Perspectives On Recent Capital Market Research

Perspectives on Recent Capital Market Research
Author(s): William H. Beaver

Reviewed work(s):
Source: The Accounting Review, Vol. 77, No. 2 (Apr., 2002), pp. 453-474
Published by: American Accounting Association
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THE ACCOUNTING REVIEW
Vol. 77, No. 2
April 2002
pp. 453-474
Perspectives on Recen t Capital
Market Research
William H. Beaver
Stan ford Un iversity
I. INTRODUCTION
T | ahe purpose
of
my
remarks is to
provide
on e
perspective
on
major
areas of
capital
markets research that have made importan t con tribution s to our un derstan din g of
accoun tin g n umbers, with an emphasis on those published durin g the past ten years.
I do n ot in ten d these remarks to be a survey;1 in stead, I select the five research areas I
believe have made the greatest con tribution to our kn owledge over the past ten years. These
areas illustrate the degree to which capital market research has become in tercon n ected. My
remarks address why these areas are importan t, briefly summarize what we have learn ed,
highlight some of the lin ks between these areas, an d raise some un resolved issues. Within
each area, I iden tify major issues an d some of the key papers, but I do n ot attempt to be
comprehen sive. In the process, I have sacrificed depth for breadth.
The five areas I have selected are market efficien cy, Feltham-Ohlson modelin g, value
relevan ce, an alysts' behavior, an d discretion ary behavior. The first two areas, market effi-
cien cy an d Feltham-Ohlson modelin g, are basic platforms that permit us to organ ize our
thin kin g about the role of accoun tin g in capital markets. The last three areas are application s
that in corporate some form of accoun tin g structure or in dividual behavior.
II. MARKET EFFICIENCY
Market efficien cy is, of course, an importan t field of study. Much of the regulation of
fin an cial reportin g is premised on the n otion that on ce firms make accoun tin g data publicly
available, the implication s will be widely appreciated an d reflected in security prices. If the
market is in efficien t, then fin an cial reportin g an d disclosure are n ot as effective, at least
with respect to prices fully reflectin g that in formation . Question s for regulators then arise
as to whether alterin g the presen tation of the data could mitigate this deficien cy.
If in vestors trade in an efficien t market, then they can rely on prices reflectin g a rich
set of the total mix of in formation , in cludin g fin an cial statemen t in formation , an d they n eed
1
Kothari (2001) provides an excellen t recen t survey of capital markets research.
Editor's Note: TheExecutive Committee of theAmerican Accoun tin g Association has recommen ded thecommis-
sion of a series of Presiden tial Research Lectures, to be delivered at an n ual meetin gs of the Association . To
en couragebroad dissemin ation , theCommitteehas requested that TheAccoun tin g Review publish this lecturegiven
at the 2001 American Accoun tin g Association An n ual Meetin g in Atlan ta, GA.
Author's Note: I am pleased an d hon ored to be the third Presiden tial Lecturer, followin g two distin guished col-
leagues, Shyam Sun der two years ago an d Bill Kin n ey last year. I than k Mary Barth, Wayn eLan dsman , Maureen
McNichols, an d Stephen Ryan for man y helpful suggestion s on earlier drafts of this paper.
453
454 The Accoun tin g Review, April 2002
n ot process all of that in formation directly. In other words, in vestors become in direct ben -
eficiaries of that in formation , even if they do n ot literally process it themselves. Efficien t
capital markets also have implication s for resource allocation an d production efficien cy, so
it is n ot surprisin g that market efficien cy was on e of the earliest areas studied.
Market efficien cy is also of in terest to researchers because, if they can assume market
efficien cy in the research design , then researchers can draw a differen t (an d poten tially
more powerful) set of in feren ces. Assumption s about market efficien cy affect the research-
ers' choice of the len gth of the win dow over which to compute abn ormal return s in an
even t study. Market efficien cy also affects the in terpretation s the researcher places on ob-
served association s between security prices an d accoun tin g n umbers.
There was a time when we thought that the issue of market efficien cy with respect to
publicly available data was "resolved." Early capital markets studies largely supported
market efficien cy. Both Ball an d Brown (1968) an d Beaver (1968) examin ed the post-
an n oun cemen t behavior of security return s an d ten tatively con cluded that market efficien cy
was a reason able approximation of the empirical results. Early studies examin ed chan ges
in accoun tin g methods (Archibald 1972; Ball 1972) an d reached similar con clusion s. Re-
searchers also examin ed differen ces in accoun tin g methods (e.g., Beaver an d Dukes 1973)
an d con cluded that the market prices behaved in a man n er con sisten t with market efficien cy.
Recen t studies have reexamin ed market efficien cy, an d several have con cluded that
capital markets are in efficien t with respect to at least three areas: post-earn in gs an n oun ce-
men t drift, market-to-book ratios an d its refin emen ts, an d con textual accoun tin g issues.
Post-Earn in gs An n oun cemen t Drift
Post-earn in gs an n oun cemen t drift was on e of the first areas to suggest that markets
may n ot be efficien t with respect to accoun tin g data. Several studies (Foster et al. 1984,
amon g others) foun d eviden ce of post-earn in gs an n oun cemen t drift in spite of attempts to
con trol for at least some of the con foun din g factors. On e reason for the fin din g of post-
an n oun cemen t drift is that the availability of daily return data en han ces the power of the
tests relative to prior research that used on ly weekly or mon thly return data. The post-
an n oun cemen t drift studies culmin ated in Bern ard an d Thomas's (1989, 1990) research,
which is an econ ometric tour de force. Their studies represen t a classic example of excellen t
research design . The studies ten aciously pursue competin g explan ation s, such as tran saction
costs vs. omitted risk factors, an d fin d them lackin g in man y respects. Moreover, their
studies, alon g with Freeman an d Tse (1989), also explicitly develop an altern ative hypoth-
esis as to the n ature of the market in efficien cy an d establish that the subsequen t abn ormal
return s ten d to cluster aroun d subsequen t earn in gs an n oun cemen t dates. Their eviden ce that
the abn ormal return s are associated with some in efficien t processin g of earn in gs an n oun ce-
men ts is compellin g.
An importan t exten sion is Abarban ell an d Bern ard (1992), whose study examin es the
question of whether a portion of the post-earn in gs an n oun cemen t drift is attributable to the
behavior of an alysts' earn in gs forecasts an d deficien cies in their processin g of accoun tin g
data. This study reaches two importan t con clusion s:
(1) The an alysts' forecasts appear to un derestimate the persisten cy in earn in gs, an d
forecast errors based on an alysts' forecasts are serially correlated. If an alysts effi-
cien tly processed in formation , then the un con dition al expected value of the forecast
error would be zero, an d the expected serial correlation would be zero.
Beaver-Perspectives on Recen t Capital Market Research 455
(2) This phen omen on explain s some, but n ot all, of the post-earn in gs an n oun cemen t
drift. We would n ot expect an alysts' behavior to be the complete explan ation be-
cause post-earn in gs an n oun cemen t drift is most pron oun ced in the small capitali-
zation firms, which are n ot as heavily followed as larger capitalization firms are.
Bartov et al. (2000) suggest that in stitution al holdin gs are also an importan t ex-
plan atory variable. In a further exten sion , Bhattacharya (2001) con cludes that trade
size, a proxy for less wealthy an d less in formed in vestors, may also be a factor.
These studies represen t a key lin k between market efficien cy an d the role of in -
formation an d fin an cial in termediaries.
Studies of post-earn in gs an n oun cemen t drift are particularly compellin g because earn -
in gs chan ges an d earn in gs forecast errors have lower serial correlation than other can didates
for market efficien cy, such as market-to-book ratios. High serial correlation raises suspicion
that the variable is a proxy for an omitted factor that is priced by the market.
Market-to-Book Ratios an d Exten sion s
A secon d area of research is abn ormal return s associated with portfolio strategies based
on market-to-book ratios. Two early studies in this area are Fama an d Fren ch (1992) an d
Lakon ishok et al. (1994). The n egative association between market-to-book ratios an d sub-
sequen t return s appears to be sign ifican t an d persisten t an d n ot explain able by con ven tion al
risk measures or their proxies. This is a con troversial area; Fama (1991), amon g others,
suggests that market-to-book ratios may represen t some (otherwise un iden tified) pricin g
factor, an d Fama an d Fren ch (1992) have posited a three-factor pricin g model that in cludes
the market-to-book ratio. As a result, recen t market efficien cy tests con trol for the market-
to-book ratio an d still fin d eviden ce of abn ormal return s.
Major exten sion s of this work refin e the market-to-book an alysis by computin g market-
to-value ratios. At its simplest level, the argumen t for the market-to-book ratio as bein g a
measure of market in efficien cy is that the market prices either fail to reflect some factor
related to the un derlyin g value, which is reflected in book value, or that they in clude some
factor un related to the un derlyin g value. For example, high market-to-book ratio stocks
represen t so-called "glamour" stocks that are overpriced. From this perspective, on e can
exten d the con cept of value to in clude accoun tin g "fun damen tals" in addition to book value.
Two major examples are Fran kel an d Lee (1998) an d Dechow et al. (1999). Both studies
employ modelin g motivated by Feltham-Ohlson to predict the in trin sic value based on book
value, earn in gs, an d an alysts' earn in gs forecasts. Both studies con clude that market-to-value
ratios are associated with even higher subsequen t abn ormal return s than are the simpler
market-to-book ratio strategies, which is con sisten t with these value estimates' bein g better
proxies for un derlyin g fun damen tals an d, hen ce, bein g better able to iden tify overpriced
an d un derpriced stocks. As with research on post-earn in gs an n oun cemen t drift, the abn or-
mal return s here appear to be more prevalen t in small capitalization stocks.
In an other exten sion of the market-to-book research, Dechow an d Sloan (1997) fin d
that stock prices appear to reflect n aively an alysts' biased forecasts of future earn in gs
growth, an d relian ce on an alysts' earn in gs growth forecasts can explain over half of the
higher return s associated with pursuin g "con trarian " (e.g., market-to-book an d price-
earn in gs-based) strategies.
Con textual Accoun tin g Issues
A key feature of the previous two areas is that they require little, if an y, kn owledge of
the distin ctive characteristics of how fin an cial statemen ts are prepared. They are based on
gen eric treatmen ts of earn in gs an d book value. Our comparative advan tage as accoun tin g
researchers is in in corporatin g the richn ess of our kn owledge of accoun tin g in stitution s,
reportin g stan dards, an d the composition of accoun tin g n umbers. Several recen t studies
have examin ed market efficien cy based on some key feature of fin an cial reportin g.
Sloan (1996) is an excellen t example of research that exploits our kn owledge of on e
key feature: accrual accoun tin g. Importan t aspects of the Sloan (1996) study are (1) an
examin ation of the "con sisten cy" between the weight placed on accruals an d cash flow
compon en ts in forecastin g earn in gs an d the implicit weight in vestors placed on the cash
flow an d accrual compon en ts of earn in gs in a valuation equation , an d (2) the examin ation
of portfolio strategies based on the magn itude of the accruals. Sloan (1996) con cludes that
capital markets overestimate the persisten cy of accruals an d un derestimate the persisten cy
of cash flows from operation s, because accruals are more subject to un certain ty of esti-
mation an d more subject to man agemen t an d man ipulation . Xie (2001) supports this con -
clusion by showin g the mispricin g documen ted by Sloan (1996) is largely due to abn ormal
accruals.
Moreover, in an attempt to address the "IPO puzzle," Teoh et al. (1998a, 1998b) an d
Teoh, Won g, et al. (1998) fin d that un usual accruals occur at In itial Public Offerin g dates
an d subsequen tly reverse. The accruals appear to be associated with at least a portion of
the n egative abn ormal return s iden tified in the IPO research. These fin din gs are con sisten t
with those of Sloan (1996), as well as Xie (2001) an d DeFon d an d Park (2001), that security
prices do n ot fully reflect either the n ature of accruals or their implication s for future
earn in gs an d valuation .
However, n ot all accruals are associated with abn ormal return s. Research also in dicates
that the supplemen tal disclosures with respect to specific accruals can permit capital markets
to form un biased estimates of the implication s of the accrual for future earn in gs an d hen ce
for valuation . For example, Beaver an d McNichols (2001) show that in creased disclosure
regardin g the history of policy loss reserves in the property casualty in suran ce compan ies
can make the accruals tran sparen t to in vestors, an d that revision s policy of loss accruals
(developmen t) are n ot associated with subsequen t abn ormal return s.
Un resolved Issues
The magn itude an d len gth of the abn ormal return s is surprisin g. For example, Fran kel
an d Lee (1998) report that in the 36 mon ths after portfolio formation , the abn ormal return s
associated with market-to-value strategies are 31 percen t, whereas strategies that also exploit
the predictability of an alysts' forecasts are associated with abn ormal return s of 45 percen t.
There are several un resolved issues:
(1) How can widely dissemin ated an d examin ed data used with simple portfolio strat-
egies that require n o kn owledge of accoun tin g be associated with abn ormal return s?
From an econ omic perspective, widely dissemin ated data are n ot likely can didates.
(2) How can studies of arcan e disclosures (e.g., n on performin g loan s an d pen sion s, as
in Beaver et al. [1989] an d Barth et al. [1992]) fin d that such disclosures are
apparen tly reflected in prices, yet more visible variables, such as earn in gs an d book
value, are n ot?
(3) How can studies of security return s in the very short run (e.g., in traday return s, as
in Patell an d Wolfson [1984]) show eviden ce of relatively rapid respon se (within
hours, if n ot min utes), an d yet have eviden ce of abn ormal return s that appear
to
persist for years after the portfolio formation date?
(4) How can the body of research in aggregate show that prices both lead (e.g., Beaver
et al. 1980; Beaver et al. 1987; Collin s et al. 1997; Ryan 1995) an d lag accoun tin g
data?
HI. FELTHAM-OHLSON MODELING
For better or for worse, capital markets research is primarily empirical, rather than
theoretical. On e major exception is the modelin g by Feltham an d Ohlson (hereafter F-O).
As on e of the few attempts durin g the last ten years to develop a "theory of accoun tin g"
(i.e., a formal represen tation of value in terms of accoun tin g n umbers), the F-O approach
is, in my opin ion , on e of the most importan t research developmen ts in the last ten years
(importan t articles are Ohlson [1995, 1999] an d Feltham an d Ohlson [1995, 1996]). F-O
modelin g is also on e of the more con troversial research areas in accoun tin g. I will discuss
the key features, empirical application s, major criticisms, an d prospects for future research.
Key Features of F-O Modelin g
On e feature is the common set of assumption s that pervades the work. The assumption s
in clude a valuation assumption that the value of equity is equal to the presen t value of
expected future dividen ds, the clean surplus relation , an d some form of a lin ear in formation
dyn amic. Feltham an d Ohlson have derived a rich set of implication s from these parsimo-
n ious assumption s.
In con trast to prior attempts to lin k accoun tin g data an d equity value, the F-O approach
is n either a theory of in formation n or a theory of measuremen t. However, it permits a
represen tation of the value of equity in terms of accoun tin g n umbers (most promin en tly,
book value an d expected abn ormal earn in gs), relyin g essen tially on the presen t value of
expected dividen ds an d clean surplus relation assumption s.
The F-O approach provides a role for man y importan t features of the accoun tin g system,
in cludin g clean surplus, book value as well as earn in gs, tran sitory compon en ts of earn in gs,
con servatism, an d delayed recogn ition . For example, we can clearly see a progression in
addin g key features of the fin an cial-reportin g system. Early modelin g assumed un biased
accoun tin g an d the clean surplus relation , while later exten sion s in corporated con servative
accoun tin g (Feltham an d Ohlson 1995; Zhan g 2000). Feltham-Ohlson alter the assumption s
regardin g the lin ear in formation dyn amics to allow for "other in formation ." In doin g so,
the model provides a role for in formation that is curren tly kn own an d reflected in price,
but is reflected with a lag in the accoun tin g n umbers. The model provides a represen tation
for delayed recogn ition . By en richin g the lin ear in formation dyn amics, Feltham an d Ohlson
(1996) con struct a theory of depreciation , which distin guishes between two poten tial sources
of con servatism: accelerated depreciation an d positive n et presen t value projects. Ohlson
(1999) decomposes earn in gs in to perman en t an d tran sitory compon en ts. In the process, he
clearly distin guishes between the con cepts of forecastin g relevan ce an d the time-series
persisten ce of an earn in gs compon en t, an d he demon strates how each relevan ce con cept
affects valuation relevan ce of that earn in gs compon en t. Exten sion s alter the lin ear in for-
mation assumption s to in corporate addition al con dition in g variables (e.g., differen t decom-
position s of earn in gs, such as cash flows an d accruals, Barth et al. [1999]). Thus the F-O
approach provides a poten tially rich platform for further modification s of the lin ear in for-
mation dyn amics to address addition al accoun tin g issues of in terest.
The F-O approach has stimulated con siderable empirical research. Fran kel an d Lee
(1998) an d Dechow et al. (1999) use the approach in testin g market efficien cy, which is a
very ambitious application of the model. Studies employin g a combin ed book value an d
earn in gs approach that either literally relies on the F-O model or is motivated by it are
Barth, Beaver, an d Lan dsman (1996, 1998), Barth an d Clin ch (1998), Burgstahler an d
Dichev (1997), Aboody et al. (1999), Barth, Beaver, Han d, an d Lan dsman (1999), Collin s,
Maydew, an d Weiss (1997), an d Collin s, Pin cus, an d Xie (1999). Other empirical appli-
cation s in clude direct tests of the F-O model (e.g., Myers 1999; Barth, Beaver, Han d, an d
Lan dsman 1999). Major fin din gs of this literature in clude the followin g:
(1) Both book value an d earn in gs are sign ifican t pricin g factors.
(2) The relative importan ce of book value is in versely related to the fin an cial health
of the firm.
(3) The coefficien t on earn in gs is lower for firms with low return on equity.
(4) The coefficien t on positive earn in gs is positive an d sign ifican t, while the coefficien t
on losses is in sign ifican tly differen t from zero.
(5) Accrual vs. cash flow compon en ts of earn in gs are priced sign ifican tly differen tly
from on e an other. In gen eral, the accrual compon en ts are associated with a lower
coefficien t.
Criticisms of the Feltham-Ohlson Approach
On e major criticism is that the model has n o en dogen ous deman d for accoun tin g data,
but how serious is this charge? The modelin g can be in formative without in cludin g an
en dogen ous deman d for accoun tin g, an d I believe the criticism is somewhat misplaced or
misdirected. By an alogy, the Capital Asset Pricin g Model (CAPM) has n o deman d for
fin an cial in stitution s, yet we observe fin an cial in stitution s empirically. What do we con -
clude? Do we con clude that the risk-return trade-off derived from the CAPM is of n o
in terest or relevan ce to in vestors or to man agers of fin an cial in stitution s? I thin k n ot. The
F-O models do n ot attempt to derive a deman d for accoun tin g. The F-O approach provides
a framework for represen tin g valuation in terms of accoun tin g n umbers, while takin g ac-
coun tin g as given exogen ously. This framework relates published accoun tin g data to equity
valuation , allows us to in terpret the coefficien ts on the valuation equation , an d allows us
to relate the coefficien ts from the valuation equation to coefficien ts from the time-series of
earn in gs equation . With con textual accoun tin g argumen ts added to the gen eral framework,
researchers can predict how accoun tin g n umbers would relate to value (e.g., prediction s on
how the coefficien ts for the cash-flow an d accrual compon en ts of earn in gs would be ex-
pected to differ in an earn in gs forecastin g equation an d a valuation equation ).
An other criticism is that there is n o in formation asymmetry, an d that hen ce n o strategic
uses of accoun tin g data arise within the F-O framework. To be sure, man y fin an cial-
reportin g issues arise out of con cern over in formation asymmetry an d in cen tives to "man -
age" the accoun tin g n umbers. For example, the research on an alysts' behavior an d discre-
tion ary behavior address issues of in formation asymmetry an d in cen tives. However, the F-O
approach is a begin n in g. As a prelude to developin g models that in corporate in formation
asymmetry an d strategic uses of accoun tin g data in valuation , it is helpful to start with a
model of the relation between the valuation an d accoun tin g n umbers in a n on strategic
settin g. Moreover, n ot all issues of in terest in accoun tin g in volve in formation asymmetry.
A large body of research examin es empirically the relation between valuation an d publicly
available accoun tin g n umbers in a n on strategic settin g (e.g., value-relevan ce studies).
A
con ceptual framework, such as the F-O approach, guides the specification an d in terpretation
of the empirical estimatin g equation s.
Of course, it would also be desirable to have a theory where deman d for accoun tin g
data is en dogen ous, an d to have models of in formation asymmetry where in cen tives to
report strategically are en dogen ous. However, it is un reason able to expect the F-O model
to be rich en ough to en compass all issues of in terest to accoun tin g research. Parsimon y is
a virtue in modelin g. The model focuses atten tion on specific variables of in terest, an d the
trade-off between in sight an d comprehen siven ess is common in modelin g exercises.
Some aspects of the models are un supported by the empirical data (e.g., Myers 1999;
Joos 2000; Barth et al. 1999), such as the lin earity properties an d the con sisten cy amon g
the coefficien ts in the system of lin ear in formation dyn amics an d valuation equation s. How-
ever, the con flictin g eviden ce highlights on e of the importan t features of the F-O framework.
Most accoun tin g research is con ducted in "reduced form." In other words, we estimate
in tuitively plausible relation s that we hope will allow us to predict the sign of the coefficien t.
Rarely do we predict the magn itude of the coefficien t. Even more rare are opportun ities to
test structural relation s amon g the coefficien ts across differen t equation s in the system. The
F-O models permit us to predict how the coefficien ts within an d across equation s in the
system are related. In particular, the coefficien ts in the valuation equation are a fun ction of
the coefficien ts in the lin ear in formation dyn amics equation s.
Although it may seem disappoin tin g that we can reject the n ull hypothesis that the
predicted coefficien ts equal the empirically observed on es, it is progress to be in a position
to specify a predicted relation amon g the coefficien ts. We make further progress by askin g
what modification s would permit a con sisten cy between the systems of equation s. In tro-
ducin g n on lin earity in in formation dyn amics is a likely can didate. For example, the F-O
model does n ot in corporate ban kruptcy or other option -related phen omen a that might in -
troduce n on lin earities in to the relation . Research is curren tly un derway to in corporate n on -
lin earities (Yee 2001).
The F-O modelin g is on e of the few attempts to pursue accoun tin g theory. It is n o
coin ciden ce that the termin ology of accoun tin g (e.g., in come) is similar to that used in
econ omics an d fin an ce. We could have called the differen ce between reven ues an d expen ses
by an other n ame, but we did n ot. The seman tics of accoun tin g was chosen because in come
theory asserts that the resultin g measure is an in dicator of firm performan ce. Hen ce, it is
n atural to focus on a theory of measures of accoun tin g n et in come an d their relation to
value.
Empirical studies applyin g the F-O framework often appen d a con textual accoun tin g
theory regardin g differen ces in cash flows vs. accruals, the fair value of fin an cial in stru-
men ts, or the n ature of pen sion obligation s to guide the empirical prediction s. Such con -
textual richn ess can help fill in some of the substan ce omitted from the parsimon ious F-O
represen tation s. On ce these con textual theories are appen ded, the combin ation of parsi-
mon ious modelin g an d con textual richn ess provides a rich basis for empirical testin g. On e
of the major application s of the F-O models is the value-relevan ce literature.
IV. VALUE-RELEVANCE RESEARCH
Value relevan ce is major area of empirical research in the last ten years.2 Holthausen
an d Watts (2001) iden tify 54 value-relevan ce studies, on ly three of which were published
before 1990. Value-relevan ce research examin es the association between a security price-
based depen den t variable an d a set of accoun tin g variables. An accoun tin g n umber is termed
"value relevan t" if it is sign ifican tly related to the depen den t variable.3 Defin ed in this most
2
A more complete review of theliteratureappears in Barth, Beaver, an d Lan dsman (2001).
3 Beaver (1998, 116), OhIson (1995), an d Barth (2000) provide closely related formal defin ition s. The key com-
mon ality is that an accoun tin g amoun t is deemed valuerelevan t if it is sign ifican tly associated with equity market
value.
gen eral sen se, value-relevan ce research has a lon g history (Miller an d Modiglian i 1966);
however, the term came in to common usage in the early 1990s (Easton et al. 1993). Papers
by Ohlson (1995, 1999) also use the term "value relevan ce," in a man n er con sisten t with
empirical studies. As with the other research areas, value-relevan ce research is con troversial
(Holthausen an d Watts 2001; Barth, Beaver, an d Lan dsman 2001).
In this paper I address some basic question s: What distin guishes value-relevan ce re-
search from other capital market research? Why is timelin ess n ot a key issue in man y value-
relevan ce studies? What is the con ceptual foun dation of the value-relevan ce studies? What
have we learn ed? What is the role of value-relevan ce research? What are some major
un resolved issues?
What Are the Distin ctive Characteristics?
Value-relevan ce research has two major characteristics. The first is that, more than an y
of the other four areas discussed, value-relevan ce research deman ds an in -depth kn owledge
of accoun tin g in stitution s, accoun tin g stan dards, an d the specific features of the reported
n umbers. This kn owledge in cludes the stated objectives of fin an cial reportin g, criteria stan -
dard setters use, the basis for specific stan dards, an d details of how to con struct the ac-
coun tin g n umbers un der a given stan dard (pen sion reportin g is an excellen t example). In -
corporatin g the accoun tin g con text gives value-relevan ce research its richn ess an d provides
a basis for empirical prediction s (Barth 1991), an d vividly illustrates accoun tin g researchers'
comparative advan tage in examin in g relation s between equity value an d accoun tin g
n umbers.
A secon d distin guishin g characteristic is that timelin ess of in formation is n ot an over-
ridin g issue. Although value relevan ce research en compasses even t studies, it also in cludes
studies that examin e the relation between the levels of stock prices an d the accoun tin g data.
The timin g of the in formation is of primary con cern in the even t-study research design .
Even t studies examin e the stock price reaction over short win dows of time cen tered on the
an n oun cemen t date. They iden tify the date of the public disclosure of the item bein g studied
an d examin e the price chan ge (usually in percen tage terms an d adjusted for market-wide
movemen ts) surroun din g the even t date.
In con trast to even t studies, levels studies iden tify drivers of value that may be reflected
in price over a lon ger time period than assumed in even t studies. For example, prices may
reflect the in formation before the an n oun cemen t date. The value-relevan ce research char-
acterizes market value at a poin t in time as a fun ction of a set of accoun tin g variables, such
as assets, liabilities, reven ues, expen ses, an d n et in come. This research design does n ot
address timelin ess, in con trast to "even t-study" research design .
Why Is Timelin ess Not the Key Issue?
The accoun tin g system recogn izes even ts later than security prices do (e.g., Ryan 1995).
Delayed recogn ition is a n atural implication of accoun tin g stan dards, such as the reven ue
recogn ition prin ciple. Moreover, we kn ow that earn in gs an n oun cemen ts are largely, but n ot
en tirely, preempted by the disclosure of other in formation (Ball an d Brown 1968; Beaver
1968). Lan dsman an d Maydew (2002) con clude this fin din g has n ot chan ged over the last
30 years. Imagin e a world in which earn in gs is the on ly in formation relevan t to the value
of the firm. With n o private in formation search or prior public disclosures that preempt the
earn in gs an n oun cemen t, we would observe large spikes in price chan ges at earn in gs an -
n oun cemen t times, in respon se to the un expected earn in gs. However, this prospect creates
in cen tives for private in formation search to obtain prior in formation about the forthcomin g
accoun tin g earn in gs. To the exten t that private in formation an d prior public an n oun cemen ts
are reflected in prices before the public earn in gs an n oun cemen t, the price reaction at the
earn in gs an n oun cemen t date is reduced. In the limit, a search for prior in formation can
completely preempt the earn in gs an n oun cemen t; however, such preemption does n ot elim-
in ate the importan ce of reported earn in gs. The primary barrier to the complete preemption
of earn in gs is the cost of obtain in g the prior in formation . This cost in cludes n ot on ly the
out-of-pocket cost of the in formation search, but also in direct costs imposed by the legal
liability for selectively dissemin atin g or obtain in g n on publicly available in formation . As
the costs approach zero, the an n oun cemen t effect can approach zero.
Models by Demski an d Feltham (1994), McNichols an d Trueman (1994), an d Kim an d
Verrecchia (1994) formalize this process. For example, in Demski an d Feltham (1994) the
sole role of the in formation obtain ed before the earn in gs an n oun cemen t is to provide in -
formation about forthcomin g earn in gs. In short, these models imply there is more to the
price-earn in gs relation than on ly the short-term price reaction s at the an n oun cemen t date.
In fact, the magn itude of price chan ge at the an n oun cemen t date is in formative about the
costs of obtain in g predisclosure in formation , but provides limited eviden ce about how
value-relevan t earn in gs are.
The in formation al approach states that a sign al is in formative on ly if the sign al can
alter beliefs con dition al upon the other in formation available. This would require that the
accoun tin g n umber have some un ique compon en t that is n ot preempted by other in formation
available prior to or simultan eous with the accoun tin g n umber. This perspective is con sisten t
with even t study research design s, which con trol for other in formation publicly available
prior to an d con curren t with the accoun tin g an n oun cemen t.
However, accoun tin g n umbers are n ot un ique represen tation s of the un derlyin g con -
structs they are design ed to capture. It is often possible to fin d a vector of publicly available
in formation that, collectively, is highly correlated with a particular accoun tin g n umber. For
example, the fair value of ban k loan s is a fun ction of default risk an d in terest rate risk
(Barth et al. 1996). Some lin ear combin ation of book value of the loan s, proxies for default
risk, an d proxies for in terest rate risk may be highly correlated with fair value measures,
even if those measures "perfectly" capture the un derlyin g con struct. However, a key role
of fin an cial statemen ts is to summarize relevan t in formation parsimon iously an d in a man n er
con sisten t with the un derlyin g con cept. It is in formative to kn ow how well accoun tin g
n umbers play this role, even if vectors of competin g proxies for the same un derlyin g con -
struct exist. In fact, if the accoun tin g n umber (e.g., fair value of ban k loan s) is capturin g
the un derlyin g con struct, then we would expect other proxies for the con struct (e.g., default
risk an d in terest rate risk) to be correlated with the accoun tin g n umber. Such correlation
would in dicate that the accoun tin g n umber is capturin g the un derlyin g con struct.
To choose an other example, assume that an altern ative set of data could produce a
variable that is perfectly correlated with depreciation expen se. Would this imply that on e
could exclude depreciation from the calculation of n et in come? Lambert (1996) con cluded
that the FASB probably would n ot exclude depreciation . The balan ce sheet an d in come
statemen ts are n ot in ten ded to list on ly those assets, liabilities, reven ues, an d expen ses n ot
preempted by other publicly available in formation . The fin an cial statemen ts are in ten ded
in stead to be "complete" within the con strain ts an d defin ition s of gen erally accepted ac-
coun tin g prin ciples. In this broader view of the role of fin an cial statemen ts, timelin ess is
on ly on e dimen sion .
This broader view has implication s for research design . For example, researchers often
use first differen ces, rather than levels, of a stock-price-related depen den t variable to mit-
igate some econ ometric problems, such as correlated omitted variables or serial depen den cy
in the regression residuals (Lan dsman an d Magliolo 1988). However, chan gin g the form of
the variable may fun damen tally chan ge the question addressed. On e chooses the levels
design when the problem is to determin e what accoun tin g n umbers are reflected in firm
value, whereas on e chooses the first differen ces research design when the problem is to
explain chan ges in value over a specific period of time. Hen ce, in the first differen ces
formulation , the issue of timin g of the in formation is importan t. Thus, if the researcher is
in terested in whether the accoun tin g amoun t is timely, then examin in g chan ges in value
can be the appropriate research design choice. However, for the reason s discussed earlier,
researchers are in terested in a variety of question s, man y of which do n ot in volve timelin ess.
What Is the Con ceptual Foun dation of Value-Relevan ce Research?
The theoretical foun dation of value-relevan ce studies is a combin ation of a valuation
theory plus con textual accoun tin g argumen ts that allow researchers to predict how accoun t-
in g variables relate to the market value of equity. There are three major types of valuation
models. The oldest is an earn in gs-on ly approach-Miller an d Modiglian i (1966) character-
ize value as the presen t value of perman en t future earn in gs. The research of Lan dsman
(1986), Barth (1991), an d Barth et al. (1996) adopts a balan ce-sheet approach. The Feltham-
Ohlson model discussed earlier represen ts firm value as a lin ear fun ction of book value of
equity an d the presen t value of expected future abn ormal earn in gs. Value-relevan ce studies
have relied heavily on a combin ed book value an d earn in gs approach (Barth, Beaver, an d
Lan dsman 2001).
However, the valuation assumption is on ly half the story. Value-relevan ce studies typ-
ically in corporate con textual accoun tin g argumen ts to predict the relation between accoun t-
in g variables an d market value. For example, the prediction that pen sion assets an d obli-
gation s are priced as if they are assets an d obligation s of the compan y is based on the
con ceptual argumen t offered by the FASB (amon g others) regardin g the econ omic substan ce
of the pen sion con tract between the compan y an d employees, un der a defin ed ben efit plan
(Lan dsman 1986).
The prediction s of the way fair value of fin an cial in strumen ts will be priced in a
valuation equation draws upon con ceptual argumen ts con cern in g relevan ce an d reliability
of fair value vis-a'-vis historical costs. This is an accoun tin g theory, albeit on e couched in
terms of measuremen t of specific assets or obligation s rather than a global statemen t that
un equivocally predicts how all assets an d liabilities would be measured an d priced. Al-
though the lack of a gen eral theory of accoun tin g can frustrate researchers (an d others),
researchers can use con textual accoun tin g argumen ts to aid in predictin g valuation -
accoun tin g n umber relation s.
What Have We Learn ed?
The hallmark of value-relevan ce studies is that their execution requires an in vestmen t
in an d un derstan din g of the in stitution al details of the way fin an cial statemen ts are prepared
an d of con textual argumen ts regardin g the properties of various measures. What we have
learn ed relates to three question s regardin g an accoun tin g n umber: Is it priced (i.e., does it
have a coefficien t that is sign ifican tly differen t from zero)? Is it priced con sisten tly with
some theoretical value (e.g., for a balan ce sheet n umber, is its coefficien t equal to 1)? Is a
particular accoun tin g n umber priced equal to or differen tly from similar accoun tin g n umbers
(e.g., do all compon en ts of n et in come have the same valuation multiples)? Here are some
examples of what we have learn ed.
Eviden ce in dicates that un recorded pen sion assets an d liabilities (un recorded but dis-
closed in the footn otes) are priced. Lan dsman (1986), Barth (1991), an d Barth et al. (1992)
fin d that the un recogn ized portion of pen sion assets an d liabilities is priced in a man n er
con sisten t with the capital market viewin g pen sion assets as assets of the compan y an d
pen sion obligation s as liabilities. Similar fin din gs with respect to other post-retiremen t ben -
efits (Amir 1993; Choi et al. 1997) are observed. Fair values of fin an cial in strumen ts are
priced (Barth et al. 1996). However, the results are mixed with respect to the fair value of
ban k loan s (Beaver an d Ven katachalam 2000; Eccher et al. 1996; Nelson 1996). Moreover,
Barth (1994a) shows that pricin g multiples vary with the type of in vestmen t security in a
man n er related to the ease with which ban k man agemen t can estimate the fair values.
Footn ote in formation is often n ot as promin en tly displayed an d may con tain complex,
arcan e data (con cern in g such items as pen sion disclosures) that can be difficult to in terpret.
The pricin g of footn ote data is a n on trivial issue. The pricin g of pen sion assets an d obli-
gation s an d the fair value of fin an cial in strumen ts is of in terest in its own right. However,
they are two promin en t examples of the broader issue of whether footn ote in formation is
priced. An other example is n on performin g loan s, which is footn ote in formation on the
default risk of ban k loan s. Empirical eviden ce in dicates n on performin g loan s are sign ifican t
in explain in g the value of ban k common equity (Beaver et al. 1989; Wahlen 1994; Beaver
an d En gel 1996; Barth, Beaver, an d Lan dsman 1996; Ven katachalam 1996).
The value-relevan ce literature also addresses question s relatin g to n on fin an cial in tan -
gible assets. These studies gen erally fin d that in tan gible assets (e.g., capitalized software,
bran ds, an d goodwill) are priced (e.g., Aboody an d Lev 1998; Barth, Clemen t, et al. 1998;
Barth an d Clin ch 1998; Chambers et al. 1999). Studies also fin d that in vestors perceive
research an d developmen t an d advertisin g expen ditures an d ban k core deposits as assets of
the firm (e.g., Abdel-khalik 1975; Hirschey an d Weygan dt 1985; Bublitz an d Ettredge 1989;
Lan dsman an d Shapiro 1995; Barth et al. 1996; Eccher et al. 1996; Lev an d Sougian n is
1996; Healy et. al. 1997; Joos 2000). Barth an d McNichols (1994) an d Hughes (2000) fin d
that un booked en viron men tal liabilities are also priced.
On e would expect various compon en ts of earn in gs to be associated with differen t pric-
in g multiples based on the persisten ce of that earn in gs compon en t (Sloan 1996; Ohlson
1999). Empirical eviden ce in dicates that the accrual compon en ts of earn in gs are n ot on ly
less persisten t than the cash-flow compon en ts in forecastin g future earn in gs, but also that
the accrual compon en ts are associated with a lower earn in gs multiple (Barth et al. 1999).
Also for ban ks, earn in gs before security gain s an d losses is associated with a higher pricin g
multiple than security gain s an d losses (Barth et al. 1990).
The Role of Value-Relevan ce Research
Accoun tin g research can play three roles:
(1) Research can help articulate the n ature of the issues, an d can provide a paradigm
or lan guage with which to frame the question s of in terest. The paradigm of the
value of in formation is n ot a predictive theory in itself, but provides a defin ition al
an d taxon omic framework for formulatin g the in formation al role of accoun tin g
n umbers.
(2) Research can provide a theory. This theory can be n ormative, which leads to
prescriptive statemen ts, or positive, which provides hypotheses an d testable
prediction s.
(3) Research can provide empirical eviden ce.
Empirical eviden ce is a sign al from an in formation system. The study's research design
describes the features of the in formation system. The researcher forms priors with respect
to the relation ships of in terest (e.g., probabilities that either of two altern ative hypotheses
is true). The eviden ce is a sign al that leads to a posterior distribution , which must differ
from the prior for at least on e possible sign al for the research to be in formative. As the
power of the research design in creases, the sign als gen erated by the design become more
in formative.
Value-relevan ce research provides eviden ce as to whether the accoun tin g n umbers relate
to value in the predicted man n er. In the pen sion con text, the prediction s are based on
con textual theory that pen sion assets are assets of the firm an d pen sion obligation s are
obligation s of the firm. A plausible prediction is that pen sion assets (obligation s) are priced
as assets (obligation s). A study's fin din gs represen t on ly on e of man y possible outcomes.
However, the subsequen t discussion s an d the subsequen t research con ducted are in formed
by an d con dition ed on the observed eviden ce.
Un resolved Issues
Some of the un resolved issues affectin g the in feren ces drawn from value-relevan ce
research in clude market efficien cy, econ ometric issues, an d other purposes of fin an cial state-
men ts. Does market efficien cy affect in terpretation of the results? I believe it does, but the
fin din gs are importan t even if markets are in efficien t. Are the stan dard econ ometric issues
more serious with respect to this research area than elsewhere? Most, if n ot all, of the
econ ometric issues faced here are common to other areas of accoun tin g research. Moreover,
value-relevan ce research in corporates design features to mitigate these con cern s. Fin ally,
what other purposes of fin an cial statemen ts should be explored as a complemen t to the
value relevan ce research? Accoun tin g for con tractin g purposes is a major can didate (Watts
an d Zimmerman 1986).
V. RESEARCH ON ANALYSTS' BEHAVIOR
An other major research area is an alysts' forecastin g abilities an d their coverage deci-
sion s. An alysts' behavior is importan t to accoun tin g research, because an alysts are amon g
the major in formation in termediaries who use an d in terpret accoun tin g data (Schipper
1991). As a result, security prices reflect the results of their an alysis. Because the average
pruden t in vestor may lack the time, skill, or resources to an alyze an d in terpret fin an cial
statemen ts, an alysts can be a major way in which accoun tin g data become reflected in
security prices. Efficien t an alysts' in formation processin g can facilitate the efficien cy of
security prices, as well. If there are limitation s an d in efficien cies in the an alysts' in formation
processin g, an d if capital markets do n ot draw on other aspects of the total mix of in for-
mation to circumven t an alysts' limited in formation processin g, then prices may n ot fully
reflect the fin an cial statemen t data. To the exten t that an alysts rely on a rich set of publicly
available data, their forecasts can be a n atural way to in corporate other in formation in to
the research design of valuation studies (e.g., via the application of the F-O models). An
in vestigation of an alysts' forecasts can assess the importan ce of accoun tin g data relative to
the total mix of in formation .
The history of an alysts' forecasts is rich (Brown 1993). In some respects, it is the
successor to the time-series of earn in gs literature (Beaver 1970; Ball an d Watts 1972). The
early literature focuses on which time-series model most accurately forecasts earn in gs.
Iden tifyin g the process tells us somethin g about the gen eral characteristics of the accoun tin g
n umbers (e.g., season ality an d adjacen t quarter-to-quarter effects). Moreover, researchers
use earn in gs forecasts derived from these models as in puts in to other forms of research
(e.g., we can use earn in gs forecast errors in security return s studies). An alysts' earn in gs
forecasts are n atural can didates for more accurate forecasts because they can reflect a richer
in formation system than simply the past earn in gs series. On e of the origin al purposes,
learn in g about the features of the accoun tin g system, has withered. However, the literature
has examin ed issues beyon d those related to fin din g the most accurate earn in gs forecast.
Biases, processin g limitation s, an d strategic con sideration s have been addressed.
Much prior research has con cluded that an alysts' forecasts are optimistic (O'Brien
1988, amon g others), although there appears to be secular reduction in the optimistic bias
(Brown 2001). The degree of bias is related to un derwriter affiliation . An alysts employed
by in vestmen t firms that are associated with the un derwritin g of the firm's securities issue
more optimistic forecasts (Lin an d McNichols 1998). An alysts' (in itially optimistic) fore-
casts ten d to be revised down ward durin g the year (Kaszn ik an d McNichols 2001). An alysts
with better forecastin g ability appear to have a higher probability of survival (Mikhail,
Walther, an d Willis 1999; Clemen t 1999).
An alysts' forecasts outperform the best statistical models (Brown et al. 1987a, amon g
others), which is n ot surprisin g, sin ce the an alysts can use a richer in formation set than the
past earn in gs series. However, a model that in corporates both statistically based forecasts
an d an alysts' forecasts outperforms an alysts' forecasts alon e, which implies that the an a-
lysts' forecasts do n ot reflect all of the in formation in the past earn in gs series (Brown et
al. 1987b). The forecast errors based on an alysts' forecasts are serially correlated, which is
also con sisten t with the idea that an alysts' forecasts do n ot fully reflect all the available
in formation (Dechow et al. 1999; Fran kel an d Lee 1998). This eviden ce is also con sisten t
with an alysts' un derestimatin g the persisten cy of earn in gs (Abarban ell an d Bern ard 1992).
These fin din gs would be of mild in terest in their own right even if capital markets fully
adjusted for this behavior. However, they take on added sign ifican ce, to the exten t that
capital markets do n ot appear to un ravel these biases an d processin g in efficien cies. Capital
markets appear to reflect n aively an alysts' forecasts in prices. This fin din g appears to explain
(at least partially) the abn ormal return s associated with market-to-book an d market-to-value
strategies (Dechow an d Sloan 1997; Fran kel an d Lee 1998). An alysts' forecasts appear to
be a parsimon ious way to capture "other in formation " (at least in part) in the Ohlson sen se
of the term (Dechow et al. 1999). An alyst coverage is greater for firms with more in stitu-
tion al in vestors (O'Brien an d Bhushan 1990) an d more. in tan gible assets (Barth, Kaszn ik,
an d McNichols 2001).
Un resolved Issues
Researchers n eed a better un derstan din g of the in cen tives of an alysts with respect to
forecastin g. In particular, why do an alysts form biased forecasts? Even in the face of evi-
den ce that the bias is associated with un derwriter affiliation , there are multiple explan ation s
for the bias. Is it in ten tion al, or is it a man ifestation of self-selection (McNichols an d
O'Brien 1997)? Why do an alysts misestimate the persisten ce of earn in gs? Why do forecasts
n ot fully reflect the available in formation ?
Do an alysts learn over time? Are they more accurate with experien ce (Clemen t 1999)?
Does the capital market learn over time in its processin g of an alysts' forecasts? How do
an alysts make decision s regardin g the allocation of their efforts across the firms covered?
How does an alysts' behavior vary with the fin an cial-reportin g en viron men t? For example,
Barth, Kaszn ik, an d McNichols (2001) fin d that an alyst coverage in creases with the pres-
en ce of un recorded in tan gible assets. What other fin an cial-reportin g features are importan t?
Furthermore, what are the mechan isms by which an alysts' forecasts are in corporated in to
price? Why do errors in an alysts' forecasts appear to result in the mispricin g of securities?
Why does the market price appear n ot to adjust fully for these documen ted regularities in
an alysts' forecasts?
An other major issue is to iden tify the other in formation besides accoun tin g data that
in fluen ces an alysts' forecasts. Fran kel an d Lee (1998) an d Dechow et al. (1999) have used
an alysts' forecasts as a proxy for other in formation . However, from the con text of a broader
system, an alysts' forecasts are en dogen ous an d are a fun ction of un derlyin g exogen ous
variables. The dimen sion ality of such other in formation is quite large. However, it is im-
portan t to iden tify at least some of the major exogen ous variables that explain an alysts'
forecasts. Amir an d Lev (1996), Den g et al. (1999), Ittn er an d Larcker (1998), Lev an d
Sougian n is (1996), an d Joos (2000) explore the ability of n on fin an cial measures, such as
population within licen sed areas, pen etration ratios, paten ts, FDA approvals, con cen tration
ratios, an d market share to aid in predictin g future earn in gs an d in explain in g prices. Is
this in formation reflected in an alysts' forecasts as well?
VI. RESEARCH ON DISCRETIONARY ACCRUALS
Man agemen t can improve or impair the quality of fin an cial statemen ts through the
exercise of discretion over accoun tin g n umbers.4 Discretion ary behavior in cludes volun tary
earn in gs forecastin g, volun tary disclosure, choice of accoun tin g methods, an d estimation
of accruals. While research exists in all these areas, I will focus on the man agemen t of
accruals (also kn own as earn in gs man agemen t). Accrual accoun tin g is the heart of our
fin an cial-reportin g system. I will discuss several aspects of earn in gs man agemen t: motives
for earn in gs man agemen t, major fin din gs, estimation of discretion ary an d n on discretion ary
compon en ts, an d un resolved issues.
Motives for Accrual Man agemen t
Motives fall in to two broad categories: opportun istic or sign alin g. We ten d to perceive
the latter as ben ign , but n ot the former. Motives for man agin g accruals relate to compen -
sation con tracts, debt coven an ts, capital market pricin g, taxes, litigation , an d regulatory
behavior (Watts an d Zimmerman 1986; Beaver an d En gel 1996). Each motive con stitutes
a broad category that en compasses a variety of specific behaviors. For example, capital
market effects in clude man agemen t's attempts to in fluen ce the offerin g price in equity
offerin gs, the terms or the value of stock option s, an d prices at which man agemen t-held
securities are sold.
These motives can operate in either opposin g or rein forcin g ways, often makin g it
difficult to isolate the primary motive (Healy an d Wahlen 1999). For example, both capital
market an d compen sation con tracts can lead to in cen tives to overstate earn in gs. As a result,
man y researchers have n ot specified the precise n ature of the un derlyin g motivation , seekin g
in stead to determin e whether an empirical estimate of the discretion ary accrual is related
to some firm characteristic (e.g., fin an cial difficulty, loss avoidan ce, in come smoothin g, big
baths).
Man agers exercise discretion in respon se to a rich set of forces. Researchers use three
major approaches to iden tify earn in gs man agemen t: gen eric models of discretion ary accru-
als (e.g., Healy 1985; Jon es 1991), tests based on discon tin uities in the reported earn in gs
distribution (e.g., Burgstahler an d Dichev 1997), accoun t-specific models of discretion ary
behavior (McNichols an d Wilson 1988; Petron i 1992; Beatty et al. 1995), an d combin ation s
of these approaches (Beaver, McNichols et al. 2000).
4 McNichols (2000) reviews recen t research in earn in gs man agemen t an d discretion with respect to accoun tin g
data. Schipper (1989) provides an early perspective on earn in gs man agemen t.
Man agemen t appears to man age earn in gs to avoid a loss, to avoid an earn in gs declin e
(Burgstahler an d Dichev 1997), an d to avoid fallin g below an alysts' forecasts (Burgstahler
an d Eames 1998). Firms that issue earn in gs forecasts ten d to man age earn in gs toward
meetin g those forecasts (Kaszn ik 1999; Matsun aga an d Park 2001). Earn in gs man agemen t
appears to be widespread an d relatively easy to detect, at least as estimated by extan t
techn iques. Loan loss reserves in the ban kin g sector an d policy loss reserves in the in sur-
an ce sector appear to be two major accoun ts subject to man agemen t. Accrual man agemen t
is on ly on e form of earn in gs man agemen t. Others in clude hedgin g activities (Barton 2001)
an d alterin g research an d developmen t expen ditures (Bushee 1998). In the ban kin g sector,
man agemen t appears to man age the loan loss reserves join tly with other forms of earn -
in gs man agemen t (Beatty et al. 1995).
Capital markets appear to price differen tly the n on discretion ary an d discretion ary com-
pon en ts of an accrual. In the ban kin g sector, capital markets treat addition al loan loss
reserves as good n ews, n ot bad n ews, con sisten t with sign alin g in terpretation s of discre-
tion ary reportin g of estimated loan losses. In particular, fin an cially stron ger ban ks sign al
they can afford to take the hit to earn in gs (Beaver et al. 1989; Wahlen 1994). Capital
markets price discretion ary compon en ts of loan loss reserves differen tly than n on discre-
tion ary portion s (Beaver an d En gel 1996).
In the property an d casualty sector, the developmen t of policy loss reserves is con sisten t
with earn in gs man agemen t (Beaver an d McNichols 1998). The stock prices of property an d
casualty firms appear to reflect fully the predictability in the policy loss developmen t
(Beaver an d McNichols 1998, 2001). However, the eviden ce from the gen eric accrual stud-
ies suggests a differen t picture with respect to market efficien cy an d the pricin g of accruals.
Accruals, con sidered to be more subject to discretion , are less persisten t than stock prices
of existin g securities imply, whereas cash flow from operation s is more persisten t than stock
prices imply (Sloan 1996; Xie 2001). Un usual accruals occur at in itial public offerin g dates
an d reverse themselves subsequen tly. These un usual accruals appear to be correlated with
the n egative abn ormal return s observed in the in itial public offerin g literature (Teoh et al.
1998a, 1998b; Teoh, Won g et al. 1998).
Estimation of Discretion ary an d Non discretion ary Accruals
A major issue with respect to the power of this research is the ability to iden tify proxies
or con dition in g variables that reflect the discretion ary an d n on discretion ary compon en ts of
the accrual. In the Jon es (1991) model, sales is the key n on discretion ary variable drivin g
curren t accruals, an d capital expen ditures is the key variable drivin g n on curren t accruals.
Needless to say, this is a parsimon ious model. Research in vestigatin g sector-specific accru-
als, such as the loan loss provision , typically uses sector-specific variables, such as n on -
performin g loan s, to in crease the precision with which on e can measure the n on discretion -
ary compon en t.
Iden tifyin g proxies for discretion ary accruals can be a challen ge. Often , studies regress
total accruals on on ly the n on discretion ary variables an d assume the residual is discretion ary
(e.g., application s of the Jon es model). Of course, failure to iden tify fully the n on discre-
tion ary compon en t implies the regression residual con tain s both discretion ary an d n on dis-
cretion ary compon en ts, an d the researcher has measured the estimated discretion ary an d
n on discretion ary compon en ts with error. Typically, the explicit con dition in g variables for
discretion ary accruals, such as earn in gs or leverage, are gen eric. These gen eric variables
can be proxies for man y firm characteristics, which make the in terpretation of coefficien ts
of the discretion ary accruals in valuation equation s challen gin g.
The developmen t of policy loss reserves in the property-casualty sector provides a
un ique opportun ity to iden tify the discretion ary compon en t of an accrual (Petron i 1992).
Property-casualty firms must report ex post estimation error for reserves reported in earlier
years, where the amoun t of this error is called developmen t. Researchers can estimate the
discretion ary compon en t without a specification of either discretion ary or n on discretion ary
variables. Developmen t in cludes ex post surprises of a n on discretion ary n ature. However,
if developmen t is n ot subject to discretion , then it has an expected value of zero, an d, by
implication , zero serial correlation . As discussed earlier, empirically, developmen t has a
positive expected value for fin an cially weaker firms, implyin g an un derstatemen t of the loss
reserve (Petron i 1992), an d developmen t is highly positively serially correlated over time,
con sisten t with man agemen t recogn izin g in formation slowly over several years (Beaver an d
McNichols 1998). Petron i et al. (2000) further decompose the developmen t in to discretion -
ary an d n on discretion ary compon en ts an d fin d they have differen t implication s for future
profitability, risk, an d market value.
Un resolved Issues
Much of this discussion implies that extan t methods for the iden tification of discre-
tion ary accruals are of poten tially low power. Usin g an empirical simulation , Dechow et
al. (1995) provide eviden ce that extan t models are n ot very powerful. Yet, empirically, the
majority of studies observe earn in gs man agemen t. Moreover, man y forms of earn in gs man -
agemen t appear to be iden tifiable n ot on ly by researchers, but also by the capital markets.
Why is it relatively easy to detect earn in gs man agemen t empirically if the models are
of low power? On e might con jecture that effective earn in gs man agemen t (at least of the
opportun istic type) would n ot be easy to un ravel. Why is it relatively easy for the research-
ers to detect earn in gs man agemen t, typically usin g con temporan eous (n ot future) data? Is
man agemen t n aive? Does earn in gs man agemen t achieve its goals (often un stated) even if
it is in vertible? What in cen tives for earn in gs man agemen t are con sisten t with the capital
market's ability to in vert the discretion ary portion an d price it differen tly? Is discretion ary
behavior a n atural man ifestation of con tractin g in in complete markets (Demski an d Frimor
1999)? The n ature of the discretion may be kn own but n ot con tractible. In cen tives an d costs
to elimin ate discretion ary behavior are un clear, an d discretion ary behavior may be an equi-
librium outcome, albeit n ot a "first best" solution .
These question s, of course, raise the possibility that what looks like earn in gs man age-
men t may n ot be. Perhaps what researchers observe is n ot discretion or man agemen t at all,
but is a proxy for some other factor. If so, then what might those factors be? McNichols
(2000) offers eviden ce that discretion ary accruals are correlated with growth an d that the
mispricin g of accruals may in fact be the "glamour stock" phen omen on (i.e., the mispricin g
of high-expected-growth stocks) in disguise. In particular, she shows that aggregate accruals
models that do n ot in corporate lon g-term earn in gs growth are poten tially misspecified an d
can result in misleadin g in feren ces regardin g earn in gs man agemen t. The implication is
differen tial behavior observed in prior studies may relate to the performan ce characteristics
of the firms (e.g., correlated with growth) rather than to differen tial in cen tives to man age
earn in gs.
VII. CONCLUDING REMARKS
Market efficien cy, Feltham-Ohlson modelin g, value relevan ce, an alysts' behavior, an d
discretion ary behavior n ot on ly have had the greatest impact on capital market research
over the last ten years, but they also have the greatest poten tial to con tribute sign ifican tly
to our kn owledge over the n ext five to ten years. These areas address importan t question s.
They are lin ked together an d build upon on e an other's kn owledge an d research design s.
They raise major issues that remain un resolved. Three recurrin g themes are markets (effi-
cien cy, valuation ), in dividual behavior (in vestors, an alysts, man agers), an d accoun tin g struc-
ture or con text. Accoun tin g research is distin ct an d importan t on ly in sofar as it con fron ts
the first two themes with the third-an observation similar in spirit to the poin t made by
my predecessor (Kin n ey 2001).
Each of these research areas is con troversial in terms of either fin din gs or research
method. Is importan t research by n ature con troversial? I believe con troversy is a n atural
con sequen ce of con ductin g importan t research, especially in the early stages of the research.
In n ovative research is likely to be the most con troversial of all. Thirty-five years ago, man y
question ed whether capital market research with respect to accoun tin g n umbers was legit-
imate accoun tin g research.
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