Knowledge that Transforms

Intangible assets, Stock price, SEC, Capitalization

We provide evidence on the relevance of earnings for valuation of NYSE common stocks from 1927-93. Based on a time series analysis of the explanatory power of yearly earnings-returns regressions, we investigate whether earnings relevance has increased following: (1) the empowerment of the Committee on Accounting Procedure (CAP) in 1939 as the first U.S. standard-setting body, and (2) subsequent reorganizations of the standard-setting process which led to the establishment of the Accounting Principles Board (APB, 1959-73) and the Financial Accounting Standards Board (FASB, 1973-Present). Income measurement and disclosure has been a central focus of accounting policymakers throughout the period covered by our study. In the early 1930's, the American Institute of Accountants (forerunner of the AICPA) emphasized the cardinal importance of income as explained by the fact that the value of a business is dependent mainly on its earning capacity (see AIA [1934]). Over 40 years later, the FASB in Statement of Financial Accounting Concepts #1 adopted a similar view when it concluded that the primary focus of financial reporting is on earnings and its components. Our analyses provide little evidence suggesting that the mean and median explanatory power (i.e., adjusted R2) of yearly returns-earnings regressions are significantly higher following empowerment of the CAP in 1939 and subsequent reorganizations leading to creation of the APB and FASB. We find weak evidence of a higher median during the CAP?s tenure (1939-59) compared to the Pre-CAP era (1927-38), but this result is not robust under alternate specifications of our primary tests where either yearly rank regressions are used, losses are excluded from the sample, or operating income is used in lieu of net income in the yearly regressions. We also estimate yearly models where stock price is regressed against earnings and book value similar to other recent longitudinal studies (e.g., Collins, Maydew, and Weiss [1997] and Francis and Schipper [1997]). Results of tests examining incremental earnings relevance in price regressions are consistent with results based on earnings-returns regressions: we find no evidence indicating that the valuation relevance of earnings has significantly increased since the initiation of U.S. standard-setting in 1939. Consistent with evidence in these other studies, we document a highly significant increase in the combined relevance of earnings and book value during the FASB?s tenure compared to the APB era. However, this result is largely the artifact of abnormally low relevance in the APB era. For instance, the combined relevance of earnings and book value is lowest during the APB?s tenure (1960-73), but the combined relevance of earnings and book value in the FASB era is similar to that observed during the Pre-CAP and CAP periods.

Price-Signal relation, Imperfect competitive market, Public information, Private information

Auditing, Auditor-Auditee interactions, Misstatements, Strategic behavior

Financial reporting, Value relevance, Usefulness, Information environment

Disclosures, 8-K filing, Form 8-K, Timeliness

Auditing, IPO, Information asymmetry, Information signaling

Discretionary disclosures, Human capital, Performance evaluation, Uncertainty

Forecasting a firm's anticipated financial performance is an essential ingredient in equity valuation. In practice, analysts generally split the forecasting into two stages. The first stage develops relatively detailed forecasts of financial statement line items up to some preselected horizon date. (Casual observation suggests that the horizon rarely exceeds 15 years.) The second stage considers forecasts beyond the horizon date. Analysts now tend simply to extrapolate the selected valuation attribute (like dividends, cash flows, or [residual] earnings). Thus a single growth/ decay parameter determines the expected evolution of the valuation attribute in periods subsequent to the horizon year. On the basis of these two sets of forecasts, analysts then apply present value calculations to estimate a firm's intrinsic value. The portion of value due to the posthorizon period is generally referred to as the continuing (or terminal) value. Textbooks, such as Copeland, Koller, and Murrin [1994] and Damodaran [1994; 1996], illustrate how one implements these valuation approaches. Though the use of a horizon date is always present, its influence on the analysis is less than apparent. The idea behind the horizon concept seems to be that posthorizon simplifications introduce only minor valuation errors. That is, the less refined analysis of information is, in the grand scheme of things, relatively inconsequential and thus costbenefit effective.

Private information, Moral Hazard, Contracting, Risk