A CAVEAT ABOUT THE “BEST” ACCOUNTING POLICY

To this point, we have argued that accountants can be guided by securities market
reaction in determining usefulness of financial accounting information. From this, it is
tempting to conclude that the best accounting policy is the one that produces the greatest
market price response. For example, if net income reported under current value accounting
produces a greater market reaction than net income reported under conservative accounting,
should current value accounting not be preferred? To some extent, the answer is yes, since, as
we have seen in this chapter, security market response is a measure of usefulness to investors
However, we must be extremely careful about this conclusion. Accountants may be
better off to the extent that they provide useful information to investors, but it does not follow
that society will necessarily be better off.
The reason is that information has characteristics of a public good . A public good is a
good such that consumption by one person does not destroy it for use by another.
Consumption of a private good —such as an apple—eliminates its usefulness for other
consumers. However, an investor can use the information in an annual report without
eliminating its usefulness to other investors. Consequently, suppliers of public goods may
have trouble charging for these products, so that we often witness them being supplied by
governmental or quasi-governmental agencies—roads and national defence, for example. If a
firm tried to charge investors for its annual report, it would probably not attract many
customers, because a single annual report, once produced, could be downloaded to many
users. Instead, we observe governments through securities legislation and corporations acts,
requiring firms to issue annual reports.
Of course, firms’ annual reports are not “free.” Production of annual reports is costly.
Other, more significant, costs include the possible disclosure of valuable information to
competitors and the possibility that managers’ operating decisions will be affected by the
amount of information about those decisions that has to be released. For example, managers
may curtail plans for expansion if too much information about them has to be disclosed.
Investors will eventually pay for these costs through higher product prices and/ or lower share
prices. Nevertheless, investors perceive annual reports as free, since the extent to which they
use them will not affect the product prices they pay. Also, investors may incur costs to inform
themselves, either directly by paying to receive the information as soon as possible, or
indirectly by paying for analyst or other information services. Nevertheless, the basic “raw
material” is perceived as free, and investors will do what any other rational consumer will do
when prices are low—consume more of it. As a result, investors may perceive accounting
information as useful even though from society’s standpoint the costs of this information
outweigh the benefits to investors .
Also, as mentioned in Chapter 1 , information affects different people differently. Thus,
information may be useful to potential investors and competitors, but managers and current
shareholders may be harmed by supplying it. As a result, the social value of such information
depends both on the benefits to potential investors and competitors and on the costs to
managers and shareholders. Such cost–benefit tradeoffs are extremely difficult to make.
Think of information as a commodity, demanded by investors and supplied by firms
through accountants. Because of the public-good aspect of information, we cannot rely on the
forces of demand and supply to produce the socially “right” or first-best amount of
production, as we can for private goods produced under competition. The essential reason is
that the price system does not, and probably cannot, operate to charge investors the full costs
of the information they use. Consequently, from a social perspective, we cannot rely on the
extent of security market response to tell us which accounting policies should be used (or,
equivalently, “how much” information to produce). Formal arguments to support this
conclusion were given by Gonedes and Dopuch (1974).
The 2007–2008 market meltdowns provide a dramatic illustration of the broader social
effects of accounting information. Following the meltdowns, arguments appeared that fair
value accounting is pro-cyclical; that is, it increases the magnitude of booms and busts. The
argument is that, in good times, fair value accounting inflates earnings. Then, firms are
encouraged to expand, and banks (whose earnings are also inflated) are encouraged to lend to
support this expansion. An economic boom results. However, when the boom collapses, as it
did in 2007–2008, liquidity pricing can result ( Section 1.3 ), in which case the fair values of
financial assets fall below their value in use. Then, banks’ legal capital is threatened, they
stop lending, and the economy falls into recession. By concentrating on providing useful fair
value information to investors, standard setters were vulnerable to charges that they ignored
these broader social effects. We will return to the question of regulation of information
production in Chapters 12 and 13 . For now, the point to realize is that it is still true that
accountants can be guided by market response to maintain and improve their competitive
position as suppliers to the marketplace for information. It is also true that securities markets
will work better to the extent that security prices provide good indications of underlying real
investment opportunities. However, these social considerations do suggest that, as a general
rule, accounting standard-setting bodies should be wary of using the securities market
response as a sole guide for their decisions.
THE VALUE RELEVANCE OF OTHER FINANCIAL STATEMENT INFORMATION
In this section, we depart from our concentration on the information content of net
income in order to consider the informativeness of other financial statement components,
such as the balance sheet and supplementary information.
Overall, it has been difficult to find direct evidence of usefulness of other financial
statement information, unlike the impressive evidence of market reaction to earnings
described earlier. For example, the value relevance of RRA ( Section 2.4 ) has received
considerable research attention. Despite its relevance, studies by Magliolo (1986) and Doran,
Collins, and Dhaliwal (1988) were unable to find more than a weak market reaction to RRA,
although Boone (2002) reported a stronger market reaction to RRA information than to
historical cost-based information, and argued that the relatively weak reaction reported by
earlier researchers is due to statistical problems in their methodology.
Low reliability is one possible explanation for these mixed results. Another possibility
is that RRA is pre-empted by more timely sources of reserves information, such as
announcements of discoveries, and analyst forecasts. Also, the point in time that the market
first becomes aware of the RRA information is often unclear. For net income, media or
conference call reporting of the earnings announcement provides a reasonable event date.
However, given the inside nature of oil and gas reserves information and its importance to
firm value, analysts and others may work particularly hard to ferret it out in advance of the
annual report. If a reasonable event date for the release of other financial statement
information cannot be found, return studies must use wide windows, which are open to a
large number of influences on price in addition to accounting information.
However, there is an indirect approach to finding evidence of usefulness that links other
information to the quality of earnings. To illustrate, suppose that an oil company reports high
earnings this year, but supplemental RRA information in the financial statement notes shows
that its reserves have declined substantially over the year. An interpretation of this
information is that the firm has used up its reserves to increase sales in the short run. If so, the
quality of current earnings is reduced, since they contain a nonpersistent component that will
dissipate if new reserves are not found. Then, the market’s anticipation of the bad news in the
RRA information may be more easily found in a low ERC than in a direct reaction to the
reserve information itself. Conversely, a higher ERC would be expected if reserves had
increased.
This approach was generalized by Lev and Thiagarajan (LT; 1993). They identified 12
“fundamentals” used by financial analysts in evaluating earnings quality. For example, one
fundamental was the change in inventories, relative to sales. If inventories increase, this may
suggest a decline in earnings quality—the firm may be entering a period of low sales, or
simply be managing its inventories less effectively. Other fundamentals include change in
capital expenditures, order backlog, and, in the case of an oil and gas company, the change in
its reserves.
For each firm in their sample, LT calculated a measure of earnings quality by assigning
a score of 1 or 0 to each of that firm’s 12 fundamentals, then adding the scores. For example,
for inventories, a 1 is assigned if that firm’s inventories, relative to sales, are down for the
year, suggesting higher inventory turnover and earnings quality, and a 0 score is assigned if
inventories are up.
When LT added these fundamental scores as an additional explanatory variable in an
ERC regression analysis, there was a substantial increase in ability to explain abnormal
security returns beyond the explanatory power of current unexpected earnings alone. This
suggests that anticipation of balance sheet information, and supplementary information in
financial statement notes, shows up in the ERC.
More recently, DeFranco, Wong, and Zhou (2011) conducted a more direct test of the
value relevance of information in notes to the financial statements. They examined a sample
of large U.S. firms over the period 2002–2007, and reported that share prices responded to
financial statement note information in a seven-day narrow window surrounding the firms’
10K reports filed with the SEC (the earliest date on which information in the notes becomes
available to the market). Examples of information in the notes include RRA, lease liabilities,
underfunded pension costs, off balance sheet securitizations, and improved ability to estimate
earnings persistence. Response to this information was after controlling for other information
that may also affect share price such as earnings announcements, tone of MD&A ( Section
3.6.4 ), and analyst forecasts.
The authors suggest that this share response is driven by sophisticated investors, such
as financial analysts. Consistent with this suggestion, they reported that the greater the
additional information in the notes is relative to the information in net income, the more
likely analysts are to issue revised target share prices and the larger these revisions are.
Overall, it seems that note information is decision useful to investors and that analyst forecast
revisions are a vehicle whereby note information becomes incorporated into share prices.
CONCLUSIONS ON VALUE RELEVANCE
The empirical literature in financial accounting is vast, and we have looked only at
certain parts of it. Nevertheless, we have seen that, for the most part, the securities market
response to reported net income is impressive in terms of its sophistication. Empirical
research in this area generally supports the efficient markets theory and underlying decision
theories.
However, accountants must ensure that unusual, non-recurring items are fully
disclosed, either in the financial statements proper or the notes. Otherwise, investors may
overestimate the persistence of current reported earnings.
Until relatively recently, it has been difficult to find evidence of market response to
other financial statement information as strong as to earnings information. The extent to
which the lack of strong market response to this other information is due to research
methodology difficulties, to low reliability, to availability of alternative information sources,
or to failure of efficient markets theory itself is not fully understood, although it may be that
investors anticipate balance sheet and supplementary information to finetune the ERC, rather
than using such information directly, and/or are guided by more sophisticated investors, such
as financial analysts. To maximize their competitive position as suppliers of information,
accountants may use the extent of security market response to various types of accounting
information as a guide to its usefulness to investors. This motivates their interest in empirical
research on decision usefulness. Furthermore, the more information accountants can move
from inside to outside the firm, the better can capital markets guide the flow of scarce
investment funds.
Despite these considerations, accountants must be careful of concluding that the
accounting policies and disclosures that produce the greatest market response are the best for
society. This is due to the public-good nature of accounting information. Investors will not
necessarily demand the “right” amount of information, since they do not bear its full costs.
These concerns limit the ability of decision usefulness research to guide accounting standard
setters.
Much of the research described in this chapter has been oriented to financial statement
information containing a significant historical cost component. While finding value relevance
in historical cost-based earnings is encouraging, standard setters have moved increasingly to
current value accounting-based financial statements, which have potential to capture more of
the information affecting firm value that becomes available during the year. Historical cost-
based financial statements capture this information only with a lag. Presumably, standard
setters feel that current value accounting will further increase value relevance. In the next
chapter, we explore possible reasons for this move.