The Usefulness of Accounting Income and Its

Components to Investors
Dr. Ahmed F. Elbayoumi
Cairo University

Studying the relationship between accounting information, on one hand, and stock prices, on the
other, is one of the most famous issues in the accounting literature since the beginning of the
1960s. That research area has gained its importance as a result of professional bodies, such as the
FASB and the IASB, and regulatory and controlling bodies of stock markets, such as the
Securities and Exchange Commission, interest in how and to what extent stock markets are
affected by accounting disclosure as an evidence on the usefulness of this disclosure to investors
(Elsharkawy 2003).

The interest of these bodies can be clearly noticed throughout their identification of financial
reporting objectives (Mahmoud 1997). For example, the FASB has set the objectives of financial
statements in SFAC No. 1 (Objectives of Financial Reporting by Business Enterprises) as to
provide information that is useful to present and potential investors and creditors and other users
in making rational investment, credit, and similar decisions to help them in assessing the
amounts, timing, and likelihood of prospective cash receipts from dividends or interest and the
proceeds from the sale, redemption, or maturity of securities or loans. The FASB believes that
financial reporting should provide information about the economic resources of an enterprise, the
claims to those resources, and the effects of transactions, events, and circumstances that change
its resources and claims to those resources. The FASB emphasized, in that statement, that the
primary focus of financial reporting is information about earnings and its components (FASB
1978).

Studying the relationship between accounting information and stock prices has developed in
many phases. In the period before the 1960s accounting research was characterized by its use of
the normative approach, where the role of accounting was to determine what accounting
treatments ought to be without reliance on any experimental basis. Instead, this determination
was based on generating assumptions that were not subject to testing. The normative approach is
not interested in characterizing the actors that are influenced by the financial reports, the nature

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of this influence, and the reaction of those actors to these reports. Due to the nature of the
normative approach, accounting studies and research in this period were characterized by the
involvement of researchers’ personal judgment when setting criteria to be used in assessing
accounting alternatives (Dardeer 1997) and, consequently, in identifying information that must be
disclosed in financial statements.

Many of the accounting studies that appeared during that period had addressed the relationship
between accounting information and stock prices. These studies have been affected by the
normative approach and adopted a set of assumptions. Examples of these assumptions are as
follows:

Mechanistic Relationship Hypothesis between Accounting Earnings and

Stock Prices
According to this hypothesis, stock markets determine share prices based on accounting earnings
reported in the published financial statements, which represents the out put of financial
accounting system. The mechanistic relationship hypothesis considers financial statements as a
single and monopolistic source of information about a firm’s value. Consequently, management
can mislead the market via using accounting methods that can lead to higher or lower accounting
earnings without any change in the actual cash flows of the firm. Several studies have been
conducted to test the validity of this hypothesis. Results of these studies have rejected the
hypothesis and concluded that the market relies on other sources of information, both within and
outside the firm, in determining the value of shares. Therefore, assuming the possibility of
deceiving or misleading stock markets by changing accounting methods and policies is an
unrealistic assumption (Elsharkawy 1994).

Traditional Functional Fixation Hypothesis

This hypothesis has its roots in the idea of traditional functional fixation in behavioral sciences,
which points out that the person’s use of a specific tool at a specific time prevents the innovation
and discovery of another tool to be used in the future. The traditional functional fixation
hypothesis assumes that the decision maker may reach a biased assessment of the probabilistic
distribution of the firm’s future cash flows due to his reliance on the final figures reported in the

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financial statements, regardless of the method used to reach these figures. According to that
hypothesis, investors in stock markets are unsophisticated. Therefore, they rely on the final
outputs of financial accounting system in determining shares’ value regardless the methods used
in preparing these outputs and regardless the other available sources of information about the
firm. Moreover, investors find it difficult to perceive the extent of the effect of different methods
of accounting followed by several firms for the recognition of the same financial transactions.
Therefore, the investor can not compare between outputs of accounting systems for several firms
or one firm over several years.

Results of studies that focused on testing the validity of the traditional functional fixation
hypothesis were inconsistent. Some studies have supported the validity of this hypothesis. Other
studies have pointed out that the studies which supported the validity of the hypothesis were
experimental (laboratory) studies and that this does not necessarily mean the validity of the
hypothesis if it was to be applied on the stock markets level. Studies that did not support the
hypothesis argued that, at the markets level, the competitive environment, the process of learning,
the quick repetition of decisions, and the impact of rational investors’ decisions will remove any
influence of unsophisticated investor actions in stock markets (Elsharkawy 1994).

Many critics to accounting procedures have emerged at that time and called for homogenizing
these procedures so as not to give the opportunity for management to manipulate accounting
earnings (Aldehrawi 1994). These criticisms have coincided with the criticism leveled at the
normative approach. Therefore, some researchers have attempted to find an approach that can
explain accounting practices and predict accounting and economic effects of accounting
information and reports. As a result, the positive approach appeared, some call it the realistic
approach. The objective of the positive approach is to explain and predict phenomena via the
induction of these phenomena and the knowledge of its reasons and to find a causal relationship
between its dimensions. Hypotheses which can be reached using the positive approach can be
rejected; its robustness can be verified with reference to practice and empirical tests (Dardeer
1997). At the same period the positive approach emerged, the efficient market hypothesis and
development in the field of finance also were developing. The efficient market hypothesis has
had the greatest impact on studies of the relationship between accounting information and stock
prices.

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Efficient Market Hypothesis
The market is described as being efficient if assets’ prices, in that market, fully reflect all the
available information in a way that no one can earn an extra profit as a result of his knowledge of
this information. This is because prices in the market have already reflected this information.
Also, according to the efficient market hypothesis, prices also reflect the available information
correctly and instantaneously as soon as the information is known (White et al. 2003). Once
efficient market hypothesis has emerged, many studies have come out to test the hypothesis.
According to the general result of these studies, stock markets can be divided, according to the
degree of market efficiency, into three forms: weak, semi strong, and strong efficiency markets.
In the weak efficiency markets, one can not realize any additional or abnormal gains via using
investment strategies based on historical stock prices or historical financial data. In the semi
strong efficiency markets, share prices change in an instant and non-biased manner based on
receiving any new available information; thus, one can not obtain unusual or abnormal returns via
trading this information. In the strong efficiency markets price reflects all available information
in the market and no one can obtain unusual or abnormal returns. In the case of strong efficiency
markets, all available information means all new and historical information available to the
public in addition to private or internal information, which may be available to a firm's
management (Aljiziri 1991).

According to efficient market hypothesis, financial statements do not contain a large amount of
information relevant to the assessment of stock prices. As , in that case, there are many other
sources of information that can help financial analysts in predicting stock prices, predicting
economic performance of the firm, and predicating accounting earnings before the disclosure of
financial statements. Stock prices, then, are not determined by individual investor, but are
determined in an environment characterized by the existence of multiple groups of investors
which have different levels of information, experience, wealth, and different assessments of risk
(Elsharkawy 1994).

Some may think that the efficient market hypothesis implies that accounting information has no
usefulness or value in determining stock prices and that at the time that financial statements are
disclosed, this information contained in these statements are already absorbed by the stock
market and are reflected in stock prices. Thus, even if the quality of accounting data is low, the

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stock prices will thoroughly reflect all information. This supports, from their point of view, that
the financial statements have no usefulness to investors in the stock market. The consequences
imposed in the efficient market hypothesis are inconsistent with the assumption that accounting
reports are the only source of information in the stock market. This inconsistency led researchers
to attempt to answer two questions. The first question is whether a change in accounting methods
and the effect of this accounting change on earnings can mislead the stock market? The second
question is whether there is any connection between accounting earnings and stock prices? In
answering these questions, researchers need to have a model that can enable them to explain how
to link accounting earnings to stock prices (Watts and Zimmerman 1986).

Pioneer accounting literature that focused on investigating the relationship between accounting
information and stock prices has emphasized the concept of accounting information usefulness to
investors in the stock market. Therefore, it was necessary to set up a definition of this usefulness.
The definition of accounting information usefulness depends on the definition of information as
defined in information theory where the message (financial report) is considered to be a carrier of
information if it results in a change in the probabilistic distribution of the receiver of this message
with respect to certain random variable (stock prices). This change in the probabilistic
distribution will result in a particular action. If that action (change in share prices or volume) can
be considered due to that information, the information may be considered to be useful (relevant)
(Lev 1989).

In another way, the usefulness of accounting information can be measured by the extent to which
it affects the expectations, decisions, and the ability of this information users to reach good
expectations and decisions (Pankoff and Virgil 1970). That is, accounting information is
considered relevant for investors’ decisions (and therefore useful) if it had the ability to influence
decisions made by these investors when forming forecasts related to certain events or to confirm
or correct earlier forecasts (Shaheer 1993). Studies that deals with the relationship between
accounting information and stock prices, which emerged as a new research trend in the late 1960s
and it continues until the present time, are known as market based accounting research
(Elsharkawy 1994).

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Market Based Accounting Research
Market based accounting research (MBAR) seeks to examine whether financial statements
contain financial information of value or usefulness in determining stock prices, and whether the
market can predict this information before the disclosure of it. Studies that belong to this trend
rely on the efficient market hypothesis. Accordingly, the value of reported accounting
information can be measured by the extent to which share prices are affected by this information.
In general, the relationship between accounting information and stock prices are measured either
by analyzing the level of shares’ performance around the accounting information disclosure or
announcement date (event or announcement study), or via studying the relationship between one
or more accounting variables, on one hand, and stock prices or returns, on the other, over a
certain period of time (association study) (Elsharkawy 1994). Both types of studies can be
classified as value relevant studies.

Types of Value Relevance Studies

As Lev (1989) noted, the question of earnings usefulness is obviously of major importance to
users of financial information as well as to accounting researchers, practitioners, and regulators.
Earnings are widely believed to be the primary information item provided in financial statements.
He also noted that assessing earnings usefulness to investors is as relevant today as it was many
years ago.

Accounting literature has looked at firm's earnings as an accounting measure that stands for the
change in the value of the firm to common equity shareholders during a period (excluding the
effects of direct transactions with shareholders such as paying dividends or issuing shares). On
the other hand, a firm's stock price represents the capital market's measure of a firm's
performance over a period of time. The theory connecting firm's earnings to changes in its market
value depends on three assumptions about information contained in earnings and share prices.
First, the theory assumes that earnings (or more generally, financial reporting) provide
information to equity shareholders about current and expected future profitability. Second, the
theory assumes that current and expected future profitability provides shareholders with
information about the firm's current and expected future dividends. Third, the theory assumes that
share price equals the present value of expected future dividends to the shareholder. These links

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imply that new accounting earnings information that causes a change in investors' expectations
for future dividends should correspond with a change in the market value of the firm. Thus, if
investors find that earnings reported in financial statements reduces their cost to forecast future
earnings, cash flows or otherwise help in valuing the firm, then the information is value relevant
(Nicholas and Wahlen 2004). To test these theories with empirical data, researchers examine the
associations between accounting earnings and share prices to assess the value relevance of
financial reporting.

The primary purpose of conducting tests of value relevance is to provide knowledge regarding
the relevance and reliability of accounting numbers as reflected in equity values. Relevance and
reliability are the two primary criteria the FASB uses for choosing among accounting
alternatives. An accounting amount is said to be relevant if it is capable of making a difference to
financial statement users’ decisions; an accounting amount is said to be reliable if it represents
what it claims to represent (FASB 1984a).

Value relevance is an empirical assessment of these criteria because an accounting amount is

value relevant, i.e., has a predicted significant relation with share prices, only if the amount
reflects information relevant to investors in valuing the firm and is measured reliably enough to
be reflected in share prices. If an accounting amount is able to make a difference in financial
statement user’s decisions, an accounting amount is relevant to that user. Accounting information
can be value relevant but not decision relevant if it is outdated by more timely information (Barth
et al. 2001). Value relevance studies can fall under one of the following types of studies:

Relative Association Studies

Relative association studies compare the association between stock market values (or changes in
values) and alternative bottom line measures. For example, a study might examine whether the
association of an earnings number, calculated under a proposed standard, is more highly
associated with stock market values or returns than earnings calculated under existing GAAP.
These studies usually look for differences in the R 2 of regressions using different accounting
measures of profitability. The accounting number with the greater R 2 is described as being more
value relevant (Holthausen and Watts 2001).

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Relative information content comparisons ask whether one measure provides greater information
content than another. Thus, relative comparisons ask whether the information content of X alone
is greater than, equal to, or less than the information content of Y alone. Questions of relative
information content arise frequently in accounting (Biddle et al. 1995). At the firm level,
questions of relative information content arise when managers make choices among alternative
accounting methods and disclosures for reporting the results of their firms’ operations. For
example, a manager choosing among alternative revenue and expense recognition methods can
take into account their relative information content. Similarly, a manager choosing among
competing disclosure treatments can consider their relative information content. For example,
Sharpe and Walker (1975) examined the movements in share prices of a sample of public
companies which announced upward asset revaluations. The results revealed that announcements
of asset revaluations were associated with substantial upward movements in stock prices. Also
the study found that the stock market anticipated this new information rapidly into stock prices.
Relative information content comparisons also could be useful when evaluating alternative
performance measures for internal evaluation and control. In applications such as these, it may be
useful to assess relative information content for a dependent variable other than stock prices or
returns. For example, a manager may be interested in evaluating the relative usefulness of
alternative performance indicators (Biddle et al. 1995).

Starting with Ball and Brown (1968), many studies use association with stock returns to compare
alternative accounting performance measures like historical cost earnings, current cost earnings,
residual earnings, operating cash flows, and so on. A major motivation for research comparing
alternative performance measures is perceived deficiencies in some of the performance measures
(Kothari 2001). Thus, questions of relative information content arise when investors, lenders, and
other users of financial disclosures face information production, acquisition, or processing costs
and a ranking of accounting measures in terms of information content is desired. As an example
of this kind of studies, Dhaliwal et al. (1999) investigated the claim that income measured on a
comprehensive basis is a better measure of a firm performance than other income measures. The
study tested whether comprehensive income or net income better summarizes a firm’s
performance as reflected in stock returns.

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An investor or analyst may wish to rank alternative information sources or evaluation techniques
in terms of information content so that limited resources can be applied to their best advantage.
For example, Mozes (2002) analyzed the value relevance of fair value disclosure in the context of
a residual income valuation model. The study suggested that when using a residual income
valuation model, unrealized gains and losses on items that are reported in the balance sheet at
market value, such as the translation adjustment on foreign subsidiaries and available for sale
marketable securities, would be related to market values in different ways than unrealized gains
and losses on items that are not reported in the balance sheet at market value, such as financial
instruments.

Relative comparisons could also be used to assess the information content of different levels of
aggregation, such as the relative information content of aggregate earnings versus earnings
components (Biddle et al. 1995). For example Chia et al. (1997) adopted a cross sectional
approach to compare aggregate earnings and disaggregated earnings in terms of their correlations
with stock returns for the purpose of assessing whether disaggregated earnings measures better
reflect the information incorporated in the market price.

Questions of relative information content also arise frequently in international accounting where
accounting methods and disclosure requirements differ among countries and across regulatory
authorities. In this context, a question of interest both to standard setting authorities and to
producers and users of accounting information is which approach provides greater relative
information content (Biddle et al. 1995). In their study, Bartov et al. (2001) expected that
earnings developed in three Anglo-Saxon countries, USA, UK, and Canada, where capital is
traditionally raised in public markets and reporting rules are unencumbered by taxation
requirements, would be superior to cash flows regarding their explanatory power for stock
returns. For two non-Anglo-Saxon countries, Germany and Japan, where capital is traditionally
raised from private sources, they expected the superiority of earnings over cash flows in
explaining stock returns to be less obvious than in the Anglo-Saxon samples.

Incremental Association Studies

Incremental association studies investigate whether the accounting number of interest is helpful
in explaining value or returns given other specified variables. That accounting number is

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considered to be value relevant if its estimated regression coefficient is significantly different
from zero (Holthausen and Watts 2001). The usefulness of the accounting number can be
measured by assessing the increase in the adjusted R 2 resulting from having such number as an
additional explanatory variable in the regression and if the estimated regression coefficient of it is
significantly different from zero. Evidence on the incremental information content of such
accounting number may help evaluating whether a multi-step formulation of earnings is
meaningful (Cheng et al. 1993).

Incremental information content comparisons assess whether one accounting number or set of
numbers provide information content beyond that which is provided by another. Incremental
comparisons assess whether the information content of X and Y together is greater than that of
one variable alone; if so, then the other variable provides incremental information content.
Questions of incremental information content raises frequently in accounting, with two prominent
streams of research examining the incremental information content of supplemental accounting
disclosures, and the incremental information content of financial statement components (Biddle
et al. 1995). As an example, Lipe (1986) examined the relations between components of
accounting earnings and stock returns by testing whether six commonly reported components of
earnings provide additional information that is not contained in the earnings figure. The six
components analyzed were gross profits, general and administrative expense, depreciation
expense, interest expense, income taxes, and other items. The results revealed significant cross-
component variation in the return reactions associated with the unexpected changes in the six
components.

The most common analysis in studies of incremental information content is to examine the
coefficients from a regression of market-adjusted security returns on the unexpected portion of
two or more accounting income variables. A nonzero coefficient on one accounting variable is
interpreted as evidence that the variable has information content that is incremental to the other
variables in the equation. The accounting interpretation of this result in terms of the composition
or disclosure of income depends on the other independent variables included in the estimated
relation. Therefore, the interpretation of results beyond a statistical statement that one variable
has information content incremental to another depends on the specification of the regression
equation that is estimated (Jennings 1990). As an example of incremental information content,

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Wilson (1986) found that the cash and total accruals components of earnings have incremental
information content beyond earnings themselves and that the total accruals components of
earnings has incremental information content beyond the cash components. In addition, there was
evidence that either non-current accruals do not have incremental information content beyond
working capital from operations or that they are known prior to earnings announcement.

Event Studies

Event studies investigate whether a particular accounting number adds to the information set
available to investors. These studies use event studies to determine if the release of an accounting
number is associated with value changes. In that case, price reactions are considered evidence of
value relevance (Holthausen and Watts 2001). In an event study, the researcher infers whether an
event, such as earnings announcement, conveys new information to market participants as
reflected in changes in the level or variability of security prices or trading volume over a short
period of time around the event. If the level or variability of prices around the event date changes
significantly, then the conclusion is that the accounting event conveys new information about the
amount, timing, and/or uncertainty of future cash flows that revised the market’s previous
expectations. The hypothesis in an event study is that capital markets are efficient in the sense
that security prices are quick to reflect the newly arrived information (Kothari 2001).

As an example of event studies, Stice (1991) addressed the question of whether the price and
volume reactions to these earnings announcements occur at the Securities and Exchange
Commission filing date or at the subsequent Wall Street Journal announcement date.

Methodological Issues Related to Event Studies

Different research designs were used in conducting value relevance researches. A wide range of
return variables, earnings variables, additional independent variables, and returns windows were
used by researchers in their attempts to asses the value relevance of financial information.

The issue of the window (time interval) over which returns are cumulated is an important one.
Regression of returns cumulated over a narrow window around announcements of earnings might
understate the usefulness of earnings, if the narrow window fails to capture earnings induced
price revisions beyond the windows (for example, a delayed investor reaction after

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announcement, post announcement drifts). Regressions using wide windows, on the other hand,
might overstate the incremental information contribution of earnings, as price changes within the
window probably reflects investors' reaction to a lot of other timely, non-earnings information
(for example, industry-wide events or stock splits and repurchases) which are correlated with
earnings. Return windows of practically all possible sizes were used in the returns/earnings
research. Narrowing the return window does not increase R 2 above the 2-5% level. Even when
researchers considered wider windows, such as a year, the resulting increase in R 2 was very
modest (Lev 1989). Studies that regressed returns on the levels of earnings does not show R 2
that is significantly different from the earnings information contribution indicated by studies
based on unexpected earnings. Also, the results do not indicate a dominance of any financial ratio
in terms of R 2 (Lev 1989).

The major conclusion of reviewing returns/earnings research is that financial reports provide new
and relevant information to investors (Healy and Palepu 2001) but the correlation between
earnings and stock returns is very low and the parameters of the returns/earnings relation
exhibited considerable instability over time (Lev 1989). Lev (1989) noted that earnings might be
very useful to investors but the methodologies used by researchers fail to confirm this. Many
methodological deficiencies were referred to (for example, the relationship between returns and
earnings seems to be nonlinear; the response coefficient is obviously not constant across firms or
over time; estimates of expected earnings used to derive the earnings innovation contain errors,
etc.).

Another possible reason for the observed low explanatory power of earnings is investor
irrationality (market inefficiency). The association between stock returns and value relevant
information, such as earnings, will clearly be low if investors make a mistake in information
interpretation or if they overreact to or ignore relevant information. A third possible explanation
for the weak returns/earnings relation, is the arbitrariness of many accounting measurement and
valuation techniques which may be accompanied by frequent earnings manipulation by managers
(Lev 1989). Kothari (2001) also stated that noise in earnings and transitory earnings could
explain the observed low magnitudes of earnings response coefficients.

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