This review explores systematic explanations for the anomalous evidence in the relation between accounting earnings and stock prices. The anomaly is that estimated future abnormal returns are predicted by public information about future earnings, contained in (1) current earnings and (2) current financial statement ratios. The current-earnings anomaly appears due to either market inefficiency or substantial costs of investors acquiring and processing information, the choice depending on one's priors concerning these costs and one's definition of market ‘efficiency’. The financial-statement-information anomaly appears due to accounting ratios proxying for stocks' expected returns. Anomaly seems likely to be a permanent state.

Accounting techniques, Stock price, Discretionary accounting decisions, Efficient market Hypothesis

A literature survey reveals consistent excess returns after public announcements of firms' earnings. If the information in publicly-announced earnings is a public good, then these results seem inconsistent with equilibrium in the securities market: public goods, being without private cost, should earn no private return. Alternative explanations of this anomaly are considered. The most likely explanation is that earnings variables proxy for omitted variables or other misspecification effects in the two-parameter model: that the measured market portfolio is not mean-variance efficient. Similar anomalies and explanations apply to other ‘yield-surrogates’, including dividend yields and Value Line ratings.

Ray Ball, George Foster, Corporate Financial Reporting: A Methodological Review of Empirical Research, Journal of Accounting Research, Vol. 20, Supplement: Studies on Current Research Methodologies in Accounting: A Critical Evaluation (1982), pp. 161-234

Philip Brown, Ray Ball, Some Preliminary Findings on the Association between the Earnings of a Firm, Its Industry, and the Economy, Journal of Accounting Research, Vol. 5, Empirical Research in Accounting: Selected Studies 1967 (1967), pp. 55-77

Ray Ball, Risk, Return and Disequilibrium: An Application to Changes in Accounting Techniques, The Journal of Finance, Vol. 27, No. 2, Papers and Proceedings of the Thirtieth Annual Meeting of the American Finance Association, New Orleans, Louisiana, December 27-29, 1971 (May, 1972), pp. 343-353

Recent evidence reveals significant negative serial correlation in aggregate (market-wide) stock returns. We extend this result to relative (market-adjusted) returns, demonstrating negative serial correlation in five-year returns. We then test two competing explanations: (1) market mispricing and (2) changing expected returns in an efficient market. The tests are conducted using the capital asset pricing model to estimate relative returns. The evidence suggests that negative serial correlation in relative returns is due almost entirely to variation in relative risks, and therefore expected relative returns, through time. We document substantial relative risk shifts, particularly for extreme-performing stocks.