USEFULNESS OF ACCOUNTING INFORMATION TO

INVESTORS AND CREDITORS

In chapter 4, we suggested that an explicit political economy of accounting recognizes that
alternative financial reporting systems (for example regulated versus unregulated) have both
private and social consequences, that in any system some people will fare better while others
fare worse, and that the choice of system itself is a political as well as an economic act.
Consistent with this, the FASB appears to recognize the existence of a diverse and pluralistic
user group (see chapter 7). However, in practice, the FASB has focused on what it calls
primary user groups (investors and creditors) who are assumed to be mainly interested in the
amounts, timing, and uncertainties of future cash flows. The rationale for the investor-creditor
focus is that other users either have a commonality of interest with investors and creditors or
the means of getting alternative information, such as governments have for taxation purposes
and rate-setting bodies for utility pricing. The FASBs cost-benefit calculus is similarly
restricted to benefits for investors and creditors, and cost considerations are confined only to
producers.
We dont believe that the FASBs focus on producers and the primary user group of
investors and creditors fully represents the political economy of accounting. However, the
purpose of this chapter is to examine theoretical and empirical evidence for the usefulness of
financial accounting data to the FASBs primary user group, investors and creditors. The
chapter concludes with a brief assessment of the usefulness of accounting allocations.
ACCOUNTING DATA AND MODELS OF FIRM VALUATION
Gordons dividend valuation model is a useful starting point in understanding the relationship
between accounting data and the value of the firm. This model posits that the value of the
firm to stockholders is the present value of future expected dividens to be received ;by
stockholders. Beaver uses the dividend valuation model to formulate the role of accounting
earnings in determining firm value. First, present security prices are defined as a function of
expected future dividens. Second, future dividends themselves are a function of future
earnings. Finally, current accounting income is useful in predicting future earnings; therefore,
current income is informative vis--vis its predictive ability with respect to future earnings
(and ultimately future dividends). So, in this formulation, accounting income has value
indirectly through its role in assessing future expected dividends. This, of course, is

predictive value, which is one of the major arguments for the relevance of accounting
information.
More recent work in financial economics regarding the theoretical value of the firms
traces back to Miller and Modiglianis seminal work in which they argue that dividend policy
is irrelevant to firm valuation. Ignoring the complicating effect of taxes, they show that the
value of the firm can be equivalently modeled (independent of dividens) as the present value
of future net cash flows, where net cash flows per period are defined as cash flows from
operations minus cash investment in assets. This notion of net cash flow is the same used in
capital budgeting-present value analysis. Miller and Modiglianis net cash flow model was
originally a certainty-equivalent model but has been extended to a more general model in
which there is uncertainty as to the future operating cash flows. The attractiveness of the cash
flow valuation model for accounting is that it maps directly into the accounting system : that
is, cash flows are explicitly measured in accounting systems, whereas dividends are a matter
of corporate policy and have nothing to do with accounting systems per se.
Interestingly, the FASB has also adopted (implicity) the cash flow valuation model. In
SFAC No.1, the role of financial reporting is characterized as aiding investors, creditors, and
others in assessing the amounts, timing and uncertainty of the enterprises prospective net
cash flows. Further the FASB has asserted that accrual accounting system, and accrual
income numbers in particular are more useful for this purpose than are simpler cash-based
systems:
.accrual accounting generally provides a better indication of an enterprises
present and continuing ability to generate favocable cash flows than information
limited to the financial effects of cash receipts and payments.(SFAC No.1,preface)
Beaver agrees with this assertion, arguing that an accrual can be viewed as a form of
forecast about the future. There is empirical evidence that future cash flows are better
forecast with accrual data than with cash flow data. And, in stock market studies, security
prices are more highly correlated with accrual income than with either cash flows or working
capital flows. Numerous studies (reviewed in this chapter) have documented that changes in
reported accounting earnings affect firm valuation through changes in stock prices. Changes
in current period earnings should affect stock prices and the markets valuation of the firm if
investors view such changes as permanent or persisting into the future. If this is the case, then
expectations of future period cash flows should also be affected, hence the explanation for
changes in stock prices as a function of the expected persistensy of earnings changes.

The implications of this theoretical literature is that accrual accounting systems

incorporate the attribute that determines firm valuationnet cash flow data. However, the
value to investors of the information in financial reporting does not lie in its role as an
historical record; rather, its usefulness lies in its potential for revising investors assessments
of future period cash flows. A theoretical formulation of how accounting information impacts
upon assessments of future cash flows appears in appendix 8-A.
THE VALUE OF ACCOUNTING INFORMATION FOR INVESTORS
As mentioned above, the usefulness of accounting information to investors has been
empirically investigated through the association (or lack thereof) of publicly released
accounting data with changes in the firms security prices. If there is a significant association,
then there is evidence that accounting information is useful with respect to firm valuation.
These studies also constitute tests of the so-called efficient-markets hypothesis.
The efficient-markets hypothesis (EMH) refers to speed with which securities in the
capital market respond to announcements of new information. The classic definition of
market efficiency is that (1) the market fully reflects available information and (2) by
implication, market prices react instantaneously to new information. In other words, new
information is quickly impounded in the price of the security. If the hypothesis is correct, an
item of information has value to investors only if there is evidence of a price response to the
new information. When this occurs, the item of information is said to have information
content. There are three forms of the efficient-markets hypothesis. The weak form says that
security prices reflect information contained in the sequence of historical (past) prices; the
semistrong form says that prices reflect all past and current information that is publicly
available; and the strong form says that prices reflect all information (both public and
private). Most testing has been of the semistrong form, which deals with publicly available
information. Much of the information tested has been of an accounting nature-for example,
financial statement data and earnings announcements.
The theoretical foundation of capital market or security price research comes from
portfolio theory, which is a theory of rational investment choice and utility maximization :
simply stated, risk can be reduced by holding a portfolio of investments. Risk that can be
eliminated in this manner is called unsystematic (diversifiable) risk, while the remaining
portfolio risk is called systematic (undiversifiable) risk. In portfolio theory, systematic risk
is defined as the variance of expected investment returns. We conveniently think of expected
return as a single number, but in reality it is a probability distribution of possible returns. The

larger the variance around the mean of expected returns, the greater the risk associated with
the investment. This variance may be quite high in individual stocks but when evaluated for a
portfolio as a whole, it is much lower. The reason for this situation is that variances lof
individual securities are offset when combined in a portfolio. In this way, it is possible to
select a stock portfolio that minimizes risk (variance) for a given rate of return. What remains
after eliminating all the risk possible is called nondifersifiableor systematic risk of the
portfolio. And that risk which has been eliminated through diversification is called
diversifiable or unsystematic risk. An investor will rationally select a portfolio with a riskreturn relation that meets the investors own utility preferences. The theoretical choice of
portfolios is graphically presented in Exhibit 8-1. The capital market line represents
alternative portfolios of increasing levels of systematic risk. Since investors are risk averse,
the expected portfolio return increases as risk increases. The capital market line is linear only
under restrictive conditions, but whether linear or curvilinear, a direct relationship exists
between the level of risk and expected returns.
Portfolio theory is the foundation for a related development in finance-the pricing of
individual stocks given the concept of diversified portfolios. A model called the capital asset
pricing model has been developed for the theoretical pricing of individual stocks. Its first
step is to relate the risk of an individual security relative to the market as a whole. The market
is assumed to be a diversified portfolio. A correlation is made between the returns on
individual stocks and market returns over a period of time. The correlations are illustrated as
a scattergram in Exhibit 8-2. Regression analysis used to fit a line to the scattergram.

The slope of the characteristic line is called beta and represents a market-based measure of
the systematic risk of an individual security relative to the average risk in the market as a
whole. If beta equals 1, the returns are perfectly associated and the risks are equal. If beta
exceeds 1, the returns on the individual stock are greater than the market. In otherwords, if
the rate of return on an individual security is greater than the market average, systematic risk
of the security must also be greater because of the direct relationship between risk levels and
expected returns. Higher returns must be accompanied by higher risks.
The assumption of capital asset pricing model is that individual securities are priced
solely on systematic risk. Given the assumption of diversified portfolios, it is argued that no

one would pay for unsystematic risk. Beta is used to represent systematic risk of individual
securities and to predict the risk-based price of securities. A standard two-parameter version
of the capital asset pricing model defines the predicted rate of return for an individual
security as

Unexpected returns or abnormal returns for any time period are captured in the error term
ej

in Equation (8.3). A common research approach in accounting studies has been to

regress these abnormal returns on accounting variables, such as unexpected reported

earnings, for the same time period to determine if there is information content, in which case
there would be evidence that firm valuation is correlated with accounting information.
Before reviewing the empirical findings, we should make a few observations
regarding the difficulties of doing this type of research. The study of price movements and
the pricing mechanism in any market is an imposing task. Determining cause and effect
between information and security prices is especially difficult because new information is
continuously causing price movements. Since the set of information affecting security prices
is large, it is extremely difficult to isolate the effects of one piece of information. This
difficulty means that the tests are going to be somewhat crude rather than precise. The
research should be examined with this in mind. Failure to find evidence of information
content should thus be interpreted cautiously, for the methodology is not always capable of
detecting information content. For this reason, the stronger evidence from efficient-markets
research exists where there is information content rather than where there is none.
Another weakness of capital market research is that it is a joint test of both market
efficiency and information content. The absence of price responses is usually interpreted to
mean that the information tested has no information content. This interpretation is correct
only if the market is efficient. But what if the market is inefficient? If the market is
inefficient, there is no way of determining what the absence of a price response means. This
is another reason why the research findings are much stronger when there is evidence of
information content.

A final point is that market-based research necessarily considers only the aggregate
effect of individual investor decision making. That is, the role of accounting information vis-vis an individual investors decision making is implicitly modeled as a black box : an
event, the reporting of accounting information, occurs, and the effect of this event is then
inferred from whether or not there was an aggregate (market) reaction. As an alternative ,
Appendix 8-A presents an investor decision model that explicity models the role of
information in revising expectations about future cash flows at the level of an individual
investor.
INFORMATION CONTENTS OF EARNINGS ANNOUNCEMENTS
The strongest evidence from capital market research concerns the information content of
annual accounting earnings numbers. The seminal study, published in 1968, showed that the
direction of change in reported accounting earnings (from the prior year) was positively
correlated with security price movements. The study also found that the price movements
anticipated the earnings results and that there was virtually no abnormal price movement one
month after the earnings were announced. This is consistent with the semistrong form of the
efficient-markets hypothesis. A later study showed that the magnitude as well as direction of
unexpected earnings are associated with changes in security prices. Quarterly earnings
announcements have also shown the same general results.
These results are not surprising. We would expect accounting income to be part of the
information used by investors in assessing risk and return. Capital market research has
confirmed an almost self-evident proposition. The findings are important, though, in formally
linking accounting information with investment decisions and hence with usefulness to
investors.
ALTERNATIVE ACCOUNTING POLICIES AND SECURITY PRICES
A more complex type of securities-price research has examined the effect of alternative
accounting policies on security prices. The initial purpose of these tests was to investigate the
so-called nave-investor hypothesis. Research has found that security prices respond to
accounting income numbers. Alternative accounting policies-for example, flexibility in the
choice of depreciation and inventory methods-can affect net income. Although these methods
affect reported earnings, there is no apparent impact on company cash flows. These types of
accounting alternatives simply represent different patterns of expense recognition or cost
allocations.

The questions of interest to researches is whether alternative accounting policies have

a systematic effect on security prices. If security prices do respond to income levels that
differ solely because of alternative accounting methods, with no cash flow consequences,
then there is support for the nave-investor hypothesis. On the other hand, if security prices
do not respond to such artificial book-income differences, then there is evidence that
investors in the market are sophisticated and able to see through such superficial bookkeeping
differences. Virtually all the initial research was interpreted as rejecting the nave-investor
hypothesis. However, recent research findings have challenged some of the earlier
conclusions and reopened what was once considered a closed issue in accounting research.
ALTERNATIVES WITH NO KNOWN CASH FLOWS CONSEQUENCES
Several studies have compared companies using different accounting methods. One of the
earliest studies compared companies using accelerated versus straight-line depreciation
methods. The two groups of companies had different accounting income numbers because
they used alternative depreciation methods; thus there were differences in income between
the two groups of companies due to the use of alternative depreciation accounting methods.
There were also differences in price-earnings multiples between the two groups. Companies
using accelerated methods had lower earnings but higher price-earnings multiples than
companies using straight-line. However, when earnings of companies using accelerated
methods were adjusted to a straight-line depreciation basis, the price-earnings multiple
between the two groups of companies was not significantly different.
The assessments of the companies in the market did not appear to be affected by
arbitrary and alternative accounting income numbers. This finding is often expressed as the
market is not fooled by arbitrary accounting differences. Other similar research has
supported this conclusions. Additional areas tested include purchase versus pooling
accounting, expensing versus capitalizing research and development costs, and recognition
versus deferral of unrealized holding gains on marketable securities.
A related area of investigation concerns security-price responses to a reported change
in accounting policy by a company. Changes in depreciation policy have been researched,
and there is no evidence that the change per se affects security prices. Another area tested has
been a change from the deferral to flow-through method of accounting for the investment
credit. Again, no prices effects were found. Although changes in accounting policies may
cause the income number to change (solely because of the policy change), these research
studies have not found that security prices respond to the changes. Higher accounting income

achieved solely from a change in accounting policy with no apparent real changes in
underlying cash flows does not appear to fool the market.
The evidence from the type of research discussed in the preceding paragraphs
supports the claim that there is no information content in accounting policy changes, at least
where there are no apparent underlying changes in cash flows. This finding has also been
interpreted as a rejection of the nave-investor hypothesis. Investors appear to adjust
accounting income to compensate for artificial bookkeeping differences with no real
substance. That is, investors do not appear to respond mechanistically and naively to changes
in reported accounting income numbers.
AN ALTERNATIVE WITH CASH FLOW
CONSEQUENCES: THE LIFO CHOICE
One type of change in accounting policy that does produce a security-price response is a
change from FIFO to LIFO inventory accounting. Changes to LIFO have been associated
with a positive security-price movement, even though LIFO lowers accounting income in a
period of rising inventory prices. Given the apparent sophistication of investors in other areas
of accounting policy differences, what can be the logical explanation for these price
responses? The suggested reason for the price response is that LIFO must be adopted for
financial statement purposes if the tax benefit is desired. In a period of rising prices, tax
expense will be lower for companies that use LIFO, in which case there are real cash flow
consequences due to the change in accounting policy. Even though book income is lowered
by the use of LIFO, cash flows are higher because the taxable income is lower. Positive
security-price responses are therefore consistent with an increase in the value of the firm due
to tax savings.
Other studies, however, contradict these findings concerning the effect of the changes.
These studies either found no evidence of price response or found evidence of a negative
price response. Either result is contrary to the earlier finding of positive price responses. The
recent studies suggest the earlier research may have failed to isolate the real effect of the
LIFO change because of a self-selection bias. (this means that companies changing to LIFO
had other things occurring simultaneously that confounded the results and may have caused
the positive price response). But if these studies are correct, then there may be some support
for the nave-investor hypothesis. There are positive tax benefits associated with the LIFO
change that should increase the value of the firm. Yet security-price responses were not
positive. Since LIFO will lower accounting book income, a negative price response could be

interpreted as a mechanistic response to a lower accounting number, a response made without

considering the positive cash flow cosequences due to lower taxes.
As discussed at the beginning of this section, security-price research is extremely
difficult to conduct. The LIFO choice issue amply illustrates this point. The early LIFO
research rejected the nave-investor hypothesis. Later research on the LIFO question
reopened what was once thought to be a closed issue with respect to market efficiency.
ALTERNATIVES WITH INDIRECT CASH CONSEQUENCES-AGENCY THERY
Recent security-price research has been probing a more subtle issue referred to as indirect
consequences. An indirect consequence occurs when an accounting policy change affects the
value of the firm through an indirect effects on owners, rather than a direct effect on company
cas flows. One such study was motivated by an attempt to explain why securities prices of
certain oil and gas companies responded negatively to a mandatory change in accounting
policy. The required change from full costing to successful efforts was regarded as simply a
change in how exploration costs are allocated to the income statement. Therefore, it was
expected that no security-price response would be evident since there was no direct cash flow
consequences to the companies.
However, security-price responses were found to exist and since previous research
had predominantly rejected the nave-investor hypothesis, a search was made for the
existence of some indirect cash flow consequences to explain the price response. The study
posited that a change to successful-efforts accounting for oil and gas exploration costs
lowered firms ability to pay dividends in the short term, because of restrictive debt
covenants. Therefore, even though the change in accounting policy appeared to affect only
book income on the surface, there were indirect cash flow consequences to investors, which
might explain the negative price response. This explanation derives from agency theory.
When accounting numbers are used to monitor agency contracts, there can be indirect
consequences on the firms owner and creditors from changes in accounting policies. In the
case of debt covenants restricting dividend payments, accounting numbers are used to protect
the security of bondholders at the expense of stockholders. If an accounting policy change
lowers accounting income (as could occur in a mandatory change to successful efforts),
stockholder returns could be lowered, thus causing a negative price response.
A similar type of study found negative security-price responses for firms using
purchase accounting when pooling was restricted by the APB in favor of purchase accounting
for combinations. Differences between purchase and pooling accounting appear on the

surface to affect only book income with no real cash effects. However, the reduced use of
pooling accounting could affect dividend distribution because of debt covenants. Income
would normally be lower under purchase accounting than pooling, and the same effect of
dividend restrictions as argued in the oil and gas study were also argued in the
purchase/pooling study. Another research study along these lines examined the requirement to
capitalize leases that had previously been reported as operating leases. There was some
evidence of negative price responses for certain companies; this situation could have been
due to the existence of debt covenants as well as the adverse effect lease capitalization would
have on the firms future borrowing capacity.
SOME FURTHER QUESTIONS RELATIVE TO MARKET EFFICIENCY
Clearly there is some degree of efficiency present in securities-market transactions. The
question is one of how much efficiency exists, which is virtually impossible to answer.
However, several recent studies provide evidence that there may be somewhat less than is
postulated in the semistrong form of the efficient-markets hypothesis.
Ou and Penman, in a very extensive study, invoked the idea of fundamental stock
analysis. Fundamental analysis assumes that securities markets are inefficient and that
underpriced shares can be found by means of financial statement analysis. This view is
directly opposed to the efficient-markets view that prices of securities rapidly reflect all
publicly available information (the semistrong form of the hypothesis).
Ou and Penman used traditional accounting measures such as return on total assets,
gross margin ratio, and percentage of change in current assets in a multivariate model to
predict whether the following years income would increase or decrease. The time period
covered was between 1965 and 1977, the model included almost twenty accounting
measures, and approximately 23.000 observations were made. Ou and Penman were able to
describe the following year earnings changes correctly almost 80 percent of the time. The key
point concerns whether their predictors were capturing information that was not already
reflected in security prices but that would be subsequently reflected in security prices and
would thus result in abnormal security return if investmet were based on the earnings
predictions of their model. Their analysis indicates that this is exactly what would have
occurred. They also believed that the excess security returns would not have been attributable
to excess risk factors, though they were not entirely sure on this particular point. Ou and
penmans research thus indicates that markets are not as efficient as efficient-markets
advocates would like to believe and that fundamental analysis is still important for

investment purposes. This study also implies that better accounting standards might
improve the predictive ability of accounting information, which leads us to Levs work.
Lev concentrated on an issue that is complementary to the factors in the Ou and
Penman study. Specifically, his point is that both over time and within years (cross-sectional
studies), the correlation between earnings numbers and stock returns has been exceedingly
low. Earnings, in other words, have very little explanatory power (as measured by R, te
coefficient of correlation) relative to changes in stock prices. Lev believes that one of the
principal reasons for this situation lies with the low quality of reported income numbers:
Research on the quality of earnings shifts the focus to an explicit consideration of
accounting issues by calling for a systematic examination of the extent to which the
specific principles underlying accounting measurements and valuations, as well as
managerialmanipulations, detract from the usefulness of earnings and other financial
variables. Such research has the potential both to further our understanding of the
role of financial information in asset valuation and to contribute meaningfully to
accounting policymaking.
Thus the Lev and Ou and Penman papers are complementary because one finds a low
explanatory relationship between earnings and stock returns while the other sees a predictive
role for accounting data in a market that may be less efficient than previously thought. One
article (Levs) looks directly at the issue of mimlproving accounting measurements while the
other may certainly be said to imply this point.
ACCOUNTING INFORMATION AND RISK ASSESSMENT
Capital market research has also investigated the usefulness of accounting numbers for
assessing the risk of securities and portfolios. These studies have found high correlations
between the variability of accounting earnings and beta, the market-risk measure. The high
correlations imply that accounting data may be useful for assessing risk. Some other research
has tried to determine if alternative accounting policies have any effect on risk. The purpose
of this type of research is to identify how alternative accounting policies or disclosures may
affect the usefulness of accounting numbers for assessing risk. For example, one study tried
to determine if unfunded pension benefits (reported in footnotes) affected beta. There was no
significant impact. From this evidence, it might be concluded that pension information is not
useful for risk assessments. However, other studies found that supplemental segment (line of
business) disclosures resulted in a revision of systematic risk, which suggests that such
information is useful for risk assessments.

Other studies have tested the association of financial ratios with beta. Some of the
ratios and computations tested include dividend payout ratio, leverage, growth rates, asset
size, liquidity, and pretax interest coverage, as well as earnings and earnings variability. In
general, these tests indicate a strong association between the accounting-based ratios and the
market measure of risk, beta.
SUMMARY OF ACPITAL MARKET RESEARCH
Empirical evidence from capital market research is supportive of these statements :
1. Accounting earnings appear to have information content and to affect security prices.
2. Alternative accounting policies with no apparent direct or indirect cash flow
consequences to the firm do not seem to affect security prices, though this issue is not
entirely settled.
3. Alternative accounting policies that have direct or indirect cash flow consequences to
the firm (or its owners) do affect security prices.
4. There are incentives to choose certain accounting policies, where choice exists, owing
to indirect cash consequences.
5. Accounting-based risk measures correlate with market risk measures, suggesting that
accounting numbers are useful for risk assessment.
In the early 1970s, some argued that capital market research could be used as a basis for (1)
choosing the best accounting policies and (2) evaluating the economic consequences of
alternative accounting policies on security prices. Accounting policies that most affected
security prices were thought to be most useful. In other words, such policies would have had
the most information content. The argument had intuitive appeal, particularly since
deductively based research had proved unable to resolve the normative accounting theory
debate about the most desirable form of accounting. However, the early advocates of
security-prices research now recognize the limitations of this research for such a use. Reasons
for these limitations are the public-good nature of accounting information, the existence of
free riders, and the resultant market failure in terms of optimal resource allocation.
In spite of its inability to resolve accounting theory and policy questions, capital
market research continues to be useful in empirically evaluating economic consequences of
accounting policies vis--vis security prices and the usefulness of accounting numbers for
risk-and-return assessments. Perhaps more than anything else, though, the impact of capital
market research is that it brought a different perspective to accounting theory and policy at a
time when the emphasis, was primarily on deductively based theory.
SURVEYS OF INVESTORS

Another way of determining the usefulness of accounting information is to directly ask

investors how (if at all) they use annual reports. Surveys of investors have been undertaken in
several countries and generally have shown

a rather low readership of accounting

information. Approximately one-half of the investors surveyed indicated they read financial
satatements. Institutional investors have shown a much higher level of readership. These
surveys , particularly of individual investors, should be interpreted cautiously, however.
Individual investors may rely on investment analysts to process accounting information. It
would be simplistic to assume accounting information has no usefulness to investors merely
because many individual stockholders do not read annual reports in detail.
Another type of survey research has asked investors to weigh the importance of
different types of investment information, including accounting information. Several studies
of this type have been reported. Accounting information ranks fairly high in importance in
these surveys, though not at the top. This status seems to be attributable to the historical
nature of accounting information and the reporting-lag effect. More timely accounting
information from company press reports, and nonaccounting information such as general
economic conditions and company announcements on products and markets, rank ahead of
annual reports in perceived importance.
ACCOUNTING INFORMATION AND CROSS-SECTIONAL VALUATION MODELS
The research discussed in the previous section primarily examined the relationship between
accounting data and changes in stock prices (measured as abnormal returns). Another
approach has been to examine the association between accounting data reported in annual
financial statements and the levels of stock prices (i.e, firm valuation, measured as market
capitalization). Conceptually, this approach, which is reffered to as cross-sectional valuation,
attempts to empirically estimate the theoretical model of equity valuation described at the
beginning of this chapter. This approach has been used to investigate how (if at all) specific
components of the financial statements are pricedin the sense of being associated with the
market valuation of the firm. If an item is pricedas an asset/revenue, it should normally
have a positive relation to market value, whereas if the item is priced as a liability/expense
it should normally have a negative relation with market value. A number of authors have
expressed enthusiasm for this methodology as a framework for evaluating the merits of
alternative accounting methods/valuations.
Several studies have used this framework to determine that a firms pension plan
assets and liabilities (as reported off-balance sheet in footnote disclosures) are consistent with
their being viewed as real (i.e, on-balance sheet) assets and liabilities, respectively. Another

study determined that clomponents of pension expense (per SFAS No.87) are not weighted
equally in terms of their association with market valuation. Of particular interest is that the
transitional asset amortization component of pension expense was implicitly valued at zero.
Which is consistent with the fact that there are no cash flows associated with the item.
Another study examined the association of research and development (R&D)
expendictures with firm value. The major finding was that, on average, each dollar of R&D
was associated with a five-dollar increase in market value. This result provides evidence that
the market is implicity capitalizing R&D outlays even though SFAS No.2 prohibits explicit
capitalization. In other words, the market interprets R&D as an asset (investment) rather than
an expense, contrary to the accounting treatment required by SFAS No.2.
The financial services industry is another area in which cross-sectional valuation
models have been used.studies have examined supplemental disclosures of nonperforming
loans (default risk) and interest rate risk in banks and thrifts. Nonperforming loans are
negatively associated with firm value, though this effect is greater for banks than for thrifts.
Interest rate risk was negatively associated with firm value only for banks. Another study
reported that banks supplemental disclosure of the fair market value of investment
securities is associated with market value over and above that explained by historical costs
alone, a finding that gives credence to the SECs and FASBs recent push for mark-to-market
accounting.
THE ROLE OF AUDITING IN THE FINANCIAL REPORTING PROCESS
An assumption underlying all of the research reviewed in this chapter is that financial
statement information is reliable in the sense of having been prepared in accordance with
generally accepted accounting principles applied on a consistent basis. The independent
auditors role is to attest that this is in fact the case. For this reason, financial statements are
properly understood as jointly produced by the firm and the auditor. The demand for auditing
can be explained by agency theory, which was discussed in chapters 2 and 4. Because of
conflicting incentives between owners and managers, monitoring or control of managers
occurs via mechanisms such as boards of directors and independent audits. In addition,
companies have voluntary incentives to signal to outsiders (potential investors and creditors)
that the financial statements are reliable. Thus, independent audits also serve the role of
enhancing outside credibility of financial statements, in addition to the control function
within the firm of monitoring managers.
How do audits enhance financial statement reliability? A recent comprehensive study
drew on a large sample of actual auditor workpapers to determine dollar amounts of
adjustments to financial statements required by auditors. These adjustments represented the

auditors correction for material misstatements in the financial statements. Assuming a

standard rule-of-thumb of 5 percent materiality level (i.e, 5 percent of net income or total
assets), the study estimated that unaudited net income and total assets would have been
overstated by amounts in the range of 2 to 8 times the materiality level (i.e, a 10 percent to 40
percent overstatement of net income and total assets). Of course, absent the prospect of an
audit, the misstatements are likely to have been even higher. This is deterrence effect of
knowing the financial statements will be audited.
Another study found that subsequent period quarterly earnings announcement
following the issuance of a qualified audit report, on average, led a lower stock price
response than for companies having unqualified audit reports. In other words, following the
issuance of a qualified audit report, investors are more skeptical of earnings announcements,
at least until the next years annual audit report.
Finally, a number of studies have examined the value of auditing by comparing
companies audited by the well-known and putatively higher-quality brand name Big Six
auditors with companies that are audited by other auditors. There is evidence that Big Six
audted companies are valued more highly when initially going public (unseasoned stock
issues) and when subsequently issuing securities (seasoned stock issues). There is also
evidence that earnings announcementsby Big Six audited companies have more credibility.
Specifically, unexpected earnings are associated with a larger stock price response when the
auditor is a Big Six firm.
ACCOUNTING DATA AND CREDITORS
Theories underlying the usefulness of accounting information to creditors is not as well
developed as is the role of accounting numbers vis--vis stock prices. It is, however,
generally agreed that the price of interest-bearing debt is based on default risk, which is
defined as the premium in excess of the risk-free interest rate on otherwise identical debt (for
example, US.Treasury obligations). Thus, firm-specific information, including accounting
data, aids creditors in assessing default risk.
Several distinct lines of research have emerged: (1) the usefulness of accounting data
in predicting corporate bankruptcy (which encompasses loan default); (2) the association of
accounting data with ond ratings wherein such ratings are presumed to proxy for default risk;
(3) the association of accounting data with estimates of interest-rate risk premiums on debt;
and (4) experimental studies of the role of accounting data in lending decisions. We will
present a brief overview of the research findings.
Accounting-based ratios have been very useful in discriminating between firms that
subsequently went bankrupt and those that did not. Predictability up to five years prior to

bankruptcy has been demonstrated. These findings do not mean that companies with bad
ratios will necessarily go bankrupt in the future. It simply means that bankrupt companies
tend to have financial ratios prior to bankruptcy that differ from nonbankrupt companies. The
existence of badratios does not mean bankruptcy will occur, just that it is more probable.
Accounting data is also associated with both bond ratings and interest-rate risk
premiums. Among the important ratios are profitability, earnings variability, and leverage.
Research has also been used to evaluate which of alternative sets of accounting data are more
highly associated with bankruptcy prediction, bond ratings, and risk premiums. Among the
issues examined have been historical cost versus price-level-adusted income, the effect of
lease capitalization versus noncapitalization, and recognition of pension liabilities versus
footnote-only disclosure.
Experimental (laboratory) studies have also tested the usefulness of accounting data
for creditors. Accounting data in the context of a loan-related decision (for example, loan
amount, bankruptcy prediction, and interest rates) are provided to subjects to determine how,
if at all, it affects their hypothetical decisions. In these experiments, the accounting data are
manipulated to see if the judgements are sensitive to whatever manipulations take place; for
example, magnitudes of accounting ratios or financial statements prepared under alternative
policies (for example, lease capitalization versus noncapitalization). Generally, these studies
support the sensitivity of loan-related decision making to key accounting data and, in this
sense, complement the findings based on economic field data.
THE USEFULNESS OF ACCOUNTING ALLOCATIONS
At present, the historical cost accounting model remains the basic framework for financial
reporting. Central to this model are revenue recognition rules and the matching of costs to
revenue. Many costs are recognized over multiple accounting periods. Some examples
include depreciation, organizational start-up costs, goodwill amortization, and bond
premium/discount amortization. The recognition of these types of costs over multiple periods
is referred to as accounting allocation. Allocations have been criticized on the grounds that
they are incorrigible. By this it is meant that there is no obviously correct way to allocate
the costs because no single

allocation method can be proved superior to another. For

example, it cannot be proved that straight-line depreciationis any more appropriate than
accelerated depreciation methods.
Another way of describing this dilemma is to say that no allocation is completely
defensible against other methods. For this reason, it has been concluded that all accounting
allocations are, in the end, arbitrary. Conceptually, this is a very disturbing idea and strikes at

the logical core of historical cost accounting. Because of the arbitrariness of accounting
allocations, allocation-free financial staatements have been advocated as a better way of
reporting useful information. Allocation-free accounting can be accomplished by using cash
flow statements, exit-price systems (as discussed in appendix 1-A of Chapter 1), and certain
types of replacement cost systems.
However, the fact that accounting allocations are arbitrary does not prove that
accounting information is useless. The allocation argument is deductive and examines the
logic of historical cost accounting. Usefulness is an empirical question, not a matter of
deductive logic. There is no evidence to support the contention that allocation-based financial
statements are useless. In fact, there is a great deal of evidence from capital market research
that supports the information content of accounting income numbers.
Capital market research in the area of alternative accounting policies does support the
arbitrariness of accounting allocations. Alternative policies with no known cash flow
consequences have no effect on security prices, which supports the argument that allocations
are arbitrary and convey no information to users. However, the research findings also support
the factthat investors are not nave and that they are capable of adjusting accounting numbers
in order to achieve comparability between companies. In spite of allocations, income
numbers are useful and investors appear able to achieve comparability by adjusting for the
effects of arbitrary allocations.
It must also be remembered that allocations represent only a part of the total
accounting information in financial statements. Much accounting information contains no
allocations. Even if the allocation criticism is valid, usefulness may still be high. That is, the
historical cost allocation-based approach may still be the most cost-effective method of
reporting financial information about firms.
A policy implication of allocation research is that the FASB should not try to resolve
problems by searching for the best allocation. On the other hand, the FASB should not
necessarily avoid allocations. They may be the most cost-effective means of producing
financial statements. Another implication is that the FASB should reduce flexibility in
accounting allocations. Given the evidence from capital market research, there is no
compellingreason to permit arbitrary flexibility. Rigid uniformity would be easier to apply
and would eliminate some arbitrary differences between companies. It will be recalled that
security prices adjust for such arbitrary differences in accounting allocations. In the case of
accounting allocations with no real cash flow consequences a strong argument exists for rigid
uniformity .