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.

ABSTRACT The economic role of an accounting regime is to increase welfare through its effects—in conjunction with complementary institutions—on firm and household behavior. I review three major streams of the archival literature (real effects; price effects, including value relevance; and costly contracting), in terms of what they can and cannot reveal as proxies for welfare effects. One conclusion is that the partial correlations and average effects that predominate in this literature have provided valuable insights into the role of accounting in the economy, but provide limited and misleading proxies for welfare effects. A major concern is that teachers, students, and researchers—indeed, regulators and standard setters—raised on this literature could lose sight of, and underestimate, the fundamental contribution of accounting to aggregate welfare.

ABSTRACT Not surprisingly, the recent accounting scandals look different when viewed from the perspectives of the political/regulatory process and of the market for corporate governance and financial reporting. We do not have the opportunity to observe a world in which either market or political/regulatory processes operate independently, and the events are recent and not well researched, so untangling their separate effects is somewhat conjectural. This paper offers conjectures on issues such as: What caused the scandalous behavior? Why was there such a rash of accounting scandals at one time? Who killed Arthur Andersen—the Securities and Exchange Commission, or the market? Did fraudulent accounting kill Enron, or just keep it alive for too long? What is the social cost of financial reporting fraud? Does the United States in fact operate a “principles‐based” or a “rules‐based” accounting system? Was there market failure? Or was there regulatory failure? Or both? Was the Sarbanes‐Oxley Act a political and regulatory overreaction? Does the United States follow an ineffective regulatory model?

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.

[We examine risk, return, and abnormal return behavior in the days around quarterly earnings announcements, using a research design that allows risk to vary daily in event time. We test several hypotheses concerning the effect on security prices of earnings announcements per se (i.e., ignoring both the sign and the magnitude of earnings). The first hypothesis concerns the resolution of uncertainty over time. By conveying information about firms' activities, earnings announcements resolve some uncertainty about future cash flows, but the concurrent price reactions increase the variability and covariability of securities' returns during the announcements. Thus, it is hypothesized that return variances and betas, and therefore expected returns, increase during earnings announcement periods (Stapleton and Subrahmanyam 1979; Epstein and Turnbull 1980; Choi and Salamon 1989). Previous research has demonstrated anomalous positive abnormal returns during earnings announcements (Chambers and Penman 1984; Penman 1984, 1987; Chari et al. 1988). Because risk was not allowed to vary in event time in this research, it does not adequately distinguish between increased expected returns and true abnormal returns. We report that abnormal returns remain after controlling for risk increases at earnings announcements. The abnormal returns are not related to any over- or under-reaction by the market to earnings news (see, e.g., DeBondt and Thaler 1985, 1987; Bernard and Thomas 1989) because we do not condition on the earnings realization. The second hypothesis (the information hypothesis) is that the timing of an earnings announcement is informative because managers systematically announce good news early and bad news late (Givoly and Palmon 1982; Chambers and Penman 1984; Kross and Schroeder 1984). The hypothesis predicts that average abnornal returns: (1) are positive at the earnings announcement, (2) are negative prior to the announcement, and (3) cumulate to zero by the end of the announcement period. Our tests extend those of Chari et al. (1988), Kross and Schroeder (1984) and Chambers and Penman (1984) by examining the pattern of returns around earnings announcements for the population of stocks. The pattern we observe is not as predicted by the information hypothesis. Finally, we investigate whether cross-sectional variation in announcement-period risks and returns is a function of firm size, which is a proxy for the increase in information arrival during earnings announcement periods. The evidence reveals that, after controlling for risk increases, abnormal returns generally are positive and decreasing in firm size. For the smallest size decile, abnormal returns in the ten days up to and including the earnings announcement are approximately 1.75 percent in the average quarter, or approximately 7 percent over only 40 trading days per year. This adds to an impressive body of size-related anomalies. We use these results to reexamine Hand's (1990) reinterpretation of the functional fixation hypothesis. Hand investigated quarterly earnings that included previously announced book gains from debt-equity swaps. He distinguished between "sophisticated" and "unsophisticated" investors, hypothesizing that only the former correctly comprehend the different implications of swap gains and other components of earnings. He found that abnormal returns increase in a variable representing the interaction between the swap gain and a proxy for the probability that the marginal investor is unsophisticated. We are skeptical about both the hypothesis and whether it predicts the observed result. We interpret Hand's result as similar to the puzzling but typical size effect around earnings announcements. It seems unlikely to be due to swap gains, to the sign or magnitude of earnings information released at the time, to errors in measuring the earnings information released, or to functional fixation.]

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