Explanatory Power Of Earnings Research Articles

Accrual-Based Earnings Management and the COVID-19 Pandemic

In this study, we document the accrual-based earnings management of Old Economy firms and New Economy firms (firms in the technology industry) and loss-making firms (firms with negative earnings in the pre-pandemic year, 2019) and profit firms in each economy, respectively, before, during, and in the recovery year of the COVID-19 pandemic. Using both univariate and difference-in-difference regression analyses, we find that old and new economy firms adopt different accrual-based earnings management, and Old Economy Loss firms changed their accrual-based earnings management the most during and in the recovery of the pandemic. During the 2020 pandemic, Old Economy Loss reported the lowest amount of accrual-based discretionary accruals. This suggests that Old Economy Loss firms are engaged in the most conservative approach to reporting their earnings, consistent with the big bath proposition. In the recovery year of the pandemic, 2021, we find that accrual-based earnings management reversed, with the old economy losing firms reporting the highest amounts of discretionary accruals. However, we do not find that the explanatory power of earnings on the variance of stock prices for the old economy loss firms is affected by their discretionary change in accounting accruals.

The Effect of Firm Life Cycle on the Relationship between Market Stock Return and Accounting Earnings, Losses and Book Value per Share: Evidence from Jordan

This study aims at examining whether the relationship between market stock return and earnings (losses) per share and book value per share varies according to each and both of the sign of net income and the stage the firm is going through within its life cycle. The study used a sample of 33 industrial public shareholding companies listed in Amman Stock Market (164 observations) during the period 2011-2019.
 To achieve the objectives of the study, the researchers executed a number of simple -and multiple- regression models of the returns-earnings (losses) and book value to examine the relationship from various dimensions: (1) the explanatory power of earnings (losses) per share, (2) the explanatory power of book value per share, (3) the incremental explanatory power of book value per share over that of earnings (losses) per share. The models were executed for various sub-samples constructed according to the sign of net income and the stage in which the company is going through within its life cycle, separately and combined.
 The results of the sub-samples which were constructed based on both the sing of net income and the stage which the company is going through revealed the following: (1) earnings per share and book value per share have no information content for profitable companies in the introduction and growth stages, (2) the main explanatory variable for market stock return for profitable companies in the maturity stage is earnings per share, (3) the only explanatory variable for market stock return for profitable companies in the shake-out and decline stages is earnings per share, (4) losses per share and book value per share separately have no information content for losing companies in the introduction and growth stages, (5) losses per share and book value per share have information content when both are entered together in the model, (6) only book value per share has information content for losing companies in the maturity stage, (7) loss per share and book value per share separately and together have no information content for losing companies in the shake-out and decline stages.
 The results suggest that the reasons behind the low explanatory power of the relationship between market stock return and earnings per share are the presence of losses, the failure to take into account the stage in which the company is going through in its life cycle and the failure to consider the book value per share in the model of the relationship, which leads to an error in the specification of the relationship, especially if the result of operations is a loss. These results are expected to assist stakeholders in making rational decisions and recommendations.

Value relevance of earnings and book value in India: significance of accounting reforms and intangible-intensity in an emerging market

The study investigates the value relevance of earnings and book value on the Bombay Stock Exchange over 21 years of accounting regulation reforms in India from 1995 to 2015. In developed markets accounting information has lost its relevance due to shift in economies from tangible to intangible intensity. However, the relevance of accounting information in an emerging market increases with the improvements in accounting regulation and market environment. Thus, we also examined the effects of both accounting regulation reforms and intangible intensity on the relevance of earnings and book value in an emerging market. Results indicate that the relevance of the combined and incremental value of both earnings and book value is increased with the improvements in accounting regulation reforms in India. Furthermore, the intangible intensity is positively (negatively) significant to explain the change in the incremental explanatory power of earnings (book value).

Accounting for property investment: an examination of the value relevance of unrealised gains and losses recognised under IAS 40

The main objective of this study is to examine the relevance of fair value accounting for investment property permitted under IAS 40. This will be achieved by examining the value relevance of unrealised gains and losses reported in the income statement in explaining stock prices for real estate companies listed in Kuwait stock exchange. The study examines further the impact of unrealised gains and losses on the incremental explanatory power of earnings and compares the explanatory power of book value of equity to that of earnings. The results indicate that unrealised gains and losses recognised under IAS 40 have no incremental information content over net income before unrealised gains and losses and that the inclusion of unrealised gains and losses in income numbers decreases the explanatory power of the valuation model and decreases the incremental explanatory power of earnings relative to that of book value. The results indicate further that the incremental explanatory power of earnings exceeds the incremental explanatory power of the book value of equity when unrealised gains and losses are excluded from the earnings measure. These results question the fair value method permitted under IAS 40.

Relative and incremental value relevance of book value and earnings during the global financial crisis

Purpose – The purpose of this study is to examine the relative and the incremental value relevance of book value and earnings in the Australian market in the context of the 2008-2009 global financial crisis (GFC) and the non-crisis period (NCP). Design/methodology/approach – Least square regressions are used to examine the research questions. Changes in the coefficient estimates and the relative explanatory power (adjusted R2) of book value (BV) and earnings between the GFC and the NCP are examined. Findings – The findings suggest that both BV and earnings are value relevant in the Australian market surrounding the GFC. There were structural breaks in the association of BV and earnings with firms’ market value. The value relevance of earnings has increased and that of BV has decreased during the GFC compared to the NCP. During the study period, the explanatory power of earnings was greater than that of the BV. Research limitations/implications – The single country context examined limits the generalisabil...

The Value Relevance of IFRS in the UAE Banking Industry: Empirical Evidence from Dubai Financial Market, 2008-2013

The objective of this paper is to examine the value relevance of accounting information for the banks listed in the Dubai Financial Market (DFM) for the period 2008 - 2013. Empirical tests are based on the return and the price models. Overall, the results show that accounting information is associated with market valuation. The earnings are positive and significantly related to stock prices and stock returns. Moreover results indicate that value relevance of accounting information has changed since 2008 which might raise the effect of the Global Financial Crisis (GFC). Finally, the explanatory power of earnings and equity book value are found to decrease during the recovery period 2011-2013.

The value relevance of unrealized gains and losses recognized under IAS 39

Purpose – The study aims to examine the role of unrealized gains and losses recognized under international accounting standards (IAS) 39 in explaining stock prices for investment companies listed on the Kuwait Stock Exchange (KSE), and how the inclusion of unrealized gains and losses in income numbers affect the incremental explanatory power of earnings. Design/methodology/approach – The study utilizes Ohlson’s (1995) valuation model combined with a technique developed by Theil (1971) that has been applied in several prior studies. Findings – The results of the cross-sectional regression indicate that net income and book values jointly and individually are positively and significantly related to stock prices; the incremental information content of net income is greater than that of book values; the inclusion of unrealized gain in income numbers increases the explanatory power of the model; and the incremental information content of net income before unrealized gains and losses is lower than that of book v...

The explanatory power of earnings for stock returns in the pre‐ and post‐IFRS era

PurposeThis study aims to examine the effects of the introduction of the International Financial Reporting Standards (IFRS) on the explanatory power of earnings for stock returns in Greece.Design/methodology/approachThe study uses variants of the Easton and Harris model. Moreover, the study controls for asymmetries in the information content of earnings and losses.FindingsThe findings show that the IFRS had several effects on the value relevance of earnings. In particular, the available information content of both earnings and earning changes decreased after the introduction of the IFRS. The reduction in the information content of earnings for returns (or the information content of book values of equity for stock prices) could be attributed to the IFRS and, in particular, to the introduction of the fair value principle. Moreover, even after controlling for the existence of asymmetries, the findings of reduced information content of earnings and earning changes for stock returns persist.Originality/valueThe study makes a significant contribution to the research of the implementation of the IFRS. In particular, the study examines the adoption of a set of high quality standards in a country where accounting was dominated by tax laws and governmental intervention.

An Examination of the Incremental Usefulness of Balance-Sheet Information Beyond Earnings in Explaining Stock Returns

Until recently, studies in accounting research have predominantly focused on using earnings information to explain stock returns. This article examines how information provided by the other primary financial statement—the balance sheet—is incrementally useful for determining returns. Based on existing models of equity value, the author shows theoretically that returns should be related to three balance sheet–related variables—the previous period’s (equity) capital investment, contemporaneous capital investment, and the profitability change—in addition to the earnings variables used in previous studies. Our empirical analysis yields the following results. First, the three balance sheet–related variables each have a statistically and economically significant effect that is incremental to those of the earnings variables on equity returns, and together they improve the explanatory power of an earnings-only-based model from 11.5% to 13.9% in annual cross-sectional samples. Second, over time, the incremental explanatory power (IEP) of the balance-sheet variables is negatively correlated with the explanatory power of earnings. Third, in cross sections, the balance sheet–related variables have a greater IEP for firms whose earnings are less informative (negative vs. positive earnings firms and young vs. mature firms) and for firms whose future earnings are more uncertain (firms with high vs. low analyst forecast errors, and firms with high vs. low analyst forecast dispersions). These results suggest that information from the balance sheet complements that contained in the income statement about equity returns.

The persistence of earnings and earnings components after the adoption of IFRS

PurposeThis paper seeks to examine the persistence of earnings and earnings components after the adoption of International Financial Reporting Standards (IFRS).Design/methodology/approachThe study analyses two years before and two years after the adoption of IFRS in order to examine whether the adoption of IFRS materially affects the persistence, as well as the explanatory power of earnings and earnings components.FindingsThe results confirm that disaggregating reported earnings into operating income, non‐operating income and extraordinary charge and credit, captures differences in the information content of the underlying events. Consequently, earnings disaggregation can be used to improve prediction of future profitability. The results suggest that IFRS measurement and reporting guidelines do not seem to improve the persistence of earnings and earnings components.Originality/valueThis is the first study that examines whether the mandatory adoption of IFRS has an impact on the information content of earnings components for future profitability.

The Information Perspective and Usefulness of Accounting Information

Relevance of earnings for explaining equity prices is investigated by many value relevance studies. This study investigates whether fiscal year end earnings as a proxy for next period’s earnings have additional information, beyond the information incorporated in contemporaneous equity price, for explaining next fiscal period’s end equity price. Results show that earnings have statistically significant additional information for explaining next fiscal year end equity price, even though the explanatory power of earnings is very low as not considerably supported for model utility. As Ohlson (1995) explores informativeness of fiscal year end earnings as a proxy for next period’s earnings, two alternative models are suggested, where next fiscal year end equity price and price change are considered as the dependent variable and fiscal year end (current) equity price is accommodated as an additional explanatory variable. However, using stationary price change as the dependent variable would be much useful in value relevance studies for econometric reasons. In this context, fiscal year end equity price provides a benchmark to assess additional informativeness of earnings and facilitate the estimated coefficients of earnings to capture and represent the information incorporated in the earnings data.

Evidence for the Possible Information Loss of Conforming Book Income and Taxable Income

Recent corporate accounting reporting scandals and aggressive corporate tax shelters have led for calls for regulatory reform. One such call is to conform (or reduce the gap between) the calculation of book and taxable income. Proponents of conformity focus on perceived benefits while ignoring possible costs. We examine one possible cost: the loss in information content to investors if one measure is removed from the information set. We provide evidence for this possible loss by examining the relative and incremental information content over the past 20 years of book and (estimated) taxable income for a large sample of firms. We find that book income exhibits significantly greater relative explanatory power, while both exhibit significant incremental explanatory power. Conforming the two measures at a minimum results in the loss of incremental explanatory power and, if book income is conformed to the tax rules, a 50 percent loss in the explanatory power of earnings.

The Relevance of Accounting Information in the Process of Valuation of Companies in the New and Old Economy – An Analysis of Asset Investments and their Effects on the Value Relevance of Earnings and Book Value

Brazilian accounting principles permit companies to capitalize expenditures on research and development, specifically as deferred charges. Therefore, the objective of this article is to analyze the effects of (deferred) investments on the value-relevance of the earnings and net equity of companies operating in the so-called new and old economies, with the sectors of the old economy chosen as comparison. The more specific objective is to examine: (i) the explanatory power of earnings and net equity; (ii) the incremental explanatory power of deferred charges, in which the stock price is a function the net earnings plus net equity less deferred charges. This study does not seek to refute or prove a specific model, but rather only to gather evidence to permit accepting or rejecting the hypotheses formulated and to offer a response to the research question. The results show that accounting information, for both sectors, is relevant to value the price of shares. However, the results on the explanatory power of deferred charges run counter to the expected results.

Evidence on the Possible Information Loss of Conforming Book Income and Taxable Income

Recent corporate accounting reporting scandals and aggressive corporate tax shelters have led for calls for regulatory reform. One such call is to conform (or reduce the gap between) the calculation of book and taxable income. Proponents of conformity focus on perceived benefits while ignoring possible costs. We examine one possible cost: the loss in information content to investors if one measure is removed from the information set. We provide evidence on this possible loss by examining the relative and incremental information content over the past 20 years of book and (estimated) taxable income for a large sample of firms. We find book income exhibits significantly greater relative explanatory power while both exhibit significant incremental explanatory power. Conforming the two measures at a minimum results in the loss of incremental explanatory power and if book income is conformed to the tax rules, an estimated 50% loss in the explanatory power of earnings.

The change in the value-relevance of earnings and book values in equity valuation over the past 20 years and the impact of the adoption of IASs: the case of Kuwait

This study investigates the change in the value-relevance of earnings and book values in equity valuation over the last 20 years in Kuwait. Following Collins et al. (1997) and Lev and Zarowin (1999), the study uses statistical association between stock prices and accounting data (earnings and book values) and a decomposition technique used in previous studies to assess: whether there is a systematic change in the value-relevance to investors of accounting data over the past 20 years; whether there is a systematic change in the relative importance of earnings and book values in explaining the changes in stock prices over time; whether the value-relevance of earnings and book values and the relative importance of them have changed since the adoption of the International Accounting Standards (IASs) in 1990 by all Kuwaiti corporations. The study reports four primary findings. First, earnings and book values, jointly and individually, have significant explanatory power for securities prices over the last 20 years. Second, the combined value-relevance of earnings and book values has increased over time. Third, the incremental value-relevance of earnings has increased over time while that of book values has declined. Fourth, the combined value-relevance of earnings and book values has improved and the incremental explanatory power of earnings (book values) has increased (decreased) since the adoption of IASs in 1990.

The Effect of Macroeconomic Changes on the Value Relevance of Accounting Information: The Case of Mexico and the 1995 Financial Crisis

Lev and Zarowin (1999) argue that the there has been a decline in the usefulness of financial information in the U.S. resulting from the inability of the current financial reporting system to contemporaneously capture changes in firms' operations and economic conditions. As a result, it appears that accounting information in the U.S. is not as timely as it could be. Francis and Schipper (1999) suggest that the emphasis on objectivity and verifiability, which constrains the early recognition of certain future economic benefits, is one reason U.S. financial statements lack timeliness. The purpose of this research is to examine the value relevance of accounting information in a setting where changes in general price levels and specific asset prices are recognized periodically in the financial statements. Essentially, we investigate whether accounting is more value relevant when it includes more relevant information. Additionally, we examine whether the market's valuation of earnings and book values in this setting is affected by an economic shock since continuous improvement of historical financial data (i.e., restatement) should improve investors' decisions (Lev and Zarowin 1999). Using a sample of Mexican firms traded on the Mexican Stock Exchange (Bolsa) during the period 1992-1997, we investigate the relation between the firms' stock prices and their book values, earnings, and cash flows, taking into account the effect of the 1995 Mexican financial crisis. In pooled cross-sectional tests, we find that book values retain their significance and explanatory power during the crisis while earnings do not. Additionally, the value relevance of book values does not significantly change during the crisis period while the value relevance and the explanatory power of earnings decline during the crisis period. The decline in the valuation of earnings and its explanatory power, however, is attributable to the presence of negative earnings. We attribute the lack of significant changes in the value relevance and explanatory power of book values to the use of replacement costs and price level accounting in Mexico. Finally, in additional analyses we find that the incremental value relevance of two components of Mexican earnings, monetary gains and losses and exchange gains and losses, does not change during the crisis implying that these features of Mexican accounting contribute to its continued relevance during the crisis.

Earnings Quality and Price Quality

Several papers have considered the relevance or quality of earnings by examining its relationship to prices, implicitly assuming that the quality of prices (or the market in which prices are set) remains constant. However, the quality of or noise in prices can vary across firms and over time, and trading pressure beyond what can be justified by correlated information about fundamentals can contribute to such variation. So we relax the assumption that the quality of prices is constant and reconsider the relevance of earnings. We construct a firm-specific measure of speculative intensity based on autocorrelation in daily trading volume adjusted for the amount of information available, and find that speculative intensity has a significant positive impact on returns. However, after controlling for speculative intensity, our results confirm a key result of previous research that earnings numbers still matter but departs from other work that suggests that earnings relevance has declined. We find that the explanatory power of earnings surprises has not declined, the influence of speculative intensity has increased, and so the omission of speculative intensity explains the previously documented decline in earnings relevance. This result is robust to excluding loss observations, which is another potential explanation for previous results.

The Roles of Earnings and Book Value in Equity Valuation: A Real Options Based Analysis

Employing a real options based valuation model, this paper examines the valuation roles of earnings and book value and cross-sectional differences in valuation properties. Consistent with theoretical predictions, we find that (i) as profitability increases, the value impact of earnings increases whereas that of book value decreases and eventually becomes negative; (ii) the explanatory power of earnings increases, and that of book value decreases, monotonically with profitability, with the two accounting measures behaving as valuation substitutes within a certain intermediate-profitability range; (iii) the P/B ratio increases with both profitability and growth opportunity, whereas P/E behaves in a non-monotonic fashion. Implications are discussed for value-relevance research.

Accounting earnings and firm valuation: the French case

Considering that the level of the association between stock returns and accounting earnings provides a measure of the extent to which earnings summarize the information which is useful for firm valuation, this paper analyses the contemporaneous association between stock returns and earnings changes or earnings level of individual French stocks and portfolios for periods of one, two and five years between 1981 and 1990. The empirical findings are as follows. (a) Stock returns are more linked to earnings changes than to earnings levels indicating that earnings provide more information about changes in firm value than about firm value. (b) Earnings prepared in accordance with the French accounting principles are not less value-relevant than those prepared in accordance with US or UK GAAP. (c) A cross-sectionally and time-aggregated data procedure provides a large increase in the explanatory power of earnings for returns which is consistent with a noise-in-earnings effect probably induced by accounting measurement and valuation principles and with a recognition lag effect due to the fact that value-relevant events are not integrated into earnings exactly when they occur. These two effects are shown to be the major causes of the low association between earnings and returns generally observed in studies based on short period data for individual stocks.

The operating cycle and the information content of earnings and cash flow

Prior studies have found that earnings are relatively more informative than cash flows (e.g. Ali and Pope, 1993; Ali, 1994; Plenborg, 1996). Applying Danish data this study investigates whether the length of the operating cycle is a useful explanation for the superiority of earnings over cash flows in explaining the contemporaneous stock return. Using a capital market approach, the study finds that the explanatory power of earnings is stable, but the explanatory power of cash flows declines as the length of the operating cycle increases. This finding holds across various research designs and model specifications.