconditional conservatism in tax corporate profits, rather than
conditional conservatism (e.g., Basu 1995; Watts 2003a, 2003b; Qiang 2007; Hanlon, Maydew, and Shevlin 2008).
As explained in Section II, NIPA corporate profits include a sizable adjustment for misreporting on income tax
returns (roughly 10 percent of tax corporate profits over our sample period). In additional analysis, we confirm that
the NIPA adjustment for misreporting in income tax returns does not exhibit evidence of asymmetric timeliness.

20
is significantly positive. A comparison with column 2 on Table 2 shows that the AT coefficient

for tax corporate profits is close to that for NIPA corporate profits, which implies that the NIPA

adjustments do not have a material effect on the AT coefficient for corporate profits. Indeed, the

regression results in column 2 of Table 3 confirm that the AT coefficient for the difference of

NIPA corporate profits minus tax corporate profits is not significantly different from zero.

Evidence of asymmetric timeliness in the IRS tabulations of tax corporate profits, however,

cannot be attributed to conditional conservatism aggregating up from the firm level.17

[INSERT TABLE 3]

Turning to GDI excluding NIPA corporate profits, the good news coefficient is

significantly negative, while the AT coefficient is significantly positive. A comparison with

column 4 of Table 2 reveals that evidence of asymmetric timeliness in gross domestic income is

only partially attributed to NIPA corporate profits. Indeed, as much as 69 percent of the AT

coefficient for GDI is attributed to all other components excluding NIPA corporate profits, which

cannot be attributed to conditional conservatism aggregating up from the firm level.

Finally, we search for evidence of asymmetric timeliness in the U.S. labor force

employment rate in the last column of Table 3. Again we find that the good news coefficient is

significantly negative, while the AT coefficient is significantly positive. Given that accounting

practices are absent in the estimation procedures followed by the Bureau of Labor Statistics,

evidence of asymmetric timeliness in U.S. labor force employment rates cannot be possibly

attributed to accounting practices.

17
We note that Crawley (2015) does not find evidence of asymmetric timeliness in tax corporate profits. His
analysis, however, is based on IRS tabulations post-1960. Focusing on the post-1960 period, our estimate of the AT
coefficient for tax corporate profits is also not significantly different from zero, which could be attributed to
insufficient power combined with an attenuation of the return variance effect post-1960s.

21
 Overall, the main message of our placebo tests is that evidence of asymmetric timeliness

in NIPA corporate profits cannot be interpreted as evidence of conditional conservatism

aggregating up from the firm level. We next provide tests of an alternative, non-accounting

explanation for this intriguing phenomenon.

Return variance effect at the macro level

Patatoukas and Thomas (2015) evaluate the construct validity of the AT coefficient at the

firm level and argue that if the first moment of the distribution of a random variable z is

negatively related to the variance of the distribution of return news, then the AT coefficient for z

is predicted to be positive even in the absence of conditional conservatism. The return variance

effect implies that even if the unconditional relation of z with return news is zero, the conditional

relations of z with positive and negative return news can be different from zero, namely positive

for bad news (i.e., negative return news) and negative for good news (i.e., positive return news).

Next, we search for evidence of the return variance effect at the macro level.

The evidence

Panel A of Table 4 reports the variance of return news across partitions of low, medium,

and high realizations of NIPA corporate profits. Looking across partitions, we find that the

variance of return news decreases with the level of economic activity. In particular, the variance

of return news is 0.069, 0.031, and 0.026 across low, medium, and high partitions, while the

variance of return news is 0.041 for the full sample period.18 A key implication of this return

variance effect, i.e., the negative relation between the level of economic activity and the variance

18
We test for equality of return news variances across low and high portfolios using bootstrapped F-tests. Our tests
reject the null hypothesis of equal variances for the macro variables considered in Table 4.

22
of aggregate return news, is that although the unconditional relation of NIPA corporate profits

with return news is indistinguishable from zero (see pairwise correlations in Panel B of Table 1),

the conditional relations are expected to be positive and negative for bad news and good news,

respectively. Indeed, we find that lower realizations of NIPA corporate profits are associated

with larger absolute values of aggregate return news.

[INSERT TABLE 4]

Panels B through E of Table 4 repeat the analysis for GDI and our three placebo test

variables, namely GDI after excluding NIPA corporate profits, IRS tabulations of tax corporate

profits, and the U.S. labor force employment rate. The evidence confirms that the variance of

return news decreases with the level of economic activity, and, relatedly, that years with lower

economic activity are associated with larger absolute values of aggregate return news.

To visually illustrate the return variance effect, Panel A of Figure 4 presents the plot of

aggregate return news (y-axis) on NIPA corporate profits (x-axis). Although the unconditional

relation between return news and NIPA corporate profits is indistinguishable from zero, as

indicated by the effectively flat fitted regression line, moving from the left to the right of the x-

axis the variance of return news is decreasing: the scatterplot cone is wider (narrower) for lower

(higher) realizations of NIPA corporate profits. Panel B of Figure 4 presents the reverse plot of

NIPA corporate profits on positive and negative return news. The cone is now inverted, which

implies that the conditional relation of NIPA corporate profits and return news is positive for bad

news and negative for good news. The fitted regression lines illustrate these conditional

relations, which correspond to the AT estimates reported in column 2 of Table 2. The reverse

plot highlights the opposite-signed conditional relations while revealing that the conditional

23
adjusted R2 for good news is more than double that for bad news, which is exactly the opposite

from predictions based on conditional conservatism (e.g., Basu 1997).

[INSERT FIGURE 4]

To clarify the mechanics of the return variance effect, Table 5 reports an analysis using

simulated data. To generate a simulated corporate profit series (z), we randomly draw 84

observations from a normal distribution using the mean and variance of the empirical distribution

of NIPA corporate profits. To generate a simulated return news series (rs), we sort the generated

values of z into partitions of low, medium, and high realizations and for each partition we draw

observations from normal distributions with mean zero and variances equal to those of observed

return news corresponding to the low, medium, and high realizations of NIPA corporate profits.

Panel A of Table 5 presents descriptive statistics for the simulated values of z and rs across 1,000

loops. Our simulation procedure performs well in terms of capturing the return variance effect

observed in actual data. Importantly, Panel B of Table 5 confirms that although the unconditional

relation of z with rs is zero, the AT regression model specification yields a negative good news

coefficient, a positive bad news coefficient, and a positive AT coefficient.

[INSERT TABLE 5]

To shed light on the econometrics of the return variance effect, Appendix 2 provides a

simple analytical framework. Our framework is based on the properties of the empirical

distribution of aggregate return news and shows that in the presence of the return variance effect,

the AT coefficient is predicted to be positive even if i) there is symmetry in the conditional

variances of positive and negative aggregate return news, and ii) macro activity and aggregate

return news are unconditionally unrelated. Appendix 2 also helps clarify that in the presence of the

return variance effect the AT coefficient is predicted to converge to zero as the conditional variance of

aggregate return news approaches infinity.

24
 Taken together, the evidence suggests that the return variance effect, i.e., the empirical

regularity that the variance of return news decreases with the level of economic activity, is key to

understanding evidence of asymmetric timeliness at the macro level. Indeed, the return variance

effect has the potential to provide a unifying explanation for puzzling facts that cannot be

explained based on conditional conservatism, including spurious evidence of asymmetric

timeliness for placebo test variables. To be clear, we do not argue that the return variance effect

results in an econometric bias in the AT regression coefficient estimates but rather that this non-

accounting effect causes the true relation between measures of macroeconomic activity and

aggregate return news to differ across partitions based on the sign of aggregate return news,

thereby compromising the validity of the AT coefficient as a measure of accounting

conservatism at the macro level.

Controlling for the return variance effect

What explains the return variance effect at the macro level? We argue that this effect is

unlikely to be attributed to accounting practices. Indeed, the AT regression model effectively

assumes that return news affect the measurement of macro variables and, therefore, there is no

reason to believe that the second moment of the distribution of return news decreases with the

level of economic activity because of conditional conservatism in corporate financial reporting.

Turning to non-accounting reasons for the return variance effect at the macro level, this

phenomenon can be traced back to well-known evidence of countercyclical stock market

volatility (e.g., Officer 1973; Schwert 1989a, 1989b; Schwert 1990; Hamilton and Lin 1996;

Campbell, Lettau, Malkiel, and Xu 2001). The link between stock market volatility and the

general health of the U.S. economy implies that periods of lower economic activity are

associated with a greater chance of large positive or large negative aggregate returns. A long-

25
standing explanation for countercyclical stock market volatility is that economic downturns are

characterized by higher uncertainty about future cash flows and discount rates and, therefore,

higher return variances (e.g., Schwert 1989a, 1989b).19

Next, we argue that a simple way to control for the return variance effect is to introduce

stock market volatility as a control variable in the AT regression model. We measure annual

stock market volatility (VLTt) as the variance of the monthly CRSP value-weighted index returns

for each year. Table 6, Panel A, reports results after expanding the right-hand-side of the AT

regression model to include VLTt.

[INSERT TABLE 6]

Consistent with our argument that evidence of asymmetric timeliness at the macro level

is due to the return variance effect rather than conditional conservatism aggregating up, we find

that such evidence disappears after controlling for the negative relation between the level of

economic activity and the variance of aggregate returns. Looking across columns 1 through 5 in

Table 6, Panel A, we no longer find evidence of asymmetric timeliness in NIPA corporate profits

and GDI as well as our three placebo test variables, including tax corporate profits, GDI

excluding NIPA corporate profits, and the U.S. labor force employment rate.20

19
Schwert (1990) explains that the relation between stock market volatility and the level of economic activity may
also reflect the effects of operating leverage and financial leverage. The operating leverage mechanism is based on
the impact of fixed costs in economic downturns. With high fixed costs, decreases in revenue cause exaggerated
decreases in profits, which are hypothesized to increase stock return volatility. With financial leverage, the
mechanism is based on the debt-to-equity ratio. As equity values decrease in economic downturns, the debt-to-
equity ratio increases, which makes equity capital riskier.
20
In contrast to measures of economic activity, such as NIPA corporate profits and gross domestic income, firm-
level financial accounting data are affected by conditionally conservative accounting practices. Therefore, although
the benchmark value for the AT coefficient that is due to conditional conservatism is zero at the macro level, the
benchmark value is positive at the firm level. Dutta and Patatoukas (2016) show that it is hard to identify this
benchmark value at the firm level because the AT coefficient itself is a function of not only the degree of asymmetry
in financial reporting but also of non-accounting, fundamental firm characteristics.

26
Alternative tests of conditional conservatism at the macro level

Dutta and Patatoukas (2016) propose that a key implication of conditional conservatism

is asymmetry in the distribution of accrual accounting data. Specifically, they predict and find

that in the presence of conditional conservatism the variability of accruals will be higher for bad

news relative to good news partitions. In a series of construct validity tests, they provide

evidence that the spread in the conditional standard deviation of accruals offers a viable

alternative to the AT coefficient as a measure of conditional conservatism at the firm level. This

alternative measure is free of the confounding effects of the return variance effect and, therefore,

one might wonder whether tests of conditional conservatism at the macro level based on this

measure would differ.

As we explain in detail in Section II, a priori one would predict that conditional

conservatism does not aggregate up in NIPA corporate profits. Therefore, construct validity

would imply that the spread in the conditional standard deviation of NIPA corporate profits

across partitions based on the sign of negative and positive aggregate return news should be zero.

We test this prediction in Table 6, Panel B. In sharp contrast to spurious evidence of asymmetric

timeliness at the macro level (see Table 6, Panel A), we find no evidence of asymmetry in the

distribution of NIPA corporate profits, gross domestic income, tax corporate profits, and the U.S.

labor force employment rate. The spread in the conditional standard deviation for each of the

macro variables considered is close to zero and the corresponding p-values based on

bootstrapped F-tests indicate that we cannot reject the null hypothesis of equality in the

conditional variances.

27
Additional analysis: Explaining variation in monetary policy

A long line of research in macroeconomics explains variation in the federal funds ratea

direct indicator of Federal Reserve monetary policy (e.g., Bernanke and Blinder 1992)using

Taylors (1993) rule. Empirical studies of the monetary policy reaction function based on

Taylors rule often rely on the following time-series regression model:

FFRt a 1GAPt 2 INFt t , (3)

where FFRt is the nominal federal funds rate, GAPt is the output gap measured as the percentage

deviation of GDP from the Congressional Budget Offices estimate of potential GDP at full

employment, and INFt is the GDP implicit price deflator.

Crawley (2015) argues that measurement issues introduced to NIPA corporate profits due

to accounting conservatism should be relevant for understanding variation in the federal funds

rate. To test this argument, he estimates equation (3) before and after adjusting the output gap for

an estimate of the dollar value impact of conservatism and finds that this adjustment helps

improve the explanatory power of Taylors rule. Next, we revisit this finding. To adjust output

gap, we follow Crawley (2015) and calculate adjusted GDP as realized GDP plus

1 I (rt 0) rt FAPt 1 , where 1 is the AT coefficient for NIPA corporate profits, I (rt 0) is an

indicator variable for positive return news, rt is return news, and FAPt-1 is the lagged value of

private fixed assets. This adjustment is purported to increase GDP by the dollar amount that

would have been realized for good news years in the absence of asymmetric timeliness.

Panels A and B of Table 7 report descriptive statistics for the monetary policy variables.

Our sample period includes 54 years from 1955 to 2008. Our sample starts in 1955 because this

is the first year for which federal funds rate data are available. Our sample ends in 2008 because

there has not been room for conventional monetary policy since the federal funds rate

28
approached the zero bound in December 2008. The average value of the unadjusted output gap

implies that economic activity fell short of its full potential by 2.9 percent over the sample

period. The adjusted output gap decreases in absolute terms because Crawleys (2015)

adjustment mechanically adds positive amounts to GDP for good news years. Figure 5 presents

the time series of the adjusted and unadjusted output gap. The two output gap series commove

with a correlation coefficient of 80 percent, while they deviate from each other only in positive

return news years (indicated by the shaded regions).

[INSERT TABLE 7]

Panel C of Table 7 reports regression results for the monetary policy reaction function in

equation (3). Following Crawley (2015), we include indicator variables for the tenure of Federal

Reserve Chairmen Paul Volcker, Alan Greenspan, and Ben Bernanke.

Starting with Model (1), our coefficient estimates are consistent with prior research on

Taylor rules (see, e.g., Table 4 in Kozicki 1999). The positive sign of the coefficient estimate on

the output gap is consistent with the Fed leaning against cyclical winds by raising the federal

funds rate if the gap is positive, i.e., if realized GDP is above potential GDP, and lowering the

federal funds rate if the gap is negative, i.e., if realized GDP is below potential GDP.21 Turning

to Model (2), we replace the unadjusted with the adjusted output gap measure and find that the

adjusted R2 slightly decreases from 76.22 percent to 75.91 percent. This decrease

notwithstanding, Vuongs (1989) non-nested likelihood ratio test cannot reject the null

21
While we measure output gap as the percentage deviation of realized GDP from potential GDP following prior
studies (e.g., Taylor 1993; Taylor 1999; Kozicki 1999; Clarida, Gali, and Gertler 2000; Woodford 2001), Crawley
(2015) measures output gap as the dollar amount difference of potential GDP from realized GDP and reports
estimates of the output gap adjustment factor that are hard to reconcile with prior studies on Taylor rules.

29
hypothesis that Models (1) and (2) are equally close to explaining the true data generating

process against the alternative that one model is closer.

[INSERT FIGURE 5]

To gain further insights into relative model performance, Figure 6 presents the time series

of the federal funds rate along with the fitted values from Models (1) and (2). First, we observe

that Taylors rule performs well in terms of describing monetary policy from 1955 to 2008.22

More relevant to our investigation is the relative performance of Models (1) and (2). Figure 6

shows that the two fitted series are almost perfectly correlated with each other with a correlation

coefficient of 98 percent. In terms of forecast errors, i.e., deviations of the federal funds rate

from the fitted values, Panel D of Table 7 shows that the mean absolute forecast error as well as

the root mean squared forecast error slightly increase moving from Model (1) to Model (2).

[INSERT FIGURE 6]

Overall, we conclude that adjusting the output gap by adding positive amounts to GDP

for positive return news years does not help in terms of explaining variation in the federal funds

rate. This conclusion is consistent with the fact that the BEAs objective is to provide neutral

estimates of economic activity regardless of whether times are good or bad.

IV. CONCLUSION

To summarize, our study delivers three key messages. First, annual estimates of NIPA

corporate profits are designed to reflect income from current production with the objective to

provide neutral estimates of economic activity regardless of whether times are good or bad.

Second, our evidence of asymmetric timeliness in placebo settings that are void of conditional
22
Orphanides (2001) notes that estimated monetary policy reaction functions based on ex post revised data obscure
the behavior suggested by information available to the Federal Reserve in real time.

30
conservatism, such as for IRS tabulations of tax corporate profits, gross domestic income after

excluding NIPA corporate profits, and survey-based estimates of the U.S. labor force

employment rate, challenge the construct validity of the AT coefficient as a measure of

conditional conservatism at the macro level. Third, evidence of a negative link between the

variance of return news and the level of economic activity, which is consistent with long-

standing evidence of countercyclical stock market volatility, provides an alternative explanation

for spurious evidence of asymmetric timeliness in NIPA corporate profits.

Our study highlights the importance of construct validity tests in archival studies and

contributes to growing research in the macroeconomic consequences of accounting and the

properties of NIPA data. An interesting direction for future research on the properties of NIPA

data would be to develop ways to measure and compare the quality of aggregate GAAP

earnings versus NIPA corporate profits for decision makers such as professional macro

forecasters and macroeconomists staffing the Federal Reserve and the White House. This group

of decision makers is largely overlooked by the Financial Accounting Standard Boards

conceptual framework.

31
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35
 APPENDIX 1
Derivation of NIPA corporate profits

Year 2009 2010 2011

Total receipts less total deductions, IRS 828.8 1,254.2 1,242.9

Plus:
Adjustment for misreporting on income tax returns 313.5 401.5 366.5
Post-tabulation amendments and revisions 80.0 78.6 94.5
Income of organizations not filing corporation income tax returns 59.5 84.9 90.3
Depletion on domestic minerals 16.1 17.7 20.2
Adjustment to depreciate expenditures for mining exploration,
25.1 25.1 40.4
shafts, and wells
State and local taxes on corporate income 45.6 47.7 50.2
Interest payments of regulated investment companies -134.4 -129.7 -130.5
Bad debt expense 379.4 316.3 252.2
Adjustment to depreciate expenditures for intellectual property
55.0 55.3 57.3
products

Less:
Tax-return measures of:
Gains, net of losses, from sale of property 59.3 152.3 175.2
Dividends received from domestic corporations 155.4 176.1 192.8
Income on equities in foreign corporations and branches (to U.S.
282.9 336.1 304.4
corporations)
Costs of trading or issuing corporate securities 52.1 62.3 54.1
Excess of employer expenses over actual employer contributions
3.5 -20.7 -27.2
for defined benefit employee pension plans

Plus: Income received from equities in foreign corporations and

357.2 395.2 421.9
branches by all U.S. residents, net of corresponding payments

Equals: Profits before taxes, NIPA 1,472.6 1,840.7 1,806.8

Plus:
Inventory valuation adjustment 6.7 -41.0 -68.3
Capital consumption adjustment -82.2 -53.3 78.1

Equals: NIPA corporate profits 1,397.0 1,746.4 1,816.6

This table derives NIPA corporate profits from total receipts less total deductions for corporations reported to the
IRS through a number of adjustments made by the BEA. The table is based on data available in NIPA Tables 7.16
and 1.14, available from the BEA website (http://www.bea.gov/itable/). All numbers are stated in billions of dollars.

36
 APPENDIX 2

In what follows we develop a simple framework illustrating the implications of the return
variance effect for Basus (1997) AT coefficient applied at the aggregate level.

Based on the properties of the empirical distribution of aggregate return news, denoted as r, we
start by making the following assumptions (time subscripts are dropped for brevity)

() = 0,

(| 0) = |(| < 0)|,

(| 0) = (| < 0).

Consistent with empirical evidence that aggregate return news and macroeconomic activity (z)
are unconditionally unrelated, we further assume that

(|) = 0.

As explained in the manuscript, the return variance effect is the phenomenon of high (low)
variance of aggregate return news during periods of abnormally low (high) macroeconomic
activity

(| 0) < (| < 0),

where positive (negative) values of z correspond to periods of abnormally high (low)

macroeconomic activity.

It follows that lower realizations of z are associated with larger absolute values of r and,
therefore, a key implication of the return variance effect is that

(, (|)| 0) < 0, and

(, (|)| < 0) > 0.

Next, we consider Basus (1997) AT regression model adopted at the aggregate level

37
 = + + + + + | 0,

= + + | 0.

where and + are the bad news, i.e., negative aggregate return news, and good news, i.e.,
positive aggregate return news, timeliness coefficients, respectively.

The AT coefficient is the difference between the bad news and the good news timeliness
coefficients

1 = + .

1 denote the OLS estimate of 1. It follows from the properties of OLS regression that
Let

(, | < 0) (, | 0)
1 =
.
(| < 0) (| 0)

Next, we perform the following decomposition

= (|) + + | 0, and

= (|) + | < 0.

Expanding and rearranging the expression for the probability limit of the AT coefficient we get

(, (|) + | < 0) (, (|) + + | 0)

1 =
.
(| < 0) (| 0)

By virtue of OLS properties

(, | < 0) = 0, and

(, + | < 0) = 0.

It follows that the expression for the probability limit of the AT coefficient simplifies as follows

(, (|)| < 0) (, (|)| 0)

1 =
.
(| < 0) (| 0)

38
Given the assumption of symmetry in the conditional variances of positive and negative
aggregate return news, we can rewrite the probability limit of the AT coefficient as follows

(, (|)| < 0) (, (|)| 0)

1 =
.
(| < 0)

The return variance effect implies that

(, (|)| < 0) (, (|)| 0) > 0

and given that

(| < 0) > 0,

it follows that the probability limit of the AT coefficient is predicted to be positive

1 > 0.

We note that due to the return variance effect the probability limit of the AT coefficient is
predicted to be positive even if the following two conditions are satisfied: i) there is symmetry in
the conditional variances of positive and negative aggregate return news, and ii) macro activity
and aggregate return news are unconditionally unrelated. We also note that in the presence of the
return variance effect the AT coefficient is predicted to converge to zero as the conditional
variance of aggregate return news approaches infinity.

39
 TABLE 1
Descriptive statistics

Panel A: Empirical distributions.

N of years Mean Std. Dev. Q1 Median Q3
CPt/FAPt-1 84 0.042 0.015 0.031 0.041 0.051
GDIt/FAt-1 84 0.367 0.041 0.345 0.370 0.388
(GDIt CPt)/FAt-1 84 0.336 0.033 0.315 0.338 0.353
TAXt/FAPt-1 84 0.043 0.019 0.032 0.045 0.053
EMPt 84 0.928 0.048 0.925 0.944 0.954
rt 84 0.000 0.204 -0.126 0.033 0.147
I(rt < 0) 84 0.440 0.499 0.000 0.000 1.000
VLTt 84 0.047 0.028 0.030 0.041 0.056

Panel B: Pairwise correlations.

(1) (2) (3) (4) (5) (6) (7)

(1) CPt/FAPt-1 0.86*** 0.76*** 0.90*** 0.73*** 0.10 -0.62***

(2) GDIt/FAt-1 0.75*** 0.98*** 0.82*** 0.80*** 0.06 -0.59***
(3) (GDIt CPt)/FAt-1 0.59*** 0.97*** 0.74*** 0.78*** 0.06 -0.54***
(4) TAXt/FAPt-1 0.87*** 0.69*** 0.56*** 0.71*** 0.13 -0.62***
(5) EMPt 0.70*** 0.81*** 0.75*** 0.73*** -0.02 -0.67***
(6) rt 0.05 -0.02 -0.04 0.07 -0.06 -0.26**
(7) VLTt -0.51*** -0.38*** -0.32*** -0.46*** -0.35*** -0.30***
This table reports descriptive statistics for the following variables: NIPA corporate profits scaled by lagged private
fixed assets (CPt/FAPt-1), GDI scaled by lagged total fixed assets (GDIt/FAt-1), GDI minus NIPA corporate profits
scaled by lagged total fixed assets (GDIt CPt)/FAt-1, tax corporate profits scaled by lagged private fixed assets
(TAXt/FAPt-1), the U.S. labor force employment rate (EMPt), return news measured as the realized stock market
return minus the time-series average return (rt), the indicator variable for negative return news (I(rt<0)), and the
variance of monthly aggregate returns in each year (VLTt). Panel A reports empirical distributions. Panel B reports
Pearson (Spearman) correlations above (below) the main diagonal. *** and ** indicate statistical significance at the
1 percent level and 5 percent level, respectively, using two-tailed tests. The sample period includes 84 years from
1929 to 2012.

40
 TABLE 2
Evidence of asymmetric timeliness in the NIPA

Dependent variable =
CPt / FAPt-1 GDIt / FAt-1
(1) (2) (3) (4)
Intercept 0.042*** 0.052*** 0.367*** 0.392***
(18.54) (12.93) (59.61) (37.69)

I (rt 0) . -0.008 . -0.020

. (-1.46) . (-1.35)

rt 0.007 -0.058** 0.013 -0.141**

(0.77) (-2.43) (0.45) (-2.26)

I (rt 0) rt . 0.088*** . 0.201***

. (3.48) . (2.72)

Adj. R2 -0.21% 11.92% -0.80% 7.31%

N of years 84 84 84 84
This table reports results from asymmetric timeliness regressions of NIPA corporate profits scaled by lagged private
fixed assets (CPt/FAPt-1) and gross domestic income scaled by lagged total fixed assets (GDIt/FAt-1) on positive and
negative return news (rt). We measure return news as the realized return in year t minus the time-series average
return. The indicator variable I(rt<0) takes the value one if return news is negative and zero otherwise. Newey and
West (1987) heteroscedasticity and autocorrelation consistent t-statistics with a finite sample adjustment are reported
in parentheses below the coefficient estimates. *** and ** indicate statistical significance at the 1 and 5 percent
level, respectively, using two-tailed tests. The sample period includes 84 years from 1929 to 2012.

41
 TABLE 3
Placebo tests of asymmetric timeliness at the macro level

Dependent variable =
TAXt/FAPt-1 (CPt TAXt)/FAPt-1 (GDIt CPt)/FAt-1 EMPt
(1) (2) (3) (4)
Intercept 0.053*** -0.001 0.354*** 0.962***
(11.58) (-0.55) (44.06) (85.88)

I (rt 0) -0.003 -0.005* -0.014 -0.020

(-0.42) (-1.73) (-1.21) (-0.95)

rt -0.054** -0.004 -0.098** -0.214**

(-2.05) (-0.50) (-2.09) (-2.17)

I (rt 0) rt 0.107*** -0.018 0.139** 0.301***

(3.24) (-1.18) (2.34) (2.87)

Adj. R2 9.89% 2.63% 4.61% 11.73%

N of years 84 84 84 84
This table reports results from asymmetric timeliness regressions of tax corporate profits scaled by lagged private
fixed assets (TAXt/FAPt-1), NIPA corporate profits minus tax corporate profits scaled by lagged private fixed assets
(CPt TAXt)/FAPt-1, gross domestic income minus NIPA corporate profits scaled by lagged total fixed assets,
denoted (GDIt - CPt)/FAt-1, and the employment rate (EMPt) on positive and negative return news (rt). We measure
return news as the realized return in year t minus the time-series average return. The indicator variable I(rt<0) takes
the value one if return news is negative and zero otherwise. Newey and West (1987) heteroscedasticity and
autocorrelation consistent t-statistics with a finite sample adjustment are reported in parentheses below the
coefficient estimates. ***, **, and * indicate statistical significance at the 1, 5, and 10 percent level, respectively,
using two-tailed tests. The sample period includes 84 years from 1929 to 2012.

42
 TABLE 4
Return variance effect at the macro level

Panel A: NIPA corporate profits.

Portfolio N of years Avg(CPt /FAPt-1) Var(rt) Avg(rt | rt < 0) Avg(rt | rt > 0)
Low 28 0.026 0.069 -0.247 0.182
Medium 28 0.041 0.031 -0.150 0.138
High 28 0.057 0.026 -0.148 0.125
Full sample 84 0.042 0.041 -0.186 0.146

Panel B: Gross domestic income.

Portfolio N of years Avg(GDIt /FAt-1) Var(rt) Avg(rt | rt < 0) Avg(rt | rt > 0)
Low 28 0.324 0.068 -0.236 0.190
Medium 28 0.370 0.033 -0.140 0.147
High 28 0.406 0.026 -0.194 0.107
Full sample 84 0.367 0.041 -0.186 0.146

Panel C: Gross domestic income excluding NIPA corporate profits.

Portfolio N of years Avg((GDIt - CPt )/FAt-1) Var(rt) Avg(rt | rt < 0) Avg(rt | rt > 0)
Low 28 0.301 0.069 -0.238 0.190
Medium 28 0.338 0.024 -0.110 0.145
High 28 0.368 0.031 -0.198 0.105
Full sample 84 0.336 0.041 -0.186 0.146

Panel D: Tax corporate profits.

Portfolio N of years Avg(TAXt /FAPt-1) Var(rt) Avg(rt | rt < 0) Avg(rt | rt > 0)
Low 28 0.024 0.065 -0.222 0.194
Medium 28 0.044 0.037 -0.203 0.143
High 28 0.062 0.022 -0.126 0.115
Full sample 84 0.043 0.041 -0.186 0.146

43
Panel E: U.S. labor force employment rate.
Portfolio N of years Avg(EMPt ) Var(rt) Avg(rt | rt < 0) Avg(rt | rt > 0)
Low 28 0.882 0.057 -0.206 0.175
Medium 28 0.942 0.043 -0.196 0.147
High 28 0.961 0.026 -0.161 0.115
Full sample 84 0.928 0.041 -0.186 0.146

Panels A through E of this table examine variation in the return news variance and the conditional average values of
positive return news (rt| rt 0) and negative return news (rt| rt < 0) across equal-sized partitions of low, medium, and
high realizations of different macro variables, including NIPA corporate profits scaled by lagged private fixed assets
(CPt/FAPt-1), GDI scaled by lagged total fixed assets (GDIt/FAt-1), GDI excluding NIPA corporate profits scaled by
lagged total fixed assets (GDIt CPt)/FAt-1, tax corporate profits scaled by lagged private fixed assets (TAXt/FAPt-1),
and the U.S. labor force employment rate (EMPt). The sample period includes 84 years from 1929 to 2012.

44
 TABLE 5
Simulation analysis of the return variance effect

Panel A: Empirical distributions of simulated data (1,000 loops).

Portfolio N per loop Avg(zt) Var(rs) Avg(rs | rs < 0) Avg(rs | rs 0)
Low 28 0.025 0.071 -0.211 0.214
Medium 28 0.041 0.032 -0.145 0.140
High 28 0.057 0.025 -0.127 0.127
Full sample 84 0.041 0.043 -0.161 0.160

Panel B: Asymmetric timeliness regression results using simulated data (1,000 loops).
Dependent variable = zt
(1) (2)
Intercept 0.042*** 0.046***
(248.86) (115.43)

I (r s 0) . 0.000
. (0.04)

rs 0.000 -0.028***
(0.09) (-14.95)

I (r s 0) r s . 0.055***
. (20.97)

Adj. R2 -0.05% 5.52%

N per loop 84 84
This table reports results from a simulation designed to illustrate the implications of the return variance effect
using generated data for corporate profits and return news. To generate a simulated corporate profit series (z), we
randomly draw 84 observations from a normal distribution using the mean and variance of the empirical distribution
of scaled NIPA corporate profits. To generate a simulated return news series (rs), we first sort the generated values
of z into partitions of low, medium, and high realizations and separately for each partition we draw observations
from normal distributions with mean zero and variances equal to those of observed return news corresponding to the
low, medium, and high realizations of scaled NIPA corporate profits. Panel A presents average descriptive statistics
for the generated values of z and rs across 1,000 loops. Panel B presents the average coefficient estimates from
regressions of z on rs across 1,000 loops. The t-statistics are based on the standard errors of the coefficient
distributions. *** indicates statistical significance at the 1 percent level, using two-tailed tests.

45
 TABLE 6
Controlling for the return variance effect

Panel A: Expanding the AT regression model.

Dependent variable =
CPt / FAPt-1 GDIt / FAt-1 TAXt / FAt-1 (GDIt - CPt ) / FAt-1 EMPt
(1) (2) (3) (4) (5)
Intercept 0.060*** 0.414*** 0.063*** 0.370*** 0.991***
(16.65) (46.28) (15.67) (52.47) (125.10)

I (rt 0) -0.004 -0.009 0.002 -0.006 -0.004

(-0.90) (-0.76) (0.44) (-0.60) (-0.27)

rt -0.027* -0.055 -0.014 -0.034 -0.097

(-1.74) (-1.27) (-0.92) (-0.95) (-1.50)

I (rt 0) rt 0.029 0.035 0.031 0.016 0.077

(1.49) (0.60) (1.36) (0.30) (0.93)

VLTt -0.308*** -0.856*** -0.392*** -0.637*** -1.159***

(-10.27) (-9.01) (-8.72) (-7.82) (-8.27)

Adj. R2 37.15% 33.46% 36.62% 27.23% 47.30%

N of years 84 84 84 84 84

46
Panel B: Alternative measure of conditional conservatism.
Std ( zt | rt 0) Std ( zt | rt 0) Spread p-value
CPt / FAPt-1 0.014 0.016 0.002 0.74
GDIt / FAt-1 0.038 0.043 0.005 0.72
TAXt / FAPt-1 0.019 0.018 -0.001 0.35
(GDIt - CPt) / FAt-1 0.031 0.034 0.003 0.67
EMPt 0.050 0.046 -0.004 0.40
Panel A reports results from asymmetric timeliness regressions of NIPA corporate profits scaled by lagged private
fixed assets (CPt/FAPt-1), gross domestic income scaled by lagged total fixed assets (GDIt/FAt-1), tax corporate
profits scaled by lagged private fixed assets (TAXt/FAPt-1), gross domestic income minus NIPA corporate profits
scaled by lagged total fixed assets (GDIt CPt)/FAt-1, and the U.S. labor force employment rate (EMPt) on positive
and negative aggregate return news (rt) and the variance of monthly aggregate returns in each year (VLTt). We
measure return news as the realized return in year t minus the time-series average return. The indicator variable
I(rt<0) takes the value one if return news is negative and zero otherwise. Newey and West (1987) heteroscedasticity
and autocorrelation consistent t-statistics with a finite sample adjustment are reported in parentheses below the
coefficient estimates. Panel B reports the conditional standard deviation of macro variables across partitions based
on the sign of aggregate return news, along with the spread of the conditional standard deviations and the
corresponding p-values of bootstrapped F-tests testing the null hypothesis of equality in the conditional variances.
*** and * indicate statistical significance at the 1 and 10 percent level, respectively, using two-tailed tests. The
sample period includes 84 years from 1929 to 2012.

47
 TABLE 7
Explaining variation in monetary policy

Panel A: Empirical distributions of monetary policy variables.

N of years Mean Std. Dev. Q1 Median Q3
FFRt 54 0.056 0.034 0.031 0.052 0.072
GAPt 54 -0.029 0.024 -0.041 -0.029 -0.015
GAPt adj 54 -0.017 0.025 -0.034 -0.018 0.001
INFt 54 0.036 0.023 0.020 0.030 0.046

Panel B: Pairwise correlations of monetary policy variables.

(1) (2) (3) (4)
(1) FFRt -0.29** -0.22 0.73***
(2) GAPt -0.11 0.80*** -0.42***
(3) GAPt adj -0.11 0.77*** -0.41***
(4) INFt 0.64*** -0.27** -0.30**

Panel C: Monetary policy reaction functions: Regression coefficient estimates.

Dependent variable = FFRt
Model (1) Model (2)
Intercept 0.016** 0.011*
(2.48) (1.92)

GAPt 0.368*** .
(3.71) .

GAPt adj . 0.329***

. (3.33)

INFt 1.067*** 1.063***

(8.44) (7.96)

VOLCKERt 0.056*** 0.052***

(8.29) (7.55)

GREENSPANt 0.015** 0.014**

(2.18) (2.08)

BERNANKEt 0.001 0.003

(0.08) (0.35)

Adj. R2 76.22% 75.91%

N of years 54 54
Vuong (1989) non-nested likelihood ratio test:
H0 Model fits are equal for the focal population;
H1a Model (1) fits better than Model (2) z-statistic = 0.140, p-value = 0.44;
H1b Model (2) fits better than Model (1) z-statistic = 0.140, p-value = 0.56.

48
Panel D: Monetary policy reaction functions: Predictive ability comparisons.
Model (1) Model (2)
Mean absolute forecast error 0.0132 0.0133
Root mean squared forecast error 0.0156 0.0157

Panel A of this table presents the empirical distributions of the following variables: the effective U.S. federal funds
rate (FFRt), the unadjusted output gap measured as the percentage deviation of GDP from potential GDP (GAPt),
adjusted output gap ( GAPt adj ) measured as the percentage deviation of conservatism-adjusted GDP from
potential GDP, and inflation measured as the percentage change in the GDP implicit price deflator (INFt). We obtain
data on the GDP implicit price deflator and the Congressional Budget Offices estimate of potential GDP at full
employment from the FRED database of the Saint Louis Fed (https://research.stlouisfed.org/). Following Crawley
(2015), we measure conservatism-adjusted GDP as realized GDP plus 0.088 I (rt 0) rt FAPt 1 , where I (r 0)
is an indicator variable for positive return news, rt is return news, and FAPt-1 is the lagged value of private fixed
assets. Panel B reports Pearson (Spearman) correlations above (below) the main diagonal. Panel C reports results
from regressions of the effective federal funds rate on output gap and inflation along with indicator variables for the
tenure of Federal Reserve Chairmen Paul Volcker from 1979 to 1986 (VOLCKERt), Alan Greenspan from 1987 to
2005 (GREENSPANt), and Ben Bernanke from 2006 to 2008 (BERNANKEt). Newey and West (1987)
heteroscedasticity and autocorrelation consistent t-statistics with a finite sample adjustment are reported in
parentheses below the coefficient estimates. ***, **, and * indicate statistical significance at the 1, 5, and 10 percent
level, respectively, using two-tailed tests. Panel D reports the mean absolute forecast errors and root mean squared
forecast errors of Models (1) and (2) estimated in Panel C. The sample period includes 54 years from 1955 to 2008.

49
 FIGURE 1
Time series of contribution of NIPA corporate profits to gross domestic income
0.14

0.12
CPt / GD
GDIt
0.10
NIPA Corporate Profits to GDI

0.08

0.06

0.04

0.02

0.00

-0.02
1957
1929
1933
1937
1941
1945
1949
1953

1961
1965
1969
1973
1977
1981
1985
1989
1993
1997
2001
2005
2009
This figure presents the time series of the percentage contribution of the domestic portion of NIPA corporate profits
to gross domestic income (CPt/GDIt). The sample period includes 84 years from 1929 to 2012.

50
 FIGURE 2
Time series of aggregate return news
0.60
Abnormal returns
Residual returns
0.40
Aggregate return news

0.20

0.00

-0.20

-0.40

-0.60
1945
1929
1933
1937
1941

1949
1953
1957
1961
1965
1969
1973
1977
1981
1985
1989
1993
1997
2001
2005
2009
This figure presents the time series of two alternative measures of aggregate return news. The solid line presents the
time series of realized aggregate returns minus the time-series average stock market return. The dashed line presents
the time series of our replication of Crawleys (2015) return news variable, which is measured as the residual from a
regression of realized aggregate returns on lagged aggregate returns, the log dividend yield on the S&P 500 index
available from Professor Robert Shillers website (http://www.econ.yale.edu/~shiller/data.htm), the spread of BAA-
rated corporate bond yields over the AAA-rated corporate bond yields available from the Saint Louis Fed, and the
small stock value spread available from Professor Kenneth Frenchs website
(http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html). The two series of return news are 98
percent correlated. The sample period includes 84 years from 1929 to 2012.

51
 FIGURE 3
Time series of NIPA corporate profits and tax corporate profits
0.10
CPt / FAPt-1
TAXt / FAPt-1
0.08

0.06

0.04

0.02

0.00

-0.02
1953

1981
1929

1933

1937

1941

1945

1949

1957

1961

1965

1969

1973

1977

1985

1989

1993

1997

2001

2005

2009
This figure presents the time series of NIPA corporate profits scaled by lagged private fixed assets (CPt/FAPt-1) and
the IRS tabulations of tax corporate profits scaled by lagged private fixed assets (TAXt/FAPt-1). The two series are 90
percent correlated. The sample period includes 84 years from 1929 to 2012.

52
 FIGURE 4
Scatterplots of NIPA corporate profits and aggregate return news

Panel A: Plot of aggregate return news on NIPA corporate profits.

0.60
y = 1.355x - 0.056
Adj. R = -0.21%
0.40
Aggregate return news

0.20

0.00

-0.20

-0.40

-0.60
-0.01 0.00 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09
NIPA corporate profits

Panel B: Plot of NIPA corporate profits on aggregate return news.

0.09

0.08 y = 0.030x + 0.044 y = -0.058x + 0.052

Adj. R = 6.05% Adj. R = 13.17%
0.07
NIPA corporate profits

0.06

0.05

0.04

0.03

0.02

0.01

0.00

-0.01
-0.60 -0.40 -0.20 0.00 0.20 0.40 0.60
Aggregate return news

Panel A of this figure presents the scatterplot of aggregate return news (rt) on NIPA corporate profits scaled by
lagged private fixed assets (CPt/FAPt-1) along with the fitted regression line for the full sample. Panel B presents the
reverse scatterplot of scaled NIPA corporate profits on positive and negative return news along with the piecewise
linear regression lines fitted separately for the good and bad news subsamples formed based on the sign of aggregate
return news. The sample period includes 84 years from 1929 to 2012.

53
 FIGURE 5
Time series of U.S. output gap
0.05 1

adjusted GAP 0

0
0.00
0
Output gap

0
-0.05
0

0
unadjusted GAP
-0.10 0
1971
1955

1959

1963

1967

1975

1979

1983

1987

1991

1995

1999

2003

2007
This figure presents the time series of two alternative measures of U.S. output gap. The solid line presents the time
series of unadjusted output gap (GAPt) measured as the percentage deviation of realized GDP from potential GDP
as of the end of year t. The dashed line presents the time series of adjusted output gap ( GAPt adj ) measured as the
percentage deviation of conservatism-adjusted GDP from potential GDP as of the end of year t. Following
Crawley (2015), we measure conservatism-adjusted GDP as realized GDP plus 0.088 I (rt 0) rt FAPt 1 , where
I(rt 0) is an indicator variable for positive return news, rt is our measure of return news based on realized aggregate
stock returns minus the time-series average stock return, and FAPt-1 is the lagged value of net fixed assets owned by
all businesses. The two measures of output gap are 80 percent correlated. The shaded regions indicate years with
positive return news. The period examined includes 54 years from 1955 to 2008.

54
 FIGURE 6
Time series of the U.S. effective federal funds rate
0.20
Realized
Fitted (1)
Fitted (2)
Realized & fitted federal funds rate

0.15

0.10

0.05

0.00
1955

1959

1963

1967

1971

1975

1979

1983

1987

1991

1995

1999

2003

2007
This figure presents the time series of the realized effective federal funds rate along with the fitted values from
the monetary policy reaction functions estimated in Models (1) and (2) of Table 5. The dotted line presents the
realized federal funds rate. The solid line presents the fitted values obtained from Model (1), which is based on the
unadjusted output gap (GAPt). The dashed line presents the fitted values obtained from Model (2), which uses the
conservatism-adjusted output gap (GAPtadj). The two fitted series are 98 percent correlated. The sample period
examined includes 54 years from 1955 to 2008.

55