Chapter 8

CHAPTER
Usefulness of Accounting
Information to Investors
and Creditors
LEARNING OBJECTIVES
After reading this chapter, you should be able to:

Understand the link between accounting information, dividends, and stock prices.
Understand the basics of residual income models, their strengths, weaknesses, and
how they are used for valuation and performance assessment.
Understand the basics of the efficient-markets hypothesis, its implications for
accounting information, and why it is under attack.
Understand the basics of event studies and cross-sectional valuation studies.
Be familiar with the general findings of market-based accounting research regarding the
usefulness of accounting information for investors.
Understand that accounting information is useful to creditors in evaluating default
risk and predicting bankruptcy.
Understand the role of accounting information for use in forecasting earnings.
he Financial Accounting Standards Board (FASB) recognizes

the existence of a diverse and pluralistic user group (see
Chapter 7). However, in practice, the FASB focused on what it
calls primary user groups (investors and creditors), those
assumed to be mainly interested in the amounts, timing, and uncertainties
of future cash flows.' The rationale for the investorcreditor focus is that
other users (e.g., governments, utility rate-setting bodies) have a
commonality of interest with investors and creditors or the means of
getting alternative information. The FASB's
265
2 66 6 AC C OU NT IN G TH EOR Y
costbenefit calculus is similarly restricted to benefits for investors and

creditors, and cost considerations are confined only to producers.
The purpose of this chapter is to examine theoretical and empirical evidence for the usefulness of financial accounting data to users. While we are
largely focused on the FASB's primary user groupinvestors and creditors
we wish to note that in its broadest sense, this group is quite large. Investors
include both individual and institutional shareholders, hold ers of interestbearing debt (bondholders, financial institutions, etc.), and the firm's board
of directors, who act on behalf of shareholders.' Although they are not
strictly investors per se, equity analysts make extensive use of financial
statements and are an integral part of the investing process.
Creditors are mainly considered suppliers of materials and services
(accounts payable). They need financial information about their customers
to determine the terms of credit. However, in a broader sense, creditors may
also include taxing authorities (taxes payable) and other individuals or enti ties that have claims on the firm before shareholders.'
Existing and potential shareholders need information to estimate the
value of the firm's shares and to make wealth-enhancing capital-allocation
decisions, which are also beneficial to the economy. The board of directors
has the responsibility for creating and implementing strategies and policies
that create wealth and ensure that management acts in the interests of the
shareholders.' In this role, the board needs to be able to evaluate and reward
management's efforts, abilities, and decisions, particularly manage ment's
capital-allocation decisions.'
Getting paid is certainly a major concern of the holders of interestbearing debt, but their concern goes beyond that. While loans from com mercial banks typically have maturities of a few years, corporate bonds
have much longer maturities.' The bonds may be sold before they mature,
and changes in the value of the firm affect the market value of those bonds.
Bondholders must be concerned with the value of the entire firm.
Our point is that many individuals and entities have a vested interest in
understanding the financial well-being of a firm. When it works well, we end
up with correct securities pricing and the efficient allocation of capital in the
economy (allocational efficiency). Everyone is better offbetter homes,
healthier children, and money for violin lessons, baseball bats, and college
tuition.
We begin this chapter by examining models of equity valuation and the
role of accounting information in these models. Next, we examine the role of
residual income models for motivating and assessing managerial perfor mance
and valuing the firm. We then provide a background on risk and return and the
efficient-markets hypothesis (EMH). Using accounting-related
Usefulness of Accounting Information to Investors and Creditors 267
capital markets research, we discuss the usefulness of accounting informa tion

for the primary user groups. In that context, we show why the efficientmarkets hypothesis is being challenged. We then discuss the role of
accounting data for creditors and discuss the importance of earnings for
forecasting. We conclude with a brief discussion of empirical research and
standard setting.
Earnings, Dividends, and Stock Prices

One of the major uses of accounting data relates to valuation. In this section,
we examine a model relating earnings, dividends, and stock prices. While we
briefly discuss cash flows, we defer a detailed discussion of this topic to
Chapter 13.
Earnings and Dividends

Lintner detailed the results of a series of interviews with corporate man agers regarding the determinants of their dividend policies.' Managers indi cated that major changes in "permanent" earnings were the most important
determinants of the companies' dividend decisions. After giving serious
consideration to both an established target payout ratio and the existing
payout ratio, managers adjusted dividends to reflect the change in "per manent" earnings. Since managers perceived that shareholders valued a
smooth dividend stream, the managers made adjustments to dividend pay out
rates gradually. Furthermore, most managers avoided making changes to
dividends that had a significant probability of being reversed in the near
future. Given the seriousness and forward-looking nature of the dividend
policy decision, investors regard cash dividends as credible signals of future
performance. We say that a change in the cash dividend has information
content.
Cash dividends are the cash flows that investors receive from a dividendpaying stock. As such, the stock price (P o ) may be modeled as the present
value of the future expected dividends, or
Po
D,
t=i
(1 + r) t
where
D, = the dividend expected at time t, and r = the
rate of return expected b y the shareholders.
(8.1)
268 ACCOUNTING THEORY
If the cash dividends are expected to grow at a constant rate (g), the
present value of the future expected dividends may be expressed as the
present value of a growing perpetuity.'
P=
________________________________________________
D
1
(8.2)
For a firm in equilibrium, a future expected dividend can be expressed

in terms of a constant dividend payout ratio (P0) and earnings per share at
time t (EPS), or D, = (PO)(EPS,). This allows us to rewrite Equation 8.1 as
Po
EPSI
P 1=1(1
(8.3)
+ r) t
and Equation 8.2 as:

(
Po
EPS1
(8.4)
r g
In these forms, we say that the stock price is equal to present value
(capitalized value) of future expected earnings, adjusted by the dividend pay out ratio. While we started with the dividend discount model, we now have the
earnings model of stock valuation. Given its relation to cash dividends, it is no
surprise that future earnings have a major effect on the share price.
Predicting Dividends From Current Earnings
Beaver uses the dividend valuation model to formulate the role of
accounting earnings in determining firm value.' Security prices are modeled
as a function of expected future dividends (Equation 8.1). Furthermore,
future dividends themselves are a function of future earnings (Equation 8.3).
Moreover, current accounting income is useful in predicting future earnings.
As such, current income has value in predicting future dividends via its value
to predict future earnings. This predictive value is one of the major
arguments for the relevance of accounting information (see the discussion of
SFAC No. 2 in Chapter 7).
Connecting the Dots: From Earnings to Stock Prices
Work in Financial economics regarding the theoretical value of the firm traces
back to Miller and Modigliani's seminal work in which they argue that
Usefulness of Accounting Information to Investors and Creditors
dividend policy is irrelevant to firm valuation.' Ignoring the complicating

effect of taxes, they show that the value of the firm is equal to the present
value of future expected net cash flows. These net cash flows per period are
defined as operating cash flow minus cash investment in assets. (This is the
same definition as that used for capital budgeting analysis.)
Miller and Modigliani's net cash flow model was originally a certaintyequivalent model but has been extended to a more general model reflecting
the uncertainty of future operating cash flows." The attractiveness of the cash
flow valuation model for accounting is that it maps directly onto the
accounting system; cash flows are explicitly measured in accounting sys tems.
In contrast, dividends are a matter of corporate policy and are not a direct
function of accounting systems. We make further tie-ins between cash flows
and decision making in Chapter 13.
Interestingly, the FASB has implicitly adopted the cash flow valua tion
model. In SFAC No. 8, The Objective of General Purpose Financial
Reporting, the role of financial reporting is characterized as aiding existing
and potential investors, lenders, and other creditors in assessing the
amounts, timing, and uncertainty of the enterprise's prospective net cash
flows. Further, the FASB asserts that accrual accounting systems, and
accrual income numbers in particular, are more useful for this purpose than
are simpler cash-based systems: "Accrual accounting depicts the effects of
transactions, and other events and circumstances on a reporting entity's
economic resources and claims in the periods in which those events occur,
even if the resulting cash receipts and payments occur in a different period.
This is important because information about a reporting entity's economic
resources and claims and changes in its economic resources and claims dur ing a period provides a better basis for assessing the entity's past and future
performance than information solely from cash receipts and payments
during that period."'
Beaver agrees with this assertion, arguing that "an accrual can be viewed
as a form of forecast about the future. . . ." 13 There is empirical evidence that
future cash flows are better forecast with accrual data than with cash flow
data." In addition, in stock market studies, security prices are more highly
correlated with accrual income than with either cash flows or working capi tal
flows." Numerous studies have documented that changes in reported
accounting earnings affect the value of the firm and its stock. This is not
surprising if investors view such changes as permanent or persisting into the
future. As such, expectations of future cash flows should also be affected;
hence, the explanation for changes in stock prices as a function of the
expected persistency of earnings changes.'
The implication of this literature is that accrual accounting systems ulti mately incorporate the attribute that determines firm valuationnet cash
269
flow data. However, the value of the information in financial reporting does
not lie in its role as a historical record but rather in its use in helping inves tors to forecast future expected net cash flows and dividends. (This informa tion is also useful for feedback purposes. See Chapter 7.)
Residual Income Models

Capital is necessary to generate income. Residual income is a general term
for income in excess of a charge for the capital that is employed to generate
that income.' The residual income concept may be applied to the enter prise
as a whole or to the firm's common equity. When applied to the enter prise's
operating income and invested capital, residual income is often called
economic profit or Economic Value Added (EVA).' When it is applied to the
firm's net income and common equity, residual income may be referred to as
abnormal earnings.'
Economic Profit
It is well established that the value of a firm is equal to the present value
of the future expected net cash flows.' Net cash flows are the periodic cash
flows that are available to all investor claims (interest-bearing debt, pre ferred stock, and common stock). They are much less subject to manipula tion
than earnings.
One shortcoming of net cash flows is that they do not provide investors
with a metric for gauging periodic performance. For example, even a highly
profitable, well-managed firm can have negative net cash flows in a given
period if the firm makes large investments in that period. If the investments
have a positive net present value, negative net cash flows in one period is
hardly a cause for concern.' Economic profit attempts to bridge the gap,
providing not only a means to value the firm but also a means to assess its
periodic performance.
Economic profit starts with the amount of capital that is invested at the
beginning of the period. This investment has a cost. When expressed as a
rate, this cost is known as the weighted average cost of capital (WACC).
(We can think of the WACC as the required rate of return to all investor
claims, commensurate with the risk of the net cash flows.) The WACC and
the amount of capital invested determine the periodic after-tax operating
income that investors expect the firm to generate. This is the dollar cost of
invested capital, the charge for capital employed, or simply the capital
charge. The realized after-tax operating income is compared to the amount
that is expected. If the after-tax operating income exceeds the income
271
expected, the firm has generated an amount of income above and beyond
the call of duty. This excess income is called economic profit. More
formally,
Economic profit = NOPAT capital charge
(8.5)
where NOPAT is net operating profit, less taxes paid.22 Expressing the capital charge
as a function of the WACC and invested capital at the beginning of the period, we
have:
Economic profit = NOPAT (WACC)(inyested capital)
(8.6)
Equation 8.6 indicates that if the firm's NOPAT exceeds the capital
charge, it earns an economic profit and creates wealth." To increase eco nomic
profit, the firm can increase NOPAT by increasing sales or decreasing costs,
decrease invested capital, or lower the firm's cost of capital (WACC).
Exhibit 8.1 presents a statement of invested capital for ABC Company.
We constructed the statement from ABC's balance sheet, shown in Chapter
13, Exhibit 13.7. Note that the statement of invested capital is sim ply a
rearrangement of the firm's balance sheet, putting net operating assets on
the "left hand side," and all investor claims on the "right hand side."
Exhibit 8.1
Statement of Invested Capital for ABC Company
Statement of Invested Capital
2004
Cash and equivalents

Accounts receivable
$300
930
Inventories
2006
2007
$244
915
$323
1,035
$339
1,018
1,010
1,037
970
1,154
$(850)
$1,390
$(854)
$1,342
$(841)
$1,487
$1,628
2,500
$3,890
2,562
$3,904
2,651
2,783
$4,138
$4,411
Notes payable
Long-term debt
73
657
524
60
539
67
606
Total interest bearing debt

Common stock
Retained earnings
Total common equity
Invested capital (equities)
730
582
599
673
860
2,300
3,160
$3,890
830
2,492
3,322
$3,904
860
2,679
3,539
$4,138
860
2,878
Accounts payable
Net operating working capital
Property, plant and equipment
Invested capital (assets)
2005
58
$(883)
3,738
$4,411
272 * ACCOUNTING THEORY
Exhibit 8.2 presents a statement of economic profit for ABC

Company. This statement uses invested capital from Exhibit 8.1 and
operating income from ABC's income statement presented in Exhibit
13.7 in Chapter 13. Notice that economic profit is positive for all three
years. However, economic profit declined in 2006 due to an increase in
invested capital in 2009 and lower net operating profit after tax
(NOPAT) for 2006.
Conceptually, economic profit has valuable characteristics from a perfor mance evaluation perspective. Managers can increase economic profit, and
their bonuses, by increasing NOPAT. Thus, managers have an incentive to
control costs and increase sales. Furthermore, managers can increase eco nomic profit by reducing the amount of invested capital.
In contrast, net income is a performance metric that ignores the amount
of capital employed. If the firm rewards its managers based on net income
alone, and if additional invested capital generates some additional net
income, managers have an incentive to invest, even if the incremental
investment does not earn its cost of capital.
The economic profit approach has the added benefit that it can also be
used to value the enterprise. The value obtained is equal to the present value
of the net cash flows. 24 Using the economic profit approach, the value of the
firm at time 0 is equal to the invested capital in place at time 0, plus the
present value of future expected economic profit, or:
Vo(firm) = Invested capital o+
NOPAT -
t=1
(WACC) (invested capital),
(8. 7)
(1 + WACC)'
In an attempt to improve economic profit as a performance metric, some

users make adjustments to the way invested capital and NOPAT are
calculated. Currently, the best-known application of economic profit is EVA,
a proprietary form of economic profit developed by Stern Stewart & Co.
Stewart (2003) notes:
Stated in brief . . . EVA begins with . . . residual income [economic
profit] . . and then proposes a series of additional adjustments to
GAAP accounting that are designed to produce a reliable measure of a
company's annual, sustainable cash [italics added]-generating
capacity- ''
Young notes that the most common accounting adjustments relate to
nonrecurring gains and losses, research and development, deferred taxes,
Exhibit 8.2
Statement of Economic
Profit
for ABC Company

2007
Statement of Economic Profit
2004
2005
Invested capital
$3,890.0
$3,904.0
$4,138.0
$4,411.0
578.0
555.0
587.0
(231.2)
(222.0)
(234.8)
Net operating profit after tax
346.8
333.0
352.2
Capital charge on invested capital (8%)
(311.2)
(312.3)
(331.0)
Economic profit
$35.6
$20.7
$21.2
Operating income
Taxes on operating income (40%)
2006
provisions for warranties and bad debts, LIFO reserves, goodwill, depreciation, and
operating losses.26
Residual Income and the Dividend Discount Model

Economic profit and EVA focus on the valuation and performance mea surement of the operations of the enterprise as a whole. Residual income
sometimes called abnormal earningsis focused on net income and the
firm's common equity. It is defined as:
Residual income = actual earnings required earnings
(8.8)
where required earnings are the amount of earnings that compensates

shareholders for the equity capital invested and the risk they bear. Required
earnings may be written as the beginning-of-period book equity, multiplied
by the cost of equity (r):
Residual income = earnings r(book equity)
(8.9)
Note the similarity between Equation 8.9 and Equation 8.6. Ohlson and,
also, Feltham and Ohlson use a residual income framework to predict and
explain stock prices.' The model starts with the dividend discount model
(Equation 8.1). Next, it specifies that all profit and loss elements go through
income. This specification, known as clean surplus accounting, relates the
current book equity to previous book equity, earnings, and dividends:
Book equity, = book equity,_, + earnings dividends,
(8.10)
The FASB comprehensive orientation of SFAS No. 130 (Chapter 11) ties
in well with the clean surplus approach. Rearranging Equation 8.10 allows
dividends to be expressed in terms of book values and earnings:
Dividends, = earnings, (book equity, book equity,_,)
(8.11)
By using Equations 8.1 and 8.11, it can be shown that the price of the
firm's stock is equal to:
[earningst
r=1
= Book equity () +
r(book equityt_i )]
(8.12)
(1 + ry
where r is the cost of equity and the numerator of the second expression is residual
income or abnormal earnings. Note the similarity between Equation 8.12 and
Equation 8.7.
We started with Equations 8.1 (dividend discount model) and 8.11 and
rearranged them to obtain Equation 8.12. As such, Equation 8.12 is simply a
restatement of the dividend discount model in terms of future expected
earnings, the cost of equity and current and future expected book equity. By
itself, this model offers little additional utility over the dividend discount
model per se. However, the utility of the Equation 8.12 can be increased if
the user can incorporate additional information regarding forecasts of future
abnormal earnings.'
Dechow, Hutton, and Sloan perform an empirical assessment of the resid ual
income model. They find that "residual income follows a mean reverting process .
. associated with firm characteristics suggested by accounting and economic
analysis."29The rate of mean reversion decreases with the quality of earnings and
increases with the dividend payout ratio. It is also correlated across firms in the
same industry. They also find that "incorporating information in analysts'
forecasts of earnings into the information dynamics increases forecast
accuracy."30 Hence, the residual income model allows the user to incorporate
nonaccounting information into the model to improve its forecast accuracy.
Note that the higher the abnormal earnings, the higher the value of the
firm's common equity. Beaver discusses several sources that give rise to
abnormal earnings. 31 First, firms do not carry on the balance sheet the posi tive excess present value above the cost of the project (positive net present
value). Second, many matching and recognition procedures under historical
costing tend to be conservative in nature (e.g., accelerated depreciation
methods and LIFO costing for inventories and cost of goods sold, immedi ate
write-off of research and development, and possible undervaluation of other
intangibles).
Qiang demonstrates that abnormal earnings increase with industry con centration, industry-level barriers to entry, and industry conservative
accounting factors. The author also finds that differences in firm abnormal
earnings increase with "market share, firm size, firm-level barriers to entry,
and firm conservative accounting factors." 32
Residual Income and Performance Measurement:
The Good and Bad
In this section, we examine the pros and cons of residual income models used
for performance measurement." While our focus is broader than EVA per se,
much of the research on residual income has been done in the context of
evaluating EVA.
Residual Income: The Good
Residual income is an accounting measure, which in its basic form uses
financial data that follow a defined set of rules. Unlike the stock price, it
can be used as a company and intracompany performance measurement
tool.
It recognizes that all capitaldebt as well as equityhas a cost; capital is
not a free good. Making capital an explicit part of the model raises the awareness
of using excess capital to generate income. Stewart notes:
If a firm cannot give its shareholders at least the return that they
could earn by investing on their own, it will lose value. Thus in an
economist's view, a company does not begin to earn a profit until it
can cover the opportunity cost of equity capita1. 34
Although not explicitly designated as an application of residual income,
Berkshire Hathaway and CEO Warren Buffett explicitly recognize the cost of
capital in communications with corporate shareholders and also with its
subsidiary managers.
When capital invested in an operation is significant, we also both charge
managers a high rate for incremental capital they employ and credit them
at an equally high rate for capital they release. . . . The consequence of
this two-way arrangement is that it pays [managers]and pays [them]
wellto send to Omaha any cash he can't advantageously use in his
business.'
As a proprietary form of residual income, EVA goes one step further and
attempts to address some of the issues related to pensions, mixing financing
and operations, reserves, research and development, energy exploration,
divestitures and restructuring transactions, investment, depreciation, and
stock options.'
Rogerson demonstrates that residual income is an income-based com pensation system that provides an incentive for the management to allocate
capital efficiently over time. (See Berkshire Hathaway discussion above.)
The corporate form of organization exhibits the separation of ownership from
control. Managers are typically better informed about investment
opportunities than shareholders are. This separation of ownership from
control and the lack of a capital charge make it difficult to design an incomebased compensation system that creates an incentive for managers to choose
the correct level of investment. Calculating income, net of a charge for the
capital employed, creates an incentive for efficient allocation of capital,
mitigating the incentive for managers to game (beat) the system by
maximizing current income at the expense of future income. 3Residual income models might be of direct help to investors. For exam ple, Feltham et al. provide evidence that EVA has more explanatory power
than reported earnings or cash flow from operations. 38
Residual Income: The Bad
There are a number of weaknesses associated with the various forms of
residual income. For any given year, the determination of the residual
income itself is dependent on an accurate estimate of the cost of capital, no
simple task. For valuation purposes, forecasts are crucial."
All forms of residual income are consistent with discounted net cash
flows for any book value and any method of depreciation.' While this might
appear advantageous, changing depreciation schedules has a direct impact
on residual income (or economic profit) for individual periods. Hence,
lengthening the depreciable life of fixed assets decreases the per-period
depreciation expense, increases NOPAT, and increases the residual income.
In some cases, it may not be possible to determine whether the residual
income calculated is actually owing to management's efforts or the lack
thereof.
Residual income is an accounting measure and, as stated in the depre ciation example above, can be manipulated for any one period. Furthermore,
if improperly applied, residual income could bias management against long term investments. Unlike the stock price, which is forward looking, residual
income focuses on historical performance.
In spite of the name given to some forms of residual income, residual

income is not economic income. A firm's economic income is equal to net
cash flows plus a change in present value or market value of the firm.
For EVA, the additional effort to make additional adjustments to GAAP
may not be justified. Chen and Dodd investigate EVA as a tool for investors
to find profitable investment opportunities. They find that while EVA does
provide information in addition to traditional accounting measures, it should
not replace them. Furthermore, they find that there is no significant
difference between EVA and residual income in terms of explaining stock
returns.'
Dodd and Johns express concerns that the overemphasis on EVA might lead
companies to exclude other important measures:
It appears that when companies adopt EVA, a subtle movement
away from customer-related measures may occur. If these early
observations represent the beginning of a trend within EVA adopt ers, we see this as one laden with risk over the longer-term. The
idea that a company can use a single financial measure to manage
its operations does not make sense in today's environment.'
The evidence for the ability of residual income to explain shareholder
returns is mixed. For example, in contrast to Feltham et al., Copeland and
Dolgoff find that EVA does not provide much explanatory power as it relates to
total shareholder returns:
It may surprise you to learn that EVA (also called economic profit)
and commonly used performance measures such as earnings per
share and the growth in earnings per share have at most a weak cor relation (at least at the level of the individual company) with the
total return to shareholders. 43
If any adjustments are made to GAAP, EVAand presumably other forms
of residual incomemay not be applied consistently or be sufficiently trans parent to outside investors. Using survey data from 29 respondents (40%
response rate), Weaver notes:
Although a consistent philosophy has been applied, none of the
companies measure EVA the same way . . . Due to the measurement
differences, Economic Value Added is a limited tool that cannot be
used for competitive analysis. In practice, there is no one consistent
definition of EVA and numerous fundamental differences exist with
respect to NOPAT [net operating profit after tax], IC [invested

capital] and COC [cost of capital]. Further, some data may not be
publicly reported, and more fundamentally, managers will behave
differently when their performance is measured differently.'
Do firms that adopt EVA do so because of poor stock performance? Does
the adoption of EVA lead to improved stock performance? Ferguson et al.
examine these questions using an event study methodology. They find:
Firms that adopt EVA appear to have above average profitability
relative to their peers both before and after [italics added] the
adoption of EVA; further, there is some evidence that EVA adopters
experience increased profitability relative to their peers following
adoption.'
This suggests that EVA adopters were already good managers, already working
to improve performance.
Do firms that have implemented an EVA-driven compensation sys tem outperform the market? Is EVA a valid forecaster of stock per formance? Griffith examines these questions using an event study
methodology, estimating abnormal returns of EVA adopters for vari ous holding periods starting from a firm's adoption to up to five
years after its adoption of EVA. His findings are not encouraging:
Before they adopted EVA as a measure of firm performance, the
firms . . . underperformed both their peers and the market. After
implementation of the EVA compensation system, the companies
continued to underperform significantly"'
Are We Asking Too Much?
We think there is value in the various forms of residual income models for
purposes of valuation when the user can incorporate additional informa tion
regarding forecasts of future economic profit or abnormal earnings. We also
think that these models have value for performance assessment and motivating
managers to control costs and avoid overinvestment. However, residual income
models are no panacea for a firm or industry plagued by unsolvable problems.'
Alternatively, if value-minded managers in good com panies or industries adopt
EVA, will the market be able to detect a difference?
For compensation purposes, Dutta and Reichelstein conclude that historical
accounting measures, and even cash flows, are too backward looking
Usefulness of Accounting Information to Investors and Creditors 0 279
by themselves and must be combined with forward-looking measures. They

conclude:
An optimal performance measure must rely on both accounting
variables and [italics added] stock price. The familiar performance
[metric] . . . of Economic Value Added (residual income) [is] useful
for calibrating stock price and accounting income to the relevant
history, in particular to the firm's dividend policy. 48
Finally, we note that if the value of the firm is determined as modeled by a
residual income model (Equation 8.7 or 8.12), the total return to shareholders in
any given year is dependent on revisions to all current and future residual
income. Why should we necessarily expect a strong relationship between the
current year's residual income and the total returns to shareholders?
Clearly, the jury is still out on the utility of various forms of residual
income, whether for purposes of valuation or performance assessment. We
think that residual income models hold promise for both security valuation
and performance assessment; however, not as a single metric, as is fre quently
advertised. We suggest that residual income models' greatest poten tial utility
likely results when used in combination with complementary nonfinancial
metrics.
Background on Risk and Return

The usefulness of accounting information to investors has been empirically
investigated through tests of association between publicly released account ing data and changes in 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 EMH.
Efficient-Markets Hypothesis (EMH)

Market efficiency refers to the speed with which securities in the capital
markets respond to new information. The (EMH) states that capital markets
fully and instantaneously reflect new information in security prices. 49 If the
hypothesis is correct, the value of new information is fully and completely
demonstrated via the security's price response. When this occurs, the item of
information is said to have information content.
There are three forms of the EMH. The weak form says that security prices
reflect information contained in historical (past) prices. The semi-strong form
says that security prices reflect all publicly available information.
280 $ ACCOUNTING THEORY
Finally, the strong form says that security prices reflect all information, both
public and private. The semistrong form is the most tested. Much of the
information tested has been of an accounting naturefor example, financial
statement data and earnings announcements. In our discussion, we concern
ourselves only with publicly available information.
Rationale and Implications of the EMH
The rationale for the EMH is simple. There are thousands of selfinterested investors and analysts trying to maximize their wealth by trading
securities. These individuals are motivated to uncover any information that
might give them a financial edge. Given that publicly available information
is accessible by everyone at about the same time, it makes sense that wealthmaximizing individuals quickly analyze that information and trade accord ingly' Given that news arrives in a random fashion, we expect that security
price changes are random as well.
The implications for efficient markets are profound. If markets are effi cient, it is useless to analyze past financial statements or read historical
articles about companies. Furthermore, it is not possible to "beat the mar ket"
on a risk-adjusted basis. There is evidence to support this view. Malkiel
notes that even professional mutual fund managers have difficulty beating
the market after fees.
During the year ended December 31, 2003, close to three quarters of
the mutual funds holding large capitalization stocks were outper formed by the (large capitalization) Standard and Poor's 500 stock
index. Results are similar for other one-year period Is]. When returns
are measured over periods of 10 years or longer, over 80% of active
managers are outperformed by the index. . . . We see that the typical
actively managed fund underperforms the index fund by over 200
basis points.'
Anomalies
For some time, it was largely accepted that the market was indeed effi cient. Then, De Bondt and Thaler presented convincing evidence that mar kets often overreact or underreact. In addition, the mispricing does not
appear to correct rapidly:
Consistent with the predictions of the overreacting hypothesis,
portfolios of prior "losers" are found to outperform prior "winners."
Usefulness of Accounting Information to Investors and Creditors * 281
Thirty-six months after portfolio formation, the losing stocks have

earned about 25% more than the winners, even though the latter are
significantly more risky.'
The debate continues to rage. In fact, it has created a new field of
"behavioral finance." The "technology bubble" of the late 1990s helped to
fuel the fire. Consider the case of the Nasdaq Composite Index, a commonly
known indicator of technology stocks. On March 10, 2000, the Index reached
a level of 5049, only to fall 3935 points (78%) to 1114 by October 9, 2002.
Which date reflected the correct pricing of the stocks in the Nasdaq
Composite Index: March 10, 2000, or October 9, 2002? As we write this chap ter in mid 2011, a decade later, the index has only recovered approximately
60% of its losses.'
Amazon.com Inc. typified the late 1990s bubble. On December 31, 1999,
its stock price, adjusted for splits, was $76.12, while it reported an operating
loss of almost $606 million. Exhibit 8.3 reveals why some, to their chagrin,
questioned the link between Amazon's earnings and its stock price in the late
1990s. It would almost appear that the earnings were anticipating the stock
price, instead of the other way around.
The bubble had devastating effects for managers who analyzed compa nies "the old-fashioned way" Consider the demise of Tiger Management.
The sudden farewell of Tiger Management, the giant hedge fund, is
being heralded in some quarters as a death knell for long-term value
investing. . . . In announcing that he would liquidate and give back
his investors' money, Julian Robertson Jr. . . . admitted that he is out
of step with a world in which Palm, the maker of the hand-held Palm
Pilot, is valued at more than GM and in which Priceline.com (which
sells airline tickets but has neither earnings nor planes) was valued at
more than US Airways and most of the other publicly traded air lines
combined. . . . "There is no point in subjecting our investors to risk in
a market which I frankly do not understand."'
Portfolio Diversification
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. As long as security returns are imperfectly corre lated (correlation is less than 1.0), the risk of a portfolio as measured by its
standard deviation of return is reduced by adding additional securities. See
Exhibit 8.4.
282 I ACCOL.N TINE THI -(
hxhibit
eY
Amazon.com
iric.: Income From ()pc . rntioas anC. Scock
Pricc
Online. wwq. rrriri..rcilionliiic.Lu:Jo
0'.:i .1linuncc
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1
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570
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7 200 risk . The reiminirig portfolio risk...-c
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/
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- ;20
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--- 520
%
The
risk that can be elm linalcul ini this
callcd
I (CAPM)
I
I _____________I____________ SO
Capital A,c,set PricingI Model
1997 1996 1999 2000 201 2002 20DS 2.2ka 2005
E
c e hi t i o r i s p b e t w c . : c r i r i s k p5cal
A n d r o A i r year
i i i s e m htending
) ( li o c i n a c hc o r s :
known
:liecap.ital Alian.t.fmozk2December
0:11P.1 , 1 . i. Si
The relationkihip between
hmm
(los5) irom
operations
Slook
risk and ccturn for d rik:L pocifolios
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by tiic
capital
Markel 1,i?7e
1
.
pro@
(C. 11.). For in: lividual as5ecA, I hi rclacionJiip rriodelcd by I hr Sec:aity
Markel Liqe
capilal. Markel Line (0-17)

The scanthird. deviation ofporciollo clulirie..9as moil.:
1.0 clic.
porifolio. Whe.n all. tradable.
are i:LCICie!
Lisi,eCScocks, hancbi,
Exhibit 8.4
The Effect of the Number of Securities on Portfolio Risk
Portfolio risk (standard deviation)
SOURCE: Mergent Online (www.mergentonline.com) and Yahoo! Finance (http://finance.yahoo .com). Accessed
February 2, 2007.
real estate, etc.) have been added to a portfolio, we have the market portfolio. The theoretical choice of portfolios for two risky assets is graphically
presented in Exhibit 8.5. The points on the curved line, the feasible set,
reflect portfolios formed by combining different proportions of two risky
assets. Each portfolio has its own unique expected return and standard
deviation.' 5
The straight line is called the Capital Market Line (CML). The CML inter sects the Y-axis at the risk-free rate of interest, typically considered to be a 90day Treasury bill. At this point, the standard deviation is equal to zero. The
CML is tangent to the feasible set at point M. (If portfolio M contained all
risky assets, it would be the market portfolio.) The points on the CML reflect
Numberwealth
of securities
various proportions of an investor's
invested in M and the risk-free
asset. When drawn through M, the CML provides the highest risk
premiumthe expected return above and beyond the risk-free rateper unit
of standard deviation of return (risk). Since investors are risk averse, the
expected portfolio return increases as risk (standard deviation of return)
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.
Security Market Line (SML)
Theoretically, with the formation of the market portfolio, the unsystem atic risk of individual securities is eliminated, and only systematic risk mat ters. Hence, the relevant risk for an individual security is systematic risk,
which is the risk of the security relative to the market portfolio.' The sys tematic risk for an individual security is measured by beta 03), which mea sures the volatility of a security's returns relative to the market portfolio.' By
definition, the beta of the market is equal to 1.0. A security with a beta of 2.0
is twice as risky as the market, whereas a security with a beta of 0.5 is half
as risky as the market.
According to the CAPM, the relationship between the expected return on
individual securities and beta is embodied in an equation known as the Security
Market Line (SML):
R = Rr + 131IR,Rd
(8.13)
where
R. = the expected return on security j,
R i = the risk-free rate of return (typically the return on Treasury bills),
K m = the expected return on the market portfolio, and
13) = the beta coefficient for security j.
Beta is estimated by performing a regression of the returns of security j
on those of the market. Beta is the slope of this regression. Statistically, beta
is defined as
13j = rimsjs,/s,2
(8.14)
L'sofmrne.55 Oi../ICCLPLinring inknimarion
28.5
Pm:ic:Te
the c:c)rre.ladi
r: ,
= the ;L:ranclord deviadcml
kr.4 1,11-11y j 2ind

1.N.: 1-(.:tiorn5
S = the AI iaritlir([ deviation cil"111r. rrturns
on
j:
the rr arra.1
vrafia0Ce 'Pr hc alums of I he rnorkc.t pc.11CfCP.ii.P. arid

E
=i.heci.ivaElafiCe t)furns of securiiv i vvir h 1.1-106e.
porr.fialil I.
In pracricc., the relaiiiin botweeri risk and R:turn 1,5 rot C-xf..11 -11,...- the way
the CliFiM
lhe model ltas re.ceivecl SupiNifl among
3C1il.ernics 1171 praciiiic)ricrs:'/
Capital Markt: Linc.
Expected vellum of portfolio (10
ENtabit 9,5
Portfolio risk (standard

deviation)
Introduction to Capital Markets Research in Accounting

Capital markets research in accounting examines the relationship between the
security prices and the information contained in the firm's financial
statements and associated documentation. Aside from its importance as an
academic exercise, this body of research is of utmost importance to inves tors, managers, and standard setters. Why? At a high level, the ability of
markets to efficiently allocate resources (allocational efficiency) is crucially
dependent on accounting information for analysis, valuation, and perfor mance measurement. However, investors need to know if analysis of
accounting data is a value-enhancing activity. Furthermore, standard setters
need to know if the existing standards are fulfilling their intended purpose to
improve the informational and allocational efficiency of markets. If not, it
might be time for a new standard. Ultimately, everyone has a stake in the
process.
In the sections that follow, we examine some of the capital markets
research in accounting. Our intent is not to present a comprehensive review
or critique but to provide a status report and outlook.
The Market Model

Many empirical studies in accounting use the empirical form of the CAPM
known as the market model:
=
Pjtkt Et
(8.15)
where
t is a time subscript,
Rp p i, and R, are the same as in Equation 8.13,
a = the intercept term, and
E = a random error term.
The model states that the returns for security j are a function of the
return on the market. (As a rearrangement of the Security Market Line, the
intercept, a, is equal to R f tl p i ].) The portion of the return not explained
by the market is reflected in E, the error term.
Usefulness of Accounting Information to Investors and Creditors + 287
Event Studies
An empirical research method used in accounting and finance studies to
detect the market's reaction to some event is the event study.' The
announcement of an unexpected event (e.g., merger or acquisition) should have
an impact on the stock price. An event study divides the period related to the
event into three "windows": an estimation window, the event window, and the
post-event window. The "normal" relationship between a security's returns and
those of the market are estimated during the estimation window. This allows
the researcher to estimate the parameters (a and (3) of Equation 8.15 using
linear regression. This is shown graphically in Exhibit 8.6.
After the parameters of Equation 8.15 have been estimated, the equa tion
is used to estimate the returns at the time of and subsequent to the event. The
difference between the actual return and the return expected using Equation
8.15 is called an abnormal return (AR). The sum of the ARs is known as the
cumulative abnormal return (CAR). In the absence of an event, the ARs
should randomly fluctuate around zero, and the CARs should show no
upward or downward trend.
If an unexpected event has occurred, the AR and the CAR should depart
significantly from zero on the date of the event. However, if the market
fully and immediately reflects the new information in the stock price, the
Exhibit 8.6
Estimation of Equation 8.15
Return on security j: R(j)
.015
y = 0.8217x + 0.0006
R2 = 0.3941
0.010
0.005
0.000
-0.010 -0.008 -0.006z , -0.0040.002 0. r 00 0.062 0.004 0.006 0.008 0.010
0
-0.005
-0.010
-0.015
_________-0.020
Return on market:
R(m)
2 88 AC CO UN TIN G THE ORY
subsequent ARs should again randomly fluctuate around zero, and the CARs should
show no trend. See Exhibit 8.7.
In contrast, if the market does not fully, immediately, and accurately
reflect the news contained in the event, we might observe an upward or
downward bias in ARs and the tendency of the CARS to drift up or down.
Exhibit 8.8 shows a graph of the ARs and CARs in which the market has not
fully adjusted to good news at the time of the event.
Before reviewing the empirical findings, we need to make a few observations
regarding the difficulties of doing this type 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 espe cially difficult because new information is continuously arriving. Since the set of
information affecting security prices is large, it is difficult to isolate the effects
of one piece of information. Furthermore, we are examining only a relatively
small group of investorsthose at the margin who influence stock prices. 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 when 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 the model used to estimate the abnormal
returns. 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 and if the model used is correct. But
what if the market is inefficient or if the model used is incorrect? In either
case, 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-a-vis an individual investor's decision making is
implicitly modeled as a black box: An "event," occurs, and the effect of this event is
then inferred from whether there was an aggregate (market) reaction.
Overview of Capital Markets Research in Accounting
Kothari provides an excellent review of the literature on capital market
research in accounting.' The main areas of interest for capital markets
research in accounting deal with fundamental analysis and valuation, tests of
Irivr..5.'or5 and Credi.'circ
Exhibit f4.7
Graph Showing WU and FrnniMiiite Adjustment to on F,vent
0.06
it\ /\
1', y/
0.04
0.02
'
A
..
0.00
;
2
-02
3 0
' L
- 2 0
- 1 5
- 1 0
- 5
10
15
20
Months (event OCOurs at time .1))

AR CAR
E x hi b i t S . S
Graph
Showing Incomple.te Adjustment to an
Evcnr.
0_08
0.0.6
4 -
1%.
0.0
'
I.
;
0_02 0.00
-30
2b
-.2D
15
-10
10
15
2D
Months Went occurs at time 09

- - - AR CAR
market efficiency relaring to accounting inforrntition, and. thc. value relevance of

financial reporting. 'K. focus on. tric first Iwo .,'ircas.
In an utricicnt market, the
of the firm 15 equal to mrpSent value
0C die future cyvected net ca::..h flaws. From 3 valuation perspective, the
2fl9
firm's financial statements are useful to the extent that they are helpful in
forecasting future cash flows. Fundamental analysis deals with using eco nomic information, including the information contained in the firm's finan cial statements, to forecast future cash flows and estimate the firm's intrinsic
value (inherent economic value).
Given that security prices serve as a mechanism to allocate resources,
the informational efficiency of financial markets is of utmost importance.
Short-term event studies have long been the staple for analyzing the degree
to which markets are efficient. Long-horizon event studies and crosssectional tests have increased the number of research opportunities. 63
Association studies test for correlation between some accounting perfor mance measure and stock returns. In general, the point of these tests is to
determine if and how rapidly accounting information is reflected in security
prices. As we have mentioned previously, it is sometimes difficult to
attribute a market reaction to a piece of accounting information as market
participants may have access to other opportune sources of information. For
example, some of the information contained in annual reports is revealed
long before the report is published.
Early studies provided evidence that there is information content in
earnings announcements, but the market's reaction may not be fully and
immediately reflected in security prices. Furthermore, accounting informa tion is not necessarily the timeliest source of data affecting security prices.
Later research focused on methodological research, alternative perfor mance measures, valuation and fundamental analysis, and tests of market
efficiency. There is evidence that accounting information is not always
immediately and fully reflected in security prices. From both an academic
and investor perspective, the research in the area of fundamental analysis is
particularly intriguing owing to the economic implications of "mount ing
evidence that suggests capital markets might be informationally ineffi cient
and the prices might take years before they fully reflect available
information."' However, Kothari notes that additional work must be clone to
improve research design and develop refutable theories of market
inefficiency.
The null hypothesis for much of the capital markets research in account ing has been that the market fully and instantaneously adjusts to new infor mation; the market price is equal to the security's intrinsic value. This
"umpire view" of the market is an extreme view and may not hold up. Lee
provides an intriguing and practical alternative:
A naive view of market efficiency, in which price is assumed to equal
fundamental value, is an inadequate conceptual starting point for
291
future market-related research. . . . It is an over simplification that fails

to capture the richness of market pricing dynamics and the process of
price discovery. Prices do not adjust to fundamental value instantly by
fiat. Price convergence toward fundamental value is better
characterized as a process, which is accomplished through the interplay
between noise traders and information arbitrageurs. This process
requires time and effort, and is only achieved at substantial cost to
society.65
Furthermore, Lee suggests that we have been asking the wrong questions:
We need to unshackle ourselves from the notion that price is equal
to value. That is, we should begin thinking about fundamental value
and the current market price as two distinct measures. . . . Rather
than assuming market efficiency, we should study how, when, and
why price becomes efficient (and why at other times it fails to do
so). Rather than ignoring the current market price, we should seek
to improve it.'
The Value of Accounting Information:

Evidence From Return Data
Information Contents of Earnings Announcements
The strongest evidence from capital market research concerns the
information content of annual accounting earnings numbers. The semi nal
study, published in 1968, showed that the direction of change in reported
accounting earnings (from the prior year) 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 efficientmarkets 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. 6 9
These results are not surprising. We expect accounting income to be part
of the information used by investors in assessing risk and return. Capital
market research 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.
Market Reaction to Alternative Accounting

Policies
A more complex type of securities-price research examined the effect of
alternative accounting policies on security prices. The initial purpose of
these tests was to investigate the so-called naive-investor hypothesis.
Research found that security prices respond to accounting income num bers.
Alternative accounting policiesfor example, flexibility in the choice of
depreciation and inventory methodscan affect net income. Although these
methods affect reported earnings, there is no apparent impact on company
cash flows. These types of accounting alternatives simply repre sent different
patterns of expense recognition or cost allocations.
The question of interest to researchers is whether alternative account ing
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 naiveinvestor 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 inter preted the
findings as a rejection of the naive-investor hypothesis. However, some
research findings challenged some of the earlier conclusions and reopened
what was once considered a closed issue in accounting research.'
Alternatives With No Known Cash Flow

Consequences
Several studies compared companies using different accounting meth ods.
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 account ing
methods. There were also differences in priceearnings multiples between
the two groups. Companies using accelerated methods had lower earnings but
higher priceearnings multiples than companies using straight-line. However,
when earnings of companies using accelerated methods were adjusted to a
straight-line depreciation basis, the priceearnings 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 find ing
is often expressed as the market not being "fooled" by arbitrary account ing
differences. Other similar research supports this conclusion. 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. When changes in depre ciation policy are researched, there is no evidence that the change per se affects
security prices. -3 Another area tested was a change from the deferral to flowthrough method of accounting for the investment credit.' Again, no price effects
were found. Although changes in accounting policies may cause the income
number to change (solely because of the policy change), these research studies
did not find that security prices responded to the changes. The market is not
fooled by higher accounting income achieved solely from a change in
accounting policy with no apparent real changes in underlying cash flows.
Evidence from the type 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 is also interpreted as a rejection of the naive-investor
hypothesis. Investors appear to adjust accounting income to compensate for
artificial bookkeeping differences with no real substance. That is, inves tors
do not appear to respond mechanistically and naively to changes in reported
accounting income numbers. Thus, early research appeared to be in line with
the semistrong form of the EMH.
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 move ment, even though LIFO lowers accounting income in a period of rising
inventory prices. 75 Given the apparent sophistication of investors in other
areas of accounting policy differences, what is 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 is 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.
Later studies, however, contradicted 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. The more recent

studies suggest that the earlier research failed to isolate the real effect of the
LIFO change because of a self-selection bias. (Companies selected because
of a LIFO change could have also experienced other positive events, which
may have been the actual cause of the positive price response.) Since LIFO
lowers accounting book income, a negative price response could be inter preted as a mechanistic response to a lower accounting number by naive
investors, who did not consider the positive cash flow consequences of
lower taxes.
More recent studies find support for a positive security price movement
when LIFO is adopted. Pincus and Wasley examined LIFO adoptions from
1978 to 1987 and found evidence for the possibility that LIFO is a "good
news" signaling event that could account for the positive security price
movement presumably resulting from its adoption. -- On the other hand, Kang
brings up the possibility of potentially high adoption costs relative to LIFO,
such as accounting system changes and a higher probability of violat ing debt
contract provisions (e.g., lower current asset ratios and higher debt-to-equity
ratios) and renegotiation of management contracts involving bonus
arrangements.' These factors might account for some of the negative price
reactions since they might offset the future tax savings.
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 naive-investor hypothesis. Later
research on the LIFO question reopened what was once thought to be a closed
issue with respect to market efficiency. However, more recent research shows
how complex the issue of LIFO adoption is. LIFO is garnering renewed
interest as a research topic, as the possibility of completely eliminating LIFO
approaches, assuming International Financial Reporting Standards (IFRS)
actually replaces U.S. GAAP, For better or worse, liquidity metrics
significantly change for LIFO adopters forced to comply with 'FRS.'
Alternatives With Indirect Cash Consequences

Security price research is 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 effect on
owners rather than a direct effect on company cash 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 account ing policy.' The required change from full costing to successful efforts is
regarded as simply a change in how exploration costs are allocated to the
income statement. Therefore, it was expected that no security price

response was evident since there was no direct cash flow consequence to
the companies.
However, security price responses were found to exist. Since previous
research predominantly rejected the naive-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 divi dends 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 from changes in accounting
policies. In the case of debt covenants restricting dividend payments, account ing numbers are used to protect the security of bondholders at the expense of
stockholders. If an accounting policy change lowers accounting income (as can
occur in a mandatory change to successful efforts), present or future cash
dividends can be reduced, 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 Accounting
Principles Board (APB) in favor of purchase accounting for combinations.'
Differences between purchase and pooling accounting appear on the sur face
to affect only book income, with no real cash effects. However, the reduced
use of pooling accounting can affect dividend distribution because of debt
covenants. Income is normally lower under purchase accounting than
pooling, and the same effect of dividend restrictions, as argued in the oil and
gas study, is also argued in the purchase/pooling study.
Another study along these lines examined the requirement to capitalize
leases previously reported as operating leases." Although there was some
evidence of negative price responses for certain companies, the price
response could be caused by the constraints imposed by the existence of
debt covenants.
Anomalies
Over longer periods of time, financial markets appear to be informationally efficient. How rapidly and completely they respond to new information
is an open question. While it is difficult to prove with certainty, there is con vincing evidence that markets may not be as efficient as postulated in the
semistrong form of the efficient-markets hypothesis.
Lags in Processing Fundamental Data

In a very extensive study, Ou and Penman examined the utility of funda mental 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 fully and 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 change in current assets in a
multivariate model to predict whether the following year's income would
increase or decrease. Using data for the period between 1965 and 1977, the
model included almost 20 accounting measures and reflected approximately
23,000 observations.' Ou and Penman were able to describe the following
year's earnings changes correctly almost 80% of the time.' The key point
concerns whether their predictors were capturing information that was
already reflected in security prices (indicating an efficient market) or were
predicting future earnings based on analysis of the accounting measures
previously mentioned. The latter situation results in abnormal security
returns if investment is based on their predictions.
Ou and Penman's analysis did indeed produce abnormal returns.' They
also believed that the excess security returns were not attributable to excess
risk factors.' Ou and Penman's research thus suggests that markets are not as
efficient as efficient-markets advocates would like to believe; fundamental
analysis is still important for investment purposes. This study also suggests
that "better" accounting standards might improve the predictive ability of
accounting information.
Low Correlation Between Earnings and Stock Returns
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" In other words,
earnings have very little explanatory power (as measured by R', the 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 exam ination of the extent to which the specific principles underlying
Usefulness of Accounting Information to Investors and Creditors + 297
accounting measurements and valuations, as well as managerial

manipulations, 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 valu ation and to contribute meaningfully to accounting policymaking. 89
Lev and the Ou and Penman papers are complementary. Lev finds a low
explanatory relationship between earnings and stock returns while Ou and
Penman see a predictive role for accounting data in an imperfectly efficient
market. Lev focuses directly on the issue of improving accounting measure ments while the Ou and Penman's work seems to imply this point. 9
Post-Earnings-Announcement Drift
Further questions concerning market efficiency arise over the phenome non
known as post-earnings-announcement drift. While markets do react significantly at the time of the earnings announcement, it takes up to 60 days for the
full effect of earnings announcements to be impounded in security prices. 91 This
effect appears to be more pronounced for smaller firms. 92 It also appears that
earnings surprises have a more persistent effect when the earnings surprise is
due to higher revenue surprises than to lower expense surprises. 93
This anomaly has not escaped the notice of professional investors.
Transient institutionsthose actively trading to maximize short-term
profitsappear able to exploit post-earnings-announcement drift. Ke and
Ramalingegowda find that these institutions earn a three-month mean
abnormal return of 5.1% (or 22% annually) net of transactions costs from
their arbitrage trades.'
At least part of the blame for post-earnings-announcement drift is laid at
the feet of financial analysts. Abarbanell and Bushee concluded that financial
analysts underreact to very fundamental signals stemming from securities,
which in turn leads to forecast errors and incomplete security price adjust ments. 9 ' Sloan found evidence that shareholders do not distinguish well
between cash flow portions of earnings and the accrual segment thereof 96 The
cash flow portion persists longer into the future and is less subject to
manipulation than the accrual part of earnings. Another possibility is that in
some cases, transaction costs are too high relative to the potential gain that
can be earned from the mispricing of the securities. Although securities
markets may be "efficient," they may not be as efficient as once believed.
This suggests that it is even more important to attempt to improve the qual ity
of accounting standards.'
Finally, Mikhail, Walther, and Willis examine if analyst experience is
related to post-earnings-announcement drift. Experience matters. Financial
markets are more efficient in the presence of experienced financial analysts, and the
effect is not trivial:
The results . . . indicate the average magnitude of the post-earnings announcement drift is reduced by approximately 18 percent . . .
when the experience level of the analysts following the firm
increases from the lowest decile to the highest decile."
Mispricing Related to Accruals
Richardson et al. focus on the reliability of accounting numbers. They
develop a comprehensive definition and categorization of accruals, and
decomposing accruals into broad balance sheet categories. They use their
"knowledge of the measurement issues underlying each accrual category to
make qualitative assessments concerning the relative reliability of each cate gory"' They then analyze the persistence of the cash flow and accrual com ponents of earnings. Finally, they analyze the abnormal returns for the firms'
common stock to determine if the market impounds the information con tained
in various accruals as it relates to earnings persistence. If the information
contained in accrual reliability is impounded in stock prices, accruals and
future abnormal stock returns should be independent of each other.
Interestingly, they find that the less reliable the accruals, the lower the
earnings persistence. More importantly, and somewhat unsettling, is that they
find the market does not fully price the less reliable accruals: "Overall, the
results are consistent with the naive investor hypothesis. Future stock returns
are negatively related to accruals, and the negative relation is stron ger for
less reliable accruals.""'
Furthermore, their findings underscore the importance of distinguishing
between earnings and free cash flow:
The standard textbook definition of free cash flow adjusts earnings
by adding back depreciation and amortization and subtracting
changes in working capital and capital expenditures. . . . The accru als that we find to be the least reliable correspond closely to the
adjustments that are made to earnings in arriving at free cash flow.
Free cash flow represents a combination of actual cash flows plus the
relatively reliable financing accruals."
Liu and Qi provide evidence that the potential mispricing of accruals is
substantial. They form companies into portfolios based on total accruals and the
"probability of information"based trading (PIN). A hedge strategy
formed by investing in the lowest accrual decile and selling short the highest
accrual decile, and confined to high PIN stocks, yielded an annualized
abnormal return of almost 19%.'
Chan et al. examine three explanations of why accruals predict stock
returns: manipulation, changing prospects, and overoptimistic expectations.
The bulk of the evidence alludes to managers' manipulation of earnings:
A large increase in accruals marks a sharp turning point in the for tunes of a company . . . In the year in which accruals are high . . .
earnings show no weakness but continue to grow rapidly. These
patterns suggest that firms with high accruals already face symp toms
of a cooling in their growth, but they use creative accounting to
delay reporting the bad news. 103
The Incomplete Revelation Hypothesis
Questions concerning market efficiency (or the lack thereon have coalesced
into a new hypothesis, the incomplete revelation hypothesis (IRH).
Bloomfield sees two principal reasons for the IRH.' First, some accounting
numbers or relationships are more difficult or costly to uncover and their effects
are not fully revealed in security prices. For example, historically, infor mation
about stock option "expense" was revealed in footnote information only as
opposed to being in the body of the income statement.' Hence, the information
and its import is more difficult to extract in footnote form, and it might take
longer for this information to fully impact security prices. This is diametrically
opposed to the efficient-markets hypothesis that disclosurein whatever form
is all that is needed to fully impact security prices.
The second factor of the IRH is the presence of "noise traders" in the
market. Noise traders are individuals who do not necessarily respond in a
completely rational way to new information. They may be rebalancing their
portfolios, responding to liquidity shocks, or even acting on whims.' Thus,
from the perspective of information effects on security prices, we have a group
of individuals who are responding to a different set of criteria. This
"distraction" impedes the market from responding in a fully efficient manner.
Finally, notice that the IRH is not only fully consistent with post-earnings announcement drift, but it may help to explain that particular phenomenon.
Accounting Information and Risk Assessment
Capital market research also investigated the usefulness of accounting
numbers for assessing the risk of securities and portfolios. These studies
300
ACCOUNTING THEORY
find high correlations between the variability of accounting earnings and

beta, the market-risk measure.' The high correlations imply that account ing data is useful for assessing risk, or at least confirming it.
Other research tries 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 can affect the usefulness of
accounting numbers for assessing risk. For example, one study tried to
determine if unfunded pension benefits (reported in Notes) 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 informa tion 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 beta.
Summary of Capital Market Research

We draw the following conclusions from the empirical evidence provided by
capital market research:
Accounting earnings appear to have information content and to affect security
prices.
Alternative accounting policies with no apparent direct or indirect cash flow
consequences to the firm do not seem to affect security prices.
Alternative accounting policies that have direct or indirect cash flow
consequences to the firm (or its owners) do affect security prices.
There is evidence that security markets do not react fully and instan taneously to certain types of accounting data in certain situations (e.g.,
high accruals, small stocks, low analyst coverage).
There are incentives to choose certain accounting policies, where choice
exists, due to indirect cash consequences.
Accounting-based risk measures correlate with market risk measures,
suggesting that accounting numbers are useful for risk assessment.
Capital market research continues to be useful in empirically evaluating
economic consequences of accounting policies vis-a-vis security prices and
the usefulness of accounting numbers for risk-and-return assessments.
301
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.
Evidence From Survey Data
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 show a
rather low readership of accounting information. 111 Approximately one-half
of the investors surveyed indicated they read financial statements.
Institutional investors show a much higher level of readership."' These sur veys, 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 infor mation has no usefulness to investors merely because many individual
stockholders do not read annual reports in detail.
Another type of survey research asked investors to weigh the impor tance
of different types of investment information, including accounting
information. Several studies of this type have been reported.' 13 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 account ing
information from company press releases, and nonaccounting informa tion
such as general economic conditions and company announcements on
products and markets, ranks ahead of annual reports in perceived
importance.
The Value of Accounting Information:

Evidence From Direct Valuation
The research discussed in the previous section primarily examined the rela tionship between accounting data and unexpected changes in stock prices,
measured as abnormal returns. Another approach is 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 capitaliza tion)."" Conceptually, this approach, which is referred to as cross-sectional
valuation, attempts to empirically estimate the theoretical model of equity
valuation described at the beginning of this chapter. This approach is used to
investigate how (if at all) specific components of the financial statements are
3 02 ACC OU N T IN G TH EOR Y
"priced" in the sense of being associated with the market valuation of the firm.
If an item is priced as an asset/revenue, it should normally have a positive rela tion 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 expressed enthusiasm for this methodology as a framework for evalu ating the merits of alternative accounting methods/valuations."'
Evidence From Pensions
Several studies used this framework to determine that a firm's pension
plan assets and liabilities (as reported off balance sheet in footnote disclo sures) are consistent with their being viewed as on-balance-sheet assets and
liabilities, respectively.' Another study determined that components 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 is implicitly
valued at zero, which is consistent with the fact that there are no cash flows
associated with the item.
Franzoni and Marin present evidence that the market significantly over values firms with severely underfunded defined benefit pension plans.
Furthermore, the effects of the overvaluation persist for a long time.
In particular, we show that the portfolio with the most underfunded
firms earns low raw returns relative to portfolios of firms with
healthier pension plans. This phenomenon persists for at least 5
years after the emergence of the large underfunding. Also, the riskadjusted returns of this portfolio are significantly negative. The
magnitude of the discount in returns is around 10% annually.'
While investors recognize the severe underfunding, it is possible that they
are not adequately factoring in the implications of that underfunding, such as
difficulty in refinancing at favorable terms or refinancing at all. Companies
can postpone the recognition of the pension liability of its earn ings, and the
underfunding eventually impacts the firm's future earnings. Franzoni and
Marin also find that a severely underfunded pension is associ ated with higher
leverage, which also constrains the ability of the firm to undertake valueenhancing investments.
One can debate whether poor operating performance and suboptimal
investment decisions lead to severe underfunding, or whether poor management of the pension fund in the form of severe underfunding eventually leads
to poor operating performance and suboptimal investment decisions. In any
303
case, it appears that investors do not fully recognize that the severe under-funding
has negative valuation effects. Why this happens is not yet resolved.
Evidence From Research and Development
Another study examined the association of research and development
(R&D) expenditures 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 implicitly capitaliz ing 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. 1 '
Evidence From Financial Services
The financial services industry is another area in which cross-sectional valu ation models are used. Studies 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 associ ated
with firm value only for banks. Another study reported that banks' supple mental
disclosure of the fair market value of investment securities is associated with
market value over and above that explained by historical costs alone. This
finding gives credence to the SEC's and FASB's push for mark-to-market
accounting and eventually to fair value measurement in SFAS No. 157. 1'
Accounting Data and Creditors

Theories underlying the usefulness of accounting information to creditors are
not as well developed as is the role of accounting numbers vis-a-vis stock
prices. Part of the problem is that interest-bearing debt securities trade
infrequently. It is, however, generally agreed that the price of interest-bearing
debt is based on the default risk premium, which is defined as the premium
in excess of the risk-free interest rate on otherwise identical debt (for example,
U.S. Treasury obligations). Thus, firm-specific information, including
accounting data, aids creditors in assessing default risk.
Several distinct lines of research have emerged: (a) the usefulness of
accounting data in predicting corporate bankruptcy (which encompasses loan
default); (b) the association of accounting data with bond ratings wherein
such ratings are presumed to proxy for default risk; (c) the association of
accounting data with estimates of interest-rate risk premiums on debt; and
304
ACCOUNTING THEORY
(d) experimental studies of the role of accounting data in lending decisions. The
following is a brief overview of the research findings for the first two.
Evidence From Bankruptcies

Accounting-based ratios are very useful in discriminating between firms
that subsequently go bankrupt and those that do not."' Bankrupt companies tend
to have financial ratios prior to bankruptcy that differ from nonbankrupt
companies. Predictability up to five years prior to bankruptcy has been demon strated. These findings do not mean that companies with "bad" ratios necessar ily go bankrupt in the future, but rather that bankruptcy is more probable.
Evidence From Credit Ratings

Accounting data are also associated with both bond ratings and default
risk premiums.' Among the important ratios are profitability, earnings vari ability, and leverage. Research is also used to evaluate which of alternative
sets of accounting data are more highly associated with bankruptcy predic tion, bond ratings, and risk premiums. Among the issues examined are
historical cost versus price-level adjusted income, the effect of lease capital ization versus noncapitalization, and recognition of pension liabilities versus
footnote-only disclosure.'
Experimental (laboratory) studies also tested the usefulness of account ing
data for creditors. Accounting data in the context of a loan-related deci sion
(for example, loan amount, bankruptcy prediction, and interest rates) are
provided to subjects to determine how, if at all, it affects their hypotheti cal
decisions.'" In these experiments, the accounting data are manipulated to see
if the judgments are sensitive to whatever manipulations take place. For
example, changes are made to the 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.
Importance of Earnings Forecasting

Copeland and Dolgoff examine the relationship between the annual total
return to shareholders and several commonly used performance measures
(sales, earnings per share, growth in earnings per share, forecasts of earn ings,
etc.). They used data about analyst expectations as a proxy for investor
expectations. The highest correlation (47%) was between the "annual return
Usefulness of Accounting Information to Investors and Creditors 0 305
to shareholders and changes during the year in expectations [italics added]

about the same year's earnings, the following year's earnings, and earnings
three to five years out."' This highlights the importance of business perfor mance, measured by accounting data, relative to market expectations. The
researchers also note that that the importance of expectations is "consistent
with a discounted cash flow view of the world."
As we noted previously, the residual income model provides a central role for
future earnings forecasts in determining the intrinsic value of a stock.' Accurate
estimates might lead to abnormal stock returns. Indeed, there is evidence that
better earnings forecasts make for wealthier investors. Loh and Mian examine
the usefulness of accurate earnings forecasts from security analysts. Each firmyear, they sort analysts based on the accuracy of their forecasts of annual
earnings. If analysts with the best earnings forecasts provide the best returns,
there is support for fundamental analysis of accounting data. Loh and Mian note:
"If the analysts with the most profitable recommendations also exhibit superior
forecasting skills, it would suggest that their stock-picking ability is real, and
that it is founded on economic rationale."'
They find that the "recommendations of superior earnings forecast ers
significantly outperform the recommendations of inferior forecast ers." 1 3 0
This is consistent with the value of fundamental accounting analysis. 1 3 1 It
also raises questions about the informational efficiency of financial
markets.
While the value of the firm is equal to the present value of the expected
future cash flows, earnings appear to play an important role in predicting
those cash flows. Dechow, Kothari, and Watts developed a model of operat ing
cash flows and the accounting process by which operating cash flows are
converted into accounting earnings. The model explains why "current earn ings, by itself, is a better forecast of future operating cash flows than current
operating cash flows by itself." 132 In addition, this prediction was borne out
empirically using a sample of 1,337 firms. Furthermore, the forecast ability is
a positive function of the firm's expected operating cash cycle.
Over the years, the relationship between earnings and stock prices has
diminished. However, the ability of earnings to forecast future cash flows has
not. Kim and Kross examine the ability of earnings to forecast one-year ahead
operating cash flows by examining three decades of data (1972-2001). Their
findings are positive: "We found an increasing relationship over time between
earnings and one-year ahead operating cash flows. . . . Further, we found that
the accuracy of cash flow predictions based on current earnings also increased
over time." 133
They hypothesize that changing accounting conservatism might play a
role. In any case, we note that the value of a stock is dependent on much
more than a one-year cash flow forecast. Clearly, more work needs to be
done to understand how earnings can be used to improve the cash flow
forecast.
Gulliver provides an analyst's perspective on financial analysis,
forecasting, and stock underperformance. He identifies five causes of stock
price underperformance: aggressive accounting, financial deterioration,
change in the industry or competitive situation, bad acquisitions, and
overvaluation. The had news: Analyzing financial statements can be
difficult. The information is contained on three separate statements and in
many footnotes. Numerous assumptions are involved, and financial rules are
complex and sometimes ambiguous. Finally, in some cases, the financial
rules are used to conceal the truth. The good news: There are numerous
cases in which "analysts and managers could have identified problem stocks
in advance of market reaction by digging deeper into the data with an eye on
earnings quality, operating efficiency, cash flow quality, and balance sheet
quality."'"
Empirical Research and Standard Setting

In the early 1970s, some argued that capital market research could be used as
a basis for choosing the best accounting policies and evaluating the eco nomic
consequences of alternative accounting policies on security prices. 135
Accounting policies that most affected security prices were thought to be
most useful. In other words, such policies had the most information con tent.
The argument had intuitive appeal, particularly since deductively based
research proved unable to resolve the normative accounting theory debate
about the most desirable form of accounting. However, the early advocates of
security price research now recognize the limitations of this research for such
a use. 13 ' Reasons for these limitations are the public-good nature of
accounting information, the existence of free riders, and the resultant mar ket
failure in terms of optimal resource allocation. The potential impact of
empirical research on the standard-setting issue recently arose again.
Opinions are mixed on whether empirical research can aid standard set ting. Holthausen and Watts take the negative position. I3- The main obstacle
for them involves the problem of different user groups with different needs, a
problem discussed in Chapter 6. For example, creditors might be most
interested in predicting debt default. Many standards involve contractual
issues, litigation, tax issues, and conservatism (booking loss contingencies
and not gain contingencies, for example). Hence, they see empirical studies
examining different alternatives and their effect on valuation and cash flow
predictions as not providing useful information for standard setters.
Usefulness of Accounting Information to Investors and Creditors o 307
Holthausen and Watts also believe that before empirical research is used as inputs for
standard-setting purposes, a theory of accounting and standard setting must be
established. What the role of such a theory might be is not made explicit. We also
question whether a theory of this type can ever be developed.
Barth, Beaver, and Landsman take the opposite tack. 138 They believe that multiple
user groups and diverse uses of accounting information do not prevent empirical research
from being useful for standard setters. For exam ple, they cite a study showing that
accumulated and projected benefit obligations in pension accounting (see Chapter 16)
measure the pension liability implicit in security prices more reliably than just the vested
benefit obligation (the two former measures give a fuller picture of the pension liability
than the latter).
Hence, the difference between the groups involves an empirical issue, which is
presently unresolved: the multiple-user-group problem. We lean toward the potential
usefulness for standard-setting groups of empirical research in areas such as valuation
and prediction of cash flows. On the question of diverse user groups with somewhat
different purposes, we believe that complementarity rather than conflict results among
users. Indeed, if extreme conflict among user groups and uses existed, we doubt that
empirical research would be useful for any purpose.

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CHAPTER

After reading this chapter, you should be able to:

he Financial Accounting Standards Board (FASB) recognizes

costbenefit calculus is similarly restricted to benefits for investors and

Usefulness of Accounting Information to Investors and Creditors 267

capital markets research, we discuss the usefulness of accounting informa tion

Earnings, Dividends, and Stock Prices

Earnings and Dividends

268 ACCOUNTING THEORY

For a firm in equilibrium, a future expected dividend can be expressed

and Equation 8.2 as:

Usefulness of Accounting Information to Investors and Creditors

dividend policy is irrelevant to firm valuation.' Ignoring the complicating

270 ACCOUNTING THEORY

Residual Income Models

Usefulness of Accounting Information to Investors and Creditors

Statement of Invested Capital for ABC Company

Statement of Invested Capital

Cash and equivalents

Total interest bearing debt

272 * ACCOUNTING THEORY

Exhibit 8.2 presents a statement of economic profit for ABC

Vo(firm) = Invested capital o+

(WACC) (invested capital),

In an attempt to improve economic profit as a performance metric, some

Usefulness of Accounting Information to Investors and Creditors 273

for ABC Company

Statement of Economic Profit

Net operating profit after tax

Capital charge on invested capital (8%)

Residual Income and the Dividend Discount Model

where required earnings are the amount of earnings that compensates

274 ACCOUNTING THEORY

Usefulness of Accounting Information to Investors and Creditors 275

276 ACCOUNTING THEORY

Usefulness of Accounting Information to Investors and Creditors 277

In spite of the name given to some forms of residual income, residual

278 ACCOUNTING THEORY

respect to NOPAT [net operating profit after tax], IC [invested

Usefulness of Accounting Information to Investors and Creditors 0 279

by themselves and must be combined with forward-looking measures. They

Background on Risk and Return

Efficient-Markets Hypothesis (EMH)

280 $ ACCOUNTING THEORY

Usefulness of Accounting Information to Investors and Creditors * 281

Thirty-six months after portfolio formation, the losing stocks have

282 I ACCOL.N TINE THI -(

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capilal. Markel Line (0-17)

porifolio. Whe.n all. tradable.

Usefulness of Accounting Information to Investors and Creditors 283

The Effect of the Number of Securities on Portfolio Risk

Portfolio risk (standard deviation)

284 ACCOUNTING THEORY

L'sofmrne.55 Oi../ICCLPLinring inknimarion

= the ;L:ranclord deviadcml

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