The Accounting Review Vol. 67 No. 4 1992
Accounting Recognition and the Relevance of Earnings as an Explanatory Variable for Returns
Abstract
[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.]
- Volume
- 67
- Issue
- 4
- Pages
- 821-842
- Sources
- bibtex:phds-export.bib