Forecasting, Structural modelling, Prediction performance, Disaggregate data

[The recognition of economic events in accounting earnings tends to lag that of the market. An informed market recognizes the effects of economic events when they occur, but earnings recognition must await compliance with formal accounting recognition criteria. The application of these criteria involves such basic concepts as reliability, objectivity, conservatism, and verifiability, and affects earnings in two ways: (1) current earnings will include recognition of certain prior periods' economic events, and (2) current earnings does not recognize all of the current period's economic events until future periods (see also Easton et al. 1992). Economic events for which accounting recognition tends to lag market recognition include purchase and sale commitments, contingencies, post-employment employee obligations, investments in human capital, and variations in the market values of assets and liabilities. The purpose of this article is to investigate accounting recognition as a major determinant of earnings' explanatory power for returns. Our hypotheses are threefold. First, if accounting recognition lags that of the market, then its effect is predictably greater in shorter reporting periods. The shorter the reporting period, the lower the percentage of economic events recognized in both earnings and returns. For example, if all economic events that are immediately recognized in returns are recognized in earnings one quarter hence, then the current quarterly earnings' explanatory power would be zero, whereas annual earnings would reflect the recognition of three-fourths of all the economic events recognized in returns. Second, if the criteria for accounting recognition yield a multiperiod lag in earnings recognition of economic phenomena, then future periods' earnings possess explanatory power for current returns. A corollary hypothesis predicts that the incremental explanatory power of future periods' earnings varies inversely with the length of the reporting period. Third, if the influence of accounting recognition criteria for earnings measurement differs by companies' economic circumstances, then cross-sectional differences in these circumstances are predictably linked with earnings' explanatory power for returns. Economic circumstances that affect earnings recognition include companies' operating cycles, riskiness of cash flows, and the reliability, objectivity, availability, and verifiability of accounting and market data. We document evidence consistent with a substantial lag in earnings recognition. Findings reveal an inverse relation between earnings' explanatory power for returns and the length of the reporting period, which is consistent with a lag in earnings recognition that deteriorates in longer reporting periods. Specifically, the explanatory power of earnings for returns in quarterly periods is about one-fourth that for semiannual periods, less than one-tenth that for annual periods, and less than one-thirtieth that for two-year periods. Moreover, the explanatory power of the regression (adjusted R2 when using quarterly earnings is less than 1 percent, but exceeds 39 percent when using four-year earnings and returns. We attribute this phenomenon to accounting criteria that recognize economic events with a lag and to the disaggregation of earnings (through time), which accentuates this lag. Easton et al. (1992) offer some evidence consistent with the first hypothesis, but their evidence is limited to reporting periods of one to ten years in length. This is the first evidence we are aware of for reporting periods of less than one year. We also present evidence that earnings lag current returns for several future periods. In certain instances, the recognition lag is of such magnitude that the explanatory power of future periods' earnings for current returns more than triples that of current earnings. For example, with quarterly reporting periods, the inclusion of future periods' quarterly earnings increases the adjusted R2 of the returns-earnings relation by more than 400 percent. This evidence is consistent with a substantial lag in accounting recognition of economic events that spans a number of reporting periods. To the extent that accounting regulatory agencies want earnings to reflect current changes in the market values of companies, this evidence implies significant potential for enhancing earnings' usefulness. Finally, we show that, when earnings measurements are less sensitive to accounting recognition criteria, earnings have greater explanatory power for returns. For example, with biennial reporting periods, current earnings' explanatory power for current returns exceeds 50 percent for companies whose earnings measurements are less sensitive to accounting recognition criteria, but is less than 20 percent for companies more sensitive to these criteria. This result is consistent with a joint relation between (1) the application of accounting principles in practice and (2) the explanatory power of earnings for returns. Evidence of systematic cross-sectional differences in accounting recognition suggests that deliberations on accounting policy must consider characteristics of the reporting and operating environments; for example, the desire for verification, reliability, or conservatism might explain the accounting practices observed. The evidence reported emphasizes the significant role that accounting recognition plays in determining earnings' explanatory power for returns. The evidence also relates the lag in accounting recognition of economic events to cross-sectional differences in fundamental economic determinants of earnings recognition. This evidence of a link between earnings' explanatory power and basic concepts of accounting recognition and measurement should encourage further efforts at mapping the complex accounting structure that determines the usefulness of earnings. In light of the Securities and Exchange Commission's recent emphasis on market-based measures of performance, which is referred to as "possibly the most significant initiative in accounting principles development in over 50 years" (Wyatt 1991, 80), our results highlight the potential for substantial improvement in earnings' explanatory power. Evidence on the reporting lag inherent in the application of accounting recognition criteria, and its cross-sectional determinants, is relevant for these policy deliberations.]

[Recent research indicates that auditors' account value estimates from analytical review are affected by knowledge of the unaudited account value (or book value). The exact nature of the consequences from the auditor's use of book value for analytical review has not been formally shown and is a source of controversy. This paper examines the audit cost and risk consequences associated with the auditor's reliance on book value for analytical review. The analysis is framed within a Bayesian decision theoretic model and is conducted for a comprehensive set of audit and environmental conditions. The results include expressions for audit cost/risk when the auditor's analytical review is and is not conditioned on book value. While definitive inferences are possible only when certain intuitive criteria are used, the advantages of incorporating book value in the practice of analytical review appear minimal. That is, reliance on book value would seem to require a procedure that, if reliable, would preclude the need for analytical review (or any other audit procedures).]

[Experiments involving variations on two analytical review task situations were used to assess practicing auditors' judgments. The first experiment required auditors to generate expected values and noninvestigation intervals given variations in the amount of audited information available and the presence or absence of unaudited information. Consistent with prior research, the auditors' judgments were biased in the direction of the unaudited information. However, this bias was moderated when additional audited information was available. The second experiment required auditors to extrapolate intuitively an expected value for an account, given six different deterministic time-series patterns. The auditors' extrapolations were more accurate for those time-series patterns that are more likely to be encountered in practice. That is, extrapolations were slightly more accurate for increasing trends than decreasing trends, and were more accurate for linear and logarithmic patterns than exponential patterns. Implications for research and practice are discussed.]

Voluntary Disclosure, Management forecasts, Earnings forecasts, Revenue forecasts

Unexpected earnings, Intraindustry information transfers, Disclosures, Market reaction

Recent research indicates that auditors' account value estimates from analytical review are affected by knowledge of the unaudited account value (or book value). The exact nature of the consequences from the auditor's use of book value for analytical review has not been formally shown and is a source of controversy. This paper examines the audit cost and risk consequences associated with the auditor's reliance on book value for analytical review. The analysis is framed within a Bayesian decision theoretic model and is conducted for a comprehensive set of audit and environmental conditions. The results include expressions for audit cost/risk when the auditor's analytical review is and is not conditioned on book value. While definitive inferences are possible only when certain intuitive criteria are used, the advantages of incorporating book value in the practice of analytical review appear minimal. That is, reliance on book value would seem to require a procedure that, if reliable, would preclude the need for analytical review (or any other audit procedures).

Experiments involving variations on two analytical review task situations were used to assess practicing auditors' judgments. The first experiment required auditors to generate expected values and noninvestigation intervals given variations in the amount of audited information available and the presence or absence of unaudited information. Consistent with prior research, the auditors' judgments were biased in the direction of the unaudited information. However, this bias was moderated when additional audited information was available. The second experiment required auditors to extrapolate intuitively an expected value for an account, given six different deterministic time-series patterns. The auditors' extrapolations were more accurate for those time-series patterns that are more likely to be encountered in prectice. That is, extrapolations were slightly more accurate for increasing trends than decreasing trends, and were more accurate for linear and logarithmic patterns than exponential patterns. Implications for research and practice are discussed.

Valuation theory recognizes that the relation between earnings innovations and changes in security valuation is increasing in the persistence of the earnings innovations. Analyses in this article reveal that the present value of revisions in expected future benefits is a function of the length of revision horizon, suggesting that earnings persistence is determined, in part, by an entity's going‐concern status. These analyses predict an inverse relation between earnings informativeness and an entity's probability of termination. Drawing on a sample of quarterly earnings and returns data from more than 1,500 distinct firms for the period 1981–1990, a statistically significant inverse relation is documented between an entity's probability of termination and the informativeness of earnings—the latter measured as the coefficient from a regression of returns on earnings. Further empirical analyses reveal that this result is a pervasive economic phenomenon not attributable to extreme conditions or other prevailing explanations of earnings informativeness. This inference is robust to variations in research design, including measurement of earnings informativeness and of termination probability and alternative specifications of the relation between returns and earnings. Consequently, the evidence in this article is consistent with a fundamental role for an entity's going‐concern status in determining the usefulness of earnings. Résumé. La théorie de l'évaluation reconnaît le fait que la relation entre les nouvelles informations relatives au bénéfice net et les changements dans l'évaluation des titres s'intensifie lorsque persistent lesdites informations. Les analyses réalisées par les auteurs révèlent que la valeur actualisée des rajustements dans les gains futurs espérés dépend de l'horizon du rajustement, ce qui donne à penser que la persistance du bénéfice net est en partie fonction de la continuité de l'exploitation de l'entreprise. Selon ces analyses, le potentiel informatif du bénéfice net devrait être en relation inverse avec la probabilité de fermeture de l'entité. En s'appuyant sur un échantillon de données trimestrielles relatives au bénéfice net et au rendement recueillies auprès de plus de 1500 entreprises distinctes pour la période 1981–1990, les auteurs observent une relation inverse statistiquement significative entre la probabilité de fermeture d'une entité et le potentiel informatif du bénéfice—ce dernier étant mesuré sous forme de coefficient, au moyen d'une régression des rendements sur les bénéfices. D'autres analyses empiriques révèlent que cette conclusion est un phénomène économique répandu qui n'est pas attribuable à des conditions extrêmes ou à d'autres explications prédominantes du potentiel informatif du bénéfice net. Cette inference résiste aux variations dans le plan de recherche, y compris la mesure du potentiel informatif du bénéfice net et de la probabilité de fermeture, et les autres caractéristiques possibles de la relation entre le rendement et le bénéfice. Les résultats obtenus confirment donc que la continuité de l'exploitation joue un rôle fondamental dans la détermination de l'utilité du bénéfice net.

This article reports the results of an investigation into the informativeness of financial communications with shareholders when the level of market uncertainty regarding future firm performance varies. Specifically, it is hypothesized that the informativeness of annual reports is positively associated with the level of market uncertainty. The informativeness of annual reports is measured by the extent of price reaction, regardless of direction, at the time of disclosure. To obtain a sample of firms with temporal variation in the level of market uncertainty, the article investigates firms nearing financial distress. Financial distress is represented by the firm's receipt of a going‐concern audit report from the external auditor. Time periods immediately preceding receipt of the going‐concern report are presumed to exhibit changing market uncertainty regarding future firm prospects. The empirical evidence is consistent with the article's hypothesis in that price reactions to annual reports systematically vary the nearer the firms are to financial distress. Specifically, price reactions to annual reports for the three years preceding distress are more than 35 percent larger than the price reactions to reports from earlier periods. This evidence is consistent with the informativeness of financial disclosures being dependent on the level of market uncertainty and advances our understanding of the usefulness of accounting disclosures to market participants. To the extent that accounting regulatory agencies are interested in environmental factors that determine the usefulness of accounting information to shareholders, this article offers evidence on one important factor. Résumé. Les auteurs exposent les résultats d'une analyse du contenu informationnel des renseignements financiers communiqués aux actionnaires lorsque varie le degré d'incertitude du marché relativement aux perspectives de rendement d'une entreprise. Ils posent plus précisément l'hypothèse selon laquelle le contenu informationnel des rapports annuels est en relation positive avec le degré d'incertitude du marché. Le contenu informationnel des rapports annuels est mesuré en termes d'importance de la réaction du cours des actions, peu importe l'orientation, au moment de la communication des renseignements financiers. Pour constituer un échantillon d'entreprises à l'égard desquelles le degré d'incertitude du marché a varié dans le temps, les auteurs ont choisi d'analyser des entreprises sur le point de connaître des difficultés financières. La réception, par l'entreprise, d'un rapport des vérificateurs externes mettant en question la continuité de l'exploitation témoigne de ces difficultés financières. Les auteurs posent l'hypothèse selon laquelle on enregistre, au cours des exercices qui précèdent immédiatement la réception d'un rapport de cette nature, une variation du degré d'incertitude du marché relativement aux perspectives d'avenir de l'entreprise. Les constatations empiriques confirment l'hypothèse formulée, en ce sens que la réaction du cours des actions à la publication des rapports annuels varie de façon systématique lorsque les entreprises se rapprochent des difficultés financières. Plus précisément, la réaction du cours des actions à la publication des rapports annuels pour les trois exercices précédant les difficultés financières est plus de 35 pour cent supérieure à la réaction du cours des actions à la publication des rapports des exercices antérieurs. Cette constatation vient confirmer le fait que le contenu informationnel des renseignements financiers publiés dépend du degré d'incertitude du marché, et elle nous permet de mieux comprendre l'utilité de la publication d'information comptable à l'intention des participants au marché. Dans la mesure où les organismes de réglementation comptable sont intéressés aux facteurs liés à l'environnement qui déterminent l'utilité de l'information comptable pour les actionnaires, les auteurs nous permettent d'acquérir certaines certitudes à l'égard d'un facteur important.