Investment Dynamics and Earnings-Return Properties: A Structural Approach

Abstract

We propose the standard neoclassical model of investment under uncertainty with short-run adjustment frictions as a benchmark for earnings-return patterns absent accounting influences. We show that our proposed benchmark produces a number of earnings-return relations commonly attributed to accounting influences. In particular, we document that the relation between earnings and returns is naturally concave (as documented by Basu (1997)) given short-run adjustment frictions and long-run optimal investment behavior. We explain the model intuition, estimate its key parameters, test its empirical predictions, and discuss the implications of our proposed benchmark for the accounting literature. We suggest that our benchmark for earnings and return properties absent accounting influences is useful in identifying the incremental effect of accounting after considering first-order economic influences in a wide number of contexts and can, therefore, contribute to the improvement of existing measures of and approaches to identifying accounting-related effects.