Accounting Research Center, Booth School of Business, University of Chicago

Accounting Research Center, Booth School of Business, University of Chicago
The Boundaries of Financial Reporting and How to Extend Them

Author(s): Baruch Lev and Paul Zarowin
Source: Journal of Accounting Research, Vol. 37, No. 2 (Autumn, 1999), pp. 353-385
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Journal of AccountingResearch
Vol. 37 No. 2 Autumn 1999
Printed in US.A.
The Boundaries of
Financial Reporting and
How to Extend Them
BARUCH LEV AND PAUL ZAROWIN*
In this study we investigate the usefulness of financial information to

investors in comparison to the total information in the marketplace.1
Our evidence indicates that the usefulness of reported earnings, cash
flows, and book (equity) values has been deteriorating over the past 20
years. We document that this deterioration in usefulness, in the face of
both increasing investor demand for relevant information and persis-
tent regulator efforts to improve the quality and timeliness of financial
information, is due to change. Whether driven by innovation, competi-
tion, or deregulation, the impact of change on firms' operations and
economic conditions is not adequately reflected by the current report-
ing system. The large investments that generally drive change, such as
restructuring costs and R&D expenditures, are immediately expensed,
while the benefits of change are recorded later and are not matched with
* New York University. Helpful comments and suggestions were obtained from David
Aboody, Mary Barth, William Beaver, Christine Botosan, Amihud Dotan, Ron Kasznik,
Nahum Melumad, Jim Ohlson, Fernando Penalva, Richard Sansing, Brett Trueman, Paul
Wachtel and Gregory Waymire.
1 We assume that the major objective of financial reporting is the provision of decision-
relevant information to investors, as stated in the FASB's Statementof Financial Accounting
ConceptsNo. 1: "Financial reporting should provide information that is useful to present
and potential investors and creditors and other users in making rational investment, credit
and similar decisions.. . . Financial reporting should provide information to help present
and potential investors and creditors and other users in assessing the amounts, timing,
and uncertainty of prospective cash receipts from dividends or interest and the proceeds
from the sale, redemption, or maturity of securities or loans" (FASB[1978, paras. 34, 37]).
353
Copyright?, Instituteof ProfessionalAccounting, 1999

354 JOURNAL OF ACCOUNTING RESEARCH, AUTUMN 1999
the previously expensed investments. Consequently, the fundamental ac-

counting measurement process of periodically matching costs with reve-
nues is seriously distorted, adversely affecting the informativeness of
financial information.2 We validate our conjecture, that business change
is an important factor responsible for the deterioration in the informa-
tiveness of financial information, first by providing evidence that the rate
of change experienced by U.S. business enterprises has increased over
the past 20 years, and then by linking the increased rate of change with
the decline in the usefulness of financial information.
We extend our inquiry by considering the accounting for innovative
activitiesof business enterprises-the major initiator of change in devel-
oped economies. These activities, mostly in the form of investment in in-
tangibleassetssuch as R&D, information technology, brands, and human
resources, constantly alter firms' products, operations, economic condi-
tions, and market values. We argue that it is in the accounting for intan-
gibles that the present system fails most seriously to reflect enterprise
value and performance, mainly due to the mismatching of costs with rev-
enues. We demonstrate the adverse informational consequences of the
accounting treatment of intangibles by documenting a positive associa-
tion between the rate of business change and shifts in R&D spending,
and an association between the decrease in the informativeness of earn-
ings and changes in R&D spending.
Having linked the increasing importance of intangible investments,
through their effect on the rate of business change, to the documented
decline in the usefulness of financial information, we address the nor-
mative question of what can be done to arrest this decline. We advance
two proposals: a comprehensive capitalization of intangible investments
and a systematic restatement of financial reports. The first proposal ex-
pands on a practice currently used in special circumstances (e.g., soft-
ware development costs), while the second proposal implies a radical
change in current accounting practices.
1. The Decreasing Usefulness of Financial Information

We use statistical associations between accounting data and capital
market values (stock prices and returns) to assess the usefulness of finan-
cial information to investors.3 Such associations reflect the consequences
of investors' actions,whereas alternative usefulness measures, such as those
2 It is not change
per se that distorts financial reporting, rather it is the increased uncer-
tainty generally associated with change (e.g., uncertainty about the consequences of a sub-
stantial restructuring, product development, or deregulation). If the consequences of change
were perfectly predictable, the accounting system would have no problem matching costs with
revenues. The uncertainty associated with change provides the justification or excuse for the
immediate expensing of practically all change-related outlays.
3 Since we are concerned with the usefulness of financial information to investors, the
contractual and stewardship (compensation) functions of such information are not exam-
ined here.

BOUNDARIES OF FINANCIAL REPORTING 355
based on questionnaire or interview studies, reflect investors' opinions

and beliefs. Furthermore, empirical associations between market values
and financial data allow for an assessment of the incrementalusefulnessof
accounting data relative to other information sources (e.g., managers'
voluntary disclosures or analysts' recommendations). Interviews or pre-
diction studies, where usefulness is assessed in terms of predictive power
(e.g., Ou and Penman [1989]), generally do not compare the usefulness
of accounting data with that of other information sources.4
1.1 THE WEAKENING RETURNS-EARNINGS ASSOCIATION
It has been previously documented (e.g., Lev [1989]) that the associa-
tion between reported earnings and stock returns is weak. Over return
intervals of up to a year, earnings account for only 5% to 10% of the
variation in stock returns.5 This result holds in cross-section and time-
series studies and applies to reported earnings as well as to earnings
surprises. In the current study we examine changesover time in the infor-
mativeness of earnings, as well as cash flows and book values. Because
our interest is in linking the rate of business change with shifts over time
in informativeness, we focus on the past 20 years, since that is the period
of greatest change affecting business enterprises (e.g., globalization of
business operations, the advent of many high-tech industries, and exten-
sive worldwide deregulations).
Our first analysis examines the usefulness of reported earnings, using
the following cross-sectional regression to estimate the association be-
tween annual stock returns and the level and change of earnings:6
Rit = 0 + alEit + a2AEit + cit, t = 1977-96 (1)
where:
Rit = firm i's stock return for fiscal year t.
Eit = reported earnings before extraordinary items (Compustatitem
#58) of firm i in fiscal year t.
AEjt = annual change in earnings: AEjt = Eit- Eit-1, proxying for the
surprise element in reported earnings.
4Association studies, such as those presented here, indicate an upperboundof usefulness

of the financial data examined. Unless the stock return interval around the announcement
is very narrow (e.g., a day), an association between an information item and stock return
does not necessarily imply that the information item indeed triggered investors' reaction.
It may be that other, more timely information caused the stock price change.
5 Nonearnings accounting data (e.g., inventories, R&D, capital expenditures) increase
the explanatory power of financial information with respect to stock returns to 15-25%
(Lev and Thiagarajan [1993] and Livnat and Zarowin [1990]).
6 A complete characterization of the returns-earnings relationship includes, in addition
to current and lagged earnings, the impact of earnings on forecasts of future earnings (Lev
[1989, sec. 5]). Several recent studies (e.g., Liu and Thomas [1998]) include analysts' fore-
casts in the returns-earnings association. But analysts' forecasts are affected by multiple in-
formation sources in addition to reported earnings. In fact, such forecasts reflect the entire
information set available to analysts (e.g., managerial voluntary disclosures), thereby over-
stating the informativeness of reported earnings.

356 BARUCH LEV AND PAUL ZAROWIN
Both Eit and AEit are scaled by firm i's total market value of equity at
the beginning of year t. Our sources of data are the 1996 versions of
the Compustat(both Currentand ResearchFiles) and CRSPdatabases.
Table 1 presents estimates of regression (1) for each of the years,
1978-96 (1977 is "lost" due to the first differencing of earnings). The
"total sample," containing 3,700 to 6,800 firms per year, includes all Com-
pustat firms with available data. The "constant sample" is 1,300 firms with
data in each of the 20 years examined. Panel A of table 1 shows that the
association between stock returns and earnings, as measured by R2, has
been declining throughout the 1977-96 period: from R2s of 6-12% in
the first ten years of the sample to R2s of 4-8% in the last ten years.7 A
regression of the annual R2s in panel A on a Time variable indicates
(panel B) that the decrease is statistically significant (the estimated Time
coefficient is -0.002, t = -2.97).8
A different perspective on the informativeness of earnings is provided
by the combined ERC (earnings response coefficient), defined as the sum
of the slope coefficients of the level and change of earnings (a1 + a2 in
regression (1)). This measure reflects the average change in the stock
price associated with a dollar change in earnings. A low slope coefficient
suggests that reported earnings are not particularly informative to inves-
tors, perhaps because they are perceived as transitory or subject to man-
agerial manipulation. In contrast, a high slope coefficient indicates that
a large stock price change is associated with reported earnings, reflecting
investors' belief that earnings are largely permanent. It has been shown
(e.g., Lev [1989]) that the estimated slope coefficient is a function of the
precision of earnings.
The estimated slope coefficients (ERCs) in table 1 (fourth column
from left) have been decreasing over 1977-96, from a range of 0.75-
0.90 in the first five years of the sample, to 0.60-0.80 in the last five
years. A regression of the yearly ERCs on Time (panel B) confirms that
the ERC's decline is statistically significant (the estimated coefficient of
Timefor the total sample is -0.011, t = -3.04).9 The evidence on the de-
clining slope coefficients of earnings complements the inferences based
on declining R2s. While the declining R2s in table 1 might be driven by
an increase in the relative importance of nonaccounting information,
with no change in the informativeness of earnings on a stand-alone basis,
7 All R2s reported in this study are adjusted R2s.

8All regressions on Time were also run with one- and two-lag autocorrelation correc-
tions, with virtually identical results.
9 Ramesh and Thiagarajan [1995] provide similar evidence of a temporal decrease of the
returns-earnings slope coefficient (ERC). They subject the data to various statistical and
specification tests and conclude that the intertemporal decrease in ERCs is both statistically
significant and robust to different model specifications (e.g., accounting for firm-size
effect). Ramesh and Thiagarajan also examine the pattern of firm-specific (time-series)
ERCs and find a similar phenomenon of temporally declining response coefficients. The
temporal decline in ERCis documented also when unexpected earnings relative to analysts'
forecasts are considered (Cheng- Honwood. and McKeown [19921).

TABLE 1
The Association betweenEarnings and StockReturns
Estimatesfrom YearlyCross-SectionalRegressionsof Annual StockReturns
on the Level and Change of ReportedEarnings
Panel A: Equation (1): Rit = ao + a, Eit + a2AEit + Fit
Total Samplel Constant Sample'
Number of
Year Observations R2 ERC R2 ERC
1978 3,689 0.115 0.907 0.167 1.689
1979 3,851 0.072 0.865 0.114 1.368
1980 4,141 0.059 0.768 0.092 1.367
1981 4,347 0.119 0.909 0.173 1.648
1982 4,822 0.066 0.755 0.099 1.190
1983 4,751 0.053 0.711 0.070 0.939
1984 5,074 0.111 0.753 0.245 1.177
1985 5,057 0.109 0.701 0.159 0.936
1986 5,048 0.076 0.633 0.169 1.067
1987 5,318 0.069 0.646 0.107 0.988
1988 5,350 0.074 0.575 0.079 0.609
1989 5,206 0.082 0.657 0.117 0.872
1990 5,162 0.070 0.537 0.135 0.788
1991 5,007 0.061 0.663 0.104 0.851
1992 5,245 0.061 0.635 0.062 0.534
1993 5,501 0.050 0.719 0.064 0.717
1994 6,532 0.064 0.671 0.098 0.826
1995 6,791 0.056 0.826 0.124 1.081
1996 6,593 0.037 0.610 0.031 0.418
Panel B: Time Regressions
R2= a + b (Timet) + ct; t = 1978-96

ERCt = a + b (Timet) + ct; t = 1978-96
(t-values in parentheses)
a b R2
Total Sample
R2 0.285 -0.002 0.30
(4.00) (-2.97)
ERC 1.688 -0.011 0.31

(5.25) (-3.04)
Constant Sample
R2 0.470 -0.004 0.16
(2.80) (-2.11)
ERC 5.353 -0.050 0.64

(7.08) (-5.76)
Variable definitions for panel A: Rit = annual stock return of firm i in fiscal t, Eit and AEit level and
change of annual earnings of firm i in fiscal t, and ERC= combined slope coefficients or "earnings
response coefficient," the sum, of the estimated regression coefficients of Eit and AEit. Both Eit and AEit
are scaled by market value of equity at the beginning of t.
Variable definitions for panel B: R2 and ERCt= estimated coefficients of determination (adjusted R2)
and earnings response coefficients (ERC),presented in panel A, and Timet= a time variable, 1978-96.
'The total sample includes all firms with the required data on Compustat'sCurrentand ResearchFiles.
The constant sample includes about 1,300 companies with the required data for the 20-year sample
period, 1977-96.

the declining slope coefficients indicate a deterioration in the value rel-

evance of earnings to investors, irrespective of the effects of other infor-
mation sources.
To assess whether the documented weakening of the returns-earnings
association is due to the addition of new firms to the Compustatdatabase
(and hence to our sample), we replicated the analysis with a "constant
sample" of 1,300 firms which operated throughout the sample period.
This sample is clearly subject to a survivorship bias, while the total sam-
ple which includes firms from the CompustatResearchFile (that is deleted,
bankrupt, or merged companies) is not subject to such a bias. The esti-
mates reported in the right two columns of table 1 indicate that the de-
clining returns-earnings association is not the result of new firms joining
the sample; both the R2s and slope coefficients of the constant sample
have been decreasing over time. The regressions on Time, reported in
panel B, indicate that the decreases in R2 and ERCs of the constant sam-
ple are even more pronounced than those of the total sample.
We also note that the R2s of the constant sample in table 1 are in
every year substantially larger than those of the total sample, indicating
that earnings are more informative for firms with extended operating
histories (for a similar result, see Lang [1991]). We return to this point
in section 4. Also, both the R2s and ERCs in table 1 exhibit substantial
volatility over time, a phenomenon noted in earlier research (e.g., Lev
[1989]), which implies the limited predictive usefulness of earnings.
To summarize, our findings indicate that the cross-sectional association
between stock returns and reported earnings, our measure of the useful-
ness of earnings to investors, has declined over the past 20 years. Our
measure is not sensitive to changes over time in the quality of analysts'
earnings forecasts because we do not measure the reactionto an earnings
announcement, which is determined in part by the extent of earnings
surprise. Rather, our analysis reflects the consistencybetween the infor-
mation conveyed by earnings and that which affected investors' decisions
during the entire year. Accordingly, our findings indicate that the con-
sistency between the information conveyed by reported earnings and the
information relevant to investors has decreased over time, irrespective
of the quality of analysts' forecasts. Nor is the increase in the availability
of nonaccounting information to investors solely responsible for the de-
crease in earnings usefulness, as indicated by the declining earnings re-
sponse coefficient.10
1.2 THE CASH FLOWS-RETURNS RELATION
Cash flows are often claimed to be more informative than earnings

because they are less subject to managerial manipulation than accrual
earnings, and because they are less affected by questionable accounting
10An increase in the variability of stock returns may also have contributed to the weak-
ening of the returns-earnings association. See Francis and Schipper [1999] on this issue.

rules, such as those which require the expensing of investments in in-

tangibles. To probe this claim we estimate the following cross-sectional
regression for each sample year (1977-96):
Rit = PO+ PICFit + f2ACPFit+ P33ACCit+ 34AACCit+ ,it, (2)

where:
Rit = firm i's stock return for fiscal year t.
CFjtand A CFjt = cash flow from operations and the yearly change in
cash flow from operations, respectively.11
ACCitand AACCit= annual reported accruals and the change in annual
accruals, where accruals equal the difference
between reported earnings and cash flow from
operations.
The four independent variables in (2) are scaled by the beginning-of-
year market value of equity. Regression (2) thus estimates the associa-
tion between annual stock returns, on the one hand, and operating cash
flows plus accounting accruals (the difference between earnings and
cash flows), on the other hand. Table 2 reports yearly coefficient esti-
mates of this regression.
Our results indicate that the association between operating cash flows
(plus accruals) and stock returns, as measured by R2, is not appreciably
stronger than the association between earnings and returns (R2s in ta-
ble 1).12 As to the pattern of temporal association, the R2s of both the
total and constant samples in table 2 decrease over the period examined,
although only the former is statistically significant at the .05 level (see
the Timecoefficients in panel B of table 2). Similarly, the combined slope
coefficients of the level and change of cash flows (1I + 12 in expres-
sion (2)), denoted as CFRC,tend to decrease over time, although only
the decrease of the constant sample is statistically significant at the .05
level, as evidenced by the Time coefficients in panel B. As was the case
with earnings, the R2s of the constant sample are substantially larger
than those of the total sample, indicating that cash flows are more infor-
mative for firms with long operating histories.
To summarize, for a broad cross-section of firms operating cash flows
do not augment appreciably the informativeness (usefulness) of accrual
earnings to investors.13 The declining association with stock returns doc-
umented in the preceding section for earnings is also evident for cash
flows, though it is less pronounced. We believe that the milder decline in
11 Since in the early sample period firms did not report cash flow from operations, we
computed this item as follows: Cash Flow from Operations = Net Income before Extraor-
dinary Items + Depreciation + Annual Deferred Taxes - Annual Change in Current Assets
- Cash + Annual Change in Current Liabilities - Current Maturities of Long-Term Debt.
12 A similar result was noted by Livnat and Zarowin [1990] and Bowen, Burgstahler, and
Daley [1987].
13 It may still be the case that in special circumstances (e.g., financially distressed com-
panies) cash flows provide incremental information over earnings.

TABLE 2
The Association between Cash Flows and Stock Returns
Estimates from Yearly Cross-Sectional Regressions of Annual Stock Returns
on Operating Cash Flows + Accruals
Panel A: Equation (2): Rit = Po + PICFit+ P2ACFit+ P3ACCit+ 4AACCit+ t

Total Sample Constant Sample
Number of
Yearl Observations R2 CFRC R2 CFRC
1979 3,276 0.074 0.750 0.074 0.772
1980 3,432 0.052 0.574 0.065 0.797
1981 3,571 0.124 0.853 0.187 1.857
1982 3,945 0.059 0.560 0.091 1.112
1983 3,948 0.041 0.536 0.068 0.869
1984 4,169 0.111 0.679 0.240 1.169
1985 4,163 0.092 0.573 0.146 0.918
1986 4,098 0.063 0.515 0.122 0.939
1987 4,361 0.052 0.518 0.114 0.916
1988 4,361 0.064 0.496 0.110 0.447
1989 4,232 0.078 0.642 0.134 1.014
1990 4,179 0.058 0.472 0.124 0.823
1991 4,097 0.042 0.467 0.054 0.434
1992 4,321 0.052 0.548 0.057 0.535
1993 4,543 0.048 0.666 0.090 0.991
1994 4,953 0.071 0.685 0.136 0.928
1995 5,142 0.051 0.704 0.163 0.949
1996 4,953 0.036 0.416 0.029 0.288
R= a + b (Timet) + ct; t = 1979-96

CFRCt = a + b (Timet) + ct; t = 1979-96
a b R2
Total Sample
R2 0.242 -0.002 0.16
(2.77) (-2.04)
CFRC 1.159 -0.006 0.04

(2.62) (-1.28)
Constant Sample
R2 0.241 -0.001 0.00
(1.13) (-0.61)
CFRC 3.424 -0.029 0.15

(2.72) (-2.03)
'The time series for cash flows starts with 1979 since the number of observations for 1977 (required
for the cash flow change of 1978) was unusually low. The total sample includes all firms with the
required data on Gompustat'sCurrentand ResearchFiles. The constant sample includes about 1,000 com-
panies with the required data on Compustatfor the 19-year sample period (1978-96).
Variable definitions for panel A: Rt = annual stock return of firm i in fiscal t, CFitand ACFit= level
and change of cash flows from operations for year t, and ACCitand AACCit= level and change of accru-
als (earnings minus cash flows from operations) for year t. CFit,A CFit,ACCitand AACCitare scaled by
market value of equity at the beginning of t. CFRC= combined slope coefficients of the cash flow vari-
ables; P, + f2 in (2).
Variable definitions for panel B: Rt2 and CFRCtare derived from panel A. Timetis a year variable,
1978-96.

TABLE 3
The Association betweenStockPrices and Book Values+ Earnings
Estimatesof YearlyCross-SectionalRegressionsof
StockPrices on Earnings + Book Values
Panel A: Equation (3): Pit = a0 + a, Eit + a2 BVit + Fit
Year R2 Year R2
1977 0.923 1987 0.993
1978 0.932 1988 0.837
1979 0.796 1989 0.525
1980 0.866 1990 0.538
1981 0.867 1991 0.780
1982 0.867 1992 0.469
1983 0.899 1993 0.546
1984 0.832 1994 0.558
1985 0.887 1995 0.560
1986 0.874 1996 0.618
R2 = a + b (Timet) + ct; t = 1977-96
Total Sample a b R2
R2 2.649 -0.022 0.57
(7.09) (-5.07)
Pit,Eit, and BVit= share price at end of the fiscal t, earnings per share,
and book value per share, respectively, of firm i in fiscal t. The sample
includes all firms with the required data on Compustat'sCurrentand Research
Files, an average of 5,500 firms per year.
Rt2is the adjusted R2 from panel A. Timetis a year variable, 1977-96.
the informativeness of cash flows relative to earnings is due to cash flows'

relative immunity to the effects of some change-related items, such as
accrued restructuring charges.
1.3 FROM STOCK RETURNS TO PRICES
Following Ohlson [1995], it has become popular in accounting re-
search to examine the relevance of financial data by regressing stock
prices on earnings plus book value:14
Pit = ao + alxEit + a2BVit + cit, t = 1977-96 (3)
where:
Pit = share price of firm i at end of fiscal year t,
Eit = earnings per share of firm i during year t,
BVit = book value (equity) per share of firm i at end of t,
Fit = other value-relevant information of firm i for year t, indepen-
dent of earnings and book value.
As indicated in table 3, the association between stock prices and earn-
ings + book value, as measured by R2, decreased during 1977-96, from
14Strictly speaking, OhIson's model relates prices to book value plus the present value
of excess earnings.

R2 levels of 0.90 in the late 1970s, to 0.80 in the 1980s, and to 0.50-0.60
in the 1990s. A regression of the yearly R2s on a Timevariable (panel B)
yields a negative and statistically significant Time coefficient (-0.022, t =
-5.07). The estimates reported in table 3 pertain to the total sample. We
obtained similar results for the constant sample (1,130 firms per year):
the estimated coefficient of Timefrom a regression of annual R2 on Time
is: -0.016 (t = -4.04). This finding of decreasing value relevance of earn-
ings + book value is consistent with our previous results derived from
the returns-earnings and returns-cash flow relationships.
Collins, Maydew, and Weiss [1997], who estimated regression (3) over
the 1953-93 period, reached the conclusion that the combined value
relevance of earnings and book values has not decreased. The source of
the inconsistency appears to lie in the periods examined. Our focus is
on the last portion of Collins, Maydew, and Weiss's 40-year sample period.
In the March 1996 version of their paper they report yearly coefficient
estimates and R2s of regression (3). We regressed these R2s for the pe-
riod 1977-93 on Time and obtained a negative coefficient (-0.003, t =
-0.53). Our sample period extends Collins, Maydew, and Weiss's by three
years (1994-96), each having a low R2 (see table 3). This extension may
have increased the statistical significance of our negative Timecoefficient
(panel B of table 3).15 Thus, while the association between stock prices
and earnings + book value may have been stable over the past 40 years,
our evidence indicates that it has decreased over the latter half of that
period.
The temporal association between capital market variables and finan-
cial data has also been studied by Francis and Schipper [1999], Ely and
Waymire [1996], Ramesh and Thiagarajan [1995], Chang [1998], and
Brown, Lo, and Lys [1998]. While all these studies report a weakening
returns-earnings association when the association is measured by R2, re-
sults from levels regressions (price on earnings + book value) are mixed.
Collins, Maydew, and Weiss [1997] and Francis and Schipper [1999] re-
port a stable association over the 40+ years 1951-93. In contrast, Chang
[1998], using various alternative methodologies, concludes that the value
relevance of earnings and book value has decreased over the past 40 years.
A decreasing association between price and earnings + book value is also
reported by Brown, Lo, and Lys [1998], accounting for scale differences.
Our overall results indicate a weakening of the association between mar-
ket values and accounting information (earnings, cash flows, and book
values) over the past 20 years.
15In their published version (table 3), Collins, Maydew, and Weiss report an average R2
of expression (3) of 0.754 for the period 1983-93. The corresponding average R2 of our
estimates (our table 3) is 0.744. It appears, therefore, that our estimates of regression (3)
conform closely to those of Collins, Maydew, and Weiss (which is not surprising, given the
identical source of data).

2. Business Change and the Deterioration of Financial

Statement Usefulness
We contend that the increasing rate of change experienced by business
enterprises, coupled with biased and delayed recognition of change by
the accounting system, is the major reason for the documented decline
in the usefulness of financial information. Empirical support for this
contention is provided in this section. We first document the increasing
rate of change affecting business enterprises and then explore the impli-
cations of business change for the usefulness of accounting information.
2.1 MEASURING BUSINESS CHANGE
While surveys of executives, investors, and policymakers generally

support a perception that the business environment is changing at an
ever-increasing rate (e.g., Deloitte & Touche [1995]), there is little em-
pirical support for this view. We document the pattern of business
change for our sample companies by ranking them on two indicators of
value: book value of equity at fiscal year-end and market value of equity
at year-end. We then classify the sample firms for each year and value
indicator into ten equal-sized portfolios based on the rank of book value
or market value.
We measure the rate of business change by the frequency and mag-
nitude of portfolio switches, namely, firms moving over time from one
value portfolio to another. Specifically, we measure firm j's "absolute
rank change" by its movement across portfolios from year t - 1 to year t.
For example, if firm j is in book value portfolio 1 in 1977 and moved to
portfolio 4 in 1978, its rank change measure is 3. For each year and value
indicator, we calculate a yearly "mean absolute rank change" (MARC)
which reflects the aggregate portfolio switches experienced by all the
sample firms in that year.16 Our change measure will be low (zero at the
limit) when portfolio membership is stable, whereas when firms bounce
a lot from year to year across portfolios, the change measure will be high.
The number of sample companies changes over the period examined
as new firms become public or existing ones merge or go bankrupt. Our
approach to measuring the rate of business change is similar to Stigler's
way of estimating optimal firm size by observing over time shifts in the
size distribution of firms within an industry (Stigler [1966, pp. 159-60]).
If a specific size is optimal (yielding maximum economies of scale), firms
should converge over time to that size. Our approach is also similar to
the use of Markov Chains transition matrices to study social and occupa-
tional mobility issues (e.g., Kemeny and Snell [1967, pp. 191-200]).
Table 4 presents the yearly "mean absolute rank change" (MARC)
measures for the sample companies. Data for market value rankings are
16Results based on multiyear changes (e.g., rank changes over three to five years) are
similar to those reported in table 4.

TABLE 4
The IncreasingRate of Business Change
Mean AbsoluteValuesof YearlyRank Changes (MARC)ExperiencedbyFirms
Classifiedinto TenPortfoliosbyMarketand Book Values
Panel A: Yearly Measures of Change (MARC)
Market Value Portfolios Book Value Portfolios
MARC MARC MARC
Year Measure Year Measure Year Measure
1978 0.404 1978 0.179
1979 0.384 1979 0.181
1980 0.429 1980 0.240
1981 0.545 1981 0.276
1982 0.568 1982 0.294
1964 0.309 1983 0.624 1983 0.374
1965 0.308 1984 0.583 1984 0.317
1966 0.418 1985 0.550 1985 0.382
1967 0.416 1986 0.588 1986 0.410
1968 0.487 1987 0.539 1987 0.390
1969 0.434 1988 0.516 1988 0.324
1970 0.499 1989 0.500 1989 0.237
1971 0.443 1990 0.565 1990 0.309
1972 0.432 1991 0.528 1991 0.387
1973 1.113 1992 0.587 1992 0.409
1974 0.547 1993 0.584 1993 0.487
1975 0.490 1994 0.517 1994 0.401
1976 0.422 1995 0.526 1995 0.417
1977 0.385 1996 0.536
Regression: MARC (Indicator) t = a + b (Timet) + ct; t = 1964-96

Dependent Variable a b R2
MARC (Market Value), 1964-95 0.0026 0.0062 0.48

(0.03) (5.33)
MARC (Market Value), 1978-95 -0.0693 0.0069 0.25

(-0.31) (2.63)
MARC (Book Value), 1978-96 -0.8357 0.0138 0.69

(-4.54) (6.44)
Sample firms are classified in each year into ten portfolios according to their market
value of equity (MV) and alternatively by their book value of equity (BV). MARC (mean
absolute rank change) indicates the average frequency of firms switching value port-
folios from the past year to the current year, as well as the number of portfolios switched
(i.e., magnitude of switch) bv each firm. MARC={=iDECit - DEC1t_1I} / N1, where DECit
and DECit-1 = decile rank (of book value or market value) for firm i in years t and t - 1,
Nt= number of firms in year t, and I means summation over all firms in t. The observa-
tions for the market value portfolios are all firms on the CRSPDaily File with share price
and number of shares at the end of years t and t - 1, an average of 4,000 firms per year.
The observations for the book value portfolios are all firms on Compustat'sCurrentand
ResearchFiles with book value of equity at end of years t and t - 1, an average of 5,800
firms per year.
MARCtis the yearly, mean absolute rank change in panel A. Time,is a year variable.

derived from the CRSP database (1963-95) and those for book value
rankings are derived from Compustat(1977-96). The generally increas-
ing MARC measures in panel A for both market and book value classi-
fications indicate that the frequency of firms switching across portfolio
rankings has increased over the past 20-30 years. For market value rank-
ings, the change measures increase from 0.3-0.4 in the 1960s to 0.5-0.6
in the 1990s. For book value rankings, the change measures increase al-
most monotonically from 0.2-0.3 in the late 1970s and early 1980s to
0.4-0.5 in the 1990s. These increases are statistically significant, as evi-
denced by the t-values of the three slope coefficients of the Timeregres-
sions in panel B. For example, the Time coefficient of the book value
change measures over 1978-96 is 0.014 (t = 6.44). Our evidence thus
supports the perception of executives and investors concerning the in-
creasing rate of change experienced by U.S. business enterprises.
We argue that the increasing rate of business change over the past two
or three decades and the deficient accounting treatment of change have
contributed to the documented decline in the usefulness of financial
information. Essentially, while the accounting system is primarily based
on the reporting of discrete, transaction-based events, such as sales, pur-
chases, and investments, the impact of change on business enterprises is
rarely triggered by specific transactions.17 Change, internally (e.g., prod-
uct development) or externally (e.g., deregulation) driven, often affects
enterprise value long before revenue or expense transactions warrant an
accounting record. Investors generally react to the impact of change on
business enterprises in real time, hence the increasing disconnection be-
tween market and accounting values.
For example, during the late 1980s and early 1990s, the regional tele-
phone service in the United States has been deregulated, gradually
transforming the industry from a monopolistic to competitive environ-
ment. Investors reacted to the deregulation, which increased the risk
and decreased the expected revenues of the formerly monopolistic tele-
phone companies, as it occurred, while the impact of deregulation on
accounting recordableeventshas been minor for years.18 Only in 1994-95,
roughly half a decade after the beginning of deregulation, did the re-
gional telephone companies (Baby Bells) write off $26 billion in assets
as a consequence of the deregulation.
We illustrate the impact of change driven by telecommunications de-
regulation on the usefulness of earnings by documenting a decline in
17The exception to transaction-based accounting entries is end-of-period adjusting en-

tries, such as those reflecting depreciation and doubtful receivables.
18 The significant and adverse reaction of investors to the impact of deregulation on tele-
phone companies is evident by the stock performance of the regional telephone companies,
which considerably lagged the market return. The average five-year (1991-95) cumulative
return of the phone companies' stocks was 93.25%, while the market return (CRSPvalue-
weighted average) over the corresponding period was 119.59%.

the statistical association between stock returns of the regional tele-

phone companies and their reported earnings beforeand during deregu-
lation. We estimate for these companies the returns-earnings regression
(1) for both the prederegulation period (1984-89) and the deregula-
tion period (1990-96). The regressions are pooled time series and cross-
section, with fixed effects for both time (year) and firms. The estimated
R2s are: 0.93 for the prederegulation period versus 0.72 for the deregu-
lation period (note that the fixed effects substantially increase R2). The
estimated combined slope coefficients (ERCs) are 1.85 for the predereg-
ulation period versus 0.68 for the deregulation period. The former com-
bined slope coefficient (1.85) is significantly different from zero at the
0.02 level, while the latter coefficient (0.68) is insignificantly different
from zero at the .10 level. Reported earnings of telephone companies
have clearly become less value relevant to investors during and after the
fast change period due to deregulation.
Business change is primarily driven by increased competition and in-
novation. In contrast to the delayed reaction of the reporting system to
deregulation, when change is driven by competition and innovation, the
accounting system front-loads the costs and delays the recognition of
benefits. For example, restructuring costs, such as those for employee
training, production reengineering, or organizational redesign, are im-
mediately expensed, while the benefits of restructuring, in the form of
lower production costs and improved customer service, are recognized
in later periods. Consequently, during restructuring, the financial state-
ments reflect the cost of restructuring, but not its benefits, and are there-
fore largely disconnected from market values which reflect the expected
benefits along with the costs.19 Similarly, the immediate expensing of
investment in innovation (e.g., R&D) -the major change-driver in tech-
nology- and science-based companies-is both biased and inconsistent.20
Costs of innovation are recognized up front, while benefits are recorded
in subsequent periods. To complicate things further, the accounting for
intangibles is beset by inconsistencies. For example, a firm which devel-
ops an instrument for internal use will expense all development costs,
but if the firm buys a similar instrument, it will be capitalized.
Thus, change-drivers, such as deregulation, competition, and innova-
tion, adversely affect the matching of costs with revenues, leading to a
decrease in the value relevance of financial information. We next pro-
19Indeed, event studies (e.g., Francis, Hanna, and Vincent [1996]) indicate that some-
times investors' reaction to the restructuring charges is in fact positive.
20While it is generally believed that the expensing of intangibles is conservative, leading
to lower reported profitability than under capitalization, for mature firms immediate ex-
pensing is in fact aggressive. Specifically, when the growth rate of investment in intangibles
is lower than the firm's return on equity (ROE), the expensing of intangibles results in higher
ROE and ROA than if the intangibles were capitalized. Intangibles' expensing also often
inflates the rate of growth of reported earnings (see Lev, Sarath, and Sougiannis [1999] and
Merck's example in Lev and Sougiannis [1996, appendix]).

vide empirical support for the link between the increasing rate of busi-
ness change and the decline in the informativeness of earnings.
2.2 CHANGE AND THE VALUE RELEVANCE OF EARNINGS
Our firm-specific change measure (the "absolute rank change") is

based on the frequency and extent of over time movement of firms
among portfolios formed by ranking on book value and market value of
equity. To link this change measure to the documented temporal de-
crease in the informativeness of earnings, we first compute for each sam-
ple firm the across time absolute rank change, reflecting the number of
times the firm switched book value portfolios during 1977-96, as well
as the extent of such switches. To standardize the firm-specific measure,
we scale it by the number of years the firm existed in the sample. For
example, if firm j was in the top book value portfolio during 1977 to
1983, the second (next to top) portfolio in 1984-91, and the fifth port-
folio from 1992 to 1996, its rank change indicator is 0.20 (one point for
the single rank switch in 1984 plus three points for the three-rank
switch-from portfolio 2 to 5-in 1992, divided by the 20 years of the
firm in the sample).
We classify the sample firms into two groups: stable and changing com-
panies. The first group includes the No Change firms (about 1,000),
namely, those that remained in the same portfolio during the entire sam-
ple period (1977-96). The second group-the Changefirms-includes the
remaining sample (ranging from 3,000 in the early sample years to 5,500
in the mid-1990s). Alternatively, we classify firms into Low Change-firms
with a firm-specific "absolute rank" change indicator < .10 (including, of
course, the No Changefirms) and High Change-the remaining sample.2'
Next, we examine the yearly cross-sectional returns-earnings regres-
sion (1) separately for the stable and changing firms. If change decreases
the informativeness of earnings, the regression's R2 and combined slope
coefficients (ERC) should be larger for stable firms (a stronger returns-
earnings association) than for changing ones. Furthermore, given our
evidence that the rate of change of business enterprises increased during
the past 20 years, that increase clearly affected the changing firms more
than stable ones. Thus, we predict that the rate of decreaseof R2 and ERC
over 1977-96 should be higher for changing firms than for stable ones.
Results in table 5 support both expectations.
Panel A of table 5 reports yearly estimates of R2s and combined slope
coefficients for the four change classifications of firms, and panel B re-
ports means and medians of the 19 yearly estimates. The data corrobo-
rate our first expectation: both the means and medians of the yearly R2
and ERC are larger for No Changefirms than for Changefirms (e.g., mean
R2 of 0.124 versus 0.097 and mean ERCof 1.22 versus 1.02). Similarly, the
21Estimates based on other rank change cutoffs, such as 0.20, 0.30, yield results similar
to those reported in table 5.

TABLE 5
Business Change and Earnings Informativeness
Estimatesfrom Annual Regressionsof StockReturns on the Level and Changeof
Annual Earnings for Firms Classifiedby the Rate of Business Change
Panel A: Yearly Estimates of Regression (1)-Returns on Earnings
No Change Change Low Change High Change
Year R2 ERC R2 ERC R2 ERC R2 ERC
1978 0.11 1.28 0.12 1.17 0.13 1.36 0.12 1.15
1979 0.16 1.96 0.09 1.02 0.15 1.85 0.09 1.01
1980 0.05 0.79 0.08 1.07 0.06 0.90 0.09 1.09
1981 0.26 1.69 0.11 1.03 0.28 1.81 0.10 1.00
1982 0.08 1.05 0.09 1.12 0.10 1.20 0.09 1.10
1983 0.09 1.11 0.07 1.01 0.07 1.02 0.07 1.03
1984 0.23 0.77 0.16 1.13 0.23 0.91 0.15 1.10
1985 0.13 0.93 0.14 1.08 0.17 1.05 0.14 1.07
1986 0.12 1.23 0.12 1.04 0.15 1.24 0.11 1.03
1987 0.03 0.65 0.07 0.87 0.04 0.75 0.07 0.86
1988 0.08 1.05 0.12 0.94 0.07 0.91 0.12 0.94
1989 0.14 1.14 0.10 0.96 0.11 1.23 0.10 0.96
1990 0.12 0.83 0.10 0.89 0.10 0.96 0.10 0.89
1991 0.08 0.99 0.09 0.96 0.11 1.11 0.09 0.95
1992 0.16 1.53 0.09 0.95 0.15 1.58 0.09 0.93
1993 0.12 1.68 0.08 1.06 0.11 1.49 0.08 1.07
1994 0.22 1.80 0.10 1.05 0.17 1.47 0.10 1.06
1995 0.10 1.22 0.06 1.01 0.12 1.43 0.06 1.00
1996 0.07 1.41 0.06 0.96 0.06 1.27 0.06 0.96
Panel B: Means and Medians of Annual R2 and ERCby Change Group (1977-96)
R2 ERC
Change Group Mean Median Mean Median
No Change 0.124 0.116 1.22 1.14
versus
Change 0.097 0.095 1.02 1.02
Significance of Difference p = 0.09 p = 0.03
Low Change 0.124 0.114 1.24 1.23
versus
High Change 0.096 0.093 1.01 1.02
Significance of Difference p = 0.06 p = 0.01
R2 and ERCs of the Low Changefirms are larger than the association mea-
sures of the High Changefirms. To determine the statistical significance
of the difference in means of change groups we regressed the R2 and
ERCs of the combined Changeand No Changegroups (and also of the com-
bined Low and High Changegroups), that is, 38 observations in each re-
gression, on a 0-1 dummy variable reflecting membership in a change
group. The significance levels of the dummy variables, all lower than 0.10,
are reported in panel B of table 5. Thus, the rate of business change is
negatively associated with the informativeness of earnings, as measured
by the extent of the returns-earnings association.
Panel C of table 5 presents estimates from regressions of the yearly R2
and ERCs (reported in panel A) on a Timevariable. The data confirm our
second expectation that the temporal decline in the returns-earnings

TA B L E 5 -continued
Panel C: Regressions of Yearly R2and ERC (from panel A) on Time (t-values in parentheses)
Intercept Time R2
No Change
R2 0.204 -0.001 0.00
(0.88) (-0.35)
ERC 0.514 0.008 0.00
(0.37) (0.50)
Change
R2 0.256 -0.002 0.11
(2.86) (-1.78)
ERC 1.636 -0.007 0.21
(6.31) (-2.39)
Low Change
R2 0.330 -0.002 0.00
(1.49) (-0.93)
ERC 1.180 0.001 0.00
(1.02) (0.05)
High Change
R2 0.246 -0.002 0.12
(3.01) (-1.84)
ERC 1.585 -0.007 0.18
(6.14) (-2.23)
Firms classified as No Changedid not switch book value ranking during 1977-96, while Changefirms
are the rest of the sample. Firms classified as Low Change have an "absolute rank change" indicator
(defined in section 2.2) < .10, while High Changefirms are the rest of the sample. ERC= combined slope
coefficients or "earnings response coefficient," namely, the sum of the estimated regression coefficients
of level and change of earnings. The sample includes all firms with the required data on Compustat's
Currentand ResearchFiles, an average of 4,000 and 700 firms per year for the Change and No Change
groups, respectively, and an average of 3,700 and 1,000 firms per year for the High Change and Low
Changegroups, respectively.
association is more pronounced for changing than for stable enterprises.

The four coefficients of Timein the R2 and ERC regressions for both the
No Changeand the Low Changegroups are not statistically significant (see
t-values in parentheses), and the R2s of those four regressions equal zero,
indicating essentially no deterioration over time in the returns-earnings
association of stable companies. In contrast, the four Timecoefficients of
both the Changeand High Changegroups are all negative and statistically
significant, and the four R2s of these Time regressions range between
0.11-0.21, indicating that the association between returns and earnings
of changing firms has declined over the past 20 years. The significance
levels of the differences in Time coefficients between the No Changeand
Changegroups (and the Low and High Changegroups) were determined
by running a regression on the combined observations of the two groups
with a dummy variable for group membership. P-levels of the dummy
variable are: R2 regression (No Change versus Change) = 0.09, ERC re-
gression (No Changeversus Change) = 0.03, R2 (Low versus High Change) =
0.06, and ERC (Low versus High Change) = 0.01.

To summarize, we have argued that the increasing rate of business

change coupled with the ineffectiveness of the accounting system in
reflecting the consequences of change contributed significantly to the
temporal decline in the value relevance of accounting information. We
have empirically established this link by providing evidence that the rate
of change experienced by business enterprises increased over the 1977-
96 period, and that the informativeness of earnings is negatively related
to the rate of business change.
We next consider an alternative explanation for the declining useful-
ness of earnings, namely, the increasing incidence of reported losses
and nonrecurring items (the two are, of course, related). For example,
Hayn [1995] reports that losses account for some of the observed de-
cline in the slope coefficient of the returns-earnings regression (ERC)
and Collins, Maydew, and Weiss [1997] attribute a shift in value rele-
vance from earnings to book values to both the increasing significance
of one-time items and the increasing frequency of losses.
However, we believe that both reported losses and nonrecurring items
are often the symptomsrather than the causes of the decline in infor-
mativeness of financial information. Specifically, it is the previously dis-
cussed failure of the accounting system to reflect change in a meaningful
and timely manner that often leads to both reported losses and nonrecur-
ring items. Examples include restructuring charges, where the reported
loss is often an investment in future benefits (e.g., operating efficiencies),
the chronic reported losses (to the mid-1990s) of cellular phone compa-
nies caused by the immediate expensing of customer acquisition costs
(Amir and Lev [1996]), and the large losses and nonrecurring items re-
ported by acquiring companies writing off all the purchased In-Process
R&D (Deng and Lev [1998]).22 Thus, we argue, it is not losses or nonre-
curring items that weaken the returns-earnings relation, rather it is the un-
derlying failure of the current accounting system to meaningfully account
for change, which is often manifested by losses and nonrecurring items.
Given recent research attention to reported losses, we examined the
role of such losses in our estimation of the association between the rate
of business change and the decline in earnings' informativeness (table
5). Specifically, we added to the Timeregressions reported in panel C of
table 5 the percentage of firms with negative EPS in each year. The re-
gressions are thus:
Estimated R2 (or ERCt) = a + b Timet
+ c (% Losses) + ?, t = 1978-96. (4)
We estimated this regression for both the Low Change and High Change
companies and found the coefficients of percentage losses (c in regres-
sion (4)) in each of the four regressions (R2 and ERCfor Low and High
22An example is IBM's reported loss of $538 million in the third quarter of 1995, due
to the write-off of $1,840 million of acquired R&D-in-process (in the same quarter a year
earlier, IBM reported positive earnings of $710 million). Obviously, the $538 million loss
does not indicate any deterioration in IBM's operations.

Change companies) to be statistically insignificant at the 0.10 level. For

the Low Changefirms the estimated coefficients of percentage losses for
R2 and ERC are 0.157 (t = 1.45) and -0.451 (t = -1.44), and for the
High Changefirms the estimated coefficients of percentage losses for R2
and ERC are 0.132 (t = 1.42) and -0.462 (t = -1.60), respectively. Thus,
the increasing incidence of reported losses in our sample of High Change
firms does not alter our conclusion concerning the relationship between
change and the decreasing value relevance of earnings.
3. Intangibles, Innovation, and Change

Intangible investments, R&D in particular, are generally considered as
the major driver of business change, creating new products, franchises,
and improved production processes. However, while some intangible in-
vestments trigger change, others are just aimed at preserving the status
quo. Thus, appliedresearch,defined as "spending aimed at learning more
about the technology process a firm is alreadyusing, or about a good that
it is alreadyproducing"(Jovanovic and Nyarko [1995, p. 5, emphasis ours]),
is generally intended to sustain an existing competitive position, not to
change the firm's operations. In contrast, basicresearch,defined as "spend-
ing directed towards processes not yet in use, or goods not yet produced"
(Jovanovic and Nyarko [1995, p. 6, emphasis ours]) is clearly aimed at
initiating change.23 Given these disparate intentions and consequences
of R&D, the levelor intensity (R&D spending to sales) of R&D is not nec-
essarily associated with change and the consequent loss of informative-
ness of financial data. From an accounting measurement perspective,
too, the level of R&D expenditures does not necessarily affect the infor-
mativeness of earnings. Thus, if the rate of R&D spending is constant
over time, reported earnings are invariant to the accounting treatment
of R&D; earnings will be the same whether R&D is capitalized and am-
ortized or immediately expensed.
These statements are relevant to results in several recent studies (e.g.,
Collins, Maydew, and Weiss [1997] and Francis and Schipper [1999]) on
the association between the intensity of intangibles and the R2 of the re-
turns on earnings or the stock price on earnings + book value associations.
Both papers report that firms intensively engaged in intangible invest-
ments were not characterized by a lower association between stock prices
(or returns) and financial data than firms less intensive in intangibles.24
23The pharmaceutical industry provides an example of these two types of R&D. Basic
research is aimed generally at developing New Molecular Entities (NMEs), which are en-
tirely new drugs capable of drastically changing the firm's product mix and competitive
position. Applied pharmaceutical R&D, the development of "me too" drugs, is aimed at
modifying existing drugs or changing the route of administration, thereby essentially pre-
serving the firm's competitive position.
24Collins, Maydew, and Weiss [1997] do, however, find that the increased importance
of intangible-intensive firms is associated with a shift in value relevance from earnings to
book values.

However, it is not a high level of intangible investment, indicated in those

papers by a firm's membership in a high-tech industry or by a high in-
tensity of R&D, that is expected to cause a decrease in the informative-
ness of financial information. In a steady-state R&D environment, the
immediate expensing of R&D will result in the same earnings as those
based on R&D capitalization; hence no loss of earnings informativeness
can be ascribed to R&D in this case.25 It is only when the investment rate
in intangibles changesover time that reported earnings based on immediate
expensing will differ materially from economic earnings based on capital-
ization of intangibles. Accordingly, we conjecture that the expensing of
R&D (the current GAAPpractice) by firms with increasinginvestment rate
in R&D is associated with a decline in the informativeness of reported
earnings.
To examine this conjecture, we split our sample period, 1976-95, into
three subperiods and compute for each sample firm the average R&D
intensity (R&D to sales) in the "recent period" (1989-95) relative to the
average R&D intensity in the "early period" (1976-83). Sample firms
were then classified by the direction of change in R&D intensity into four
categories: Low-Lowfirms, with R&D intensity of .01 or lower in both the
early and recent periods; High-High firms, with R&D intensity exceeding
.01 in both periods; Low-Highfirms, with R&D intensity below .01 in the
early period and above .01 in the recent period; and High-Low firms,
the converse of Low-High.26We then reestimated the cross-sectional re-
turns on earnings (level and change) regression (1) for each of the four
groups of firms for every year, 1976-95. The average yearly regression es-
timates of R2 and the combined slope coefficients (ERCs), over the early
sample period (1976-83) and the recent period (1989-95), are reported
in table 6.
The main diagonal of table 6 reports mean regression estimates for
stable R&D companies: Low-Lowand High-High. The mean R2s of both
groups decreased from the early (1976-83) to the recent (1989-95) pe-
riod: from 0.137 to 0.099 for Low-Low, and from 0.156 to 0.126 for
High-High companies. These decreases in average R2s for both groups,
however, are statistically insignificant (at the .05 level). The average ERCs
of the Low-Lowand High-High groups also decreased between the two
periods: from 1.44 to 0.820 for Low-Low(t= -6.28) and from 1.94 to 1.14
(t = -3.45) for High-High. Consistent with the findings of other authors
(e.g., Collins, Maydew, and Weiss [1997]), the R2s and ERCs of the High-
High subsample-companies intensive in R&D-are larger than those
25 This steady-state R&D environment is not an unrealistic case, as researchers report

that the firm-specific time series of R&D of most firms are remarkably stable (e.g., Helfat
[1994]).
26 Results based on an R&D intensity cutoff of 0.5% (0.005) are similar to those re-
ported in table 6.

TABLE 6
R&D Changeand Earnings Informativeness
Estimatesfrom Returns-Earnings Regressions(1) for Firms Classified
by theDirection of Changein TheirR&D Intensityfrom theEarly SamplePeriod
(1976-83) to the RecentSamplePeriod (1989-95)
Arrowsin Each Panel Indicate the Change in the Measure
(R2 or ERC)from theEarly to the RecentPeriod
Early Sample Period (1976-83)
Recent Sample Period
(1989-95) Low R&D High R&D
Low R&D
MED R&D 0.000 0.000 0.016 0.003
Mean R2 0.137 0.099 0.080 0.178
Mean ERC 1.440 0.820 0.750 1.290
1,259 67
High R&D
MED R&D 0.004 0.018 0.034 0.044
Mean R2 0.233 0.126 0.156 0.126
Mean ERC 2.170 1.060 1.940 1.140
96 455
Low R&D are firms with an R&D intensity < 0.01 (1% of sales) and High R&D firms are those with
R&D intensity 2 0.01. MED R&D = median R&D intensity (R&D over sales) in the early and recent
periods of firms in the panel. Mean R2 = mean over 1976-83 and 1989-95 of adjusted R2 of the yearly
returns on earnings cross-sectional regression (1). Mean ERC = mean of combined slope coefficients
(al + a2 in (1)) over 1976-83 and 1989-95. # = number of firms.
of the Low-Lowcompanies, confirming our earlier contention that high yet

stable R&D spending does not induce a weak earnings-returns relation.
The lower-left panel of table 6 presents results for Low-High compa-
nies, those characterized by an increasing rate of R&D expenditures.
As indicated in the table, the median R&D intensity of these compa-
nies increased from 0.4% during 1976-83 to 1.8% in 1989-95. These
firms experienced a sharp decline over the sample period in the re-
turns-earnings R2 from 0.233 to 0.126 (t = -2.03) and in the combined
ERC from 2.17 to 1.06 (t = -2.29). In contrast, High-Low firms, whose
R&D intensity decreased from a median of 1.6% to 0.3%, experienced
a borderline significant increasein the association between returns and
earnings: the R2 of these firms increased from 0.080 to 0.178 (t = 1.54,
p = .15) and the ERC increased from 0.75 to 1.29 (t = 1.61, p = .13).
Thus, while the informativeness of earnings of all the sample com-
panies decreased during the past 20 years, an increase in R&D inten-
sity (Low-Highfirms) is associated with an abnormally steep decrease in
earnings informativeness. In addition, a portion of the weakening of the
returns-earnings association of the stable firms (Low-Low and High-
High) may also be related to R&D increases, as the R&D intensity of
both groups increased within our cutoff of 1% R&D intensity. For ex-
ample, as indicated in table 6, the median R&D intensity of the High-
High group increased from 3.4% to 4.4%. We conclude that while R&D

TABLE 7
R&D Increases and Earnings Informativeness
Estimates from Regressions of Yearly R2 and ERCs, Derived from Cross-Sectional
Returns-Earnings Regressions, on a Time Variable, 1977-95
Regressions on TIME: R2 (or ERCt) = a + b(Timet) + c
R&D-Stable Firms R&D-Increasing Firms
a b R2 a b R2
ERC Regressions 3.53 -0.030 .59 7.187 -0.067 .56

(-7.09) (-5.20) (6.09) (-4.91)
R2 Regressions 0.465 -0.004 .28 0.703 -0.007 .36

(3.54) (-2.81) (3.95) (-3.35)
R&D-increasing firms have R&D intensity 2 .01 in the period 1989-95. R&D-stable firms are all
other firms. The sample includes all firms with the required data on Compustat'sCurrentand Research
Files, an average of 2,200 and 900 firms per year for the R&D-stable and R&D-increasing groups,
respectively.
change is not the only reason for the temporal decline in the informa-
tiveness of earnings, it appears to be an important one. The results re-
ported in table 6 are based on firms that existed throughout the period
1976-95, and some subsamples contain relatively few firms (e.g., there
are 96 Low-High firms). To overcome the survivorship bias and increase
sample sizes, we created a new sample classification: We define as R&D-
increasingfirms with an R&D intensity exceeding .01 (1% of sales) in the
recent subperiod (1989-95), and all other firms as R&D-stable. Thus,
all sample firms (not just surviving ones) must be in one of either the
R&D-increasing or R&D-stable (or no R&D) groups. The firms classified
as R&D-increasing (having an R&D intensity > .01 during 1989-95) in-
deed increased in R&D; their mean R&D intensity increased from 0.032
in 1976-83 to 0.049 in 1989-95. In contrast, the mean R&D intensity of
the R&D-stable firms over the corresponding periods decreased from
0.0024 to 0.0021.
We reestimated the returns-earnings regressions (1) for each year
(1976-95) separately for the R&D-increasingand R&D-stablegroups, and
regressed the resulting R2s and ERCs on Time. We report the regression
estimates in table 7. It is evident that the estimated Time coefficients (b)
of the R&D-increasinggroup are more negative than those of the R&D-
stablegroup: -0.067 versus -0.030 for the ERC regressions and -0.007 ver-
sus -0.004 for the R2 regressions.27 We conclude that the weakening of
the returns-earnings association is more pronounced for firms whose
R&D intensity increased over the sample period than for stable R&D
companies. Table 7 results are somewhat weaker than those reported in
27 The difference between the ERCs Time coefficients in table 7 (-0.067 and -0.030) is
statistically significant at the 0.01 level (t = 4.9), while the difference in the R2 Time co-
efficients (-0.007 and -0.004) is not statistically significant (t = 0.7, p = .46).

TABLE 8
Firms'Rate of Change and TheirR&D Intensity
Estimatesfrom Regressionsof YearlyAverageR&D Intensity on Timefor
Firms GroupedbyRate of Business Change
Regression: Mean R&D Intensityt = a + b (Timet) + st, t = 1978-96
Coefficient Estimates
Mean R&D
Change Group Intensity a b R2
No Change 0.015 -0.0174 0.0004 0.23

versus (-1.38) (2.55)
Change 0.030 -0.1490 0.0021 0.92
(-12.15) (14.61)
Low Change 0.013 -0.0138 0.0003 0.31

versus (-1.57) (3.03)
High Change 0.032 -0.1567 0.0022 0.91
(-11.37) (13.71)
The classification of firms into the four change groups is described in section 2. The sample includes
all firms with the required data on Compustat'sCurrentand ResearchFiles, an average of 4,000 and 700
firms per year for the Change and No Changegroups, respectively, and an average of 3,700 and 1,000
firms per year for the High Changeand Low Changegroups, respectively. The sample is the same as that
used for table 5.
table 6, because the classifications used in table 6 are more effective in

capturing R&D change than in table 7. For example, the mean R&D
intensity of the Low-Highfirms in table 6 (not reported) increased from
0.004 in 1976-83 to 0.031 in 1989-95, while the mean R&D-intensity of
the R&D-increasing firms in table 7 only changed from 0.032 to 0.049
during the corresponding periods.
To complete the linkages between the declining usefulness of earn-
ings and the rate of business change, which is partially driven by R&D
increases, we analyze now the association between the rate of business
change and the change in R&D expenditures. Specifically, we show that
fast-changing firms experienced a larger increase in R&D-intensity than
stable companies. Thus, for the No Changeand Changegroups, and for the
Low Change and High Change groups, as previously analyzed in table 5,
we examine the annual average R&D intensity. We expect that the aver-
age R&D intensity of changing firms is higher than that of stable firms
and, more important, that the rate of increase in R&D intensity of
changing firms is higher than that of stable companies.
The data in table 8 confirm both expectations. First, the mean R&D
intensity (over the 1978-96 period) of the Changegroup is larger than
the intensity of the No Changegroup (0.030 versus 0.015; t = 5.2; p = .01),
and the mean R&D intensity of the High Changegroup is larger than that
of the Low Changegroup (0.032 versus 0.013; t = 6.3, p = .01). To examine
the second expectation, we regress for each of the four change groups

the yearly mean R&D intensity of the group on Time.Results (presented

in the table 8) indicate that the rate of increase in R&D intensity during
1978-96 was substantially larger for changing firms than for stable ones:
The Timecoefficients of the Changeand High Changegroups, 0.0021 and
0.0022, are 5-7 times larger than the Time coefficients of the No Change
and Low Change groups, 0.0004 and 0.0003, respectively. To determine
the significance of the differences in the estimated time coefficients, we
regressed the mean R&D intensity on Time, combiningthe No Changeand
Changegroups (and the Low and High Changegroups), using a 0-1 dummy
for group membership. Both differences in Timecoefficients, between No
Changeversus Changeand Low versus High Change,are significant at the
0.01 level. Note also the large differences in R2s in table 8: The Timevari-
able explains almost perfectly the temporal variation in R&D intensity
for changing firms (R2: 0.92 and 0.91), while for stable companies, Time
provides only a partial explanation for the temporal variance in R&D
intensity (R2: 0.23 and 0.31).
To summarize, we have provided evidence supporting the following
phenomena and relationships: (i) the rate of change experienced by
U.S. business enterprises has increased over the past 20 years; (ii) the
increasing rate of business change is associated with a decline in the in-
formativeness of earnings; (iii) an increase in R&D intensity is associ-
ated with a decline in earnings informativeness; and (iv) an increase in
the rate of business change is associated with an increase in R&D inten-
sity. This evidence, we believe, supports the view that the documented
decline in the usefulness of financial information was mainly caused by
the increasing pace of change affecting business enterprises and the in-
adequacy of the accounting system in reflecting the consequences of
change. Among change-drivers, innovation, generally brought about by
investment in R&D, is an important factor in the declining usefulness of
financial information. We next discuss two proposals for enhancing the
usefulness of financial reports.
4. Improving the Usefulness of Financial Information
We discuss two proposals aimed at enhancing the usefulness of financial

information. The first-capitalization of intangibles-extends a practice
currently used in limited circumstances, while the second-a systematic
restatement of financial reports-calls for a substantial modification of
current reporting practices.
4.1 THE CAPITALIZATION OF INTANGIBLE INVESTMENTS
We believe that the almost universal expensing of intangible invest-

ments in the United States is inconsistent with the FASB's conceptual
framework (Statement of Financial Accounting ConceptsNo. 6) and with
empirical evidence. The conceptual framework defines an asset as: "prob-
able future economic benefit obtained or controlled by a particular entity

as a result of past transactions or events.... assets ... may be intangi-

ble, and although not exchangeable they may be usable by the entity in
producing or distributing other goods or services.... anything that is
commonly used to produce goods or services, whether tangible or intan-
gible and whether or not it has a market price or is otherwise exchange-
able, also has future economic benefit" (FASB[1985b, paras. 25, 26, 173]).
Surely, the recognition of intangible investments with attributable future
benefits as assets is within the boundaries of GAAPObjections to capital-
ization center on the uncertainty associated with the benefits of intangi-
bles: "The uncertainty [e.g., about R&D] is not about the intent to
increase future economic benefits but about whether and, if so, to what
extent they succeeded [sic] in doing so" (FASB[1985b, para. 175]).
Given the uncertainty concerns, it makes sense to recognize intangi-
ble investments as assets when the uncertainty about benefits is con-
siderably resolved. It is well known that as projects under development
advance, from formulation of the initial idea through increasingly de-
manding feasibility tests (e.g., alpha and beta tests) to the final product,
the uncertainty of commercial success continually decreases. Accord-
ingly, a reasonable balance between relevance and reliability of informa-
tion would suggest the capitalization of intangible investment when the
project successfully passes a significant technological feasibility test, such
as a working model for software or a clinical test for a drug. Surely,
uncertainty about the future benefits of a clinically proven drug is not
larger than the uncertainty associated with the expected benefits of a
record or a movie under production whose capitalized costs are recog-
nized as assets by current accounting practices (SFASNos. 50 and 53; see
FASB [1981 a; 1981 b]). This approach to capitalization was taken in SFAS
No. 86 (software for sale), the major exception in the United States to
intangibles expensing. A similar approach is followed, subject to certain
constraints, by the recently enacted international standard for intangi-
bles (IASC [1998]).
Accordingly, we propose the capitalization of all intangible invest-
ments with attributable benefits which have passed certain prespecified
technological feasibility tests. We depart from the software capitaliza-
tion standard (SFASNo. 86) by proposing that once capitalization com-
mences (post feasibility test), all the project-related, previously expensed
R&D should also be capitalized. Given that the uncertainty about the
project's viability has been substantially reduced, we see no reason for a
different accounting treatment of pre- and postfeasibility R&D.
Note that our capitalization proposal, which is conditioned on the
achievement of technological feasibility, differs substantially from a me-
chanical capitalization (accumulation) of all past expenditures on intan-
gibles, which can easily be replicated by investors from successive income
statements. The proposed capitalization allows management to convey
important inside information about the progress and success of the de-
velopment program. Indiscriminate capitalization of all past R&D expen-
ditures does not provide such information.

The proposed capitalization of intangibles is consistent with recent

empirical evidence interpreted within the "residual earnings" valuation
framework for analyzing accounting principles issues (Dietrich et al.
[1997]). This valuation framework equates an enterprise's intrinsic value
to its current book value plus the present value of residual earnings
(reported earnings minus a charge for equity capital). Accordingly, ac-
counting standards which improve the alignment of reported book value
with the firm's intrinsic value (usually proxied by market value) and/
or improve the prediction of earnings should be preferred over stan-
dards which do not.
Empirical evidence supports the notion that the recognition of intan-
gibles as assets may achieve one or both of the above criteria for a pre-
ferred accounting standard. For example, Lev and Sougiannis's [1996]
finding that capitalized values of R&D are significantly associated with
stock prices (after controlling for reported book values) implies that
R&D capitalization will improve the alignment of book values with in-
trinsic values (proxied by stock prices). Similarly, Aboody and Lev's [1998]
finding that reported capitalized values of software development costs are
positively and significantly associated with market values, after control-
ling for reported book values and earnings, is consistent with the notion
that capitalized software costs improve the alignment of book values with
intrinsic values (proxied by market value). Furthermore, Aboody and Lev's
finding that the annual values of capitalized software costs are associated
with subsequent changes in earnings suggests that such capitalizations
provide relevant information for the prediction of earnings-the sec-
ond desired element of a standard according to the residual earnings
model.28 Amir and Lev's [1996] study of cellular companies, indicating
that investors implicitly capitalize customer acquisition costs, also indi-
cates that the capitalization of these costs will improve the alignment of
book values with intrinsic values.29 Internationally, Abrahams and Sidhu
[1998] finding that capitalized R&D values on Australian companies' bal-
ance sheets are significantly associated with market values, and Barth and
Clinch [1998] finding that revaluations of intangibles by Australian com-
panies are associated with market values, are also consistent with the
claim that the capitalization of intangibles will improve the alignment of
book values with intrinsic values. Finally, a simulation-based analysis
(Healy, Myers, and Howe [1998]) demonstrates the general superiority of
28 The predictive ability of annual software capitalization with respect to future earnings
is expected, since the capitalization of software development costs is predicated on the
success of the development program (e.g., passing feasibility tests or developing a working
pilot). Such developmental success should be associated with increases in subsequent sales
and earnings.
29The implied capitalization of customer acquisition costs is indicated by a regression
of stock returns on earnings before general expenses (which mainly include customer ac-
quisition costs) and general expenses, which finds the latter variable to have a positive,
large (relative to earnings), and statistically significant coefficient.

intangibles' capitalization (successful efforts) over immediate expensing

in providing meaningful performance data to investors. Furthermore, the
analysis shows that even when the majority of firms manage earnings-a
major concern with capitalization-intangibles' write-downs continue to
be significantly related to economic returns.
As with tangible assets, the amortization of the capitalized intangibles
will be based on management's estimates of productive lives, guided by
industry norms and research findings.30 The amortization rates may be
revised as the actual benefits of intangibles materialize. A strict periodic
impairment test along the lines of SFASNo. 121 (FASB[1995]) should be
applied as a safeguard against overvaluation.
How will the reporting deficiencies discussed in previous sections be
alleviated by the proposed capitalization of intangibles? First, such capi-
talization will improve the periodic matching of costs and benefits, par-
ticularly for firms with high growth rates of intangible investment. This
will lead to reported earnings which more meaningfully reflect enter-
prise performance than currently measured earnings. Second, the capi-
talized intangibles will be reported on corporate balance sheets, placing
intangible assets on a common footing with tangible assets. The amorti-
zation and write-offs of these assets will convey valuable information
about managers' assessment of the expected benefits of intangibles.31
Third, the capitalization of intangibles is a crucial step in providing a
basis for evaluating the success of innovative activities. Data on the invest-
ment in intangibles classified by homogeneous product/activity groups
and coupled with a breakdown of revenues and gross margins attribut-
able to the intangibles will enable investors to assess the return on invest-
ment in research, product development, and brand enhancement. This
important objective of capitalization-allowing for the assessment of re-
turn on investment-is often overlooked by those who object to capital-
ization on the grounds that most intangibles are not traded, or because
the cost of intangibles often differs from current values (e.g., Scheutze
[1993]).
On the downside, capitalization of intangibles obviously increases the
possibilities of earnings management. However, in contrast to other
means of earnings management, such as the early recognition of reve-
nues or an exaggerated restructuring charge, intangibles' capitalization
is clearly and separately disclosed in the financial reports, allowing skep-
tical investors to easily reverse the capitalization. Thus, at best, intan-
gibles' capitalization is a vehicle for managers to share with investors
30 For example, the U.S. Bureau of Economic Analysis capitalizes aggregate R&D ex-
penditures in a satellite account to the national income and product accounts. This
national R&D capital is amortized by 11% per year, roughly the midpoint of the range of
amortization rates estimated by economists (Carson, Grimm, and Moylan [1994]).
31 Indeed, Aboody and Lev [1998] find that the amortization of capitalized software is
negatively and significantly associated with stock returns. Write-offs were also found value
relevant by Healy, Myers, and Howe [1998].

information about the progress and success of innovation-producing ac-

tivities. At worst, capitalization can be reversed, thereby returning the
financial reports to their current (full expensing) status.
4.2 RESTATED FINANCIAL REPORTS
Change, we have argued, and the inadequacy of its reflection by the

current accounting system are mainly responsible for the deterioration
in the usefulness of financial information. However, the consequences
of change (e.g., the benefits of a corporate reorganization or of a signifi-
cant drug development) are generally uncertain, and it is this uncertainty
which is often invoked to justify the immediate expensing of change-
related investments. The capitalization of technologically feasible intan-
gible investments proposed above provides a reasonable balance between
relevance and reliability of financial information, but this procedure is
restricted to products under development. Other change-drivers, such as
corporate reorganization or industry deregulation, cannot be accounted
for by the proposed capitalization. We accordingly propose a new ac-
counting procedure-the systematic restatement of financial reports-
to accommodate those change-drivers and other uncertainties affecting
the quality of financial information.
Consider, for example, a corporate restructuring where a significant in-
vestment is made in efficiency-enhancing and revenue-generating mech-
anisms, such as extensive employee training, reorganization of divisions
and production lines, and acquisition of technology and know-how (e.g.,
in-process R&D). Current accounting rules require the immediate ex-
pensing of such outlays (e.g., restructuring charges), given the uncertainty
of their benefits. Such an expensing, however, understates current earn-
ings and book values and overstates subsequent earnings, if the planned
efficiencies materialize. We propose that as the expected consequences
of the reorganization materialize, both the current and previous fi-
nancial statements will be restated to reflect the capitalization of the
restructuring charges (i.e., reversing their previous expensing) and the
amortization of the capitalized amount over the expected duration of
benefits. Such a restatement will correct both the understatement of
earnings in the restructuring period and the overstatement of earnings
in subsequent periods.
Consider once more the example of the telecommunications dereg-
ulation which, beginning in the late 1980s, opened the local telephone
markets to competition. The regional telephone companies belatedly re-
acted to their loss of monopoly and to the new regulatory system which
no longer assured asset values by writing off $26 billion of assets during
1994-95. Thus, throughout the early 1990s the earnings and book val-
ues of the telephone companies were overstated (reflecting inflated asset
values), while the 1994-95 earnings were understated, given the massive
write-offs. By our proposal, upon the write-off in 1995, a telephone com-
pany would have restated its 1990-94 financial reports to reflect a gradual
write-off of asset values according to the realized impact of competition

and consequent loss of asset values which has been experienced during
that period. Thus, the 1995 report would be spared the nonrecurring
massive loss, which in most cases is ignored by investors anyway, and the
preceding reports would reflect the actual consequences of deregulation.
The logic underlying the proposed restatements is that while financial
statements purportedly report the consequences of past events, they are
crucially dependent on assumptions about future outcomes (e.g., accounts
receivable that will default, contingencies that will materialize, or the ac-
tual depreciation pattern of assets). As future events evolve and uncer-
tainty is resolved, our understanding of the past is increasingly improved.
Shortly after quarter-end, for example, our knowledge about the quar-
terly results is fuzzy, whereas two years, say, after quarter-end our uncer-
tainty about the quarterly results is greatly reduced.32 Similarly, at launch,
the expensing of R&D for a new drug may seem reasonable, yet when the
drug receives FDA approval the past expensing is clearly inappropriate.
Why then not restate past reports as uncertainty is resolved and one can
better measure the past performance of the firm?
We believe the systematic restatement of past reports is essential,
given the contextual role of financial information (Finger, Lev, and Rose
[1996]). Financial reports not only convey new information to investors,
they also provide a rich history or context for interpreting current infor-
mation and events. In fact, evidence presented in this and other studies
indicates a deterioration in the amount of new information (timeliness)
conveyed by key financial statement items, leaving the contextual func-
tion of financial reports to play an increasing role in investors' decisions.
Though not extensively researched, some evidence indicates the impor-
tance of the contextual role of accounting. For example, Barth, Elliott,
and Finn [1999] report that investors' reaction to an earnings surprise is
conditioned on the sequence and signs of past surprises. Thus, an earn-
ings increase following past increases is associated with a larger stock price
change than an earnings increase following earnings decreases. Similarly,
Lev, Radhakrishnan, and Seethamraju [1998] report that investors' reac-
tion to an FDA drug approval depends, among other things, on the past
operating success of the developing company. The evidence presented
above that the returns-earnings R2s of firms with the full 20-year history
are substantially larger than the R2s of firms with shorter historical rec-
ords (tables 1 and 2) is also consistent with a contextual role of financial
information. Finally, the findings of Petroni, Ryan, and Wahlen [1997]
that revisions of reserve estimates of insurance companies extending as
far back as ten years are significantly associated with investors' reaction to
current information is consistent with both the contextual role of finan-
cial data and the value relevance of restatements.
32 Ijiri [1989, chap. 7] elaborates on this important idea, that understanding the past
requires improved information about the future, and quotes the British mathematician
Raymond Smullyan: "To know the past, one must first know the future."

If historical financial data affect the interpretation of new signals,

then a continuous improvement of such history, in the form of a better
matching of revenues with costs achieved by the proposed restatement
of past reports, should improve investors' decisions. The restated data,
reflecting the continuous resolution of uncertainty, will portray more
realistic patterns of earnings, growth, and profitability (e.g., ROE) than
the originally reported data.
A natural reaction to the proposed restatement is that the revised in-
formation will no longer be relevant to decision makers and might even
confuse them by presenting several different earnings numbers pertain-
ing to a given accounting period. We doubt the validity of these concerns.
First, a restatement of past reports is currently a GAAPrequirement in
the case of acquisitions accounted for by the pooling method, without
documented harm to investors. More importantly, and closer to our pro-
posal, key macroeconomic variables, such as the gross domestic product
(GDP) and the industrial production index, are routinely revised over
several years after the initial estimates are released.33 For example, the
first estimate of quarterly GDP is released toward the end of the month
following the quarter. This "advance estimate" of GDPis based on judg-
mental assumptions and incomplete data on GDP components. The ad-
vance estimate of GDPis revised by the "preliminary GDPestimate" which
is released toward the end of the second month following the quarter.
The "final GDPestimate" for the quarter is released toward the end of the
third month and is based on replacement of preliminary with compre-
hensive data and on changes in definitions and estimations. Following
the final GDPestimate, the Bureau of Economic Analysis (BEA) schedules
annual revisions of GDP,usually released in July, to improve the accuracy
of GDPestimates as new information is obtained. The BEAalso revises the
entire history of the quarterly data series every five years in what is known
as a benchmark revision.
Note the close resemblance of early estimates of macroeconomic data
based on incomplete information to quarterly financial reports, which
are similarly based on estimates and incomplete data. Regarding the con-
cern with the usefulness of revised data and the confusion they can cause,
a survey of the economic literature dealing with revisions of macro-
economic data (e.g., Mankiw and Shapiro [1986] and Diebold and Rude-
busch [1991]) does not support such concerns. The evidence indicates
that revisions are useful in conveying new information which cannot be
forecasted by the early estimates.
33For example, on July 31, 1998, the Bureau of Economic Analysis (BEA) of the U.S.
Department of Commerce announced that the seasonally adjusted estimate of real Gross
Domestic Product (GDP) growth for the second quarter of 1998 was an annualized 1.4%.
In addition, the July press release contained revised estimates for the real GDPseries (and
components) from the first quarter of 1995 until the first quarter of 1998. The revision
showed an increase in the estimated average year-over-year real GDPgrowth from 2.9% to
3.3% for the period from 1995 to 1997.

5. Conclusions
We have documented in this study a systematic decline in the use-
fulness of financial information to investors over the past 20 years, as
manifested by a weakening association between capital market values
and key financial variables-earnings, cash flows, and book values. We
have identified a major reason for the usefulness decline-the increas-
ing rate and impact of business change and the inadequate accounting
treatment of change and its consequences-and linked change empiri-
cally to loss of informativeness of financial data. Of the various change-
drivers, we have focused on intangible investments, thereby completing
the linkage: intangibles-business change-loss of value relevance of finan-
cial information.
The social consequences of the decline in the usefulness of finan-
cial information are yet to be fully examined. If investors were able to
obtain the information increasingly missing from financial reports from
alternative sources, at no added cost, then the social consequences of
a decline in accounting usefulness may not be serious, except for ac-
countants. Preliminary evidence, however, is inconsistent with a smooth,
costless information substitution. Thus, for example, Barth, Kasznik, and
McNichols [1998] report that analysts expend more resources in the analy-
sis of intangible-intensive companies. Aboody and Lev [1998] find that
gains to officers from insider trading in R&D-intensive companies are
substantially larger than insider gains in firms without R&D. Insider gains
come, of course, at the expense of other investors and are probably re-
lated to the poor information on R&D available in financial statements.
And Boone and Raman [1997] report that unexpected changes in R&D
are associated with an increase in the size of bid-ask spreads and price
volatility. Wider bid-ask spreads, a reaction to an increase in informa-
tion asymmetry, imply larger transaction costs to investors and, in turn,
an increased cost of capital to the firm. These findings suggest that the
reporting inadequacies documented above may adversely affect inves-
tors' and firms' welfare. Given these concerns with reporting deficien-
cies, we have advanced two proposals that may enhance the usefulness
of financial information-an extended capitalization of intangible in-
vestments and a systematic restatement of past financial reports.
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Accounting Research Center, Booth School of Business, University of Chicago

The Boundaries of Financial Reporting and How to Extend Them

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In this study we investigate the usefulness of financial information to

This content downloaded from 130.15.241.167 on Thu, 15 Aug 2013 22:58:52 PM

the previously expensed investments. Consequently, the fundamental ac-

1. The Decreasing Usefulness of Financial Information

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based on questionnaire or interview studies, reflect investors' opinions

4Association studies, such as those presented here, indicate an upperboundof usefulness

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7 All R2s reported in this study are adjusted R2s.

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Panel B: Time Regressions

R2= a + b (Timet) + ct; t = 1978-96

ERC 1.688 -0.011 0.31

ERC 5.353 -0.050 0.64

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the declining slope coefficients indicate a deterioration in the value rel-

Cash flows are often claimed to be more informative than earnings

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rules, such as those which require the expensing of investments in in-

Rit = PO+ PICFit + f2ACPFit+ P33ACCit+ 34AACCit+ ,it, (2)

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Panel A: Equation (2): Rit = Po + PICFit+ P2ACFit+ P3ACCit+ 4AACCit+ t

Panel B: Time Regressions

R= a + b (Timet) + ct; t = 1979-96

CFRC 1.159 -0.006 0.04

CFRC 3.424 -0.029 0.15

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Panel B: Time Regressions

R2 = a + b (Timet) + ct; t = 1977-96

the informativeness of cash flows relative to earnings is due to cash flows'

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This content downloaded from 130.15.241.167 on Thu, 15 Aug 2013 22:58:52 PM

2. Business Change and the Deterioration of Financial

2.1 MEASURING BUSINESS CHANGE

While surveys of executives, investors, and policymakers generally

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Regression: MARC (Indicator) t = a + b (Timet) + ct; t = 1964-96

MARC (Market Value), 1964-95 0.0026 0.0062 0.48

MARC (Market Value), 1978-95 -0.0693 0.0069 0.25

MARC (Book Value), 1978-96 -0.8357 0.0138 0.69

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17The exception to transaction-based accounting entries is end-of-period adjusting en-

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the statistical association between stock returns of the regional tele-

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2.2 CHANGE AND THE VALUE RELEVANCE OF EARNINGS

Our firm-specific change measure (the "absolute rank change") is

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association is more pronounced for changing than for stable enterprises.

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To summarize, we have argued that the increasing rate of business

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Change companies) to be statistically insignificant at the 0.10 level. For

3. Intangibles, Innovation, and Change

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However, it is not a high level of intangible investment, indicated in those

25 This steady-state R&D environment is not an unrealistic case, as researchers report

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of the Low-Lowcompanies, confirming our earlier contention that high yet