The Information Content of Accounting Reports: An Information Theory Perspective

Abstract

Is it possible to quantify the information content of financial statements? If possible, then how? This study examines accounting as a classical communication system with the purpose of providing a framework with which to approach these fundamentally important questions. Information theory was established in the early-mid 20th century to describe the properties of classical communication systems. Applying concepts from this theory to an accounting context provides insight into the questions asked above. Specifically, a measure of the information content of a message in general and the financial statements in particular is developed from information theory concepts which originated with Claude Shannon -- the father of modern information theory -- in the 1940's. The measure is able to extract information contained in the financial statement numbers to predict firm performance despite the fact the numbers themselves do not easily admit insight. Thus, there seems to be hidden'' information in the numbers that the measure captures which, in hindsight, helps predict firm price movements. Specifically, as a validity check, I provide evidence that the measure alone explains 10% of the variation in returns for a cross-section of firms.