USEFULNESS OF ACCOUNTING INFORMATION TO

INVESTORS AND CREDITORS

In chapter 4, we suggested that an explicit political economy of accounting recognizes that

alternative financial reporting systems (for example regulated versus unregulated) have both

private and social consequences, that in any system some people will fare better while others

fare worse, and that the choice of system itself is a political as well as an economic act.

Consistent with this, the FASB appears to recognize 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 commonality 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 considerations are

confined only to producers.

We don’t believe that the FASB’s focus on producers and the primary user group of

investors and creditors fully represents the political economy of accounting. However, 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. The

chapter concludes with a brief assessment of the usefulness of accounting allocations.

ACCOUNTING DATA AND MODELS OF FIRM VALUATION

Gordon’s dividend valuation model is a useful starting point in understanding 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 future expected dividens to be received ;by

stockholders. Beaver uses the dividend valuation model to formulate the role of accounting

earnings in determining firm value. First, present security prices are defined as a function of

expected future dividens. Second, future dividends themselves are a function of future

earnings. Finally, current accounting income is useful in predicting future earnings; therefore,

current income is informative vis-à-vis its predictive ability with respect to future earnings

(and ultimately future dividends). So, in this formulation, 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

information.

More recent work in financial economics regarding the theoretical value of the firms

traces back to Miller and Modigliani’s seminal work in which they argue that dividend policy

is irrelevant to firm valuation. Ignoring the complicating effect of taxes, they show that the

value of the firm can be equivalently modeled (independent of dividens) as the present 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-present 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 accounting 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.

Interestingly, the FASB has also adopted (implicity) the cash flow valuation model. In

SFAC No.1, the role of financial reporting is characterized 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 system, and accrual

income numbers in particular are more useful for this purpose than are simpler cash-based

systems:

….accrual accounting generally provides a better indication of an enterprise’s

present and continuing ability to generate favocable 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 documented that changes in

reported accounting earnings affect firm valuation through changes in stock prices. Changes

in current period earnings should affect stock prices and the market’s valuation of the firm if

investors 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 function of the expected persistensy of earnings changes.

The implications of this theoretical literature is that accrual accounting 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 theoretical formulation of how accounting information impacts

upon assessments of future cash flows appears in appendix 8-A.

THE VALUE OF ACCOUNTING INFORMATION FOR INVESTORS

As mentioned above, the usefulness of accounting information to investors 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 valuation.

These studies also constitute tests of the so-called efficient-markets hypothesis.

The efficient-markets hypothesis (EMH) refers to 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, market prices react instantaneously to new information. 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 accounting 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 remaining

portfolio risk is called systematic (undiversifiable) risk. In portfolio theory, systematic risk

is defined as the variance of expected investment 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 lof

individual securities are offset when combined in a portfolio. In this way, it is possible 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 nondifersifiableor 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 curvilinear, a direct relationship exists

between the level of risk and expected returns.

Portfolio theory is the foundation for a related development in finance-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 used to fit a line to the scattergram.

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 1, the returns on the individual stock are greater than the market. In otherwords, 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 returns. Higher returns must be accompanied by higher risks.

The assumption of 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 unsystematic risk. Beta is used to represent systematic risk of individual

securities 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

Unexpected returns or abnormal returns for any time period are captured in the error term

e j in Equation (8.3). A common research approach 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 accounting information.

Before reviewing the empirical findings, we should make a few observations

regarding the difficulties of doing this type of research. The study of price movements and

the pricing mechanism in any market is an imposing task. Determining cause and effect

between information and security prices is especially difficult because new information is

continuously causing price movements. Since the set of information affecting security prices

is large, it is extremely difficult to isolate the effects of one piece of information. This

difficulty means that the tests are going to be somewhat crude rather than precise. The

research should be examined with this in mind. Failure to find evidence of information

content should thus be interpreted cautiously, for the methodology is not always capable of

detecting information content. For this reason, the stronger evidence from efficient-markets

research exists where there is information content rather than where there is none.

Another weakness of capital market research is that it is a joint test of both market

efficiency and 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

inefficient, there is no way of determining what the absence of a price response means. This

is another reason why the research findings are much stronger when there is evidence of

information content.

A final point is that market-based research necessarily considers only the aggregate

effect of individual investor decision making. That is, the role of accounting information vis-

à-vis an individual investor’s decision making is implicitly modeled as a black box : an

“event”, the reporting of accounting information, occurs, and the effect of this event is then

inferred from whether or not there was an aggregate (market) reaction. As an alternative ,

Appendix 8-A presents an investor decision model that explicity 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 information content of

annual accounting earnings numbers. The seminal study, published in 1968, showed that the

direction of change in reported accounting earnings (from the prior year) was positively

correlated with security price movements. The study also found that the price movements

anticipated the earnings results and that there was virtually no abnormal price movement one

month after the earnings were announced. This is consistent with the semistrong form of the

efficient-markets hypothesis. A later study showed that the magnitude as well as direction of

unexpected earnings are associated with changes in security prices. Quarterly earnings

announcements have also shown the same general results.

These results are not surprising. We would expect accounting income to be part of the

information used by investors in assessing risk and return. 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 usefulness to

investors.

ALTERNATIVE ACCOUNTING POLICIES AND SECURITY PRICES

A more complex type of securities-price research has examined the effect of alternative

accounting policies on security prices. The initial purpose of these tests was to investigate the

so-called naïve-investor hypothesis. Research has found that security prices respond to

accounting income numbers. Alternative accounting policies-for example, flexibility in the

choice of depreciation and inventory methods-can affect net income. Although these methods

affect reported earnings, there is no apparent impact on company cash flows. These types of

accounting alternatives simply represent different patterns of expense recognition or cost

allocations.

The questions of interest to researches is whether alternative accounting policies have

a systematic effect on security prices. If security prices do respond to income levels that

differ solely because of alternative accounting methods, with no cash flow consequences,

then there is support for the naïve-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 naïve-investor

hypothesis. However, recent research findings have challenged some of the earlier

conclusions and reopened what was once considered a closed issue in accounting research.

ALTERNATIVES WITH NO KNOWN CASH FLOWS CONSEQUENCES

Several studies have compared companies using different accounting methods. One of the

earliest studies compared companies using accelerated versus straight-line depreciation

methods. The two groups of companies had different accounting income numbers because

they used alternative depreciation methods; thus there were differences in income between

the two groups of companies due to the use of alternative depreciation accounting methods.

There were also differences in price-earnings multiples between the two groups. Companies

using accelerated methods had lower earnings but higher price-earnings multiples than

companies using straight-line. However, when earnings of companies using accelerated

methods were adjusted to a straight-line depreciation basis, the price-earnings multiple

between the two groups of companies was not significantly different.

The assessments of the companies in the market did not appear to be affected by

arbitrary and alternative accounting income numbers. This finding is often expressed as the

market is not “fooled” by arbitrary accounting differences. Other similar research has

supported this conclusions. Additional areas tested include purchase versus pooling

accounting, expensing versus capitalizing research and development costs, and recognition

versus deferral of unrealized holding gains on marketable securities.

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

in accounting policy by a company. Changes in depreciation policy have been researched,

and there is no evidence that the change per se affects security prices. Another area tested has

been a change from the deferral to flow-through method of accounting for the investment

credit. Again, no prices 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 accounting policy changes, at least

where there are no apparent underlying changes in cash flows. This finding has also been

interpreted as a rejection of the naïve-investor hypothesis. Investors appear to adjust

accounting income to compensate for artificial bookkeeping differences with no real

substance. That is, investors do not appear to respond mechanistically and naively to changes

in reported accounting income numbers.

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. 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 purposes if the tax benefit is desired. In a period of rising prices, tax

expense 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 responses 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.

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 earlier 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 confounded the results and may have caused

the positive price response). But if these studies are correct, then there may be some support

for the naïve-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 income, a negative price response could be

interpreted as a mechanistic response to a lower accounting number, a response made without

considering the positive cash flow cosequences due to lower taxes.

As discussed at the beginning of this section, security-price research is extremely

difficult to conduct. The LIFO choice issue amply illustrates this point. The early LIFO

research rejected the naïve-investor hypothesis. Later research on the LIFO question

reopened what was once thought to be a closed issue with respect to market efficiency.

ALTERNATIVES WITH INDIRECT CASH CONSEQUENCES-AGENCY THERY

Recent security-price research has been probing a more subtle issue referred to as indirect

consequences. An indirect consequence occurs when an accounting policy change affects the

value of the firm through an indirect effects on owners, rather than a direct effect on company

cas flows. One such study was motivated by an attempt to explain why securities prices of

certain oil and gas companies responded negatively to a mandatory change in accounting

policy. The required change from full costing to successful efforts was regarded as simply a

change in how exploration costs are allocated to the income statement. Therefore, it was

expected that no security-price response would be evident since there was no direct cash flow

consequences to the companies.

However, security-price responses were found to exist and since previous research

had predominantly rejected the naïve-investor hypothesis, a search was made for the

existence of some indirect cash flow consequences to explain the price response. The study

posited that a change to successful-efforts accounting for oil and gas exploration costs

lowered firms’ ability to pay dividends in the short term, because of restrictive debt

covenants. Therefore, even though the change in accounting policy appeared to affect only

book income on the surface, there were indirect cash flow consequences to investors, which

might explain the negative price response. This explanation derives from agency theory.

When accounting numbers are used to monitor agency contracts, there can be indirect

consequences on the firm’s owner 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 bondholders at the expense of stockholders. If an accounting policy change

lowers accounting income (as could occur in a mandatory change to successful 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. Differences between purchase and pooling accounting appear on the

surface to affect only book income with no real cash effects. However, the reduced use of

pooling accounting 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. Another research study along these lines examined the requirement

to capitalize leases that had previously been reported as operating leases. There was some

evidence of negative price responses for certain companies; 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 semistrong form of the efficient-markets hypothesis.

Ou and Penman, in a very extensive study, invoked the idea of fundamental stock

analysis. Fundamental analysis assumes that securities markets are inefficient and that

underpriced shares can be found by means of financial statement analysis. This view is

directly opposed to the efficient-markets view that prices of securities 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 twenty accounting

measures, and approximately 23.000 observations were made. Ou and Penman were able to

describe the following year earnings changes correctly almost 80 percent of the time. 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 return if investmet were based on the earnings

predictions of their model. Their analysis indicates that this is exactly what would have

occurred. 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. 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 implies 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 earnings numbers and stock returns has been exceedingly

low. Earnings, in other words, have very little explanatory power (as measured by R, te

coefficient of correlation) relative to changes in stock prices. Lev believes that one of the

principal reasons for this situation lies with the low quality of reported income numbers:

Research on the quality of earnings shifts the focus to an explicit consideration of

accounting issues by calling for a systematic examination of the extent to which the

specific principles underlying accounting measurements and valuations, as well as

managerialmanipulations, detract from the usefulness of earnings and other financial

variables. Such research has the potential both to further our understanding of the

role of financial information in asset valuation and to contribute meaningfully to

accounting policymaking.

Thus the Lev and Ou and Penman papers are complementary because one finds a low

explanatory relationship between earnings and stock returns while the other sees a predictive

role for accounting data in a market that may be less efficient than previously thought. One

article (Lev’s) looks directly at the issue of mimlproving accounting measurements while the

other may certainly be said to imply this point.

ACCOUNTING INFORMATION AND RISK ASSESSMENT

Capital market research has also investigated the usefulness of accounting numbers for

assessing the risk of securities and portfolios. These studies have found high correlations

between the variability of accounting earnings and beta, the market-risk measure. The high

correlations 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. There was no

significant impact. From this evidence, it might be concluded that pension information is not

useful for risk assessments. However, other studies found that supplemental segment (line of

business) disclosures resulted in a revision of systematic risk, which suggests that such

information is useful for risk assessments.

Other studies have tested the association of financial ratios with beta. Some of the

ratios and computations tested include dividend payout ratio, leverage, growth rates, asset

size, liquidity, and pretax interest coverage, as well as earnings and earnings variability. In

general, these tests indicate a strong association between the accounting-based ratios and the

market measure of risk, beta.

SUMMARY OF ACPITAL MARKET RESEARCH

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

1. Accounting earnings appear to have information content and to affect 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 measures, suggesting that

accounting numbers are useful for risk assessment.

In the early 1970’s, some argued that capital market research could be used as a basis for (1)

choosing the best accounting policies and (2) evaluating the economic consequences of

alternative accounting policies on security prices. 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 resolve the normative accounting theory

debate about the most desirable form of accounting. However, the early advocates of

security-prices research now recognize the limitations of this research for such a use. 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 questions, capital

market research continues to be useful in empirically evaluating economic consequences of

accounting policies vis-à-vis security prices and the usefulness of accounting numbers for

risk-and-return assessments. Perhaps more than anything else, though, the impact of capital

market research is that it brought a different perspective to accounting theory and policy at a

time when the emphasis, was primarily on deductively based theory.

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. Approximately one-half of the investors surveyed indicated they read financial

satatements. Institutional investors have shown a much higher level of readership. These

surveys , particularly of individual investors, should be interpreted cautiously, however.

Individual investors may rely on investment analysts to process accounting information. It

would be simplistic to assume accounting information has no usefulness to investors merely

because many individual 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 accounting information. Several studies

of this type have been reported. Accounting information ranks fairly high in importance in

these surveys, though not at the top. This status seems to be attributable to the historical

nature of accounting information and the reporting-lag effect. More timely accounting

information from company press reports, and nonaccounting 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 (measured 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). Conceptually, this approach, which is reffered to as cross-sectional valuation,

attempts to empirically estimate the theoretical model of equity valuation described at the

beginning 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/expense

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 methods/valuations.

Several studies have used this framework to determine that a firm’s pension plan

assets and liabilities (as reported off-balance sheet in footnote disclosures) are consistent with

their being viewed as real (i.e, on-balance sheet) assets and liabilities, respectively. Another

study determined that clomponents of pension expense (per SFAS No.87) are not weighted

equally in terms of their association with market valuation. Of particular interest is that the

transitional asset amortization component of pension expense 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)

expendictures with firm value. The major finding was that, on average, each dollar of R&D

was associated with a five-dollar increase in market value. This result provides evidence that

the market is implicity capitalizing R&D outlays even though SFAS No.2 prohibits explicit

capitalization. In other words, the market interprets R&D as an asset (investment) rather than

an expense, contrary to the accounting treatment required by SFAS No.2.

The financial services industry is another area in which cross-sectional valuation

models have been used.studies have examined supplemental disclosures of nonperforming

loans (default risk) and interest rate risk in banks and thrifts. Nonperforming loans are

negatively associated with firm value, though this effect is greater for banks than for thrifts.

Interest rate risk was negatively 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 principles 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 between owners and managers, monitoring or control of managers

occurs via mechanisms such as boards of directors and independent audits. In addition,

companies have voluntary incentives to signal to outsiders (potential investors and creditors)

that the financial statements are reliable. Thus, independent audits also serve the role of

enhancing outside credibility of financial statements, in addition to the control function

within the firm of monitoring managers.

How do audits enhance financial statement reliability? A recent comprehensive study

drew on a large sample of actual auditor workpapers to determine dollar amounts of

adjustments to financial statements required by auditors. These adjustments represented the

auditor’s correction for material misstatements in the financial statements. Assuming a

standard rule-of-thumb of 5 percent materiality level (i.e, 5 percent of net income or total

assets), the study estimated that unaudited net income 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

percent 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 deterrence effect of

knowing the financial statements will be audited.

Another study found that subsequent period quarterly earnings announcement

following the issuance of a qualified audit report, on average, led a lower stock price

response than for companies having unqualified audit reports. In other words, following the

issuance of a qualified audit report, investors are more skeptical of earnings announcements,

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 Six

auditors with companies that are audited by other auditors. There is evidence that Big Six

audted 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 announcementsby Big Six audited companies have more credibility.

Specifically, unexpected earnings are associated with a larger stock price response when the

auditor is a Big Six firm.

ACCOUNTING DATA AND CREDITORS

Theories underlying the usefulness of accounting information to creditors is 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, US.Treasury obligations). Thus, firm-specific information, 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 ond ratings wherein such ratings are presumed to proxy for default risk;

(3) the association of accounting data with estimates of interest-rate risk premiums 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 between firms that

subsequently went bankrupt and those that did not. Predictability up to five years prior to

bankruptcy has been demonstrated. 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-rate risk

premiums. Among the important ratios are profitability, earnings 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-adusted income, the effect of

lease capitalization versus noncapitalization, and recognition of pension liabilities versus

footnote-only disclosure.

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 affects their hypothetical decisions. In these experiments, the accounting data are

manipulated to see if the judgements are sensitive to whatever manipulations take place; for

example, magnitudes of accounting ratios or financial statements prepared under alternative

policies (for example, lease capitalization versus noncapitalization). Generally, these studies

support the sensitivity of loan-related decision making to key accounting data and, in this

sense, complement the findings based on economic field data.

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

revenue. 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. Allocations have been criticized on the grounds that

they are “incorrigible”. 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 that straight-line depreciationis 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. Conceptually, this is a very disturbing idea and strikes at

the logical core of historical cost accounting. Because of the arbitrariness of accounting

allocations, allocation-free financial staatements 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 replacement cost systems.

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. Usefulness 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 accounting 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 security prices, which supports the argument that allocations

are arbitrary and convey no information to users. However, the research findings also support

the factthat investors are not naïve 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 investors 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 accounting 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.

A policy implication of allocation research is that the FASB should not try to resolve

problems by searching for the best allocation. On the other hand, the FASB should not

necessarily avoid allocations. They may be the most cost-effective means of producing

financial statements. Another implication is that the FASB should reduce flexibility in

accounting allocations. Given the evidence from capital market research, there is no

compellingreason to permit arbitrary flexibility. Rigid uniformity would be easier to apply

and would eliminate some arbitrary differences between companies. It will be recalled that

security prices adjust for such arbitrary differences in accounting allocations. In the case of

accounting allocations with no real cash flow consequences a strong argument exists for rigid

uniformity .