An Empirical Evaluation of Accounting Income Numbers Ray Ball; Philip Brown Journal of Accounting Research, Vol. 6, No. 2. (Autumn, 1968), pp. 159-178 Stable URL htp:/flinks.jstor-org/sicisici=( 121-8496% 28 196823%296%3A2%3C159%3A AEEO AIG 3E2.0,CO%3B2-W Journal of Accounting Research is currently published by The Institute of Professional Accounting, Graduate School of Business, University of Chicago. ‘Your use of the ISTOR archive indicates your acceptance of JSTOR’s Terms and Conditions of Use, available at hutp:/uk,jstor.org/abouvterms.himl. JSTOR’s Terms and Conditions of Use provides, in part, that unless you have obiained prior permission, you may not download an entire issue of journal or multiple copies oF articles, and you ‘may use content in the JSTOR archive only for your personal, non-commercial use. Please contact the publisher regarding any further use of this work. Publisher contact information may be obtained at hutp://uk.jstor.org/journals/grad-uchicago.html ch copy of any part of'a JSTOR transmission must contain the same copyright notice that appears on the sereen or printed page of such transmission, ISTOR is an independent not-for-profit organization dedicated to creating and preserving a digital archive of scholarly journals. For more information regarding JSTOR, please contact support @ jstor.org. hups//uk.jstororg! ‘Sat Mar 25 20:31:22 2006An Empirical Evaluation of Accounting Income Numbers RAY BALL® and PHILIP BROWNt Accounting theorists have generally evaluated the usefulness of aecount- ing practices by the extent of their agreement with a particular analytic model. ‘The model may consist of only a few assertions or it may be a rigorously developed argument. In each case, the method of evaluation has been to compare existing practices with the more preferable practices im- plied by the model or with some standard which the model implies all practices should possess. ‘The shortcoming of this method is that it ignores significant source of knowledge of the world, namely, the extent to which the predictions of the model conform to observed behavior. It is not enough to defend an analytical inquiry on the basis that its assumptions are empirically supportable, for how is one to know that a theory embraces all of the relevant supportable assumptions? And how does ‘one explain the predictive powers of propositions which are based on un- verifiable assumptions such as the maximization of utility functions? Further, how is one to resolve differences between propositions which arise from considering different aspects of the world? ‘The limitations of a completely analytical approach to usefulness are il lustrated by the argument that income numbers cannot be defined sub- stantively, that they lack “meaning” and are therefore of doubtful utility? ‘The argument stems in part from the patchwork development of account- * University of Chicago. { University of Western Australia. The authors are indebted to the participants in the Workshop in Aecounting Research at the Univer- -ago, Professor Myron Scholes, and Messrs. Owen Hewett and Ian Watts. ns of this particular argument appear in Canning (1029); Gilman (1930); Paton and Littleton (1040); Vatter (1947), Ch. 2; Edwards and Bell (1961), Ch. 1 Chambers (1964), pp. 267-68; Chambers (1968), pp. and 102; Lim (1986), esp. pp. 645 ‘and 649; Chambers (1967), pp. 745-85; Tri (1907), Ch ©, esp. pp. 120-81; and Sterling (4967), p. 6. 150160 JOURNAL, OF ACCOUNTING RESRAROH, AUTUMN, 1968 ing practices to meet new situations as they arise. Accountants have had to deal with consolidations, leases, mergers, research and development, price- level changes, and taxation charges, to name just a few problem areas. Because accounting lacks an all-embracing theoretical framework, dissimi- larities in practices have evolved. As @ consequence, net income is an ag- sgregate of components which are not homogeneous It is thus alleged to be a “meaningless” figure, not unlike the difference between twenty-seven, ‘tables and eight chairs. Under this view, net ineome ean be defined only as the result of the application of a set of procedures {X:, Xz, «--] to a.set of events (Yi, Ya, +++} with no other definitive substantive meaning at all ‘Canning observes: What is set out as s measure of net income an never be supposed tobe a fat in ny sense at all excopt that itis the gure that results when the accountant has finished applying the procedures which he adopts? ‘The value of analytical attempts to develop measurements capable of definitive interpretation is not at issue. What is at issue is the fact that an ‘analytical model does not itself assess the significance of departures from its implied measurements. Hence it is dangerous to conclude, in the absence of further empirical testing, that a lack of substantive meaning implies a lack of utility. ‘An empirical evaluation of accounting ineame numbers requires agree- ment as to what real-world outcome constitutes an appropriate test of use- fulness. Because net income is a number of particular interest to investors, the outcome we use as a predictive criterion is the investment decision as it is reflected in security prices? Both the content and the timing of existing ‘annual net income numbers will be evaluated since usefulness could be im- paired by deficiencies in either. An Empirical Test ‘Recent developments in capital theory provide justification for selecting the behavior of security prices as an operational test of usefulness. An im- pressive body of theory supports the proposition that capital markets are both efficient and unbiased in that if information is useful in forming capital asset prices, then the market will adjust asset prices to that information quickly and without leaving any opportunity for further abnormal gain.t If, as the evidence indicates, security prices do in fact adjust rapidly tonew information as it becomes available, then changes in security prices will re- * Canning (1929), p. 98. * Another approach pursued by Besver (1968) is to use the investment decision, as it is reflected in transactions volume, for a predictive criterion, ‘(For example, Samuelson (1965) demonstrated that « market without bias in its evaluation of information will give rise to randomly Suetuating time series of prices. Bee alto Cootner (ed.) (1964); Fame (1965); Fama and Blume (1966); Fama, et al (2967); and Jensen (1068).