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Chapter Highlights
Chapter 8 is concerned with the usefulness of external accounting reports for decision making.
The FASB emphasizes decision usefulness in both the conceptual framework project and in
policy deliberations for specific standards. Therefore, it is possible to judge (to some extent) the
benefits of external accounting reports by evaluating their usefulness to investors/creditors, the
FASB’s primary user group.
“Benefits” are the focus of the chapter. Questions of costs and the apportionment of costs are
equally important. Some of the recent capital market research has focused on questions of how
accounting policies affect owner wealth. These studies are often cast in terms of agency theory,
and consider the “costs” of accounting policy changes in terms of their wealth impact on owners.
However, the evidence on economic consequences is largely one-sided, focusing on benefits
(e.g., information content) rather than costs. This point should be emphasized and related back
to the question of determining optimal regulation (raised in Chapter 4). All of the research is
empirical except information “economics,” which is included because decision theory illustrates
how information has value in an uncertain decision setting.
One point that is becoming clear is limitations on the efficient markets hypothesis. This point
arises in relation to post-earnings – announcement drift which has been determined from
empirical research and the incomplete revelation hypothesis which is a deductive hypothesis.
Combining these with empirical studies by Ou and Penman also showing that the market is not
as efficient as we might believe and Lev’s study showing low correlation between earnings
numbers and stock returns and the door is certainly open for putting time and effort into
improving accounting standards.
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Questions
Q-1 How is accounting data useful to investors? To creditors?
The financial economics valuation models reviewed in the chapter suggest that accounting
reports are useful in assessing a firm’s future cash flows. This is consistent with SFAC No. 1,
which views the role of accounting reports as aiding in assessing the amounts, timing, and
uncertainty of prospective cash flows. Beaver’s work, while similar in spirit, sees the linkage as
Q-2 In what ways do you think information useful for investors (in assessing future cash
flows) differs from that useful for creditors (in assessing default risk)?
In general, investors and creditors are interested in the amounts, timing, and uncertainties of a
firm’s expected future cash flows. Cash payments to equity holders are theoretically unlimited,
and the focus is typically on the upside potential of the expected future cash flows. In contrast,
Q-3 Besides the primary investor-creditor group, what other user groups could claim to be
stakeholders in the firm? How might their information needs be the same as the the
primary investor-creditor group? How might their information needs differ?
Any individual or entity whose income or payments are affected by a firm’s financial wellbeing
has stake in the firm. This would include taxing authorities, utility ratepayers, suppliers of
materials and services, and even current or potential employees. To varying degrees, all of these
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Q-4 Who are creditors?
Creditors are mainly considered suppliers of materials, services, or capital. They need financial
Q-5 Why do we sometimes say that the dividend discount model is actually an earnings
model? How does Lintner’s findings relate dividends and earnings?
The dividend discount model is a mathematical model that expresses the value of a stock as the
present value of the expected future dividends. Since dividends are considered to be paid from
earnings, the dividend discount model can be rearranged to express the value of a stock in terms
of the expected future earnings per share and the dividend payout ratio.
Q-6 What is residual income? Abnormal earnings? Economic profit? EVA?
Residual income is a general term for income in excess of a charge for the capital employed to
generate that income. The concept may be applied to the enterprise as a whole or to the firm’s
Q-7 How does EVA differ from economic profit?
Economic Value Added (EVA) is a proprietary form of economic profit developed by Stern
Stewart & Co. EVA begins with residual income [economic profit] and makes a series of
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Q-8 What are some advantages and disadvantages of using residual income (including
economic profit and EVA) for performance measurement?
On the positive side, residual income can be used as a company and intra-company performance
measurement tool. It recognizes that capital has a cost. Making capital an explicit part of the
model raises the awareness of using excess capital to generate income; capital has a cost. In
addition, residual income has been shown to have more explanatory power than reported
earnings or cash flow from operations. It can also be used for valuation purposes. On the
negative side, for any given year, the determination of the residual income itself is dependent on
an accurate estimate of the cost of capital. And for valuation purposes, forecasts are crucial.
Q-9 Comment on the following statement. “The residual income model is no different from
the dividend discount model. Therefore, it has no value to investors and analysts.”
The residual income model is consistent with the dividend discount model. However, this does
not mean that it has no value. As indicated above, it can be used as a performance measurement
Q-10 Comment on the following. “Maximizing residual income is the same as maximizing
earnings. Managers should be rewarded for maximizing either one.”
Managers can increase earnings by increasing the amount of capital employed. On average,
investing in more assets translates to increased earnings. The problem is that there is no
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Q-11 Why do managers of Berkshire Hathaway have an incentive to send cash to Omaha?
Managers at Berkshire Hathaway are charged a high rate for the incremental capital that they
employ. If they can generate income in excess of that capital charge, they create value and are
Q-12 Should firm’s capitalize research and development expenditures? Why or why not?
Research and development expenditures are cash outflows. If they are expected to generate
future income, one can make an argument that these expenditures are really investments, which
Q-13 What is clean surplus accounting? What is its role in linking dividends and abnormal
earnings?
Clean surplus accounting is a term indicating that all profit and loss elements go through income.
Q-14 What is the efficient-markets hypothesis?
In its simplest form, the efficient-markets hypothesis states that information is quickly
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Q-15 Why does the concept of market efficiency (with respect to information) have no
necessary relation to the quality of accounting information? Why is this distinction
important with respect to accounting policy making?
Market efficiency refers only to the speed with which new information is incorporated into
Q-16 Why is the efficient-market hypothesis being challenged?
Numerous market anomalies have been reported. The Ou and Penman study, among others,
raises the question of whether all publicly available information is really impounded in security
Q-17 What is meant by “information content” and how does capital market research
determine the information content of accounting numbers?
Information content is a term referring to abnormal security returns in response to the release of
new, publicly available information. The research method is described in the chapter. There are
Q-18 What is the advantage of being well diversified? Is there a downside? Why or why
not?
There are two types of risk. The risk associated with an individual firm or entity is called
unsystematic (diversifiable, unique) risk. This risk can be eliminated with diversification. The
remaining portfolio risk is called systematic (undiversifiable, market) risk. Systematic risk is also
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Q-19 If investors are well diversified (e.g., own several hundred stocks), will they have a
greater or lesser need for accounting information? What does this say about
diversification?
As indicated above, an investor who holds many securities does not have the time or resources to
meaningfully analyze them. In this case, the investor is not able to effectively use the accounting
Q-20 What are some limitations of capital market research?
The study of price movements and the pricing mechanism in any market is an imposing task.
Determining cause and effect between information and security prices is especially difficult
because new information is continuously arriving. Since the set of information affecting security
prices is large, it is difficult to isolate the effects of one piece of information. Furthermore, we
are examining only a relatively small group of investors, those at the margin who influence stock
Q-21 What is an event study?
Q-22 What are abnormal returns (AR) and cumulative abnormal returns (CARs)? What do
they have to do with research in accounting? What do they have to do with accounting
standards?
An event study divides the period related to the event into three “windows:” an estimation
window, the event window, and the post-event window. The “normal” relationship between a
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security’s returns and those of the market is estimated during the estimation window. This allows
the researcher to estimate the parameters for the linear regression equation.
Q-23 Explain Lee’s (2001) view of market efficiency.
The null hypothesis for much of the capital markets research in accounting has been that the
market fully and instantaneously adjusts to new information; the market price is equal to the
Q-24 Lee (2001) rejects the “naive view” of market efficiency. Explain. If Lee is correct,
what are the implications for capital markets research in accounting?
Lee suggests that we have been asking the wrong questions. Instead of focusing on or assuming
that the market responds instantaneously to new information, he suggests that we consider
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Q-25 For event studies, the post event window is typically short (days or months). What are
some issues associated with examining longer event windows (e.g., years)?
For all practical purposes, event tests assume that aside from the event tested, all other things
Q-26 What do we mean when we say that capital market research involves a joint test of
both market efficiency and the model used to estimate abnormal returns?
In order to test the markets response to new information, the researcher must have a model of
expected security returns. If the market does not appear to be efficient with respect to a piece of
Q-27 Describe the general findings from capital market research concerning the information
content of accounting numbers and the effects of alternative accounting policies.
Accounting income numbers have evidenced information content in a wide variety of tests. It
must be emphasized, though, that stock prices are probably affected as much or more by
Q-28 Why is the choice between the FIFO-LIFO inventory methods an interesting issue in
capital market research?
The early capital market studies were motivated by tests of whether or not investors were
“fooled” by bookkeeping differences that had no direct cash flow effects on firms. This is an
important issue with respect to how sophisticated we assume users are—it will also affect the
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Q-29 As an investor, how would you react to a company changing is inventory accounting
from FIFO to LIFO? Why?
It would depend on the level of analysis. Change inventory accounting from FIFO to LIFO
Q-30 Over the years, the research findings regarding changing from FIFO to LIFO have
varied? Why do you suppose this is the case?
This issue, along with oil and gas accounting continues to produce some of the most anomalous
results in capital market research. As with the oil and gas issue, the technical aspects of the
Q-31 Why may accounting policies with no direct cash flow consequences indirectly affect
investors or creditors?
The argument derives from the agency or contracting theory. Existing contracts can be
affectedby changes in accounting methods that affect accounting numbers used in the contracts.
Q-32 Why is it argued that capital market research cannot determine the optimality of
accounting policies even for the limited investor-creditor group?
Q-33 How do market-level and individual decision-maker analyses complement one another
in studying the usefulness of accounting information to investors and creditors?
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Q-34 Lev talks about the low correlation between earnings and stock returns. Ou and
Penman paper discuss the possibility of making abnormal returns based upon
published financial data. Are these papers in conflict with each other or
complementary to each other?
The papers complement each other. Since Ou and Penman see a predictive role for accounting in
Q-35 What is post-earnings announcement drift (PEAD)?
If markets are efficient, security prices respond instantly and fully to new, relevant information.
Q-36 Why does post-earnings-announcement drift challenge the efficient-markets
hypothesis?
Post-earnings-announcement drift is a contradiction of the efficient-markets hypothesis. The
Q-37 Why does post-earnings announcement drift appear to be more pronounced with
smaller firms? What could be done from a company perspective to rectify this
situation? What could be done from a standard setting perspective to mitigate the
effects of PEAD?
Post-earnings-announcement drift appears to be more pronounced for smaller firms. There is
evidence that financial analysts underreact to very fundamental signals stemming from securities,
which in turn, lead to forecast errors and incomplete security price adjustments. There is also
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Q-38 What is the incomplete revelation hypothesis?
The incomplete revelation hypothesis is a hypothesis that may help to show why markets are less
efficient than we have previously believed. One reason is that it may be more difficult to
determine the effect of some numbers, particularly if they are buried in footnotes. Hence, stock
Q-39 Suppose an accounting event occurs and there is no market reaction. What should we
conclude?
It is sometimes hard to say. It could be that information was made available earlier via
nonaccounting means. An example might be industry information revealed by a competitor. It is
Q-40 Give some examples in which accounting information is not the most timely source of
information affecting security prices.
There are many examples. In this space we offer only a few. A competitor might announce that
the industry is in a slump. This is apt to affect all firms in the industry. A supplier might
Q-41 Instead of employing capital markets research techniques (e.g., event studies) why
don’t we just ask investors how they would react to a hypothetical event? Why don’t
we ask managers why they make specific accounting changes?
This is an age-old question. Will the investors and managers provide a truthful answer? If they
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Q-42 Why is it important to improve the quality of accounting standards?
Accounting information is useful in making valuation and compensation decisions. These
decisions affect securities pricing and ultimately, the efficient allocation of capital in the
economy (allocational efficiency). Directly or indirectly, everyone has a vested interest in the
Q-43 What do pensions have to do with a company’s operating performance? What do
pensions have to do with the firm’s financing and investment decisions?
Operating performance and the ability to generate cash eventually affects the firm‘s financing
and investment decisions. Poor operating performance might lead to increased financing needs or
to a reduction in investment expenditures. The converse is true for good operating performance.
Q-44 There is evidence that investors do not fully recognize the valuation effects of severe
pension underfunding. (See for example Franzoni, Francesco and José M. Marín
(2006). Why do you suppose this is the case? What changes could be made to mitigate
this problem?
Franzoni and Marín present evidence that the market significantly overvalues firms with severely
underfunded defined benefit pension plans. Furthermore, the effects of the overvaluation persists
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Q-45 Why are accounting ratios valuable for predicting bankruptcy? What cautions do we
need in evaluating accounting ratios?
Accounting-based ratios have been very useful in discriminating between firms that subsequently
went bankrupt and those that did not. Prior to bankruptcy, companies that eventually go bankrupt
Q-46 Accounting earnings are useful in predicting one-year ahead cash flows. Is this
sufficient? Why or why not?
From a financial economic perspective, the value of a firm is equal to the present value all
Q-47 Why do high levels of accruals appear to be mispriced?
Richardson, Sloan, Soliman, and Tuna find empirical evidence that suggests that accruals are
related to earnings persistence. In addition, the less reliable the accruals, the lower the earnings
Q-48 Evaluate Stewart’s (2009) discovery of a single overarching ratio, EVA Momentum,
which is “superior to all other ratios.”
Stewart III, G. Bennett (Spring 2009). “EVA Momentum: The One Ratio That Tells the Whole
Story,” Journal of Applied Corporate Finance, 74–84.
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Cases, Problems, and Writing Assignments
1. The usefulness of accounting data to investors and creditors for predictive purposes is
necessarily forward looking. However, under generally accepted accounting principles,
financial statements are constructed primarily as an historical record.
Required:
(a) What limitation does this impose on the usefulness of financial statements for
predictive purposes, and how is this limitation evident from the research reviewed in
the chapter?
(b) Provide examples of important forward-looking events that either are not reported
in financial statements or are not reported in a timely manner.
(c) Why may the feedback value of audited financial statements make them very
important to investors and creditors even though predictive value is not necessarily
high?
(a)
The FASB conceives of accounting as an information system with the emphasis mainly on
prospective cash flows. Since accounting systems are, by construction, historical records, they
are necessarily backward looking. Therefore, feedback value is going to be better achieved than
predictive value. Consistent with this is the low explanatory power of some capital market
research. Unexpected earnings “explain” only about 5 percent or less of a firm’s abnormal stock
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2. A retail company begins operations late in 2000 by purchasing $600,000 of
merchandise. There are no sales in 2000. During 2001 additional merchandise of
$3,000,000 is purchased. Operating expenses (excluding management bonuses) are
$400,000, and sales are $6,000,000. The management compensation agreement
provides for incentive bonuses totaling 1 percent of after-tax income (before the
bonuses). Taxes are 25 percent, and accounting and taxable income will be the same.
The company is undecided about the selection of the LIFO or FIFO inventory methods.
For the year ended 2001, ending inventory would be $700,000 and $1,000,000,
respectively, under LIFO and FIFO.
a. How are accounting numbers used to monitor this agency contract between
owner and managers?
b. Evaluate management incentives to choose FIFO versus FIFO?
c. Assuming an efficient capital market, what effect should the alternative policies
have on security prices and shareholder wealth?
d. Why is the management compensation agreement potentially counterproductive
as an agency-monitoring mechanism?
e. Devise an alternative bonus system to avoid the problem in the existing plan.
(a) The bonus is part of the compensation agreement and is limited to financial performance.
(b) See computations that follow.
FIFO LIFO
Sales $6,000,000 $6,000,000
Cost of Sales 2,600,000 2,900,000
Gross Margin 3,400,000 3,100,000
FIFO LIFO
Gross Margin $3,400,000.00 $3,100,000.00
Operating Expenses 400,000.00 400,000.00
Bonus (1%) 22,500.00 20,250.00
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(d) The agreement is a poor one because the bonus encourages a personal gain of $2,250 to the
managers for choosing FIFO at a cost of $74,437.50 in higher taxes to the firm. This choice
reduces shareholder wealth.
Critical Thinking and Analysis
1. How do you think the efficient-markets hypothesis impacts the drafting of accounting
standards? Bear in mind that many questions have been raised about the efficient-
markets hypothesis itself.
It’s nice that accounting information is presumably rapidly impounded into security prices but
the FASB shouldn’t—and hasn’t—been seduced by the EMH. First of all, the quality of
accounting information can be improved (see Lev, 1989 and Wyatt, 1983). Second, the FASB
2. To what extent should the liquidity measures revisions be considered if LIFO were to
be eliminated from U.S. GAAP? Provide examples of those likely measures that would
be affected. . As an interesting side note, what does the 2016 United States Budget
estimate the effect on revenues will be if LIFO accounting for inventory is repealed?
This is a problem somewhat like the one faced when FASB first considered requiring all leases
be placed on the balance sheet. In the case of leases, ratios were affected, severely in some
cases. Inventory days supply on hand, current ratio, debt to asset ratios: they are all affected if a
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2. Trombetta, et al (2012) discusses how effects analyses might help determine the
usefulness of accounting standards. Which research method do you argue provides the
best analysis of a new standard?
Trombetta, Marco, Alfred Wagenhofer, and Peter Wysocki (2012). “The Usefulness of
Academic Research in Understanding the Effects of Accounting Standards,” Accounting in
Europe, 127-146.
Discussions should consider two macro approaches:
• Theoretical approaches: economic, behavioral, historical research, and theorizing.