Chapter 8 - Usefulness of Accounting Information To

Accounting Theory: Conceptual Issues
in a Political and Economic Environment

Usefulness of Accounting Information to
Investors and Creditors
Contributors: By: Harry I. Wolk, James L. Dodd & John J. Rozycki

Book Title: Accounting Theory: Conceptual Issues in a Political and Economic Environment
Chapter Title: "Usefulness of Accounting Information to Investors and Creditors"
Pub. Date: 2017
Access Date: September 13, 2018
Publishing Company: SAGE Publications, Inc
City: Thousand Oaks
Print ISBN: 9781483375021
Online ISBN: 9781506300108
DOI: http://dx.doi.org/10.4135/9781506300108.n8
Print pages: 195-236
©2017 SAGE Publications, Inc. All Rights Reserved.
This PDF has been generated from SAGE Knowledge. Please note that the pagination of
the online version will vary from the pagination of the print book.
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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.
The Financial Accounting Standards Board (FASB) recognizes the existence of a diverse and
pluralistic user group. 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.1 The rationale for the investor – creditor 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 cost – benefit 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 group ' investors and creditors ' we wish to note that in its broadest sense, this
group is quite large. Investors include both individual and institutional shareholders, holders
of interest-bearing debt (bondholders, financial institutions, etc.), and the firm ' s board of
directors, who act on behalf of shareholders.2 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 entities that have claims on the firm before shareholders.3
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.4 In this role, the board needs to be able to evaluate and reward
management ' s efforts, abilities, and decisions, particularly management ' s capital-allocation
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decisions.5
Getting paid is certainly a major concern of the holders of interest-bearing debt, but their
concern goes beyond that. While loans from commercial banks typically have maturities of a
few years, corporate bonds have much longer maturities.6 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 off
' better 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 performance and valuing the firm. We then provide a
background on risk and return and the efficient-markets hypothesis (EMH). Using accounting-
related capital markets research, we discuss the usefulness of accounting information for the
primary user groups. In that context, we show why the efficient-markets 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 managers regarding the
determinants of their dividend policies.7 Managers indicated 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 “permanent”
earnings. Since managers perceived that shareholders valued a smooth dividend stream, the
managers made adjustments to dividend payout 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 dividend-paying stock. As
such, the stock price (P0) may be modeled as the present value of the future expected
dividends, or
(8.1)

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where
Dt = the dividend expected at time t, and

r = the rate of return expected by the shareholders.
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.8
(8.2)
For a firm in equilibrium, a future expected dividend can be expressed in terms of a constant
dividend payout ratio (PO) and earnings per share at time t (EPSt), or Dt = (PO)(EPSt). This
allows us to rewrite Equation 8.1 as
(8.3)
and Equation 8.2 as:
(8.4)
In these forms, we say that the stock price is equal to present value (capitalized value) of
future expected earnings, adjusted by the dividend payout 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.9 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.
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 dividend policy is irrelevant to firm
valuation.10 Ignoring the complicating effect of taxes, they show that the value of the firm is

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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 certainty-equivalent model but
has been extended to a more general model reflecting the uncertainty of future operating
cash flows.11 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
systems. 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 valuation 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 during 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.”12
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.14 In addition, in stock market studies,
security prices are more highly correlated with accrual income than with either cash flows or
working capital flows.15 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.16
The implication of this literature is that accrual accounting systems ultimately incorporate the
attribute that determines firm valuation ' net cash 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 investors to forecast future expected net cash flows and dividends. (This
information 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.17 The residual
income concept may be applied to the enterprise as a whole or to the firm ' s common equity.
When applied to the enterprise ' s operating income and invested capital, residual income is

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often called economic profit or Economic Value Added (EVA).18 When it is applied to the firm '
s net income and common equity, residual income may be referred to as abnormal
earnings.19
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.20 Net cash flows are the periodic cash flows that are available to all
investor claims (interest-bearing debt, preferred stock, and common stock). They are much
less subject to manipulation 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.21 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 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,
(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:
(8.6)
Equation 8.6 indicates that if the firm ' s NOPAT exceeds the capital charge, it earns an
economic profit and creates wealth.23 To increase economic 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 simply a rearrangement of the firm ' s balance sheet, putting

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net operating assets on the “left-hand side,” and all investor claims on the “right-hand side.”
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
2005 and lower net operating profit after tax (NOPAT) for 2006.
Exhibit 8.1 Statement of Invested Capital for ABC Company
Conceptually, economic profit has valuable characteristics from a performance 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 economic 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:
(8.7)
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

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application of economic profit is EVA, a proprietary form of economic profit developed by Stern
Stewart & Co. Stewart 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.25
Young notes that the most common accounting adjustments relate to nonrecurring gains and
losses, research and development, deferred taxes, 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 measurement of the
operations of the enterprise as a whole. Residual income ' sometimes called abnormal
earnings ' is focused on net income and the firm ' s common equity. It is defined as:
(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):
(8.9)
Exhibit 8.2 Statement of Economic Profit for ABC Company
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.27 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:
(8.10)

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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:
(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:
(8.12)
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 Equation 8.12 can be increased if the user can
incorporate additional information regarding forecasts of future abnormal earnings.28
Dechow, Hutton, and Sloan perform an empirical assessment of the residual income model.
They find that “residual income follows a mean reverting process . . . associated with firm
characteristics suggested by accounting and economic analysis.”29 T h e r a t e o f m e a n
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 positive 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, immediate write-off of research and
development, and possible undervaluation of other intangibles).
Qiang demonstrates that abnormal earnings increase with industry concentration, 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

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performance measurement.33 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 capital ' debt as well as equity ' has 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
capital.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] well ' to send to Omaha any cash he can ' t
advantageously use in his business.35
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.36
Rogerson demonstrates that residual income is an income-based compensation 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 income-based 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.37
Residual income models might be of direct help to investors. For example, Feltham et al.
provide evidence that EVA has more explanatory power than reported earnings or cash flow
from operations.38
Residual Income: The Bad

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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.39
All forms of residual income are consistent with discounted net cash flows for any book value
and any method of depreciation.40 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 depreciation 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.41
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 adopters, 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.42
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 correlation (at least at the level of the individual
company) with the total return to shareholders.43
If any adjustments are made to GAAP, EVA ' and presumably other forms of residual income '
may not be applied consistently or be sufficiently transparent 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

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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.44
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.45
This suggests that EVA adopters were already good managers, already working to improve
performance.
Do firms that have implemented an EVA-driven compensation system outperform the

market? Is EVA a valid forecaster of stock performance? Griffith examines these
questions using an event study methodology, estimating abnormal returns of EVA
adopters for various 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.46
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 information 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.47 Alternatively, if value-minded managers in good companies 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 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

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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 frequently advertised. We suggest that residual income models ' greatest
potential 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 accounting 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 semistrong form says that security prices reflect all
publicly available information. 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 nature ' for 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 self-interested 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 wealth-
maximizing individuals quickly analyze that information and trade accordingly.50 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 efficient, it is useless to
analyze past financial statements or read historical articles about companies. Furthermore, it
is not possible to “beat the market” 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.

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During the year ended December 31, 2003, close to three quarters of the mutual
funds holding large capitalization stocks were outperformed by the (large
capitalization) Standard and Poor ' s 500 stock index. Results are similar for other
one-year period[s]. 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.51
Anomalies
For some time, it was largely accepted that the market was indeed efficient. Then, De Bondt
and Thaler presented convincing evidence that markets 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.” 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.52
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 chapter in mid 2011, a decade later, the index
has only recovered approximately 60% of its losses.53
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 companies “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 airlines combined. . . . “There is no
point in subjecting our investors to risk in a market which I frankly do not
understand.”54
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

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security returns are imperfectly correlated (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.
The risk that can be eliminated in this manner is called unsystematic (diversifiable, unique)
risk. The remaining portfolio risk is called systematic (undiversifiable, market) risk. Systematic
risk is also known as the relevant risk, as this risk is not affected by diversification; investors
have no other choice than to bear it.
Capital Asset Pricing Model (CAPM)
The relationship between risk and return is embodied in a theory known as the capital asset
pricing model. The relationship between risk and return for diversified portfolios is modeled by
the Capital Market Line. For individual assets, the relationship is modeled by the Security
Market Line.
Exhibit 8.3 Amazon.com Inc.: Income From Operations and Stock Price
Capital Market Line (CML)
The standard deviation of a portfolio declines as more assets are added to the portfolio. When
all tradable and nontradable assets (stocks, bonds, 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.55
The straight line is called the Capital Market Line (CML). The CML intersects the Y-axis at the
risk-free rate of interest, typically considered to be a 90-day 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

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reflect various proportions of an investor ' s wealth invested in M and the risk-free asset. When
drawn through M, the CML provides the highest risk premium ' the expected return above and
beyond the risk-free rate ' per 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 CML is linear only under restrictive conditions, but whether linear or curvilinear,
a direct relationship exists between the level of risk and expected returns.
Exhibit 8.4 The Effect of the Number of Securities on Portfolio Risk
Security Market Line (SML)
Theoretically, with the formation of the market portfolio, the unsystematic risk of individual
securities is eliminated, and only systematic risk matters. Hence, the relevant risk for an
individual security is systematic risk, which is the risk of the security relative to the market
portfolio.56 The systematic risk for an individual security is measured by beta (β), which
measures the volatility of a security ' s returns relative to the market portfolio.57 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):
(8.13)
where
Rj = the expected return on security j,

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Rf = the risk-free rate of return (typically the return on Treasury bills),

Rm = the expected return on the market portfolio, and
βj = 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
(8.14)
where
rjm = the correlation coefficient between security j and m,

sj = the standard deviation of the returns on security j,
sm = the standard deviation of the returns on the market portfolio,
sm2 = the variance of the returns of the market portfolio, and
rjmsjsm = the covariance of the returns of security j with those of market portfolio.
In practice, the relation between risk and return is not exactly the way the CAPM specifies.
Nevertheless, the model has received support among academics and practitioners.58
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 investors, 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 performance 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.
Exhibit 8.5 Capital Market Line

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The Market Model
Many empirical studies in accounting use the empirical form of the CAPM known as the
market model:
(8.15)
where
t is a time subscript,
Rj, βj, and Rm are the same as in Equation 8.13,
α = the intercept term, and
ε = 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, α, is equal to Rf[1 − βj].) The
portion of the return not explained by the market is reflected in ε, the error term.
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.59 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 (α and β) of Equation 8.15 using linear regression. This is shown graphically

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in Exhibit 8.6.
After the parameters of Equation 8.15 have been estimated, the equation 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 subsequent ARs should again randomly fluctuate around
zero, and the CARs should show no trend. See Exhibit 8.7.
Exhibit 8.6 Estimation of Equation 8.15
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.60 The study of price movements and the pricing
mechanism in any market is an imposing task. Determining cause and effect between
information and security prices is especially difficult because new information is continuously
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 investors ' those at the margin who influence stock prices. This difficulty means that
the tests are going to be somewhat crude rather than precise.61 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

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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-à-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.62 The main areas of interest for capital markets research in accounting deal with
fundamental analysis and valuation, tests of market efficiency relating to accounting
information, and the value relevance of financial reporting. We focus on the first two areas.
In an efficient market, the value of the firm is equal to the present value of the future expected
net cash flows. From a valuation perspective, the firm ' s financial statements are useful to the
extent that they are helpful in forecasting future cash flows. Fundamental analysis deals with
using economic information, including the information contained in the firm ' s financial
statements, to forecast future cash flows and estimate the firm ' s intrinsic value (inherent
economic value).
Exhibit 8.7 Graph Showing Full and Immediate Adjustment to an Event
Exhibit 8.8 Graph Showing Incomplete Adjustment to an Event

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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 cross-sectional tests have increased the number of research
opportunities.63Association studies test for correlation between some accounting performance
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 information is not necessarily the timeliest source of data affecting
security prices.
Later research focused on methodological research, alternative performance 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 “mounting evidence that
suggests capital markets might be informationally inefficient and the prices might take years
before they fully reflect available information.”64 However, Kothari notes that additional work
must be done to improve research design and develop refutable theories of market
inefficiency.
The null hypothesis for much of the capital markets research in accounting has been that the
market fully and instantaneously adjusts to new information; 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 future market-related research. .

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. . 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.66
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 seminal study, published in 1968, showed that the
direction of change in reported accounting earnings (from the prior year) positively correlated
with security price movements.67 The study also found that the price movements anticipated
the earnings results and that there was virtually no abnormal price movement one month after
the earnings were announced. This is consistent with the semistrong form of the efficient-
markets hypothesis. A later study showed that the magnitude a s w e l l a s direction o f
unexpected earnings are associated with changes in security prices.68 Quarterly earnings
announcements have also shown the same general results.69
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
numbers. Alternative accounting policies ' for example, flexibility in the choice of depreciation
and inventory methods ' can affect net income. Although these methods affect reported
earnings, there is no apparent impact on company cash flows. These types of accounting
alternatives simply represent different patterns of expense recognition or cost allocations.
The question of interest to researchers is whether alternative accounting policies have a

systematic effect on security prices. If security prices do respond to income levels that differ
solely because of alternative accounting methods, with no cash flow consequences, then
there is support for the naive-investor hypothesis. On the other hand, if security prices do not
respond to such artificial book-income differences, then there is evidence that investors in the

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market are sophisticated and able to see through such superficial bookkeeping differences.
Virtually all the initial research interpreted 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.70
Alternatives With No Known Cash Flow Consequences
Several studies compared companies using different accounting methods. One of the earliest
studies compared companies using accelerated versus straight-line depreciation methods.71
The two groups of companies had different accounting income numbers because they used
alternative depreciation methods; thus there were differences in income between the two
groups of companies due to the use of alternative depreciation accounting methods. There
were also differences in price – earnings multiples between the two groups. Companies using
accelerated methods had lower earnings but higher price – earnings multiples than
companies using straight-line. However, when earnings of companies using accelerated
methods were adjusted to a straight-line depreciation basis, the price – earnings multiple
between the two groups of companies was not significantly different.
The assessments of the companies in the market did not appear to be affected by arbitrary
and alternative accounting income numbers. This finding is often expressed as the market not
being “fooled” by arbitrary accounting 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.72
A related area of investigation concerns security price responses to a reported change in

accounting policy by a company. When changes in depreciation policy are researched, there
is no evidence that the change per se affects security prices.73 Another area tested was a
change from the deferral to flow-through method of accounting for the investment credit.74
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 of research discussed in the preceding paragraphs supports the claim
that there is no information content in accounting policy changes, at least where there are no
apparent underlying changes in cash flows. This finding 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, investors 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 movement, even though LIFO lowers accounting income in a period of
rising inventory prices.75 Given the apparent sophistication of investors in other areas of

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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.76
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 interpreted 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.77 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 violating debt contract provisions (e.g.,
lower current asset ratios and higher debt-to-equity ratios) and renegotiation of management
contracts involving bonus arrangements.78 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 replace U.S. GAAP, For better or
worse, liquidity metrics significantly change for LIFO adopters forced to comply with IFRS.79
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 accounting policy.80 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
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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
dividends in the short term because of restrictive debt covenants. Therefore, even though the
change in accounting policy appeared to affect only book income on the surface, there were
indirect cash flow consequences to investors, which might explain the negative price
response. This explanation derives from agency theory. When accounting numbers are used
to monitor agency contracts, there can be indirect consequences from changes in accounting
policies. In the case of debt covenants restricting dividend payments, accounting numbers are
used to protect the security of bondholders at the expense of stockholders. If an accounting
policy change lowers accounting income (as can occur in a mandatory change to successful
efforts), present or future cash dividends can be reduced, causing a negative price
response.81
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.82 Differences between purchase and pooling
accounting appear on the surface to affect only book income, with no real cash effects.
However, the reduced use of pooling accounting 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.83 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 convincing 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 fundamental 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.84 Ou and Penman were able to describe the following

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year ' s earnings changes correctly almost 80% of the time.85 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.86 They also believed that
the excess security returns were not attributable to excess risk factors.87 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.88 In
other words, earnings have very little explanatory power (as measured by R2, 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 examination of the extent to which the
specific principles underlying 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 valuation 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 measurements while Ou and Penman ' s work seems to imply this
point.90
Post-Earnings-Announcement Drift
Further questions concerning market efficiency arise over the phenomenon 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 institutions '
those actively trading to maximize short-term profits ' appear able to exploit post-earnings-
announcement drift. Ke and Ramalingegowda find that these institutions earn a three-month

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mean abnormal return of 5.1% (or 22% annually) net of transactions costs from their arbitrage
trades.94
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 adjustments.95 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 quality of accounting
standards.97
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.98
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 category.”99 They then analyze the persistence of the cash flow and accrual
components of earnings. Finally, they analyze the abnormal returns for the firms ' common
stock to determine if the market impounds the information contained 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 stronger for less reliable accruals.”100
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 accruals that we find to be the least reliable correspond
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Free cash flow represents a combination of actual cash flows plus the relatively
reliable financing accruals.101
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%.102
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 fortunes 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 symptoms 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 thereof) have coalesced into a new
hypothesis, the incomplete revelation hypothesis (IRH). Bloomfield sees two principal reasons
for the IRH.104 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,
information about stock option “expense” was revealed in footnote information only as
opposed to being in the body of the income statement.105 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 disclosure ' in 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.106 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 find high correlations between
the variability of accounting earnings and beta, the market-risk measure.107 The high
correlations imply that accounting 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

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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 affected beta.108 There was no
significant impact. From this evidence, it might be concluded that pension information is not
useful for risk assessments. However, other studies found that supplemental segment (line of
business) disclosures resulted in a revision of systematic risk, which suggests that such
information is useful for risk assessments.109
Other studies have tested the association of financial ratios with beta.110 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 instantaneously 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-à-vis security prices and the usefulness of
accounting numbers for risk-and-return assessments. Perhaps more than anything else,
though, the impact of capital market research is that it brought a different perspective to
accounting theory and policy at a time when the emphasis was primarily on deductively based
theory.
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.112 These surveys, particularly
of individual investors, should be interpreted cautiously, however. Individual investors may rely
on investment analysts to process accounting information. It would be simplistic to assume
accounting information has no usefulness to investors merely because many individual
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Another type of survey research asked investors to weigh the importance of different types of
investment information, including accounting information. Several studies of this type have
been reported.113 Accounting information ranks fairly high in importance in these surveys,
though not at the top. This status seems to be attributable to the historical nature of
accounting information and the reporting-lag effect. More timely accounting information from
company press releases, and nonaccounting information 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 relationship 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
capitalization).114 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 “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 relation to market value, whereas if the item is priced as a liability/expense it should
normally have a negative relation with market value. A number of authors expressed
enthusiasm for this methodology as a framework for evaluating the merits of alternative
accounting methods/valuations.115
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 disclosures) are consistent with their being
viewed as on-balance-sheet assets and liabilities, respectively.116 Another study determined
that components of pension expense (per SFAS No. 87) are not weighted equally in terms of
their association with market valuation.117 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 Marín present evidence that the market significantly overvalues 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 risk-adjusted returns of this portfolio are significantly
negative. The magnitude of the discount in returns is around 10% annually.118
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

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its earnings, and the underfunding eventually impacts the firm ' s future earnings. Franzoni
and Marín also find that a severely underfunded pension is associated with higher leverage,
which also constrains the ability of the firm to undertake value-enhancing 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 case, it appears that investors do not fully recognize that the
severe underfunding 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.119 This result provides evidence that the market is
implicitly capitalizing R&D outlays even though SFAS No. 2 prohibits explicit capitalization. In
other words, the market interprets R&D as an asset (investment) rather than an expense,
contrary to the accounting treatment required by SFAS No. 2.120
Evidence From Financial Services
The financial services industry is another area in which cross-sectional valuation models are
used. Studies examined supplemental disclosures of nonperforming loans (default risk) and
interest rate risk in banks and thrifts.121 Nonperforming loans are negatively associated with
firm value, though this effect is greater for banks than for thrifts. Interest rate risk was
negatively associated with firm value only for banks. Another study reported that banks '
supplemental disclosure of the fair market value of investment securities is associated with
market value over and above that explained by historical costs alone. 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. 157.122
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-à-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 (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

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Accounting-based ratios are very useful in discriminating between firms that subsequently go
bankrupt and those that do not.123 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 demonstrated. These findings do not mean that companies with “bad”
ratios necessarily 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.124
Among the important ratios are profitability, earnings variability, and leverage. Research is also
used to evaluate which of alternative sets of accounting data are more highly associated with
bankruptcy prediction, bond ratings, and risk premiums. Among the issues examined are
historical cost versus price-level adjusted income, the effect of lease capitalization versus
noncapitalization, and recognition of pension liabilities versus footnote-only disclosure.125
Experimental (laboratory) studies also tested the usefulness of accounting data for creditors.
Accounting data in the context of a loan-related decision (for example, loan amount,
bankruptcy prediction, and interest rates) are provided to subjects to determine how, if at all, it
affects their hypothetical decisions.126 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 earnings, etc.). They used data about analyst
expectations as a proxy for investor expectations. The highest correlation (47%) was between
the “annual return 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.”127 This highlights the importance of business performance, measured by
accounting data, relative to market expectations. The researchers also note 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.128 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 firm-year, 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.”129

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They find that the “recommendations of superior earnings forecasters significantly outperform
the recommendations of inferior forecasters.”130 This is consistent with the value of
fundamental accounting analysis.131 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 operating cash flows and the accounting process by which
operating cash flows are converted into accounting earnings. The model explains why
“current earnings, 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 bad 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.”134
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 economic 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 content. 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.136 Reasons for these limitations are
the public-good nature of accounting information, the existence of free riders, and the
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empirical research on the standard-setting issue recently arose again.
Opinions are mixed on whether empirical research can aid standard setting. Holthausen and
Watts take the negative position.137 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. 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 example, they cite a study showing that accumulated
and projected benefit obligations in pension accounting (see Chapter 15) 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.
Summary
This chapter has surveyed the research literature on the usefulness of accounting information
to what the FASB calls the primary user group of investors and creditors. The picture that
emerges is that accounting data are important to investors for valuing securities, assessing
the performance of managers, and making loan-related decisions by creditors. There should,
however, be no illusions about the relative importance of financial reporting for these external
users. For example, unexpected accounting earnings explain only a small percentage (around
5%) of a firm ' s revaluation vis-à-vis security prices. Although some of this is owing to
econometric problems in the research, it is more or less consistent with investor surveys that
show accounting information ranking lower in importance than more timely information about
the economy, the relevant industry, and the firm itself.
Market efficiency has increasingly come under challenge. There is evidence that it is possible
to earn abnormal returns through diligent analysis. In some cases, the information from
earnings announcements is not totally or rapidly absorbed into security prices.
Further, although the evidence supports the usefulness of accounting information to this
primary user group, we do not really know the extent of the value. The good news for
accountants, analysts, and investors is the systematic evidence that financial reporting and
analysis is useful. The bad news is that we still know very little about how useful it is, and we

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are unable to infer much about the social benefits of any current investment in accounting
information production. Nevertheless, we believe that efforts to improve the quality of earnings
and other accounting numbers are valid and meaningful.
Questions
1. How is accounting data useful to investors? To creditors?

2. In what ways do you think information useful for investors (in assessing future cash
flows) differs from that useful for creditors (in assessing default risk)?
3. Besides the primary investor – creditor group, what other user groups can claim to be
stakeholders in the firm? How are their information requirements the same as the
primary investor – creditor group? How do their information needs differ?
4. Who are creditors?
5. Why do we sometimes say that the dividend discount model is actually an earnings
model? How do Lintner ' s findings relate dividends and earnings?
6. What is residual income? Abnormal earnings? Economic profit? EVA?
7. How does EVA differ from economic profit?
8. What are some advantages and disadvantages of using residual income (including
economic profit and EVA) for performance measurement?
9. Comment on the following statement: The residual income model is no different from
the dividend discount model. Therefore, it has no value to investors and analysts.
10. Comment on the following statement: Maximizing residual income is the same as
maximizing earnings. Managers should be rewarded for maximizing either one.
11. Why do managers of Berkshire Hathaway have an incentive to send cash to Omaha?
12. Should firms capitalize research and development expenditures? Why or why not?
13. What is clean surplus accounting? What is its role in linking dividends and abnormal
earnings?
14. What is the efficient-markets hypothesis?
15. Why does the concept of market efficiency (with respect to information) have no
necessary relation to the quality of accounting information? Why is this distinction
important with respect to accounting policy making?
16. Why is the efficient-markets hypothesis being challenged?
17. What is meant by “information content,” and how does capital market research
determine the information content of accounting numbers?
18. What is the advantage of being well diversified? Is there a downside? Why or why not?
19. If investors are well diversified (e.g., own several hundred stocks), will they have a
greater or lesser need for accounting information? What does this say about
diversification?
20. What are some limitations of capital market research?
21. What is an event study?
22. What are abnormal returns (ARs) and cumulative abnormal returns (CARs)? What do
they have to do with research in accounting? What do they have to do with accounting
standards?
23. Explain Lee ' s (2001) view of market efficiency.
24. Lee (2001) rejects the “naive view” of market efficiency. Explain. If Lee is correct, what
are the implications for capital markets research in accounting?
25. For event studies, the post-event window is typically short (days or months). What are
some issues associated with examining longer event windows (e.g., years)?
26. What do we mean when we say that capital market research involves a joint test of both
market efficiency and the model used to estimate abnormal returns?

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27. Describe the general findings from capital market research concerning the information
content of accounting numbers and the effects of alternative accounting policies.
28. Why is the choice between the FIFO – LIFO inventory methods an interesting issue in
capital market research?
29. As an investor, how do you react to a company changing its inventory accounting from
FIFO to LIFO? Why?
30. Over the years, the research findings regarding changing from FIFO to LIFO have
varied. Why do you suppose this is the case?
31. Why may accounting policies with no direct cash flow consequences indirectly affect
investors or creditors?
32. Why is it argued that capital market research cannot determine the optimality of
accounting policies even for the limited investor – creditor group?
33. How do market-level and individual decision-maker analyses complement one another
in studying the usefulness of accounting information to investors and creditors?
34. Lev talks about the low correlation between earnings and stock returns. Ou and
Penman discuss the possibility of making abnormal returns based on published
financial data. Are these papers in conflict with each other or complementary to each
other? Why?
35. What is post-earnings-announcement drift?
36. Why does post-earnings-announcement drift challenge the efficient-markets
hypothesis?
37. Why does post-earnings-announcement drift appear to be more pronounced with
smaller firms? What can be done from a company perspective to rectify this situation?
What can be done from a standard-setting perspective to mitigate the effects of post-
earnings-announcement drift?
38. What is the incomplete revelation hypothesis?
39. Suppose an accounting event occurs and there is no market reaction. What should we
conclude?
40. Give some examples in which accounting information is not the most timely source of
information affecting security prices.
41. Instead of employing capital markets research techniques (e.g., event studies) why don
' t we just ask investors how they would react to a hypothetical event? Why don ' t we
ask managers why they make specific accounting changes?
42. Why is it important to improve the quality of accounting standards?
43. What do pensions have to do with a company ' s operating performance? What do
pensions have to do with the firm ' s financing and investment decisions?
44. There is evidence that investors do not fully recognize the valuation effects of severe
pension underfunding. (See, for example, Franzoni and Marín, 2006.) Why do you
suppose this is the case? What changes could be made to mitigate this problem?
45. Why are accounting ratios valuable for predicting bankruptcy? What cautions do we
need in evaluating accounting ratios?
46. Accounting earnings are useful in predicting one-year-ahead cash flows. Is this
sufficient? Why or why not?
47. Why do high levels of accruals appear to be mispriced?
48. Evaluate Stewart ' s (2009) discovery of a single overarching ratio, EVA momentum,
which is “superior to all other ratios.”
Cases, Problems, and Writing Assignments
1. The usefulness of accounting data to investors and creditors for predictive purposes is

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necessarily forward looking. However, under generally accepted accounting principles,

financial statements are constructed primarily as a historical record.
Required:
a. What limitation does this impose on the usefulness of financial statements for
predictive purposes, and how is this limitation evident from the research reviewed
in the chapter?
b. Provide examples of important forward-looking events that either are not reported
in financial statements or are not reported in a timely manner.
c. Why can the feedback value of audited financial statements make them very
important to investors and creditors even though predictive value is not
necessarily high?
2. A retail company begins operations late in 2000 by purchasing $600,000 of

merchandise. There are no sales in 2000. During 2001, additional merchandise of
$3,000,000 is purchased. Operating expenses (excluding management bonuses) are
$400,000, and sales are $6,000,000. The management compensation agreement
provides for incentive bonuses totaling 1% of after-tax income (before the bonuses).
Taxes are 25%, and accounting and taxable income is the same.
The company is undecided about the selection of the LIFO or FIFO inventory methods.
For the year ended 2001, ending inventory is $700,000 and $1,000,000, respectively,
under LIFO and FIFO.
Required:
a. How are accounting numbers used to monitor this agency contract between
owners and managers?
b. Evaluate management incentives to choose LIFO versus FIFO.
c. Assuming an efficient capital market, what effect can the alternative policies have
on security prices and shareholder wealth?
d. Why is the management compensation agreement potentially counterproductive
as an agency-monitoring mechanism?
e. Devise an alternative bonus system to avoid the problem in the existing plan.
Critical Thinking and Analysis
1. How do you think the efficient-markets hypothesis impacts the drafting of accounting
standards? Bear in mind that many questions have been raised about the efficient-
markets hypothesis itself.
2. To what extent should the liquidity measures revisions be considered if LIFO were to be
eliminated from U.S. GAAP? Provide examples of those likely measures that would be
affected. As an interesting side note, what does the 2016 United States budget
estimate the effect on revenues will be if LIFO accounting for inventory is repealed?
3. Trombetta et al. (2012) discuss how effects analyses might help determine the
usefulness of accounting standards. Which research method do you argue provides
the best analysis of a new standard?
cash flow

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dividends
accounting
capital markets
residuals
prices
valuation
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Accounting Theory: Conceptual Issues

in a Political and Economic Environment

Contributors: By: Harry I. Wolk, James L. Dodd & John J. Rozycki

Usefulness of Accounting Information to Investors and Creditors

After reading this chapter, you should be able to:

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Earnings, Dividends, and Stock Prices

Earnings and Dividends

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Dt = the dividend expected at time t, and

and Equation 8.2 as:

Predicting Dividends From Current Earnings

Connecting the Dots: From Earnings to Stock Prices

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Residual Income Models

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Exhibit 8.1 Statement of Invested Capital for ABC Company

Conceptually, economic profit has valuable characteristics from a performance evaluation

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

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Residual Income and the Dividend Discount Model

Exhibit 8.2 Statement of Economic Profit for ABC Company

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Residual Income and Performance Measurement: The Good and Bad

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Residual Income: The Good

Although not explicitly designated as an application of residual income, Berkshire Hathaway

When capital invested in an operation is significant, we also both charge managers a

Rogerson demonstrates that residual income is an income-based compensation system that

Residual Income: The Bad

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Do firms that have implemented an EVA-driven compensation system outperform the

Are We Asking Too Much?

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Background on Risk and Return

The usefulness of accounting information to investors has been empirically investigated

Efficient-Markets Hypothesis (EMH)

Rationale and Implications of the EMH

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Consistent with the predictions of the overreacting hypothesis, portfolios of prior

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Capital Asset Pricing Model (CAPM)

Capital Market Line (CML)

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Exhibit 8.4 The Effect of the Number of Securities on Portfolio Risk

Security Market Line (SML)

Rj = the expected return on security j,

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Rf = the risk-free rate of return (typically the return on Treasury bills),

Beta is estimated by performing a regression of the returns of security j on those of the

rjm = the correlation coefficient between security j and m,

Introduction to Capital Markets Research in Accounting

Exhibit 8.5 Capital Market Line

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The Market Model

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Exhibit 8.6 Estimation of Equation 8.15

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there is information content rather than where there is none.

Overview of Capital Markets Research in Accounting

Kothari provides an excellent review of the literature on capital market research in

Exhibit 8.7 Graph Showing Full and Immediate Adjustment to an Event