LEARNING OBJECTIVES

After reading this chapter, you should be able to: • Understand how accounting information is linked
to theoretical

models of equity valuation. prices regarding the usefulness of accounting information for in vestors.

• Be familiar with general findings of market-based research con ducted over the past 30 years and
what we have learned from stock

• Understand the efficient-markets hypothesis and why it is coming under attack.

• Comprehend the basic difference between event studies, which

look at changes in stock prices, and cross-sectional valuation stud ies, which look at levels of stock
prices. • Understand the respective roles of companies and their indepen

dent auditors in jointly producing financial statements. evaluating default risk and predicting
bankruptcy.

• Understand that accounting information is useful to creditors in

• Understand the arguments for and against the usefulness of ac counting allocations.

• Understand the usefulness of accounting information in a theoreti cal information economics

context (appendix).

The FASB recognizes the existence of a diverse and pluralistic user group (see Chapter 7). However,
in practice, the FASB has focused on what it calls primary user groups (investors and creditors) who
are assumed to be mainly interested in the amounts, timing, and uncertainties of future cash flows.
The rationale for the

investor creditor focus is that other users either have a common ality of
interest with investors and creditors or the means of getting alternative

information, such as governments have for taxation purposes and rate setting bodies for utility
pricing. The FASB's cost-benefit calculus is similarly restricted to benefits for investors and creditors,
and cost con siderations are confined only to producers. The purpose of this chapter is to examine
theoretical and empirical evidence for the usefulness of financial accounting data to the FASB's
primary user group, investors and creditors. We begin by examining models of firm valuation and
the role of accounting information in these models. Next we see how and why accounting
information is useful for investors. Within this context we examine the efficient-markets hypoth esis
and why it has been challenged recently. We then briefly examine how cross-sectional research
differs from event studies. The role of au diting underlying reliability of financial statements then
presented. We then look at accounting data and its role relative to creditors. The chapter concludes
with a discussion of the usefulness of accounting al locations. Appendix 8-A shows why information
is important to decision makers in terms of helping them to reassess their decisions.

ACCOUNTING DATA AND MODELS OF FIRM VALUATION

Gordon's dividend valuation model is a useful starting point in under standing the relationship
between accounting data and the value of the firm. This model posits that the value of the firm to
stockholders is the present value of expected future dividends to be received by stockhold ers.
Beaver uses the dividend valuation model to formulate the role of ac counting earnings in
determining firm value. First, present security prices are defined as a function of expected future
dividends. Second, future dividends themselves are a function of future earnings. Finally, current
accounting income is useful in predicting future earnings; there fore, current income is informative
vis-à-vis its predictive ability with re spect to future earnings (and ultimately future dividends). So, in
this for mulation, accounting income has value indirectly through its role in assessing future
expected dividends. This, of course, is predictive value, which is one of the major arguments for the
relevance of accounting in formation (see the discussion of SFAC No. 2 in Chapter 7).

More recent work in financial economics regarding the theoretical value of the firm traces back to
Miller and Modigliani's seminal work in which they argue that dividend policy is irrelevant to firm
valuation. Ig- noring the complicating effect of taxes, they show that the value of the firm can be
equivalently modeled (independent of dividends) as the pre sent value of future net cash flows,
where net cash flows per period are defined as cash flows from operations minus cash investment in
assets. This notion of net cash flow is the same used in capital budgeting-pre sent value analysis.
Miller and Modigliani's net cash flow model was originally a certainty-equivalent model but has been
extended to a more general model in which there is uncertainty as to the future operating cash
flows. The attractiveness of the cash flow valuation model for ae counting is that it maps directly into
the accounting system; that is, cash flows are explicitly measured in accounting systems, whereas
dividends are a matter of corporate policy and have nothing to do with accounting systems per se.
Further tie-ins between cash flows and decision making are made in Chapter 12.

Interestingly, the FASB has also adopted (implicitly) the cash flow valuation model. In SFAC No. 1, the
role of financial reporting is char acterized as aiding investors, creditors, and others in assessing the
amounts, timing, and uncertainty of the enterprise's prospective net cash flows. Further, the FASB
has asserted that accrual accounting systems, and accrual income numbers in particular, are more
useful for this pur pose than are simpler cash-based systems:
... accrual accounting generally provides a better indication of an en terprise's present and
continuing ability to generate favorable cash flows than information limited to the financial effects of
cash receipts and payments (SFAC No. 1, preface).

Beaver agrees with this assertion, arguing that "an accrual can be viewed as a form of forecast about
the future. ... There is empirical evidence that future cash flows are better forecast with accrual data
than with cash flow data. And, in stock market studies, security prices are more highly correlated
with accrual income than with either cash flows or working capital flows. Numerous studies
(reviewed in this chapter) have docu- mented that changes in reported accounting earnings affect
firm valua tion through changes in stock prices. Changes in current period earnings should affect
stock prices and the market's valuation of the firm if in vestors view such changes as permanent or
persisting into the future. If this is the case, then expectations of future period cash flows should
also be affected, hence the explanation for changes in stock prices as a func tion of the expected
persistency of earnings changes.

The implications of this theoretical literature is that accrual account ing systems incorporate the
attribute that determines firm valuation net cash flow data. However, the value to investors of the
information in financial reporting does not lie in its role as an historical record; rather, its usefulness
lies in its potential for revising investors' assessments of future period cash flows. A thcoretical
formulation of how accounting in formation impacts upon assessments of future cash flows appears
in Ap pendix 8-A.

Clean Surplus Theory

A recent theory of security valuation that is even more closely attuned to accounting concepts and
numbers is the clean surplus theory of Ohlson and Feltham and Ohlson.10 The crux of their
approach lies in the accounting tautology that ending book value of equity equals the begin ning
book value plus earnings minus dividends. The underlying pre mise here is that all profit and loss
elements go through income, hence the designation of clean surplus. Thus the FASB comprehensive
orienta tion of SFAS No. 130 (Chapter 11) ties in well with the clean surplus approach

The valuation of the firm's equity would be based upon the beginning of period book value plus the
present value of expected future abnor mal earnings. Abnormal earnings are defined as earnings in
excess of expected normal earnings. Hence abnormal earnings are a differential amount above or
below (though usually above) expected normal earn ings. Normal earnings would be equal to the
beginning of period book value multiplied by the cost of equity capital. The valuation of the firm's
equity would then be equal to the beginning book value of equity plus the discounted present value
of abnormal earnings in tje equation shown here :

Rumussss

What gives rise to abnormal carnings? Beaver discusses several sources, First, in selecting
investment projects, the positive excess present value above the cost of the project is not carried on
the balance sheet. Secondly, many matching and recognition procedures under his torical costing
tend to be conservative in nature. Two methods that im mediately come to mind are accelerated
depreciation methods and LIFO costing for inventories and cost of goods sold. Immediate writeoff of
re search and development and possible under-valuation of other intangi bles provide another
example of conservatism. When considering these sources of abnormal earnings, Equation (8.1)
results in an approximation of the current value of enterprise equity.
There are many issues under the clean surplus theory (really a hy pothesis) that require further
clarification. These include determining abnormal earnings itself, and also the appropriate discount
rate for ab normal earnings and how far into the future they should be taken. 12 Clean surplus
theory is a very new formulation and it is going through an intensive gestation period. 13 Even at this
early stage, it appears to be a very promising security valuation approach for relating the actual mar
ket value of equity to the clean surplus theoretical construct.

THE VALUE OF ACCOUNTING INFORMATION FOR INVESTORS

As mentioned before, the usefulness of accounting information to in vestors has been empirically
investigated through the association (or lack thereof) of publicly released accounting data with
changes in the firm's security prices. If there is a significant association, then there is evidence that
accounting information is useful with respect to firm valu ation. These studies also constitute tests of
the so-called efficient markets hypothesis.

The efficient-markets hypothesis (EMH) refers to the speed with which securities in the capital
market respond to announcements of new information. The classic definition of market efficiency is
that (1) the market fully reflects available information and (2) by implication, mar ket prices react
instantaneously to new information.15 In other words, new information is quickly impounded in the
price of the security. If the hypothesis is correct, an item of information has value to investors only if
there is evidence of a price response to the new information. When this occurs, the item of
information is said to have information content. There are three forms of the efficient-markets
hypothesis. The weak form says that security prices reflect information contained in the sequence of
historical (past) prices; the semistrong form says that prices reflect all past and current information
that is publicly available; and the strong form says that prices reflect all information (both public and
private). Most testing has been of the semistrong form, which deals with publicly available
information. Much of the information tested has been of an ac counting nature-for example,
financial statement data and earnings announcements.

The theoretical foundation of capital market or security price research comes from portfolio theory,
which is a theory of rational investment choice and utility maximization: simply stated, risk can be
reduced by holding a portfolio of investments. Risk that can be eliminated in this manner is called
unsystematic (diversifiable) risk, while the remain ing portfolio risk is called systematic
(undiversifiable) risk. In port folio theory, systematic risk is defined as the variance of expected in
vestment returns. We conveniently think of expected return as a single number, but in reality it is a
probability distribution of possible returns. The larger the variance around the mean of expected
returns, the greater the risk associated with the investment. This variance may be quite high in
individual stocks, but when evaluated for a portfolio as a whole, it is much lower. The reason for this
situation is that variances of individual securities are offset when combined in a portfolio. In this
way, it is pos sible to select a stock portfolio that minimizes risk (variance) for a given rate of return.
What remains after eliminating all the risk possible is called undiversifiable or systematic risk of the
portfolio. And that risk which has been eliminated through diversification is called diversifiable or
unsystematic risk. An investor will rationally select a portfolio with a risk-return relation that meets
the investor's own utility preferences. The theoretical choice of portfolios is graphically presented in
Exhibit 8-1. The capital market line represents alternative portfolios of increasing levels of systematic
risk. Since investors are risk averse, the expected portfolio return increases as risk increases. The
capital market line is linear only under restrictive conditions, but whether linear or curvilin ear, a
direct relationship exists between the level of risk and expected returas.

Portfolio theory is the foundation for a related development in fi nance—the pricing of individual
stocks given the concept of diversified portfolios. A model called the capital asset pricing model has
been developed for the theoretical pricing of individual stocks. Its first step is to relate the risk of an
individual security relative to the market as a whole. The market is assumed to be a diversified
portfolio. A correlation is made between the returns on individual stocks and market returns over a
period of time. The correlations are illustrated as a scattergram in Exhibit 8-2. Regression analysis is
used to fit a line to the scatter gram. The slope of the characteristic line is called beta and represents
a market-based measure of the systematic risk of an individual security relative to the average risk in
the market as a whole. If beta equals 1, the returns are perfectly associated and the risks are equal.
If beta exceeds

Tabelllll

1, the returns on the individual stock are greater than the market. In other words, if the rate of
return on an individual security is greater than the market average, systematic risk of the security
must also be greater because of the direct relationship between risk levels and expected re turns.
Higher returns must be accompanied by higher risks.

The assumption of the capital asset pricing model is that individual securities are priced solely on
systematic risk. Given the assumption of diversified portfolios, it is argued that no one would pay for
unsys tematic risk. Beta is used to represent systematic risk of individual se curities and to predict
the risk-based price of securities. A standard two parameter version of the capital asset pricing
model defines the predicted rate of return for an individual security as

Rumussss

Unexpected returns or abnormal returns for any time period are captured in the error term e, in
Equation (8.4). A common research ap proach in accounting studies has been to regress these
abnormal returns on accounting variables, such as unexpected reported earnings, for the same time
period to determine if there is information content, in which case there would be evidence that firm
valuation is correlated with ac counting information.

Before reviewing the empirical findings, we should make a few obser vations regarding the
difficulties of doing this type of research. 17 The study of price movements and the pricing
mechanism in any market is an imposing task. Determining cause and effect between information
and security prices is especially difficult because new information is continuously causing price
movements. Since the set of information af fecting security prices is large, it is extremely difficult to
isolate the ef fects of one piece of information and we are examining only a relatively small group of
investors: those at the margin who influence stock prices. This difficulty means that the tests are
going to be somewhat crude rather than precise. 18 The research should be examined with this in
mind. Failure find evidence of information content should thus be in terpreted cautiously, for the
methodology is not always capable of detec ting information content. For this reason, the stronger
evidence from efficient-markets research exists where there is information content rathe: than
where there is none.
Another weakness of capital market research is that it is a joint test of both market efficiency and
information content. The absence of price responses is usually interpreted to mean that the
information tested has no information content. This interpretation is correct only if the market is
efficient. But what if the market is inefficient? If the market is ineffi cient. there is no way of
determining what the absence of a price re sponse means. This is another reason why the research
findings are much stronger when there is evidence of information content.

A final point is that market-based research necessarily considers only the aggregate effect of
individual investor decision making. That is, the role of accounting information vis-à-vis an individual
investor's decision making is implicitly modeled as a black box: an "event," the reporting of
accounting information, occurs, and the effect of this event is then in ferred from whether or not
there was an aggregate (market) reaction. As an alternative, Appendix 8-A presents an investor
decision model that explicitly models the role of information in revising expectations about future
cash flows at the level of an individual investor.

Information Contents of Earnings Announcements

The strongest evidence from capital market research concerns the infor mation content of annual
accounting earnings numbers. The seminal study, published in 1968, showed that the direction of
change in re ported accounting earnings (from the prior year) was positively corre lated with security
price movements. 19 The study also found that the price movements anticipated the earnings
results and that there was vir tually no abnormal price movement one month after the earnings
were announced. This is consistent with the semistrong form of the efficient markets hypothesis. A
later study showed that the magnitude as well as direction of unexpected earnings are associated
with changes in security 20 prices. Quarterly earnings announcements have also shown the same
general results.

These results are not surprising. We would expect accounting income to be part of the information
used by investors in assessing risk and re turn. Capital market research has confirmed an almost self-
evident proposition. The findings are important, though, in formally linking accounting information
with investment decisions and hence with use fulness to investors.

Alternative Accounting Policies and Security Prices

A more complex type of securities-price research has examined the ef- fect of alternative accounting
policies on security prices. The initial pur pose of these tests was to investigate the so-called naive-
investor hy pothesis. Research has found that security prices respond to accounting income
numbers. Alternative accounting policies-for example, flexi bility in the choice of depreciation and
inventory methods—can affect net income. Although these methods affect reported earnings, there
is no apparent impact on company cash flows. These types of accounting al ternatives simply
represent different patterns of expense recognition or cost allocations.

The question of interest to researchers is whether alternative ac counting policies have a systematic
effect on security prices. If security prices do respond to income levels that differ solely because of
alterna tive accounting methods, with no cash flow consequences, then there is support for the
naive-investor hypothesis. On the other hand, if security prices do not respond to such artificial
book-income differences, then there is evidence that investors in the market are sophisticated and
able to see through such superficial bookkeeping differences. Virtually all the initial research was
interpreted as rejecting the naive-investor hypothe sis. However, recent research findings have
challenged some of the ear lier conclusions and reopened what was once considered a closed issue
in accounting research.22

Alternatives with No Known Cash Flow Consequences

Several studies have compared companies using different accounting methods. One of the earliest
studies compared companies using accelerated versus straight-line depreciation methods.23 The
two groups of com panies had different accounting income numbers because they used al ternative
depreciation methods; thus there were differences in income between the two groups of companies
due to the use of alternative de preciation accounting methods. There were also differences in price
earnings multiples between the two groups. Companies using acceler ated methods had lower
earnings but higher price-earnings multiples than companies using straight-line. However, when
earnings of compa nies using accelerated methods were adjusted to a straight-line depreci ation
basis, the price-earnings multiple between the two groups of com panies was not significantly
different.

The assessments of the companies in the market did not appear to be affected by arbitrary and
alternative accounting income numbers. This finding is often expressed as the market not being
"fooled" by arbitrary accounting differences. Other similar research has supported this con clusion.
Additional areas tested include purchase versus pooling ac counting, expensing versus capitalizing
research and development costs, and recognition versus deferral of unrealized holding gains on mar
ketable securities.

A related area of investigation concerns security-price responses to a reported change in accounting

policy by a company. Changes in depre ciation policy have been researched, and there is no evidence
that the change per se affects security prices.25 Another area tested has been a change from the
deferral to flow-through method of accounting for the in vestment credit.26 Again, no price effects
were found. Although changes in accounting policies may cause the income number to change
(solely because of the policy change), these research studies have not found that security prices
respond to the changes. Higher accounting income achieved solely from a change in accounting
policy with no apparent real changes in underlying cash flows does not appear to fool the market.
The evidence from the type of research discussed in the preceding paragraphs supports the claim
that there is no information content in ac counting policy changes, at least where there are no
apparent underlying changes in cash flows. This finding has also been interpreted as a rejec tion of
the naive-investor hypothesis. Investors appear to adjust account ing income to compensate for
artificial bookkeeping differences with no real substance. That is, investors do not appear to respond
mechanisti cally and naively to changes in reported accounting income numbers.

An Alternative with Cash Flow Consequences: The LIFO Choice

One type of change in accounting policy that does produce a security price response is a change
from FIFO to LIFO inventory accounting. Changes to LIFO have been associated with a positive
security-price movement, even though LIFO lowers accounting income in a period of rising inventory
prices.27 Given the apparent sophistication of investors in other areas of accounting policy
differences, what can be the logical explanation for these price responses? The suggested reason for
the price response is that LIFO must be adopted for financial statement pur poses if the tax benefit is
desired. In a period of rising prices, tax ex pense will be lower for companies that use LIFO, in which
case there are real cash flow consequences due to the change in accounting policy. Even though
book income is lowered by the use of LIFO, cash flows are higher because the taxable income is
lower. Positive security-price re sponses are therefore consistent with an increase in the value of the
firm due to tax savings.

Other studies, however, contradict these findings concerning the effect of the changes.28 These
studies either found no evidence of price response or found evidence of a negative price response.
Either result is contrary to the earlier finding of positive price responses. The recent studies suggest
the eerlier research may have failed to isolate the real effect of the LIFO change because of a self-
selection bias. (This means that companies changing to LIFO had other things occurring
simultaneously that con founded the results and may have caused the positive price response.) But if
these studies are correct, then there may be some support for the naive investor hypothesis. There
are positive tax benefits associated with the LIFO change that should increase the value of the firm.
Yet security-price responses were not positive. Since LIFO will lower accounting book in come, a
negative price response could be interpreted as a mechanistic re sponse to a lower accounting
number, a response made without consider ing the positive cash flow consequences due to lower
taxes.

There has, however, been some recent support for the earlier studies which found positive security-
price movement when LIFO was adopted. Pincus and Wasley examined LIFO adoptions from 1978-
1987 and found evidence for the possibility that LIFO is a "good news” signalling event which could
account for the positive security-price movement pre sumably resulting from its adoption.29 On the
other hand, Kang brings up the possibility of potentially high adoption costs relative to LIFO such as
accounting system changes and higher probability of violating debt contract provisions (e.g., lower
current asset ratios and higher debt-to equity ratios), and renegotiation of management contracts
involving bonus arrangements. 30 These factors might account for negative price re actions since
they might dilute presumed future tax savings.

As discussed at the beginning of this section, security-price research is extremely difficult to conduct.
The LIFO choice issue amply illus trates this point. The early LIFO research rejected the naive-
investor hy pothesis. Later research on the LIFO question reopened what was once thought to be a
closed issue with respect to market efficiency. However, ore recent research shows how really
complex the issue of LIFO adop tion may be. The more recent research on LIFO adoption has begun
fo cusing upon indirect cash flow consequences, a subject which we next examine in more depth.

Alternatives with Indirect Cash Consequences-Agency Theory

Recent security-price research has been probing a more subtle issue re ferred to as indirect
consequences. An indirect consequence occurs when an accounting policy change affects the value
of the firm through an indirect effect on owners, rather than a direct effect on company cash
flows. One such study was motivated by an attempt to explain why secu rities prices of certain oil
and gas companies responded negatively to a mandatory change in accounting policy 31 The
required change from full costing to successful efforts was regarded as simply a change in how ex
ploration costs are allocated to the income statement. Therefore, it was expected that no security-
price response would be evident since there was nɔ direct cash flow consequence to the
companies.
However, security-price responses were found to exist and since pre vious research had
predominantly rejected the naive-investor hypothe sis, a search was made for the existence of
some indirect cash flow con sequences to explain the price response. The study posited that a
change to successful-efforts accounting for oil and gas exploration costs lowered firms' ability to
pay dividends in the short term because of restrictive debt covenants. Therefore, even though the
change in accounting policy appeared to affect only book income on the surface, there were
indirect cash flow consequences to investors, which might explain the negative price response.
This explanation derives from agency theory. When ac counting numbers are used to monitor
agency contracts, there can be indirect consequences on the firm's owners and creditors from
changes in accounting policies. In the case of debt covenants restricting dividend payments,
accounting numbers are used to protect the security of bond holders at the expense of
stockholders. If an accounting policy change lowers accounting income (as could occur in a
mandatory change to suc cessful efforts), stockholder returns could be lowered, thus causing a
negative price response.

A similar type of study found negative security-price responses for firms using purchase
accounting when pooling was restricted by the APB in favor of purchase accounting for
combinations.32 Differences between purchase and pooling accounting appear on the surface to
affect only book income with no real cash effects. However, the reduced use of pool ing
accounting could affect dividend distribution because of debt covenants. Income would normally
be lower under purchase accounting than pooling, and the same effect of dividend restrictions as
argued in the oil and gas study were also argued in the purchase/pooling study. An other research
study along these lines examined the requirement to cap italize leases that had previously been
reported as operating leases.33 There was some evidence of negative price responses for certain
compa nies; this situation could have been due to the existence of debt covenants as well as the
adverse effect lease capitalization would have on the firms' future borrowing capacity,

Some Further Questions Relative to Market Efficiency

Clearly there is some degree of efficiency present in securities-market transactions. The question is
one of how much efficiency exists, which is virtually impossible to answer. However, several recent
studies provide evidence that there may be somewhat less than is postulated in the semi strong
form of the efficient-markets hypothesis.

Ou and Penman, in a very extensive study, invoked the idea of fun damental stock analysis.
Fundamental analysis assumes that securi ties markets are inefficient and that underpriced shares
can be found by means of financial statement analysis. This view is directly opposed to the efficient-
markets view that prices of securities rapidly reflect all publicly available information (the semistrong
form of the hypothesis).

Ou and Penman used traditional accounting measures such as return on total assets, gross margin
ratio, and percentage of change in current assets in a multivariate model to predict whether the
following year's income would increase or decrease. The time period covered was between 1965
and 1977, the model included almost 20 accounting measures, and approximately 23,000
observations were made. 34 Ou and Penman were able to describe the following year earnings
changes correctly almost 80 percent of the time. 35 The key point concerns whether their predictors
were capturing information that was not already reflected in security prices but that would be
subsequently reflected in security prices and would thus result in abnormal security returns if
investment were based on the earnings predictions of their model. Their analysis indicates that this
is exactly what would have occurred.36 They also believed that the excess security returns would
not have been attributable to excess risk factors, though they were not entirely sure on this
particular point.37 Ou and Penman's research thus indicates that markets are not as efficient as
efficient-markets advocates would like to believe and that fundamental analysis is still important for
investment purposes. This study also im plies that "better" accounting standards might improve the
predictive ability of accounting information, which leads us to Lev's work.

Lev concentrated on an issue that is complementary to the factors in the Ou and Penman study.
Specifically, his point is that both over time and within years (cross-sectional studies), the correlation
between earn ings numbers and stock returns has been exceedingly low.38 Earnings, in other words,
have very little explanatory power (as measured by R, the coefficient of correlation relative to
changes in stock prices. Lev be lieves that one of the principal reasons for this situation lies with the
low quality of reported income numbers:

Research on the quality of earnings shifts the focus to an explicit consid eration of accounting issues
by calling for a systematic examination of the extent to which the specific principles underlying
accounting mea surements and valuations, as well as managerial manipulations, detract from the
usefulness of earnings and other financial variables. Such research has the potential both to further
our understanding of the role of financial information in asset valuation and to contribute
meaningfully to accounting policy making.

Thus the Lev and Ou and Penman papers are complementary because one finds a low explanatory
relationship between earnings and stock re turns while the other sees a predictive role for
accounting data in a mar kel that may be less efficient than previously thought. One article (Lev's)
looks directly at the issue of improving accounting measurements while the other may certainly be
said to imply this point.

Post-Earnings-Announcement Drift Casu Further questions concerning market efficiency have arisen
over the phenomenon known as post-earnings-announcement drift. While markets do react
significantly at the time of the earnings announcement, it takes up to 60 days for the full effect of
earnings announcements to be im pounded in security prices. This effect appears to be more
important for smaller firms as opposed to larger ones. $ 42 At least part of the blame for post-
earnings-announcement drift has been laid at the feet of financial analysts. Abarbanell and Bushee
con cluded that financial analysts underreact to very fundamental signals stemming from securities
which lead, in tum, to forecast errors which, in turn, lead to incomplete security price adjustments.
Sloan found evi dence that shareholders do not distinguish well between cash flow por tions of
earnings and the accrual segment thereof. The cash flow portion persists longer into the future and
is less subject to manipulation than the accrual part of earnings. Another possibility is that
transaction costs are too high relative to the potential gain that can be eamed from the mis pricing
of the securities. While securities markets may be "efficient," they may not be as efficient as we once
believed. Given that there is certainly some amount of efficiency that is present, it becomes even
more important to attempt to improve the quality of accounting standards.

Accounting Information and Risk Assessment

Capital market research has also investigated the usefulness of ac counting numbers for assessing
the risk of securities and portfolios. These studies have found high correlations between the
variability of ac counting earnings and beta, the market-risk measure. 46 The high corre lations imply
that accounting data may be useful for assessing risk. Some other research has tried to determine if
alternative accounting policies have any effect on risk. The purpose of this type of research is to
identify how alternative accounting policies or disclosures may affect the usefulness of accounting
numbers for assessing risk. For example, one study tried to determine if unfunded pension benefits
(reported in footnotes) affected beta. 47 There was no significant impact. From this evidence, it
might be concluded that pension information is not useful for risk assessments. However, other
studies found that supplemental segment (line of business) disclosures resulted in a revision of
system atic risk, which suggests that such information is useful for risk assess ments.

Other studies have tested the association of financial ratios with beta. 19 Some of the ratios and
computations tested include dividend pay out ratio, leverage, growth rates, asset size, liquidity, and
prelax interest caverage, as well as earnings and earnings variability. In general, these tests indicate
a strong association between the accounting-based ratios and the market measure of risk, beta.

Summary of Capital Market Research

Empirical evidence from capital market research is supportive of these statements:

1. Accounting earnings appear to have information content and to af fect security prices.

2. Alternative accounting policies with no apparent direct or indirect cash flow consequences to the
firm do not seem to affect security prices, though this issue is not entirely settled.

3. Alternative accounting policies that have direct or indirect cash flow consequences to the firm (or
its owners) do affect security prices.

4. There are incentives to choose certain accounting policies, where choice exists, owing to indirect
cash consequences. 5. Accounting-based risk measures correlate with market risk mea sures,
suggesting that accounting numbers are useful for risk assessment.

In the early 1970s, some argued that capital market research could be used as a basis for (1)
choosing the best accounting policies and (2) eval uating the economic consequences of alternative
accounting policies on security prices. 50 Accounting policies that most affected security prices were
thought to be most useful. In other words, such policies would have had the most information
content. The argument had intuitive appeal, particularly since deductively based research had
proved unable to re solve the normative accounting theory debate about the most desirable form of
accounting. However, the early advocates of security-price re search now recognize the limitations
of this research for such a use. Si Reasons for these limitations are the public-good nature of
accounting information, the existence of free riders, and the resultant market failure in terms of
optimal resource allocation.

In spite of its inability to resolve accounting theory and policy ques tions, capital market research
continues to be useful in empirically eval uating economic consequences of accounting policies vis-à-
vis security prices and the usefulness of accounting numbers for risk-and-return as sessments.
Perhaps more than anything else, though, the impact of cap ital market research is that it brought a
different perspective to account ing theory and policy at a time when the emphasis was primarily on
deductively based theory.
Surveys of Investors

Another way of determining the usefulness of accounting information is to directly ask investors how
(if at all) they use annual reports. Surveys of investors have been undertaken in several countries
and generally have shown a rather low readership of accounting information.2 Ap- proximately one-
half of the investors surveyed indicated they read financial statements. Institutional investors have
shown a much higher level of readership. 53 These surveys, particularly of individual investors,
should be interpreted cautiously, however. Individual investors may rely on investment analysts to
process accounting information. It would be simplistic to assume accounting information has no
usefulness to in vestors merely because many individual stockholders do not read annual reports in
detail.

Another type of survey research has asked investors to weigh the importance of different types of
investment information, including ac counting information. Several studies of this type have been
reported. 54 Accounting information ranks fairly high in importance in these surveys, though not at
the top. This status seems to be attributable to the histori cal nature of accounting information and
the reporting-lag effect. More timely accounting information from company press reports, and
nonac counting information such as general economic conditions and company announcements on
products and markets, rank ahead of annual reports in perceived importance.

ACCOUNTING INFORMATION AND CROSS-SECTIONAL VALUATION MODELS

The research discussed in the previous section primarily examined the relationship between
accounting data and changes in stock prices (mea sured as abnormal returns). Another approach has
been to examine the association between accounting data reported in annual financial statements
and the levels of stock prices (i.e., firm valuation, measured as market capitalization).55
Conceptually, this approach, which is re ferred to as cross-sectional valuation, attempts to
empirically esti mate the theoretical model of equity valuation described at the begin ning of this
chapter. This approach has been used to investigate how (if at all) specific components of the
financial statements are "priced" in the sense of being associated with the market valuation of the
firm. If an item is "priced" as an asset/revenue, it should normally have a positive relation to market
value, whereas if the item is "priced” as a liability/ex pense it should normally have a negative
relation with market value. A number of authors have expressed enthusiasm for this methodology as
a framework for evaluating the merits of alternative accounting meth ods/valuations.

Several studies have used this framework to determine that a firm's pension plan assets and
liabilities (as reported off-balance sheet in foot note disclosures) are consistent with their being
viewed as real (i.e., on balance sheet) assets and liabilities, respectively.57 Another study de
termined that components of pension expense (per SFAS No. 87) are not weighted equally in terms
of their association with market valuation. 58 Of particular interest is that the transitional asset
amortization compo nent of pension expense was implicitly valued at zero, which is consistent with
the fact that there are no cash flows associated with the item. Another study examined the
association of research and development (R&D) expenditures with firm value.59 The major finding
was that, on average, each dollar of R&D was associated with a five-dollar increase in market value.
This result provides evidence that the market is im plicitly capitalizing R&D outlays even though SFAS
No. 2 prohibits ex- plicit capitalization. In other words, the market interprets R&D as an asset
(investment) rather than an expense, contrary to the accounting treatment required by SFAS No. 2.

The financial services industry is another area in which cross sectional valuation models have been
used. Studies have examined sup plemental disclosures of nonperforming loans (default risk) and
interest rate risk in banks and thrifts. Non Performing loans are negatively as- 60 sociated with firm
value, though this effect is greater for banks than for thrifts. Interest rate risk was negatively
associated with firm value only for banks. Another study reported that banks' supplemental
disclosure of the "fair market value" of investment securities is associated with market value over
and above that explained by historical costs alone, a finding that gives credence to the SEC's and
FASB's recent push for mark-to-market accounting.

THE ROLE OF AUDITING IN THE FINANCIAL REPORTING PROCESS

An assumption underlying all of the research reviewed in this chapter is that financial statement
information is reliable in the sense of having been prepared in accordance with generally accepted
accounting princi ples applied on a consistent basis. The independent auditor's role is to attest that
this is in fact the case. For this reason, financial statements are properly understood as jointly
produced by the firm and the auditor. The demand for auditing can be explained by agency theory,
which was discussed in Chapters 2 and 4. Because of conflicting incentives be tween owners and
managers, monitoring or control of managers occurs via mechanisms such as boards of directors and
independent audits.62 In addition, companies have voluntary incentives to signal to outsiders (po-
tential investors and creditors) that the financial statements are reliable. Thus, independent audits
also serve the role of enhancing outside ered ibility of financial statements, in addition to the control
function within the firm of monitoring managers.

How do audits enhance financial statement reliability? A recent com prehensive study drew on a
large sample of actual auditor workpapers to determine dollar amounts of adjustments to financial
statements re quired by auditors.3 These adjustments represented the auditor's cor rection for
material misstatements in the financial statements. Assuming a standard rule-of-thumb of a 5
percent materiality level (i.e., 5 percent of net income or total assets), the study estimated that
unaudited net in come and total assets would have been overstated by amounts in the range of 2 to
8 times the materiality level (i.e., a 10 percent to 40 per cent overstatement of net income and total
assets). Of course, absent the prospect of an audit, the misstatements are likely to have been even
higher. This is the deterrence effect of knowing the financial statements will be audited. Another
study found that subsequent period quarterly earnings an nouncement following the issuance of a
qualified audit report, on average, led to a lower stock price response than for companies having un
qualified audit reports. In other words, following the issuance of a qualified audit report, investors
are more skeptical of earnings an nouncements, at least until the next year's annual audit report.
Finally, a number of studies have examined the value of auditing by comparing companies audited
by the well-known and putatively higher quality brand name Big Five auditors with companies that
are audited by other auditors. There is evidence that Big Five audited companies are valued more
highly when initially going public (unseasoned stock issues) and when subsequently issuing securities
(seasoned stock issues).

There is also evidence that earnings announcements by Big Five audited companies have more
credibility. Specifically, unexpected earnings are associated with a larger stock price response when
the auditor is a Big Five firm.
ACCOUNTING DATA AND CREDITORS

Theories underlying the usefulness of accounting information to credi tors are not as well developed
as is the role of accounting numbers vis à-vis stock prices. It is, however, generally agreed that the
price of interest-bearing debt is based on default risk, which is defined as the premium in excess of
the risk-free interest rate on otherwise identical debt (for example, U.S. Treasury obligations). Thus,
firm-specific infor mation, including accounting data, aids creditors in assessing default risk.

Several distinct lines of research have emerged: (1) the usefulness of accounting data in predicting
corporate bankruptcy (which encompasses loan default); (2) the association of accounting data with
bond ratings wherein such ratings are presumed to proxy for default risk; (3) the as sociation of
accounting data with estimates of interest-rate risk premi ums on debt; and (4) experimental studies
of the role of accounting data in lending decisions. We will present a brief overview of the research
findings.

Accounting-based ratios have been very useful in discriminating be tween firms that subsequently
went bankrupt and those that did not. 67 Predictability up to five years prior to bankruptcy has been
demon strated. These findings do not mean that companies with "bad" ratios will necessarily go
bankrupt in the future. It simply means that bankrupt companies tend to have financial ratios prior
to bankruptcy that differ from nonbankrupt companies. The existence of "bad" ratios does not mean
bankruptcy will occur, just that it is more probable. Accounting data is also associated with both
bond ratings and interest 68 rate risk premiums.* Among the important ratios are profitability, earn-
ings variability, and leverage. Research has also been used to evaluate which of alternative sets of
accounting data are more highly associated with bankruptcy prediction, bond ratings, and risk
premiums. Among the issues examined have been historical cost versus price-level adjusted income,
the effect of lease capitalization versus no noncapitalization, and recognition of pension liabilities
versus footnote-only disclosure. 69 Experimental (laboratory) studies have also tested the usefulness
of accounting data for creditors. Accounting data in the context of a loan- related decision (for
example, loan amount, bankruptcy prediction, and interest rates) are provided to subjects to
determine how, if at all, it af fects their hypothetical decisions.70 In these experiments, the account
ing data are manipulated to see if the judgments are sensitive to what ever manipulations take
place; for example, magnitudes of accounting ratios or financial statements prepared under
alternative policies (for ex ample, lease capitalization versus noncapitalization), Generally, these
studies support the sensitivity of loan-related decision making to key ac co inting data and, in this
sense, complement the findings based on eco nomic field data.

THE USEFULNESS OF ACCOUNTING ALLOCATIONS

At present, the historical cost accounting model remains the basic framework for financial reporting.
Central to this model are revenue recognition rules and the matching of costs to revenues. Many
costs are recognized over multiple accounting periods. Some examples include depreciation,
organizational start-up costs, goodwill amortization, and bond premium/discount amortization. The
recognition of these types of costs over multiple periods is referred to as accounting allocation. 71 Al
locations have been criticized on the grounds that they are "incorrigi- ble." By this it is meant that
there is no obviously correct way to allocate the costs because no single allocation method can be
proved superior to another. For example, it cannot be proved conclusively that straight-line
depreciation is any more appropriate than accelerated depreciation methods.
Another way of describing this dilemma is to say that no allocation is completely defensible against
other methods. For this reason, it has been concluded that all accounting allocations are in the end,
arbitrary. Con ceptualiy, this is a very disturbing idea and strikes at the logical core of historical cost
accounting. Because of the arbitrariness of accounting al locations, allocation-free financial
statements have been advocated as a better way of reporting useful information. Allocation-free
accounting can be accomplished by using cash flow statements, exit-price systems (as discussed in
Appendix 1-A of Chapter 1), and certain types of re placement cost systems (also discussed in
Appendix 1-A of Chapter 1). However, the fact that accounting allocations are arbitrary does not
prove that accounting information is useless. The allocation argument is deductive and examines the
logic of historical cost accounting. Useful ness is an empirical question, not a matter of deductive
logic. There is no evidence to support the contention that allocation-based financial statements are
useless. In fact, there is a great deal of evidence from capital market research that supports the
information content of ac counting income numbers.

Capital market research in the area of alternative accounting policies does support the arbitrariness
of accounting allocations. Alternative policies with no known cash flow consequences have no effect
on secu rity prices, which supports the argument that allocations are arbitrary and convey no
information to users. However, the research findings also support the fact that investors are not
naive and that they are capable of adjusting accounting numbers in order to achieve comparability
between companies. In spite of allocations, income numbers are useful and in vestors appear able to
achieve comparability by adjusting for the effects of arbitrary allocations.

It must also be remembered that allocations represent only a part of the total accounting
information in financial statements. Much account ing information contains no allocations. Even if
the allocation criticism is valid, usefulness may still be high. That is, the historical cost allocation
based approach may still be the most cost-effective method of reporting financial information about
firms.

Since allocations have value, a strong case can be made that the FASB should reduce flexibility in
accounting allocations. Given the ev idence from capital market research, there is no compelling
reason to permit arbitrary flexibility. Allocations would be particularly useful if they tried to provide
information on real phenomena. This is sometimes referred to as efficient contracting. If, for
example, a fixed asset is ex pected to provide greater benefits in earlier years, an accelerated
method of depreciation might provide very useful information to the mar ket. Of course, agency
theory issues largely prevent this ideal from oc curring. More will be said on these issues in Chapter
9.

SUMMARY

This chapter has surveyed the research literature on the usefulness of accounting information to
what the FASB calls the primary user group of investors and creditors. The picture that emerges is
that accounting data are important to investors vis-à-vis security prices and to loan-related decision
making by creditors. There should, however, be no illusions about the relative importance of
financial reporting for these external users. For example, unexpected accounting earnings explain
only a. Small percentage (around 5 percent) of the firm’s revaluation vis-à-vis security prices.
Although some of this is due to econometric problems in the research, it is more or less consistent
with investor surveys that show accounting information ranking lower in importance than more
timely in formation about the economy, the relevant industry, and the firm itself. Market efficiency
has also come under challenge. It is possible that abnormal returns can be earned through diligent
analysis. Also, it has begun to be clear that information from earnings announcements are not totally
absorbed into security prices for approximately two months.

Further, although the evidence supports the usefulness of accounting information to this primary
user group, we do not really know just how valuable it is. Thus, we cannot evaluate either the social
welfare of the current financial reporting system or the value of hypothetical alterna tives, such as
current value accounting. The good news for accountants is the systematic evidence that financial
reporting is useful. The bad news is that we still know very little about how useful it is, and we are
unable to infer much about the social benefits of the current investment in accounting information
production. Nevertheless, the issue of im proving the quality of earnings and other accounting
numbers is still alive.