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The Relevance of the Value-Relevance Literature for Financial

Accounting Standard Setting
Robert W. Holthausen
University of Pennsylvania

Ross L. Watts

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Recommended Citation
Holthausen, R. W., & Watts, R. L. (2001). The Relevance of the Value-Relevance Literature for Financial
Accounting Standard Setting. Journal of Accounting and Economics, 31 (1-3), 3-75. http://dx.doi.org/
10.1016/S0165-4101(01)00029-5

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The Relevance of the Value-Relevance Literature for Financial Accounting
Standard Setting

Abstract
In this paper we critically evaluate the standard-setting inferences that can be drawn from value relevance
research studies that are motivated by standard setting. Our evaluation concentrates on the theories of
accounting, standard setting and valuation that underlie those inferences. Unless those underlying
theories are descriptive of accounting, standard setting and valuation, the value-relevance literature's
reported associations between accounting numbers and common equity valuations have limited
implications or inferences for standard setting; they are mere associations. We argue that the underlying
theories are not descriptive and hence drawing standard-setting inferences is difficult.

Keywords
accounting theory, standard setting, value relevance, valuation

Disciplines
Accounting

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 The Relevance of the Value Relevance Literature
For Financial Accounting Standard Setting

Robert W. Holthausen
The Wharton School
University Pennsylvania

Ross L. Watts
William E. Simon Graduate School of Business Administration
University of Rochester

First draft: November 14, 1999

Current draft: September 22, 2000

COMMENTS WELCOME

This paper was prepared for the Journal of Accounting & Economics Conference held
April 28-29, 2000. We wish to thank Kirsten Ely, Rick Lambert, Fred Lindahl, Greg
Waymire, the discussants (Mary Barth, Bill Beaver and Wayne Landsman), the editors
(S.P. Kothari, Tom Lys and Jerry Zimmerman) and workshop participants at George
Washington University, M.I.T. and the Journal of Accounting & Economics Conference
for their helpful comments.
 The Relevance of the Value Relevance Literature
For Financial Accounting Standard Setting

Abstract

We evaluate the literature that, for standard-setting purposes, assesses the usefulness of
accounting numbers on their stock market value association. For several reasons we
conclude the literature provides little insight for standard setting. First, the association
criterion has no theory of accounting or standard setting supporting it. Standard setters'
descriptions of their objectives and accounting practice are both inconsistent with the
criterion. Important forces shaping accounting standards and practice are ignored.
Second, many tests in the literature rely on valuation models that omit important factors
and many studies do not provide links between valuation model inputs and accounting
numbers. Finally, there are a variety of significant econometric issues in the studies.
1. Introduction
Over the last decade a large number of accounting papers investigate the
empirical relation between stock market values (or changes in values) and particular
accounting numbers for the purpose of assessing or providing a basis of assessing those
numbers’ use or proposed use in an accounting standard. We call the group of papers
that are at least partially motivated by standard setting purposes, the “value-relevance”
literature. This paper’s objective is to critically evaluate the standard-setting inferences
that can be drawn from these value-relevance papers. The evaluation provides
suggestions for future research for standard setting purposes.
A number of papers raise issues about the methodology used in the value-
relevance literature, particularly econometric issues (e.g., Lambert, 1996; Lys, 1996; and
Skinner, 1996, 1999). While we address econometric issues in this paper, we concentrate
more on the logic and assumptions underlying the standard setting implications of the
value-relevance papers. The logic and assumptions imply theories of standard-setting,
accounting and valuation. Assessing the papers’ implications for standard-setting
requires evaluating the descriptiveness of those theories. Moreover, an understanding of
these issues is necessary to address econometric issues.
There are other papers in the accounting literature that address the value-
relevance of accounting information without regard to standard setting. For example, the
capital markets literature in accounting provides evidence on topics such as the
information content of accounting numbers and the determinants of earnings response
coefficients. That literature is reviewed in detail in Kothari (2001). While we don’t
review that literature directly, our assessments of the valuation models and the assumed
links between the accounting numbers and the valuation models (section 5) are directly
applicable to those papers in the capital markets literature that rely on the same models.
Other accounting papers address reasons various parties to standard-setting (for
example, management) prefer particular accounting method alternatives. Evidence from
those papers is directly relevant to developing theories of accounting and standard setting
of the type we discuss in sections 3 and 4. However, the theories of accounting and
standard setting underlying value-relevance studies generally do not incorporate factors
 7:57 AM 10/6/2000 2

other than association with value.1 Moreover, studies of management preferences among
accounting alternatives are part of the literature reviewed in Fields, Lys and Vincent
(2001). For these reasons we do not review that literature in this paper.

1.1 Types of studies

To facilitate our analysis we classify the value-relevance studies into three
categories. Other papers use a similar classification (e.g., Lambert, 1996). Some
individual papers fall into several categories of studies.
i) Relative association studies compare the association between stock market
values (or changes in values) and alternative bottom line measures. For
example, a study might examine whether the association of an earnings
number, calculated under a proposed standard, is more highly associated
with stock market values or returns (over long windows) than earnings
calculated under existing GAAP (e.g., Dhaliwal, Subramanyam and
Trezevant, 1999). Other examples compare the associations of foreign
GAAP and US GAAP earnings (e.g., Harris, Lang and Moller, 1994).
These studies usually test for differences in the R2 of regressions using
different bottom line accounting numbers. The accounting number with the
greater R2 is described as being more value-relevant. Table 1 provides a
partial listing of papers in the value-relevance literature classified by type of
study performed. Fifteen (24 percent) of the 62 papers listed in Table 1
perform a relative association study.
ii) Incremental association studies usually use regressions to investigate
whether the accounting number of interest is helpful in explaining value or
returns (over long windows) given other specified variables. That
accounting number is typically deemed to be value relevant if its estimated
regression coefficient is significantly different from zero. For example,
Venkatachalam (1996) examines the incremental association of the fair
value of risk management derivatives disclosed under SFAS 119 in a

1
One of the papers listed in Table 1, Aboody and Lev (1998), investigates both value-relevance and
management preferences. That paper does not, however, include management preferences as a standard
 7:57 AM 10/6/2000 3

regression of equity market value on a variety of on and off balance sheet

items. Some incremental association studies make additional assumptions
about the relation between accounting numbers and inputs to a market
valuation model in order to predict coefficient values and/or to assess
differences in the error with which different accounting numbers measure a
valuation input variable. For example, Venkatachalam (1996) also tests
whether the coefficient on the fair value of derivatives is significantly
different from one. Differences between the estimated and predicted values
are often interpreted as evidence of measurement error in the accounting
number. For that reason we call those studies measurement studies. Fifty-
three (85 percent) of the 62 papers in Table 1 perform an incremental
association study. Thirteen (25 percent) of the 53 papers perform
measurement studies.
iii) Marginal information content studies investigate whether a particular
accounting number adds to the information set available to investors. They
typically use event studies (short window return studies) to determine if the
release of an accounting number (conditional on other information released)
is associated with value changes. Price reactions would be considered
evidence of value-relevance. For example, Amir, Harris and Venuti (1993)
test the marginal information content of the Form 20-F reconciliation of
foreign and US GAAP earnings numbers for foreign firms by regressing
five-day abnormal announcement returns on the difference and the change
in the difference between foreign and US GAAP earnings. Only seven (11
percent) of the 62 papers perform an information content study.
Given 94 percent of value-relevance papers perform association studies (relative
and/or incremental) while only 11 percent perform information content studies and that
marginal information content is probably not necessary nor sufficient for standard-setting
(see section 3), we concentrate on association studies. Holthausen and Palepu (1994)
contains an extensive review of marginal information content studies.

setting criterion.
 7:57 AM 10/6/2000 4

1.2 Standard-setting motivation

We rely on statements in the papers to assess whether the authors view their
results as having implications for standard setting. Papers that explicitly state that their
results have such implications are included in the literature and listed in Table 1. We find
54 such papers. We also include in Table 1 a small number of papers (eight) whose
language implies (but does not explicitly state) standard setting implications. This latter
determination is necessarily subjective. Note that standard setting is not necessarily the
sole motivation of the papers listed in Table 1 since many also contribute to the
accounting valuation literature.
We quote four papers as examples of the types of statements made in this
literature. The first three examples have explicit standard-setting motivations (Ayers,
1998; Barth, 1994; and Dhaliwal et al, 1999), while the fourth (Amir and Lev, 1996) is an
example of a more implicit standard setting motivation. Ayers (1998, p. 196) motivates
his incremental association study as follows:
“. . .the question of whether SFAS No. 109 provides incremental value-
relevant firm specific information is of interest for at least two related
reasons. First, the FASB is obligated to consider the costs and benefits of
its standards . . . Second, the objective of accounting policy decisions is to
produce information that is relevant and reliable (FASB 1980, SFAC
No.2).”

The motivation for Barth’s (1994, p. 1) incremental association study is also

explicit:
“By examining how share prices reflect historical costs and fair values,
evidence is provided on the measures' relevance and reliability. Because
these are the FASB's two principal criteria for choosing among accounting
alternatives . . . the evidence can inform the FASB’s deliberations on
using fair value accounting for investment securities, to the extent the
disclosed fair value estimates would be used to measure investment
securities under fair value accounting.”

Dhaliwal et al (1999, pp. 44-47) provide explicit standard setting motivation for
their relative association study:
“SFAS 130 is the culmination of a long-standing debate in the accounting
profession between the ‘all-inclusive’ (or ‘comprehensive income’) and
the ‘current operating performance’ concepts of reporting income. This
debate has been at the forefront of accounting-standard setting from the
 7:57 AM 10/6/2000 5

1930s to the present. . . . This analysis allows us to draw inferences

regarding the appropriateness of current and potential items of
comprehensive income. These inferences should assist the Financial
Accounting Standards Board as it turns to the broader-scope projects
(described in SFAS 130, paragraph 54) that will address the issue of which
items should be included in ‘other comprehensive income.’”

In our view, the above quoted papers and the others listed in Table 1 as explicitly
motivated by standard setting, contain direct statements of their standard setting
motivations. Occasionally, however, the standard-setting motivation is implicit. For
example, Amir and Lev (1996, p. 28) state in their conclusion:
“The evidence presented in this study indicates that current financial
reporting of wireless communications companies –– a large world-wide
and technologically leading industry –– is inadequate. Specifically,
significant value-enhancing investments in the cellular franchise and in
expanding the customer-base are fully expensed in financial reports,
leading to distorted values of earnings and assets.”

In this quote the description of current financial reporting as “inadequate” and generating
“distorted” values suggests that reporting should be improved, presumably via new
accounting standards. In particular, Amir and Lev (p. 5) suggest capitalization of
customer-acquisition costs in the financial statements or “clear separation between
regular expenses and costs which potentially enhance future cash flows . . .”

1.3 Theories underlying studies and inferences for standard-setting

Drawing standard setting inferences from the results of a value-relevance study
requires theories of standard setting, accounting and valuation. This may not be
immediately obvious from many value-relevance papers, because they do not always
fully articulate those theories. Some authors, however, are quite explicit in laying out the
required links necessary to draw any implications for standard setting.
The nature of implicit standard setting theories underlying value-relevance
papers’ inferences can be gleaned from the experimental designs in the papers. For
example, as quoted earlier, Dhaliwal et al (1999) draw inferences regarding the relative
superiority of two alternative summary measures of income by assessing those measures’
 7:57 AM 10/6/2000 6

association with stock returns.2 This implies that the association between an accounting
number and value is a factor in standard setters’ decisions on the specification of
accounting income. This contrasts with Barth (1994) who is explicit about the standard
setters’ decision criteria. Based on Statement of Financial Accounting Concepts (SFAC)
No.2 she assumes the FASB’s two prime criteria for choosing among accounting
measures are those measures’ relevance and reliability. While her measures of relevance
and reliability are based on associations with value, she does not assume that the
associations themselves are of direct interest to standard setters.
Value-relevance papers also rely on accounting theories. In particular, in drawing
inferences for standard setting, most authors assume that accounting’s dominant role
(from a standard setter’s perspective) is to provide information relevant for equity
valuation (see Barth, 2000; and Lambert, 1996). Other accounting functions may be
recognized, but they are not explicitly considered in the research design.
Finally, valuation models or theories underlie some value-relevance papers’
standard setting inferences. For example, the experimental design in Barth (1994)
requires specific valuation models in order to generate estimates of the relevance and
reliability of fair values of investment securities from the association between accounting
numbers and stock prices.
The potential to draw standard setting inferences from value-relevance papers’
results depends on the descriptiveness of the underlying theories of standard setting,
accounting and valuation. The less descriptive the theories, the less likely standard
setting inferences are valid. To illustrate the importance of the descriptive ability of the
underlying standard setting theory, consider the two examples given above. The less the
FASB relies on an income measure’s association with stock returns in setting accounting
standards, the less reliable are Dhaliwal et al’s implications for the composition of
accounting income measures. If the concepts of relevance and reliability employed by
Barth do not match the concepts of relevance and reliability as used by the FASB, then
any inferences drawn about the relevance and reliability of the fair value estimates of
investment securities in those tests are subject to question. Since it is not obvious that the

2
As a specification check, Dhaliwal et al (1999) also examine the associations between comprehensive
income and net income with operating cash flows and net income measured one-year ahead. Those results
 7:57 AM 10/6/2000 7

underlying standard setting theories are descriptively accurate, assessment of the

potential of the value-relevance literature to inform standard setting requires a
determination of the descriptive ability of the underlying standard setting theory.
Standard setting inferences also depend on the underlying accounting theory’s
descriptive ability. It is not obvious that standard setters consider equity valuation to be
the sole or dominant function of accounting reports. There are other well-recognized
functions of accounting (private contracting with its associated monitoring, regulation,
litigation, etc.) and there is ample evidence to suggest that they influence standard setting.
Assessment of the value-relevance’s implications for standard setting requires a
determination of the descriptive ability of the underlying accounting theory.
The valuation models employed in the value-relevance literature (like all
valuation models and theories) necessarily incorporate a number of assumptions that are
not descriptive. A theory is necessarily a simplified model of the world. However, some
of the valuation model assumptions employed seem likely to make those models
significantly less descriptive, which potentially affects the validity of any standard setting
inferences that could be drawn from those results. For example, the valuation models
used in the value-relevance literature frequently assume that firms do not earn rents, so
that the market value of equity is equal to the market value of net assets. That enables
papers to predict significant positive (negative) coefficients on measures of individual
assets (liabilities), predict the magnitude of the coefficients (under certain assumptions)
and estimate a linear valuation equation. However the existence of rents (and
abandonment and expansion options) is likely, implying a non-linear valuation equation.
In that case estimation using a linear model could generate coefficients different from
those predicted. The descriptive ability of the valuation theory, like the descriptive
validity of the standard setting and accounting theories is important.
Note that in looking to equity market values to determine relevance, the value
relevance literature assumes capital markets are efficient (e.g., equity prices containing
unbiased estimates of the market values of assets and liabilities). There is a significant
body of literature that questions the efficiency of capital markets (see Kothari, 2001).
Some studies make even stronger assumptions than market efficiency: the market’s

are not the primary criterion on which they draw inferences.

 7:57 AM 10/6/2000 8

estimates are assumed not just to be unbiased but instead to be error-free (prices are not
noisy).
Because many value-relevance studies do not articulate the theories underlying
their tests and inferences, the links between the theories and accounting are not often well
specified. For example, rarely is the link between the accounting measure (coming out of
some accounting theory) and a valuation variable (from a valuation model or theory) well
specified. Studies often employ valuation models that express the market value of equity
as some multiple of permanent earnings and then substitute current earnings for
permanent earnings without explaining the relation between the accounting measure and
the valuation model input. These ill-specified links also likely reduce the descriptive
ability of the theories and weaken any potential standard setting inferences.
Given the importance of the descriptive ability of the theories underlying the
value-relevance literature, we investigate the theories’ empirical implications and
conclude that the theories are not very descriptive. This raises questions regarding the
appropriate inferences that can be drawn from this literature and the ability of the
literature to inform standard setting. We also explore avenues of research that we believe
would yield additional insights about standard setting and the role of accounting.
While not our primary focus, many of the issues we discuss in this paper are
important to empirical work in the capital markets literature in general, for example
valuation research using accounting measures. As such, some of the comments here can
be viewed as a critique of elements of that literature as well, particularly the discussion of
the assumed valuation models and the links between the accounting numbers and the
models’ required inputs. What makes the value-relevance literature different from most
of the general capital markets literature, are the value-relevance literature’s underlying
theories of standard-setting and accounting. In addition, not all of the capital markets
literature, as it is generally defined, relies on the valuation models discussed here.

1.4 Outline of the paper

Section 2 examines value relevance papers’ stated explanations of the logic and
assumptions underlying their empirical tests and the assumptions implicit in the empirical
tests themselves in order to infer underlying theories of accounting and standard setting.
 7:57 AM 10/6/2000 9

Those papers often base some of their stated assumptions about standard-setting and the
role of accounting on FASB statements. In Section 3 it is noted that the role of
accounting implicit in a consistent application of the value relevance tests, valuation of
equity securities, is explicitly contradicted by SFAC No.1. This suggests problems with
the assumptions and logic underlying the tests’ derivation. Three assumptions are
identified as not following from FASB statements. We conclude that the value-relevance
tests omit some factors that the FASB states are important for assessing whether
information is useful and use some criteria that are contrary to FASB statements.
In the fourth section, we investigate whether the explicit and implicit standard
setting and accounting theories used in the value-relevance literature can explain
observed accounting practice. The objective is to provide evidence on the descriptive
ability of the literature’s underlying theories of standard setting and accounting. We
identify some important characteristics of current accounting practice (for example
conservatism) that are not explained by the criteria used in the value-relevance literature.
This raises questions about the literature’s underlying theories of standard setting and
accounting, for example the dominance of the valuation use of accounting numbers. We
discuss a number of uses of accounting reports, extant in the more general accounting
literature, that have the potential to explain characteristics of observed practice. This is
important because it indicates that the value-relevance literature alone is not likely to be
very informative to the standard setting community.
Section 5 evaluates the valuation models used in value-relevance empirical
studies and the links between accounting numbers and valuation model inputs. We find
the three basic valuation models used in the literature are appropriate only under very
restrictive circumstances and that none of them can adequately deal with growth and
abandonment options. It is also important to note that none of the valuation models
provide any role for accounting. For example, two of the models typically used provide
no role for components of earnings. This lack of a role for accounting makes their use in
assessing the desirability of alternative accounting constructs problematic.
Finally, section 6 offers our conclusions and suggestions for future research. The
main conclusion is that value-relevance tests do not incorporate, and in some instances
conflict with, a variety of considerations involved in standard setting and the role of
 7:57 AM 10/6/2000 10

accounting. In other words, the theories of standard setting and accounting underlying
the value-relevance literature are not descriptive. This determination is based on both
statements of the FASB and observed practice. Even if the theories of standard-setting
underlying the value-relevance literature were completely consistent with FASB
statements about standard setting, the literature would still fail to meet its objectives due
to deficiencies in the valuation models used. Many authors in this literature offer
appropriate caveats for some of these problems. But, what is not often made clear is that
the criteria underlying the value-relevance literature are quite narrow in scope, relative to
the multiple uses of financial statements and so are unlikely to be very informative to the
standard setting community.
Our discussion suggests a variety of researchable issues that could help inform
standard setting. One is that accounting researchers investigate the existence and strength
of forces, other than equity valuation, that affect accounting standards and practice. A
more thorough understanding of those forces would make our research more useful to
standard setters. An understanding of those forces is also important to the accounting
valuation literature.

2. The Underlying Logic and Assumptions

Value-relevance papers vary in the depth of their explanations of the logic and
assumptions underlying the links between their methodology and standard-setting,
ranging from minimal or no explanation to relatively complete explanations. The logic
and assumptions essentially embody theories of standard setting, accounting and
valuation. Below we give an example of each of the extremes of explanation,
recognizing that many papers fall between these benchmarks.
Minimal or no explanation. Many value-relevance studies provide minimal
explanation of the logic and assumptions underlying their methodology. Some rely on
references to more complete explanations in papers such as Barth (1991, 1994), one of
which is discussed below. Others, many of them relative association studies, do not
reference more complete explanations, nor do they provide their own logic or support for
their assumptions. Dhaliwal et al (1999) is an example. Additional examples include,
 7:57 AM 10/6/2000 11

among others, Alford, Jones, Leftwich and Zmijewski (1993), Harris, Lang and Moller
(1994) and Harris and Muller (1999).
Dhaliwal et al (1999) assess whether net income or comprehensive income is a
better measure of firm performance by comparing the two measures’ associations with
stock returns. The paper’s motivation (quoted previously) and its stated implications (pp.
60-61) assume accounting standard-setters are interested in which income measure is
most highly associated with stock market value changes. No evidence that standard-
setters have such interest is given or referenced in the paper, and no rationale for why
they would be interested in the results of relative association tests is discussed in the
paper.
Presumably Dhaliwal et al’s rationale for comparing the explanatory power of
income numbers is that the one with the highest association is more consistent with the
information investors use in setting stock prices (see Lambert , 1996, p. 19). This
conclusion is derived from the theory underlying many value-relevance studies that views
accounting as supplying inputs to equity valuation (see Lambert, 1996; and Barth, 2000).
Investors can use the estimated relation between stock prices and income to obtain an
estimate of the equity value from the income number that is most highly associated. Note
that the mostly highly associated income number is not necessarily the most accurate
measure of equity value. To illustrate, assume net income is intended to measure
permanent income (a perpetuity whose value equals the value of equity) and stock
price/income regressions are estimated for each alternative net income measure. Then
the most accurate measure is the income number whose regression yields an estimated
intercept of zero and an estimated slope coefficient of one over the discount rate (see
Lambert, 1996, pp. 19-26). The income measure most associated with stock price could
be one with an estimated intercept significantly different from zero and an estimated
slope coefficient significantly different from one over the discount rate. An estimate of
equity value could be obtained from the most associated income number by using the
estimated regression. 3 Choosing between the accuracy and association criteria requires

3
For example, suppose the R2 of a regression using earnings series 1 is 40%, the intercept is –55,001 and
the slope coefficient is 25.25. For earnings series 2, assume the R2 of the series is 36%, the intercept is zero
and the slope coefficient is 10, exactly equal to the predicted value of the coefficient of permanent income,
one over the discount rate (10%). Furthermore, assume the 4% difference in the R2 is statistically
 7:57 AM 10/6/2000 12

an accounting and standard setting theory. If the FASB is interested in investors being
able to use the information to generate their own estimates of value, association is the
appropriate test. If the FASB is interested in income measuring value, accuracy might be
the appropriate test. Without a theory of accounting and standard setting, one cannot
determine which is the appropriate criterion.
Pursuing the objective of maximizing association would lead to income being
highly associated with value or changes in value. While this is motivated by an input to
valuation argument, it will in practice lead to an income number that is a linear
transformation of value itself. This hardly seems consistent with an input to valuation
view of accounting. Dhaliwal et al argue they are merely testing claims of various parties
who argue over whether net income or comprehensive income is a better summary
measure of performance. But, as indicated above, is a “better summary measure of
performance” one that more accurately measures permanent income or one that is more
highly associated with changes in value? They judge the quality of alternative summary
measures primarily by mere association with changes in equity value. Note that the
reliance on aggregate changes in value means Dhaliwal et al do not have to specify a
valuation model.
Relatively complete explanation. Some of the incremental association studies
have more complete explanations of their underlying logic and assumptions, though again
there are large differences across studies. Many, as suggested in the earlier Ayers quote,
link an accounting measure’s incremental value-relevance to the concepts of relevance
and reliability, which are explicitly discussed by the FASB as being important
characteristics of accounting information.
The Barth (1994) incremental association study provides one of the most
complete explanations for the logic and assumptions underlying a value-relevance study.
As we have noted, Barth’s underlying standard setting theory relies on standard-setters’
statements about the criteria for choice among accounting alternatives. In particular,

significantly at the 5% level. How would the FASB consider the tradeoff of explanatory power versus
accuracy? Earnings series 1 clearly has the greater explanatory power and would be pronounced “the
winner” in a relative association test study. In order to estimate equity value from earnings series 1, one
would scale the earnings series by an appropriate factor and adjust for the intercept. Earnings series 2,
despite its slightly lower explanatory power, closely approximates permanent income and estimated value is
the earnings multiplied by 10.
 7:57 AM 10/6/2000 13

based on SFAC No.2, she assumes the FASB’s two prime criteria for choosing among
accounting alternatives are the comparative relevance and reliability of the alternative
measures. Her objective in the paper is to compare the relevance and reliability of fair
market value and historical cost measures of the value and change in value of investment
securities held by banks. Barth (2000,p.16) states that “relevance refers to the ability of
the item to make a difference to decisions of financial statement users” and “reliability
refers to the ability of the measure to represent what it purports to represent.” The
relevance definition is consistent with SFAC No.2 paragraph 47. The reliability
definition is roughly consistent with SFAC No.2 paragraph 59 except that it makes no
mention of verification. Paragraph 59 states “the reliability of a measure rests on the
faithfulness with which it represents what it purports to represent, coupled with an
assurance for the user, which comes through verification , that it has representational
quality.” As we shall see verifiability can be important and might not be reflected in
incremental association.
The links articulated in Barth (1994) including the measurement error model of
Section V (pp. 20 – 23) employs a variation of the methodology in Barth (1991) that is
found in varying degrees in other value-relevance papers. A comparison of the
differences in the relevance and reliability of different accounting measures requires a
benchmark of the variable being measured, the “true” value of investment securities and
the true gain and loss on those securities. To achieve this, Barth uses the asset value of
investment securities implicit in the stock price: “The approach views accounting
measures as variables measured with error and the amounts implicit in share prices as
‘true’ variables.” (Barth, 1994, p. 20). The assumption that the amounts in share prices
are the “true” variables is stronger than market efficiency: the market’s estimates are not
just unbiased they error-free. The comparison of accounting numbers to variables implicit
in stock prices implies accounting provides measures of variables that are inputs to
valuation.
Comparison of “true” asset values implicit in share prices with accounting
measures of those values requires the assumption of a particular stock market valuation
model. Barth assumes three stock market valuation models; one for the market value of
equity used in evaluating the relevance and reliability of measures of the asset’s value,
 7:57 AM 10/6/2000 14

and two for changes in value or stock returns used in evaluating changes in the asset’s
value. In all the valuation models, the “true” value of the investment securities is the
asset’s market value implicit in the market value of the equity.
Barth uses a variety of regression specifications to simultaneously determine the
“true value” of the investment securities implicit in price as well as to assess the
relevance and reliability of the alternative accounting measures. To illustrate Barth’s
logic with minimal investment and no loss of explanatory power, we use only one of her
specifications. The specification includes a single accounting measure of the value of
investment securities, fair value. In that specification, stock market values are regressed
on investment securities’ fair value and the book value of equity before investment
securities. The same model is also run where historical cost measures of investment
securities are substituted for the fair value measures.
The relevance and reliability of a fair value measure are inferred from the
significance of the fair value measure’s estimated regression coefficient. Based on her
assumed valuation models, Barth argues (p. 7) the estimated coefficient on the fair value
of investment securities should be one. As Barth recognizes, this requires; (1) the
valuation models be correct; (2) all the accounting measures equal the value of their
relevant variables in the valuation models (there is no measurement error or bias); and (3)
the measures of all the variables in the valuation models be included (no correlated
omitted variables). If fair value measures the asset’s market value with sufficient error or
bias, the estimated coefficient could be other than one and potentially insignificant.
Barth argues that a significant incremental association with the implicit market
value of investment securities indicates the fair value of investment securities is used as
an estimate of an input into an equity valuation model, which in turn implies it is relevant
to some business decisions. The finding that the measurement error is insufficient to
generate insignificance suggests that the measure is at least somewhat reliable.4

4
These conclusions assume there are no correlated omitted variables and that the accounting measures of
assets and liabilities other than non-investment securities have no measurement error . Barth recognizes
that, if some valuation variables are omitted from the regression, the significance of the fair value
measure’s coefficient could be due to correlation between the fair value measure and the omitted variables
rather than to the relevance and reliability of the fair value measure. She also allows for measurement error
in the historical cost and fair value variables in her tests, by imposing a specific structure for the
measurement error. In addition, she attemp ts to discriminate between a measurement error and correlated
omitted variables explanation for her finding that the fair values of assets are highly correlated with the
 7:57 AM 10/6/2000 15

The discussion of the Barth (1994) paper clearly demonstrates the theories and
assumptions necessary to draw standard setting inferences from her tests. Among the
necessary conditions for drawing any type of inference on whether the fair value of
investment securities should be included in the balance sheet are the following. First, any
inference requires the FASB be concerned about the extent to which investment
securities’ fair value estimates measure their “true” market values (e.g. the extent of bias
and measurement error) as a precondition for recognition in the balance sheet. Thus,
implicit here is a theory of standard setting and the role of accounting. Second, it
requires the market valuation model be descriptive (e.g., in the levels model, it is
assumed that the market value of equity approximately equals the market value of the
separable net assets). Thus, this presumes the valuation model is appropriate and
observed equity prices are not very noisy estimates of “true value” of the common equity.
Third, it requires the book value of net assets (other than investment securities) measure
the market value of those net assets without bias and or measurement error (or that
somehow, the tests control for those problems). Fourth, it requires no correlated omitted
variables.
Between the extremes of the Dhaliwal et al (1999) and the Barth (1994) papers lie
a wide range of explanations of the standard setting and accounting theories underlying
the associations estimated and the standard setting inferences generated. Regardless of
the completeness of their explanation, all of the value-relevance papers assume the
primary purpose of financial reporting (financial statements and disclosures) is to provide
information to investors for use in assessing the value of the firm for investment decision
purposes. This assumption seems to be made both as a description of accounting practice
as part of an accounting theory and as a description of the objective pursued by
accounting standard setters as part of a standard setting theory. Barth (2000, p. 10) states
“Investors represent a large class of financial statement users and thus much academic
research addressing financial reporting issues relevant to practicing accountants,
particularly standard setters, adopts an investor perspective . . . investors are primarily

market value of equity, but that the fair value of security gains and losses is not related to returns,
ultimately favoring a measurement error explanation.
 7:57 AM 10/6/2000 16

interested in information that can help them assess the value of the firm for purposes of
making informed investment choices.”
Value-relevance studies determine whether an accounting number is useful for
valuing the firm by investigating whether the accounting number is associated with stock
prices. As we have seen, relative association studies test the relative usefulness of
alternative financial statement bottom line numbers. Incremental association studies test
the usefulness of individual financial statement components or disclosures. As noted in
discussing the Dhaliwhal et al explanation, the relative association test implies that
income numbers can be transformed into estimates of the equity value or change in value.
Incremental association study tests are supposed to indicate the usefulness of accounting
measures as inputs to valuation. However, the distinction between the two interpretations
is more cosmetic than real. To see this consider what would happen if the FASB literally
followed the standard setting inferences made from incremental association studies and
did not consider any other factors.
Consider studies involving balance sheet components and using the balance sheet
valuation model described in Barth (1994) (i.e., the market value of equity equals the
market value of net assets). Assume the incremental studies solve all the problems
identified earlier: the valuation model is descriptive, the problems of bias and
measurement error in the variables are controlled and there are no correlated omitted
variables. Suppose the FASB embarked on a program of conducting incremental
association studies on all assets and liabilities one at a time.5 First, assume they select the
accounting measure for each asset or liability that has the highest incremental association
with equity market value. If the program were successful the net asset value would be

5
The value relevance literature seems to be expanding to cover a wide range of assets, liabilities and
earnings components. It is not restricted to assets such as investment securities where the circumstances
are more suitable for studies such as Barth (1994). Nine of the papers listed in Table 1 study investment
securities, but 57 papers study other accounting topics (the numbers add to more than 62 because some
papers study multiple accounting topics). The numbers of studies on various issues are: eight on intangible
assets (including software development, brand names, development expense, goodwill, patents and research
and development); five on other asset valuation (current cost, property, oil and gas reserves and
acquisitions); 17 on liabilities (pensions, post-retirement benefits other than pensions, environmental
liabilities, deferred taxes and stock options); eight on various performance measures (earnings components,
various EPS measures, economic value added, cash flow alternatives, comprehensive income and
alternative real estate investment trust measures); two on foreign income and exchange gains and losses; 15
incremental and relative association studies on different countries’ accounting methods; one on intemporal
value relevance; and one on fundamental analysis.
 7:57 AM 10/6/2000 17

highly associated with the market value of equity. Since the book value of net assets is
the book value of equity, this program would be similar to a program aimed at selecting
alternative book values of equity based on their relative association with the market value
of equity. The incremental association program would end up with a book value of
equity that is a transformation of the market value of equity. Now assume the FASB
adopts a measurement approach and selects the accounting measure for each asset or
liability that measures the market value of that asset or liability with least error. If the
program was very successful, each asset and liability measure would approximate its
market value and the book value of equity would approximate the market value of equity.
Given the valuation model, a standard setting program based on measurement or
incremental association would end up providing equity value estimates directly or
measures that could be transformed into equity value estimates. The same point could be
made for a program of measurement or incremental studies studies on earnings
components using a given earnings valuation model: earnings would become an estimate
of equity value or the change in equity value, depending on the chosen valuation model,
or a measure that could be transformed into an equity value estimate.
Most value-relevance researchers likely do not believe that either the book value
of equity or earnings should be an estimate of equity market value or a measure that can
be transformed into an estimate of equity market value. Many are careful to indicate that
they are only providing information to standard setters that the standard setters can weigh
along with other relevant factors (see Barth, 2000, pp. 8-9), that they are merely assessing
the relevance and reliability of alternative accounting estimates, or that they are testing
the claims of various parties about the properties of alternative accounting estimates.
But, the other factors’ nature and trade-off with value relevance are not discussed in the
literature. Thus, the validity of any standard setting inferences drawn from this literature,
or the extent to which this literature can inform standard setters, depends positively on
the extent to which accounting is concerned with equity valuation and providing
estimates of equity values, and negatively on the extent to which accounting plays other
important roles.
The underlying premise in the value-relevance literature is that accounting’s
primary or dominant role is the valuation of equity securities. To the extent accounting
 7:57 AM 10/6/2000 18

has other roles, the value-relevance literature’s lack of consideration of those roles
assumes an accounting measure’s usefulness in other roles is captured by its association
with equity valuations. In this paper we refer to this underlying assumption of the
literature as the value-relevance criterion.

3. FASB Statements and Value -Relevance Theories

In the previous section we argue the value relevance literature’s tests imply
accounting’s role is equity valuation and that accounting fulfils that role by providing
estimates of value or transformations of value. In deriving their tests, value relevance
researchers often rely on some FASB statements about the nature of accounting and
standard setting. Our first point in this section is that other FASB statements explicitly
contradict the implication that the FASB intends accounting to provide estimates of
equity valuation. Assuming FASB statements are consistent, we compare assumptions
made in deriving value relevance tests to FASB statements and ask what assumptions are
made that could lead to that contradiction. The first assumption we identify is that the
FASB considers users other than equity investors and uses other than valuation of equity
securities in determining accounting standards. Indeed, FASB statements do not imply
the FASB regards provision of inputs to equity valuation as the sole, or even dominant,
function of financial statements let alone that equity valuation is accounting’s role. Thus,
relevance do not require an accounting measure to be a measure of an equity valuation
model input. The second assumption made in the value relevance literature that we
identify as not implied by FASB statements is the assumption that stock prices
adequately represent equity investors’ use of information in valuing equity securities.
The third assumption we identify is that the tests of relevance and reliability teased from
stock prices do not necessarily reflect reliability as defined by FASB statements.
In reaching the above conclusions, we assume the FASB’s stated position predicts
their standard setting actions or indicates the actions they take if unconstrained by other
factors (e.g., cost). Of course, it is possible that the FASB’s actions deviate from their
stated position, so in the following section we also examine whether the properties of
financial statements are consistent with the implicit standard setting and accounting
theories underlying the value-relevance literature.
 7:57 AM 10/6/2000 19

3.1 FASB statements and the value -relevance criterion

The FASB explicitly denies that financial accounting’s objective is to value
equity: “information (provided by financial reports) may help those who desire to
estimate the value of a business enterprise, but financial accounting is not designed to
measure directly the value of an enterprise.” (SFAC No. 1, paragraph 41).
The FASB statement’s denial of a direct valuation role for accounting suggests
there are factors apart from the value-relevance criterion that enter into the determination
of accounting and its standards; factors that cannot be captured by that criterion. These
factors prevent accounting standard setters from adopting accounting standards that value
equity directly. A comparison of the assumptions of the theories underlying the value-
relevance literature with FASB statements, can help us identify factors that impact
accounting and its standards but which are misstated in, or missing from, the value-
relevance literature. This serves two roles. First, it helps identify why the value-
relevance literature is likely to have a limited impact on standard setting. Second, it
yields some interesting research questions that might provide additional relevant
information to standard setters, while at the same time improving our understanding of
the theory of accounting.

3.2 FASB statements and assumptions underlying value -relevance

Examples of assumptions in the theory underlying the value-relevance literature
that are not consistent with FASB statements are discussed below. We focus on
assumptions about the users and uses of financial reporting, the reflection of individual
decisions in the aggregate market as reflected by the stock price and the definition of
reliability.

3.2.1 Users and uses

Based on SFAC No.1 and the FASB’s mission statement, value-relevance papers
assume the objective of financial reporting is to provide information useful in making
business and economic decisions. As we noted in the previous section, the value-
relevance literature assumes investors are the users of accounting numbers and their
 7:57 AM 10/6/2000 20

prime use is in valuing firms for investment decision purposes (see Lambert, 1996, p. 6;
and Barth, 2000, p. 10). Since all of the empirical work in the literature involves equity
values, in practice “investors” has come to mean equity investors.
The value-relevance literature’s assumptions about the users and uses of financial
reporting are not representative of FASB statements about users and uses. The FASB
includes among its definition of users individuals who are not primarily interested in
equity valuation including some that may not be interested in valuing any of the firms
securities. The FASB considers external investors and creditors to be users of
information provided by financial reporting (SFAC No.1, paragraphs 30 and 35). The
terms “investor” and “creditor” are broadly defined to include actual and potential
holders of equity and debt securities, trade creditors, customers and employees with
claims, lending institutions, and individual lenders.
The FASB statements about the uses of financial reporting do not suggest any
primacy for equity valuation. The FASB describes financial statements as general-
purpose statements that provide inputs to a range of different decisions that have
generally similar (but not identical) information demands (see SFAC No. 5, paragraphs
15 and 16). Some of those decisions involve valuation. For example, the FASB’s
concern with users assessing cash receipts from dividends or interest and proceeds from
sale, redemption or maturity of securities or loans (SFAC No.1, paragraph 37) suggests it
is concerned with the valuation use of financial reports. Other statements, however,
suggest many uses that need not involve equity valuation. For example, SFAC No. 1,
paragraph 49 suggests a concern with demands by lenders for assessing whether the firm
is in financial difficulty, for assessing liquidity and solvency. Accounting ratios that
measure solvency and liquidity are used in monitoring debt contracts (see Holthausen,
1981; Leftwich, 1981; Holthausen and Leftwich, 1983; and Sweeney, 1994). When these
ratios reach their specified values they generate an investigation of the borrower’s
solvency. The FASB also explicitly recognizes management stewardship and corporate
governance users of financial reporting (SFAC No. 1 paragraphs 50-53).
The FASB’s listing of broad ranges of users and uses and its emphasis that as a
consequence financial statements are general purpose statements strongly suggest the
assumption that financial reporting and financial statements are primarily aimed at equity
 7:57 AM 10/6/2000 21

investors and equity valuation is not descriptive. Moreover, it suggests that those
different uses are not served by the same information that an equity investor might
choose.
Implications for value-relevance literature. Equity value-relevance is not a
necessary condition for standard setting given the FASB’s broad definition of users and
uses. For example, creditors and lenders are more interested in valuing a firm’s debt and
default probability than in valuing the firm’s shares. Given the value-relevance rationale,
this suggests that studies using loan values might provide different results to studies using
equity values. It is not apparent that the relevance of a given number would be the same
for equity investors and lenders. For example, variables that provide information about
the value of a loan, bond, or an accounts receivable if the firm defaults, may not explain
cross-sectional variation in equity values for a sample of firms where the liquidation
probability is low. The value of future growth options in the event of a firm’s success are
likely to be more relevant to equity investors than to lenders, bond investors or creditors.
If the firm is successful, the individual creditor is paid the face value of the debt and
doesn’t have any claim on the growth options that result from the success. This is
important because it implies that there is no absolute construct of relevance and reliability
that can be gleaned from association with equity values. What is relevant for one user or
user group, may not be relevant for another. Relevance and reliability as assessed from a
lender’s perspective may be quite different from that of an equity investor.
We do not observe any value-relevance studies using bond, loan or debt values as
the dependent variable, perhaps because those values are less readily available.
However, even if a researcher were to conduct a study using bond or loan values, it
would still be important to design a study that would have the power to detect the
relevance of default information for valuing bonds or loans. In particular, it may be
necessary to use a sample of firms where the probability of default is substantial.

3.2.2 Stock prices and individual investors’ use of information

As Lambert (1996, pp. 6-7) points out, the value-relevance literature uses stock
prices to assess investors’ use of financial reporting information because those prices
“represent the aggregation of individual investors’ valuations of the firm and the
 7:57 AM 10/6/2000 22

information upon which that valuation is based.” The use of this aggregate measure
narrows the scope of equity investors’ information demands from that expressed in the
FASB’s statements. From its statements, the FASB is interested in individual investors,
not investors in the aggregate as represented by the stock market. This interest could be
due to concerns about unequal access to information and different costs of information
acquisition. The FASB (SFAC No.1, paragraph 28) states that the objectives of financial
reporting “stem primarily from the informational needs of external users who lack the
authority to prescribe the financial information they want from an enterprise and
therefore must use the information that management communicates to them.”
Since stock market prices incorporate more information than that available to any
single investor or his advisor, no investor likely has all the information that is
incorporated in prices. Similarly, and perhaps as a result, individual investor valuation
models and hence demand for inputs to those models can vary substantially in the cross-
section in a way not reflected in the market price. In addition, few individuals may be
aware of information at the time it is incorporated into stock prices, so information can be
timely for many investors when it is not timely for the market in aggregate. The FASB
considers timeliness critical for information to be relevant (SFAC No.2, paragraph 56),
and defines it as “having information available to a decision maker before it loses its
capacity to influence decisions (emphasis added).” For this reason the FASB could be
interested in including information in accounting statements of a period later than the
period in which it is reflected in the stock price. This would be particularly true if a
reliable measure of the information could not be obtained at the time the market
incorporated the information (because of verification difficulties –– see below).
Implications for value-relevance literature. The virtually exclusive reliance on
stock market data in relative and incremental association studies raises issues regarding
whether value-relevance studies can appropriately capture the demands of individual
investors.

3.2.3 Reliability and verifiability

As we noted in section 2, a significant incremental association (as reflected in a
significant coefficient on the accounting number of interest) is interpreted as evidence
 7:57 AM 10/6/2000 23

that the accounting number meets the FASB’s two prime criteria of relevance and
reliability. Reliability is interpreted in terms of measurement error. Barth (2000, p. 16)
puts it as follows:
“Value-relevant means the accounting amount is associated with some
measure of value, e.g., share prices. If the amount significantly increases
the power of the estimating equation to explain equity value, then it must
be relevant and measured with at least some reliability. If it is not relevant
there would be no relation with equity value. If the amount is fraught with
‘too much’ measurement error, the researcher also would not detect a
significant relation.”

However, there is an attribute of the FASB definition of reliability that may not be
reflected in the significance of the estimated relation. That attribute is verifiability. As a
result significant incremental association does not necessarily imply the number under
consideration is reliable.
Verifiability is
“the ability through consensus among measurers to ensure that
information represents what it purports to represent or that the chosen
method of measurement has been used without error or bias.” (SFAC No.
2).

SFAC No. 2 also states:

“the quality of verifiability contributes to the usefulness of accounting
information because the purpose of verification is to provide a significant
degree of assurance that accounting measures represent what they purport
to represent. Verification is more successful in minimizing measurer bias
than measurement bias and thus contributes in varying degrees toward
assuring that particular measures represent faithfully the economic things
or events that they purport to represent . . . ” (paragraph 81) and

“Measurer bias is a less complex concept than measurement bias. In its

simplest form, it arises from intentional misrepresentation. But even
honest measurers may get different results from applying the same
measurement method, especially if it involves a prediction of the outcome
of a future event, such as the realization of an asset. Measurer bias can be
detected and eliminated by having the measurement repeated with the
same results . . .” (paragraph 82)

Verification is concerned with preventing misrepresentation. Misrepresentation

in financial statements occurs because the management responsible for preparing the
statements has better information than the auditor and the investors and has an incentive
 7:57 AM 10/6/2000 24

to misrepresent. There is an information asymmetry and an agency problem. For

example, management’s incentives to misrepresent may stem from the fact they are
evaluated and compensated on accounting performance measures from the published
audited financial statements to which FASB standards apply. In addition, management is
often evaluated and compensated on the basis of the firm’s stock price, which may be
temporarily influenced by misstatement. Note management’s incentive is not necessarily
always to bias performance measures upward, in some cases they have incentives to bias
downward (e.g., bonus plans can provide such an incentive, see Healy, 1985).
Management also has incentives to bias accounting numbers because of debt contracts
that use audited published financial statements (see Watts and Zimmerman, 1986). Note
also that in order to mislead auditors and the stock market about their manipulation,
management may introduce noise as well as bias.
Assuming efficient markets, measurement method and measurer errors and biases
will be reflected in the value-relevance of accounting numbers. For example, an
incremental association study’s coefficients’ magnitudes and signs can be affected.
Biases will affect the magnitudes since the coefficients will reflect them. Measurement
errors can affect the magnitudes and signs with the effect depending on the correlation
structure among the true values of the independent variables and the measurement errors
(see Barth, 1991; and Lambert, 1996). If management incentives to bias and introduce
measurement error are present, lack of verifiability will affect the reliability and the
value-relevance of the accounting numbers.
Implications for value-relevance literature. Identifying potential verifiability
difficulties is likely to be a serious problem when value-relevance researchers are
evaluating accounting numbers or methods that are not currently included in GAAP and
so are not currently reflected in actual financial statements used in compensation
contracts, debts contracts, etc. The estimated accounting numbers used in the research
have to be estimated (e.g., the environmental liability estimates of Barth and McNichols,
1994) or obtained from existing disclosures in footnotes or other sources (e.g., Barth,
1994), or directly from firms (as in the case of other post-retirement benefits). Such
estimates or disclosures, even if produced by management prior to their forced
recognition, could be relatively free from bias and noise because the managers’
 7:57 AM 10/6/2000 25

incentives to bias and include measurement error are not as strong. In that case, the
coefficients and their significance would not be affected by the lack of verifiability.
However, once the numbers are included in the financial statements, the incentive to
misrepresent increases and if the numbers are not verifiable they could become useless
for decision-making and unrelated to stock price. Failure to consider the potential
verifiability of the numbers in value-relevance studies could lead to misleading results
even ignoring the other problems raised in this section.
An accounting number that is value relevant in a study before it becomes part of
GAAP could well cease to be value relevant after it becomes part of GAAP, if it is not
verifiable. Standard setters must address issues of this type in their determination of
accounting standards. Thus a finding of value-relevance is not a sufficient condition for
an accounting standard.
The verification aspect of financial statements may perform an important role in
generating more timely credible voluntary disclosures by firms, disclosures that make
required disclosures less timely in the sense of conveying information to the market in
aggregate. Management’s knowledge that the effect of events disclosed will be reflected
in the near future in audited financial statements or required disclosures controls
management’s incentives to issue misleading voluntary disclosures making those
disclosures more credible. This reinforces the point made earlier that marginal
information content is unlikely to be a necessary condition for standard setting. If the
required audited number was not reported because it had no marginal information
content, the pre-empting voluntary disclosure may no longer be credible and may lose its
marginal information content. An important function of audited financial statements may
be in supplying credibility to other disclosures and information.

3.3 Conclusion
We have observed that for multiple reasons, value-relevance, as defined in the
literature, is neither a necessary nor sufficient condition for standard setting given the
FASB statements about how it sets standards. The FASB’s statements imply that it is
concerned with a multitude of users, uses and financial accounting attributes in the
determination of standards. The many other uses and requirements of accounting
 7:57 AM 10/6/2000 26

potentially limit the impact of the value-relevance literature on standard setting.

However, as social scientists, we should not just accept what the FASB says it does, we
should also investigate what the FASB does. The next section investigates whether the
value-relevance literature plays a central role in explaining FASB actions as reflected in
accounting practice and the extent to which commonly observed attributes of accounting
information are inconsistent with the value-relevance criterion. Of course, accounting
practice not only depends on the FASB actions, but also on the implementation of GAAP,
which in turn depends on preparers, auditors and the SEC.

4. Value-Relevance and GAAP

Although the value-relevance criterion is neither necessary nor sufficient for
standard setting given the FASB’s description of standard setting, it might describe the
way the FASB behaves. More broadly, perhaps it describes GAAP and the accounting
that we observe in practice. Does the observed association between earnings and stock
prices suggest GAAP is created to maximize that association, or that changes in GAAP
are attempts to increase that association? Does the nature and evolution of
contemporaneous balance sheets suggest GAAP is designed to equate the book value of
equity with the market value of the equity? This section asks those questions and
concludes that in practice GAAP does not value the equity in the balance sheet or report
earnings that attempt to measure value changes or value levels. Nor does GAAP try to
estimate transformations of value or value changes. In practice, as in the FASB
statements, the income statement and balance sheet are asked to serve multiple functions
and non-valuation functions have important implications for the form and content of
those statements.
The above conclusion is important because the value-relevance criterion implies
that accounting’s fundamental role is to measure or help to measure market value and the
value-relevance literature ignores other forces affecting the form and content of financial
statements. To the extent those other forces are pervasive, the usefulness of the value-
relevance research is diminished. While authors of value-relevance studies may not
claim the value-relevance criterion is the only criterion for standards, the accounting
 7:57 AM 10/6/2000 27

literature’s concentration on that criterion impedes the development of a descriptive

theory that is useful to standard setters. Development of a theory that explains all the
factors important for the determination of accounting standards and the conditions under
which they are more or less powerful, would be a substantive addition to the accounting
literature.
To gain insights into why the balance sheet and earnings are not simply measures
of value (or transformations of estimates of value) we identify some characteristics of the
income statement and balance sheet that are inconsistent with, or are not explained by,
the valuation criterion and investigate alternative explanations for those characteristics.
In some of those cases the characteristics are consistent with financial statements
providing inputs to investors’ decision models that involve valuation. For example, the
contents of the balance sheet are consistent with the balance sheet being an input to
valuation (as described by the FASB), but are inconsistent with it being an estimate of
value itself.
In other cases, the identified characteristics are not explained by either the
literature’s position that the predominant function of financial statements is to provide
inputs to valuation or the value-relevance criterion. For example, there is evidence not
only that financial statements prepared under US GAAP exhibit significant conservatism
(e.g., Basu, 1997; and Ball, Kothari and Robin, 1999), but also that the exhibited
conservatism increased under formal standard-setting regimes, particularly that of the
FASB (see Basu, 1997; Givoly and Hayn, 2000; and evidence reported later in this
paper). Four non-mutually exclusive hypotheses that could explain conservatism and its
increase are considered: litigation, contracting, political and tax considerations. All four
hypotheses are consistent with some casual and/or formal evidence. The section
concludes by investigating the mechanisms by which litigation, contracting and tax could
influence standard setting.

4.1 The nature and evolution of the balance sheet

The nature of the balance sheet and its evolution over time are inconsistent with
the balance sheet’s role being to value the firm or equity. The nature and evolution of the
balance sheet are consistent with the provision of inputs to valuation being one of the
 7:57 AM 10/6/2000 28

balance sheet’s multiple functions. That evidence is consistent with contracting being
another of those multiple roles. Finally, the evidence suggests litigation and political
considerations influence the form and content of the balance sheet.

4.1.1 The nature of the balance sheet

The balance sheet today still consists mostly of individual, separable assets and
liabilities just as it did prior to the Securities Acts. The FASB’s reintroduction of market
value accounting is for individual assets, not for the firm.6 There is no attempt to value
the firm or equity directly in the statement of financial position. The valuation of
individual assets is consistent with the balance sheet providing an estimate of the market
value of net assets. However, the market value of net assets is only one ingredient to
valuation, and generally, equity valuation would additionally require valuation of the
firm’s future cash flows (see next section). The general nature of the balance sheet is
more consistent with several alternative hypotheses about its function than with direct
equity or firm valuation. For example, the balance sheet’s nature seems more consistent
with it providing an input to firm and loan valuation, in particular the value of the
abandonment option, as opposed to valuation of the firm or equity directly.
The view that the book values of assets are estimates of their separable market
values is also consistent with another non-mutually exclusive hypothesis about the role of
accounting –– the contracting role of audited financial statements. For example, debt
contracts use book values of assets and liabilities as estimates of the resources and debt
claims of the firm to trigger covenants that restrict management actions that reduce firm
and debt value (see Smith and Warner, 1979; and Leftwich, 1983).
The treatment of goodwill in practice provides insights into whether the balance
sheet is intended to measure the value of the firm. Goodwill represents the difference
between the market value of the firm and net assets (as well as omitted assets). It is
recorded only if purchase accounting is used, and if recorded, is amortized. This
treatment is inconsistent with standard setters pursuing a value-relevance criterion in an

6
Individual assets were occasionally revalued to market prior to the SEC, often prior to new financing (see
Finney, 1935, chapter 40). Also, revaluations of individual assets continue to occur today in other Anglo-
American accounting countries.
 7:57 AM 10/6/2000 29

unconstrained manner, since goodwill is not revised periodically to make equity equal to
firm value.
The recording of goodwill at all seems inconsistent with debt-contracting since
debt agreements use the reported financial statements but generally exclude goodwill and
intangibles (see Leftwich, 1983). This inconsistency could be due to other factors. 7
Prior to the SEC, goodwill was often written down to a nominal amount (see Ely and
Waymire, 1999a, p. 15) with a write-off against equity (a practice that was common in
the UK until recently). This practice is consistent with debt contracting. Debt-contracts
likely excluded goodwill from the balance sheets because in liquidation, goodwill would
presumably be zero (continuing the firm would not be a positive net present value
project).
Another contracting role of the balance sheet relates to executive compensation
contracts. Some executive compensation contracts use the book value of assets or equity
to assess whether the firm earns a return above a normal rate of return on the firm’s assets
or net assets (see Smith and Watts, 1982; Healy, 1985; and Holthausen, Larcker and
Sloan, 1995). Such use is appropriate if the book value of assets is an estimate of the
market value of the separable assets or the book value of the equity is an estimate of
market value of the separable assets, net of liabilities. This view of the balance sheet is
supported by the FASB’s description of the complementarities of the balance sheet and
the statements of earnings and comprehensive income:
“Statements of earnings and comprehensive income generally reflect a
great deal about the profitability of an entity during a period, but that
information can be interpreted most meaningfully or compared with that
of the entity for other periods or that of other entities only if it is used in
conjunction with a statement of financial position, for example, by
computing rates of return on assets or equity.” (SFAC No. 5, paragraph

7
An interesting issue is why didn’t firms immediately write-off goodwill. The answer likely has to do with
the effects of such a write-off on the firm. Many large US industrial firms formed by mergers of existing
firms around 1900 had the par value of their shares considerably higher than the tangible book value of the
merged firms. The alternative for these firms was to record the difference between par and tangible values
as a discount on issue, a number that would have to be eliminated via profits before dividends could be paid
(see Ely and Waymire, 1999a, p. 13). Writing off goodwill would have imposed the same dividend
constraint on the firm. By the late 1920’s it appears that most of these firms had been able to write off
these intangible assets. It would be interesting to investigate the firms that had capitalized goodwill in the
1920s to determine if the failure to write-off goodwill was associated with similar constraints on dividends
or financial policy (by then states had revised their laws that required large par values). The explanation
for the capitalization of purchased goodwill today could well lie in related constraints on firms.
 7:57 AM 10/6/2000 30

24a)

4.1.2 The evolution of the balance sheet

The evolution of the balance sheet in the US is not only consistent with the
balance sheet providing an input to valuation and to contracting, it suggests political and
litigation considerations play a role in shaping the form and content of the balance sheet.
Prior to the creation of the SEC and formal standard setting, the input to loan valuation
and debt contracting played dominant roles in shaping the balance sheet. According to
SFAC No. 2, paragraph 93, prior to the SEC the balance sheet was the primary financial
statement and bankers and other lenders were the primary users.
Prior to the SEC, asset values were written up (as well as down) to market or
“current values” consistent with both loan valuation input and debt contracting. Most of
the upward revaluations were of property, plant and equipment or investments (assets that
could be used as collateral). Fabricant (1936) found that in a sample of 208 large listed
industrial firms, there were 70 write-ups of property, plant and equipment and 43 write-
ups of investments in the period 1925-1934. There were only seven write-ups of
intangibles for the sample, consistent with the accountants’ recommendations at the time
that rights-based intangibles be written-up only in exceptional circumstances (see Yang,
1927, p. 166; and Ely and Waymire, 1999a, p. 14) and with debt covenants’ tendency to
exclude intangibles.
Revaluation was often associated with new financing (see Finney, 1935, chapter
40). Presumably, revaluation occurred when the marginal benefit exceeded the cost. If a
property had already been revalued by an independent appraiser for debt financing
purposes, the marginal cost of reporting it in the financial statements (prior the SEC)
would seem relatively low. The marking of individual assets to market at the time of new
financing is consistent with the balance sheet being an estimate of net asset value for the
purposes of lending and valuing the loan. It is also consistent with the debt-contract use
of financial statements since the revalued numbers serve as the base for the book values
used to control management actions and monitor the borrower during the life of the debt
contract. Note that write-ups after the loan do not typically increase the net assets for the
purpose of the loan contract (see Leftwich, 1983, p. 32).
The political process appears to have entered standard setting sometime in the late
 7:57 AM 10/6/2000 31

1930s. By 1940 the practice of revaluing fixed assets was “virtually extinct” (Walker,
1992, p. 3). The SEC used the registration process to eliminate these write-ups. The
elimination of fixed asset revaluation appears tied to the emergence of political
considerations in accounting standard setting. In particular, several founding
commissioners of the SEC were associated with a public political argument that the
financial difficulties of the 1930s were due to asset write-ups. 8 Empirical research
suggests the argument was false. 9 Given their prior public argument, the commissioners
could not allow asset write-ups to continue. Once in place for a number of years, the
policy was difficult to change. Many recent examples also point to the effects of the
political process on the setting of accounting standards in general (e.g., the recent debates
on accounting for stock options, Beresford, 1996, fair value accounting, Johnson and
Swieringa, 1996, and the recent purchase/pooling debates).
From 1940 until the 1970s the SEC effectively banned upward asset revaluation
in the financial statements and even disclosures of current values. When the SEC lifted
its ban in the early 1970s, few firms voluntarily wrote-up their assets. In the 1970s, as in
the 1920s, investors making equity and debt investment decisions undoubtedly still
demanded information about the market values of the separable assets. So the failure of
the return to marking fixed assets to market in the 1970s is inconsistent with both the
FASB’s valuation input demand and contracting. What changed in the interim? A
reasonable hypothesis that has supporting evidence, is the failure to mark fixed assets to
market was due to the growth in class action lawsuits against listed firms. This growth
occurred after the 1966 revision of Rule 23 of the Federal Rules of Civil Procedure and
the consequent increased legal liability for overstatements of assets and earnings (see
Kothari, Lys, Smith and Watts, 1988; and Basu, 1997).

8
Some of the SEC’s initial staff were drawn from the Federal Trade Commission (FTC) and three of the
SEC’s founding commissioners were involved in the FTC’s dealings with public utilities” (Walker, 1992,
p. 7). The most outspoken opponent of write-ups was “Judge” Healy, a foundation SEC commissioner who
headed the FTC’s investigation of the financial affairs of utilities, an inquiry that became protracted
following the utilities’ financial difficulties in the early 1930s. That experience apparently soured Healy on
asset write-ups. The FTC and Healy considered asset write-ups as an important factor in the utilities’
financial difficulties.
9
Many accountants writing after the stock market crash stated or implied (without formal evidence) that
assets written up in the 1920s were written down again in the 1930s. Fabricant’s evidence, however,
suggests the write-downs involved capitalized intangibles rather than previously revalued fixed assets or
 7:57 AM 10/6/2000 32

On net, the nature and evolution of contemporaneous balance sheets is more

consistent with the provision of an estimate of net asset value as an input into firm
valuation and/or contracting than with valuation of the firm per se. There is some
suggestion that other factors, in particular the political process and litigation, have also
played a role in determining the balance sheet’s nature. Overall it seems clear the value-
relevance criterion has not been the prime determinant of the nature of today’s balance
sheet.
It is important to understand all of the influences that shape accounting in order to
derive standard setting implications. For example, measurement techniques are being
developed to value assets like customer loyalty. Assuming these techniques were refined,
would we want to include these valuation estimates on the balance sheet if their inclusion
moved the book value of equity value closer to the market value of equity? Should the
customer acquisition costs in the wireless industry be capitalized if that recognition
helped equate book and market values of equity? From a debt contracting perspective,
the answer is likely no, since the net assets measure the value of the firm under
liquidation and if the firm were liquidated, the customer assets might be worth far less
than in a going concern. Consider the same perspective in the context of Barth’s (1994)
investigation of the fair value of banks’ investment securities. From a depositor’s
perspective, one might argue for recognizing the fair value of investment securities in the
balance sheet, as it provides estimates of the value of the investment securities, even if
the bank is not a going concern. Unlike customer loyalty or goodwill, where the assets
are not likely to be worth very much if the company is not a going concern, the value of
the investment securities is likely to represent a reasonable liquidation value. From this
perspective, Barth’s (1994) setting is likely a reasonable one.10

4.2 The conservatism of the income statement

An aspect of accounting exhibited by firms all around the world is the

investments (see Walker, 1992, pp. 5-6). There was no evidence that the write-ups overstated the value of
separable tangible assets for industrial listed firms.
10
However, political considerations may be operating in this environment and that can affect the accounting
methods used in the balance sheet. For example, savings and loans regulators allowed S & L’s to continue
to value assets above market to delay closure of insolvent S&L’s and to encourage their acquisitions (see
Andrew, 1981; and Barth, Bartholomew and Bradley, 1990).
 7:57 AM 10/6/2000 33

conservatism of the earnings number (see Ball, Kothari and Robin, 1999). This
conservatism takes the form of accounting anticipating losses but not gains so that stock
prices reflect good news (gains) earlier than do earnings while bad news is reflected in
stock prices and earnings more contemporaneously. Stock prices lead earnings more for
gains than for losses. Delaying recognition of gains while anticipating losses leads to the
understatement of net assets. Conservatism could be due to contracting, litigation and/or
tax issues, thus highlighting the multi-purpose aspect of financial statements. The pattern
of conservatism observed around the world, and in the United States over time, is not
explained by the value-relevance criterion.
The degree of conservatism observed in US income statements is inconsistent
with the FASB’s stated views. In SFAC No. 2, paragraph 93, the FASB states that
conservatism “was once commonly expressed as the admonition to ‘anticipate no profits
but anticipate all losses” and “Conservatism in financial reporting should no longer
connote deliberate, consistent understatement of net assets and profits.” SFAC No. 2
attributes the development of conservatism to “bankers and other lenders who were the
principal users of financial statements (prior to the SEC).” The Statement further
remarks (in 1980) that the “notion became deeply ingrained and is still in evidence
despite efforts over the past 40 years to change it.”

4.2.1 Conservatism arising for contracting purposes

Watts (1993, pp. 3-7) hypothesizes as to why conservatism might have evolved
for both management and debt contracting purposes. Conservatism reinforces debt
contract provisions that ensure resources are kept within the firm to meet obligations to
lenders. Conservatism defers the recognition of income and, when combined with
restrictions on dividends, reduces the likelihood that resources will be distributed
inappropriately to parties with claims of lower precedence than the lenders. It performs
much the same function as the liquidator’s recognition of all potential losses before
making an interim distribution of funds to claimants on the firm.
Hayn (1995) and Basu (1997) find that the relation between annual earnings and
annual stock returns for US firms varies according to the nature of the news for the year.
Hayn finds that the slope coefficient and the R2 in a regression of stock returns on
 7:57 AM 10/6/2000 34

earnings are higher for firms showing profits than for firms showing losses. Basu
conducts a “reverse” regression of annual earnings on annual returns and finds that the
slope coefficient and the R2 are higher for firms with negative unexpected returns than for
firms with positive unexpected returns for the year. As Basu shows, the two sets of
results are essentially the same phenomena. “Bad news” tends to be more fully reflected
in both current earnings and returns than “good news.” Losses are anticipated and
written off at the time of the news. Good news affects the current year’s return but the
profit is not fully anticipated and is spread over the earnings of current and future years.
In a given year the earnings effect is smaller relative to the return effect for profits than
for losses. The consequence is that the slope coefficient is higher for profits than losses if
returns are regressed on earnings, but lower if earnings are regressed on returns.
The effect documented by Hayn and Basu is consistent with conservatism:
“anticipate no profits but anticipate all losses.” While Basu hypothesizes the effect is due
to conservatism, Hayn hypothesizes it arises because of the abandonment option.
Shareholders prefer to abandon the firm rather than bear predictable losses, hence
observed losses are likely to be temporary. Basu discriminates between the two
hypotheses on the basis of the effect of accruals on the extent to which earnings are
contemporaneous with returns and on the time series variation in the earnings-return
relation. He concludes the evidence is more consistent with conservatism.
The extent to which bad news is contemporaneous in earnings and returns is
substantial in Basu’s study. Earnings are four and a half times more sensitive to negative
returns than to positive returns over the period, 1963-1990. Ball, Kothari and Robin
(1999) perform similar regressions on US and non-US firms for the period 1985-1995
and find earnings is ten times more sensitive to negative returns than to positive returns in
the period 1985-1995. UK earnings are five times more sensitive to negative returns than
to positive returns over the same period. These results suggest a high degree of
conservatism in US accounting, twice that observed in UK accounting, despite SFAC No.
2’s condemnation of conservatism.
Ball, Kothari and Robin (1999) find evidence of conservatism in 19 of 25
countries they study. Moreover, they hypothesize the demand for conservatism is less in
code law than common law countries because of lesser information asymmetry problems
 7:57 AM 10/6/2000 35

in code law countries arising from the different governance structures. They find
evidence consistent with their predictions and so consistent with a contracting
explanation. Further, the value-relevance criterion for assessing accounting standards
offers no explanation for the pervasive existence of conservatism or the varying demand
for conservatism around the world. While one of accounting’s roles is providing inputs
to valuation, the substantial asymmetry between good news and bad news in the
association between earnings and stock prices suggests the existence of other strong
forces at work, including contracting.

4.2.2 Conservatism arising from litigation

As we saw above, conservatism is consistent with contracting. It is also
consistent with a litigation motivation. Overstatement of earnings or assets is far more
likely to generate a lawsuit than understatement (see Kellogg, 1984, p. 186, footnote 3)
and this creates incentives for managers to be conservative in reporting both earnings and
assets. Basu investigates the sensitivity of earnings to positive and negative returns over
sub-periods of low or high auditor liability identified by Kothari, Lys, Smith and Watts
(1988). He finds no differences in the sensitivity to positive and negative returns in the
low liability periods, but significant differences in the sensitivity in the predicted
direction in the high liability periods. One of the low periods is the period 1963-1966,
prior to the changes in the rules for class actions suits. These results are consistent with
the change in litigation climate affecting the degree of conservatism of US accounting.11

4.2.3 Conservatism and corporate income taxes

The existence of corporate income taxes can also lead to conservatism in
accounting. Guenther, Maydew and Nutter, 1997, pp. 230-234) discuss the effect of
court decisions and IRS behavior on the relation between accruals for tax purposes and
accruals for financial reporting purposes. They conclude (p. 232): “Overall, the evidence
suggests the existence of implicit pressure to conform tax accounting methods to those

11
However, alternative explanations and countervailing evidence exist. Ball (1989) argues that the change
in litigation climate could have been driven by contracting changes. Further, Ball, Kothari and Robin
(1999) point out that in recent years the asymmetry of sensitivity of earnings according to good or bad
news has also increased in France and Germany where litigation is not particularly an issue.
 7:57 AM 10/6/2000 36

used for financial reporting purposes.” Guenther, Maydew and Nutter present empirical
evidence that firms forced to switch for tax purposes from the cash method of accounting
to the accrual method by the Tax Reform Act of 1986, increased their deferral of income
for financial statement purposes (became more conservative).
Whether or not it is contracting, litigation, political pressure (as in the lack of
revaluation of fixed assets), income taxes, and/or something else that is causing the
conservatism of US accounting practice, conservatism is not explained by the value-
relevance criterion. Moreover, conservatism appears to be part of accounting practice
around the world, albeit, in varying degrees.

4.2.4 Evidence on conservatism over time in US financial statements

In this section, we provide evidence on the conservatism in US financial
statements over time. We find that conservatism in US financial statements (i) existed
prior to formal standard setting in the US, (ii) has increased over time, and (iii) has
increased to the point where virtually all of the association between earnings and stock
prices is driven by bad news.
Despite the FASB’s condemnation of the notion of conservatism that implies
different standards for recognizing gains versus losses (SFAC No. 2), there is evidence
that conservatism in earnings of US listed companies has increased significantly during
the FASB’s tenure (see Basu, 1997; and Givoly and Hayn, 2000). Basu (1997) finds no
evidence of conservatism prior to 1967 (see Basu, 1997, table 6) and that most of the
increase in conservatism occurs after the establishment of the FASB in 1973 (see Basu,
1997, figure 3). This does not imply that the FASB caused an increase in conservatism,
as it is possible that the implementation of standards by preparers and auditors, and not
the standards themselves, have affected the degree of conservatism.
Basu’s failure to find significant conservatism prior to 1970 is puzzling given the
many claims that it existed prior to that date. Moreover, such a finding would be
inconsistent with the view that conservatism would arise for contracting reasons which
implies it should exist prior to the SEC’s establishment. We thought the result could be
due to Basu’s limited number of observations in the period prior to 1970. To investigate
that possibility, we asked Kirsten Ely to estimate a regression, similar to that estimated by
 7:57 AM 10/6/2000 37

Basu in his table 6, for every year for the 1927-1993 sample of US firms used in Ely and
Waymire (1999b). That sample was generated by randomly drawing 100 firms each year
from the CRSP Monthly Price File that met two criteria. The criteria were that the firm
had (1) stock price data available for 29 months from February of the prior year through
June of the subsequent year; and (2) a four digit SIC code between 1000 and 3999.
Earnings data were obtained from Compustat or Moody’s Industrial Manual and were not
available for 30 of the 6,700 firm/years in the sample. Most of these 30 firm/years are in
the pre-1951 (pre-Compustat) period. All years have at least 97 observations available.
The exact form of the regression estimated is:
Xt /Pt-1 = α 0 + α 1 DRt + β 0 Rt + β 1 DRt Rt
where Xt is the firm earnings or operating earnings per share for year t, Pt-1 is the price at
the beginning of year t, DRt is a dummy variable equal to 1 if Rt < 0 and zero otherwise,
and Rt is the rate of return on the firm’s stock for year t. The test for conservatism is
whether the slope coefficient for the last term is significantly positive.
Mean estimated coefficients and mean t-statistics are calculated for sub-periods
reflecting different standard setting, regulatory and litigation regimes. Those sub-periods
are 1927-41, 1942-46, 1947-50, 1951-53, 1954-66, 1967-75, 1976-82 and 1983-93. The
last three sub-periods are used by Basu and represent regimes of standard setting with
high, low and high litigation, respectively. The periods 1942-46 and 1951-53 are periods
of general price controls that appear to affect the earnings/stock return relation. The
period 1927-1941 includes the period prior to the SEC’s elimination of write-ups in 1940
(1941 is included rather than merely eliminating it –– its exclusion does not affect the
results). We consider the 1927-41 to be a period without standard setting or litigation.
The periods after 1941 all had standard setting. Those prior to 1967 had virtually no
litigation. Litigation increased significantly in 1967-75, decreased in 1976-82 and
increased significantly again in 1983-93. Mean coefficients are calculated for the 1963-
66 period for comparison to Basu’s results.
Table 2 reports mean coefficients for the overall sample period and for each sub-
period for both earnings and operating earnings. The table also reports Basu’s results and
the results of Ball, Kothari and Robin (1999) for a similar regression. Basu uses a sample
of 43,321 firm years in the period 1963-1990. He estimates a pooled regression with
 7:57 AM 10/6/2000 38

dummies on the coefficients for particular sub-periods. We report sums of estimated

coefficients from the Basu regressions that are comparable to the estimated coefficients
from the Ely regressions. Earnings and returns in the Basu regressions are adjusted for
market earnings and returns. Ball, Kothari and Robin (1999) run pooled regressions for
two sub-periods of the 1985-95 period, using earnings before extraordinary items rather
than earnings. The Ball, Kothari and Robin 1985-90 regression is over 11,978 firm/years
and their 1991-95 regression is over 9,247 firm/years.
From table 2 we see that for earnings, the mean coefficient of the dummy variable
multiplied by return is significantly positive in the period prior to standard setting and
litigation (1927-1941) and all periods post 1953 (other than the 1963-66 period). The
significance of the pre-standard setting period (1927-41) is consistent with our
expectations that conservatism existed prior to formal standard setting and concerns
about litigation. The insignificance of the coefficient for that period in the operating
earnings regressions suggests non-operating items are largely responsible for the
conservatism. Our insignificant result for the 1963-66 period confirms Basu’s result but
suggests that period is not representative of the pre-litigation and standard-setting period.
The lack of significant conservatism and the large significant mean coefficient of the
return variable in the World War II price control period suggests those controls changed
reported profits substantially.
Like Basu’s results, our results in table 2 indicate a substantial increase in
conservatism since the creation of the FASB: for regressions using earnings, the
coefficient of the dummy multiplied by the return increases from something less than .10
before 1976 to .16 in the period 1976-1982 and .43 in the period 1983-1993. Similar
increases are observed for the regressions using operating earnings, especially in the
1983-1993 period. Unlike Basu’s results, table 2 shows the increase beginning in the
earnings regressions in the 1976-82 period rather than the 1967-75 period. This
difference could be due to different specifications of the regressions as well as
differences in the sample. The result remains though, that conservatism has increased
during the FASB regime, though we do not attribute causality to the FASB.
Note also that in the earnings regressions the value-relevance of earnings in good
news years (the mean coefficient of return) decreases during the FASB regime and
 7:57 AM 10/6/2000 39

becomes zero and insignificant in the last (1983-93) period. In the operating earnings
regressions, though, the value-relevance of good news is still significant in the last
period. Basu also reports a coefficient close to zero (but still significant) in the last
period and Ball, Kothari and Robin (1999) report a significant coefficient, which is close
to zero in the period 1985-95. These results suggest valuation (whether in the form of the
valuation criterion or the form of provision of inputs to valuation) is not the sole force,
and perhaps not even the dominant force, at work in the contemporaneous accounting
model.12

4.3 The existence of dirty surplus

US accounting standard-setters have periodically professed a desire to require
clean surplus (e.g., APB Opinion No. 9 in 1966, SFAC No.5 in 1984 and FASB
Statement No. 130 in 1997). Clean surplus means that changes in the book value of
equity, other than those resulting from transactions with equity holders (investments and
dividends), flow through earnings. An objective of a clean surplus policy is “to avoid
discretionary omissions of losses (or gains) from an income statement, thereby avoiding
presentation of a more (or less) favorable report of performance or stewardship than is
justified” (SFAC No. 5, paragraph 35). Dirty surplus is surplus that is dirtied by the
inclusion of the effects of non-equity holder transactions that have not flowed through
earnings. US standard setters’ professed desire to follow a clean surplus policy has not
been fulfilled. Their difficulty in achieving clean surplus and the existence of dirty
surplus in other Anglo-American countries is not explained by the value relevance
criterion and suggests multiple forces are at work in determining accounting standards.
After the issuance of APB Opinion No. 9 in 1966, standard-setting bodies in the
US nominally followed a clean-surplus policy. More recently, the FASB included a
clean surplus policy in SFAC No. 5 (paragraph 13) in 1984. In practice, however, the
clean surplus policy has not been followed very strictly. For example, the FASB allowed
certain gains and losses to by-pass the income statement and go directly to equity

12
An issue we do not discuss, but also worth investigating is the conservative properties of the balance
sheet. We know that assets are much more likely to be written down than written up (lower of cost or
market rule, rules on write-downs of assets, etc.). Moreover, we know that average price/book ratios are
 7:57 AM 10/6/2000 40

(unrealized gains and losses on marketable securities, the change in foreign currency
translation adjustment and additional pension liability in excess of unrecognized prior
service cost). FASB Statement No. 130 requires the disclosure of comprehensive income
which, if it were the bottom line of the income statement, would result in clean surplus.
However, the statement does not specify the financial statement in which comprehensive
income must appear and preliminary evidence indicates that it is disclosed in practice in
the statement of changes in equity (see Hirst and Hopkins, 1998, p.49). Thus, in practice,
surplus is still dirty.
The magnitude of dirty surplus appears to be material in many cases. Lo and Lys
(1999) estimate the amount of dirty surplus as the absolute difference between
comprehensive (clean surplus) income and GAAP net income as a percentage of
comprehensive net income in the period 1962-1997. They find that while the median
deviation is only 0.40%, the mean is 15.71%, and 14.4% of firm/years have dirty surplus
that exceeds 10% of comprehensive income.
We have argued that consistent application of the value relevance criterion would
result in the book value of equity being an estimate (or transformation of an estimate) of
the market value of equity and earnings being an estimate (or transformation of an
estimate) of the level of or change in equity market value. In doing so, we relied on two
of the three valuation models used in the literature (the earnings model and the balance
sheet model). The other valuation model used in the literature (the Ohlson model)
expresses equity market value as a linear function of current earnings, dividends and
book value of equity. In that case the linear combination would be an estimate (or
transformation of an estimate) of market value. In none of the three cases can the value
relevance criterion explain dirty surplus.
Studies using both earnings and balance sheet valuation models do not explain
how the two estimates of value would interact (i.e., how the income statement and
balance sheet would articulate). If earnings are an estimate of equity value (or an
estimate of the change in equity value) and book equity is an estimate of equity value,
how would differentces in the estimates be reconciled in the financial statements? No

well over one in most time periods. This suggest the balance sheet contains many conservative elements as
well, another fact that cannot be explained by the value relevance criterion.
 7:57 AM 10/6/2000 41

one seems to have thought of that problem.13 The third valuation model, the Ohlson
model, uses both the book value of equity and earnings and assumes clean surplus.
The failure of the relevance literature to explain dirty surplus is significant given
dirty surplus has existed for most of the period in which we have had formal accounting
standards in the US and other Anglo-American accounting countries. Dirty surplus
existed prior to standard setting and continues to exist today. Prior to the SEC in the US,
unrealized gains from asset write-ups went to surplus rather than income (Dillon, 1979)
or were used to offset intangible assets or accumulated losses in retained earnings (Saito,
1983, pp. 14-19). Today upward revaluations of assets in Australia and the UK still go to
reserves in owners’ equity rather than to the income statement (Brown, Izan and Loh,
1992, p. 37). These observations are inconsistent with clean surplus being an equilibrium
accounting choice.
The existence of dirty surplus can be explained by the existence of multiple roles
for financial reporting. For example, as we have already noted, the balance sheet could
provide an estimate of the liquidation value of net assets for lenders while earnings could
be used as a performance measure for compensation contracting and monitoring
purposes. Given the different purposes of the statements, dirty surplus would be
necessary to have the two statements articulate. The lending role for the balance sheet
suggests it would reflect the market value of assets such as property plant and equipment
and we noted earlier in this section that prior to the SEC asset revaluation was often
associated with financing events. Changes in the values of those assets, however, may be
considered beyond the manager’s control and so excluded from the performance measure
(earnings) that is used for compensation and monitoring purposes. As we saw above,
prior to the SEC that is exactly what occurred.

4.4 How contracting, litigation and taxes affect accounting standards and
practice
Anglo-American accounting had evolved to a significant degree prior to the
formation of the SEC and listed firms were audited. There was concern with issues such

13
In some cases (e.g.,Barth, 1994) the lack of explanation is might be due to an implicit assumption that the
value relevance criterion will not be used widely in standard setting.
 7:57 AM 10/6/2000 42

as verifiability and evidence of accounting principles. For example, Dillon (1979) found
that, while approximately a quarter of his sample of 110 NYSE firms had an upward
revaluation during 1925-34, not one used a revaluation to increase earnings. That
observation is consistent with accounting and financial reporting fulfilling a contracting
role (see above). Also consistent with contracting was the general view that accounting
and financial reporting served a stewardship function (see Zeff, 1999, p. 17). As we have
seen, the FASB itself viewed the balance sheet as the prime statement prior to the SEC
and considered it a document aimed at lenders. In addition to the parties to the firm itself
(e.g., shareholders and managers), a broad set of external institutions (banks, private debt
holders, etc.) relied on audited financial accounting reports for contracting purposes.
It is difficult to believe that Congress, the SEC and standard setters could or
would be able to take an institution (financial reporting) fulfilling an important economic
function (contracting) and, by fiat, totally convert it to a different function. There was a
large set of parties with vested interests in the contracting use of the audited financial
reports with the resources to oppose changes that made contracting more costly. These
interests’ potential lobbying with Congress and the SEC likely deterred standard-setters
from changing financial reporting such that it did not meet contracting demands. There is
some suggestion they did not. As late as 1975 the FASB found that only 37 percent of
respondents to their survey agreed that “The basic objective of financial statements is to
provide information useful for making economic decisions. . . . Those who disagreed
took the position that the basic function of financial statements was to report on
management’s stewardship of corporate assets and that the informational needs of readers
was of secondary importance ” (Armstrong, 1977, p.77). While the increase in litigation
could have changed attitudes and actions since 1975, it seems likely that current-day
accounting numbers reflect contracting objectives as well as the broad investor
information objective.
Litigation and taxes could also affect standard setting via the political process.
Auditors and others negatively affected by increased liability under litigation are likely to
lobby with Congress and the SEC to make financial statements conservative. Managers
and investors in firms affected by a proposal to require the capitalization of development
expenditures in the wireless communication industry are likely to lobby against such a
 7:57 AM 10/6/2000 43

proposal because of its effect on taxes and firm value.

It is conceivable that we are in a period in which standard setters are moving
away from the demands that accounting originally evolved to meet to one that adopts a
pure information to equity investors perspective. If this is true, standards should be
reflecting the value-relevance criterion or the input to valuation role with increasing
frequency. However, the evidence on conservatism suggests this is not the case.
Moreover, very recent decisions of the FASB, such as the recent stock options standard,
are consistent with a standard setting process that does not follow the value-relevance
criterion. Beresford (1996) discusses how the FASB responded to the political pressure
arising from its stock options project in order to survive, at the expense of what the board
felt was the superior standard. Further, Zeff (1999) details how the FASB’s potential
reliance on the conceptual framework has been repeatedly broken by political pressure
from preparers, users, auditors and Congress. Leftwich (1995) argues that the FASB
even sets its agenda by choosing areas where it can restrict the set of currently available
choices and appease the SEC. Thus, if we are moving closer to a value-relevance
criterion, the move seems almost imperceptible. Moreover, recent evidence (Chang,
1999; and Brown, Lo and Lys, 1999) suggests the value-relevance of financial statements
has declined in recent in recent years.
Auditors and managers may also choose to make accruals more income deferring
and net asset reducing within the bounds of GAAP causing accounting practice to be
more conservative. As we have seen, the evidence of Basu (1997) is consistent with US
accounting practice becoming more conservative after increases in auditor liability.
There is also evidence that the link between tax and reporting accruals has also become
stronger in recent years (see Guenther, Maydew and Nutter, 1997). Institutional
arrangements play an important role in the way standards are implemented. Ball, Robin
and Wu (2000) investigate the timeliness and conservatism of virtually identical
accounting standards adopted in Hong Kong, Malaysia, Singapore and Thailand. They
find large differences in the timeliness and conservatism of earnings as judged by the
association between earnings and returns in these four countries. They conclude that the
differences are driven by managers’ and preparers’ incentives to disclose material
information, which are a function of the market-orientation of the economy, litigation,
 7:57 AM 10/6/2000 44

taxes and political costs. Thus, accounting standards alone, do not determine the
properties of the accounting reports, and the same forces that affect the adoption of new
standards affect the implementation of those standards as well.

4.5 Conclusion on value -relevance and GAAP

It is apparent that the value-relevance criterion does not determine the nature of
GAAP, nor is it obvious it is a dominant force. Other factors that appear to affect the
nature of GAAP include contracting, litigation, political and tax considerations. None of
this means that accounting’s role in providing inputs into valuation is irrelevant. What it
does mean is that role is only part of the equation.
If, as researchers, we provide standard-setters with value-relevance evidence only,
we do the standard-setters a disservice because we ignore the fact that financial
statements have multiple purposes. The existence of the competing hypotheses to explain
conservatism is due in part to the many roles that accounting statements are asked to
fulfill. If we imply that standard-setters should try to make the balance sheet measure
firm value when such an outcome is not the equilibrium demand of financial statements
users, we encourage standard-setters to fail. In addition, if input to valuation is only a
part of the role of accounting, our research will have a small influence on the standard-
setting process if we do not take account of the other roles that accounting standard
setters consider.
Value-relevance research might be more useful if we could explain when the
valuation input role is likely to be operating without interference from other forces and
when it is likely to be affected by other factors. Research of that type would require an
explicit understanding of the other factors and forces that shape accounting standards and
some predictive ability of their strength in varying circumstances. As it is now, the
value-relevance literature is attempting to provide evidence that is useful for standard
setting without a descriptive theory of accounting or standard setting. Understanding the
nature and strength of the other forces that shape accounting would lead to an improved
understanding of accounting and should aid standard setters in balancing the multiple
objectives of financial reporting.
In the next two sections we ignore the inconsistencies between the rationale for
 7:57 AM 10/6/2000 45

value-relevance and what the FASB says and does in setting standards. Instead we
assume the value-relevance criterion is correct and look at the implications of the value-
relevance literature’s valuation models for accounting standards (section 5).

5. The Valuation Model and Links to Accounting Numbers

As we noted, investigating the relation between accounting numbers and firm
value requires a valuation model to specify the attributes affecting firm value and their
relation to firm value. A link between the accounting numbers and firm attributes is also
required. It is important that the valuation model chosen to investigate the relation
between accounting numbers and firm value be appropriate for valuing the attributes of
the firms investigated in the study. Further, the links between the attributes valued and
accounting numbers should be carefully specified to generate implications for those
numbers (e.g., as in the balance sheet model in Barth, 1994). In this section we
investigate the appropriateness of the valuation models used in the literature and the
specification of their links to accounting numbers allow inferences. The ability to make
standard setting inferences depends critically on both the valuation model’s
appropriateness and the links’ specification. This is true also of inferences in areas of
capital markets research (e.g., valuation literature) so that much of the discussion in this
section applies to those areas as well.
The valuation models are often inappropriate for the use to which they are put and
the accounting links to those models are often not specified. One result is potentially
incorrect predictions for the signs and magnitudes of coefficients of accounting numbers
in regressions in incremental association studies. Another is an exacerbated correlated
omitted variables problem.
In many incremental association studies of balance sheet components, the
valuation model is that the market value of equity is equal to the market value of the
assets minus the market value of the liabilities (e.g., Barth, 1991). We label that the
balance sheet model. Twenty-one studies in Table 1 use the balance sheet model and 20
of them are incremental association studies. The model holds only if all the relevant
markets exist (there is a market for each asset and liability as well as for the stock) and all
markets are competitive so there are no expected above-competitive returns (rents) to the
 7:57 AM 10/6/2000 46

firm. In addition, there can be no corporate control frictions, so management liquidates

the firm if that is the optimal action. In other words, we would not observe a firm’s
market value below the market value of its net assets. The link between the accounting
numbers and the attributes valued is that book values of accounting assets and liabilities
convey information about the market values of those assets and liabilities.
In earnings association studies, earnings are assumed to be informationally linked
to future cash flows or valued directly (earnings model). Consequently, stock market
rates of return (or the equity values) are regressed on: i) components of earnings and/or
earnings component changes; or ii) earnings and/or earnings changes (e.g., Dhaliwal,
Subramanyam and Trezevant, 1999). In some cases, a reverse regression is estimated
with earnings regressed on market rates of return (as in Beaver, Lambert and Morse,
1980). Twenty-two studies in Table 1 use an earnings model. Eight conduct relative
association studies and 18 conduct incremental association studies (four studies conduct
both kinds of association studies).
A third specification comes from the Ohlson (1995) and Feltham and Ohlson
(1995) which indicates that, given a dividend valuation model and clean surplus
accounting, stock price can be written as a linear function of earnings and book value of
equity (Ohlson model). In this case, abnormal earnings (earnings minus cost of book
capital) can be thought of as an attribute investors value; an informational link to earnings
is not required. Amir, Harris and Venutti (1993) use this approach in a relative
association study. Twenty-nine studies in Table 1 use the Ohlson model as motivation
for specification of their empirical tests, but only 15 use the specification that includes
both earnings and book value as independent variables. The others regress returns on
earnings and earnings changes.

5.1 Balance sheet model

5.1.1 Valuation model
In its levels form, the balance sheet model for an incremental association study
takes the following form:
MVE = MVA + MVL +MVC (1)
Where
 7:57 AM 10/6/2000 47

MVE = market value of equity

MVA = market value of separable assets other than the component whose
incremental association is being assessed
MVL = market value of separable liabilities other than the component whose
incremental association is being assessed (liabilities are assumed to be
negative values)
MVC = market value of the balance sheet component whose incremental
association is being assessed.
As noted, this model holds if the firm is earning a competitive rate of return on its net
assets. The future cash flows, discounted using the appropriate cost of capital, equal the
net asset values.
If the firm has some competitive advantage (e.g., proprietary technology that may
not be separable and saleable) that allows it to earn a positive abnormal return (rents),
then equation (1) does not hold. The equity value exceeds the net assets value. Then
equity value is a weighted average of operations value (the value from continuing
operations plus the value of future expansion options), and abandonment value (net asset
value) (see Berger and Ofek, 1996; Burgstahler and Dichev, 1997; and Wysocki, 1999).
Ignoring agency costs, the firm would liquidate (abandon) when the net assets value
exceeds the operations value of the firm. With rents, the relevance of net assets depends
on the likelihood of abandonment. If the likelihood of abandonment is effectively zero,
the value of net assets is not associated with the value of the firm except to the extent it
affects future operating cash flows (for example, when replacing assets). If operations
value exceeds net assets but there is a likelihood of abandonment then equity value is an
increasing convex function of net assets. It is also an increasing convex function of
operations value (see Wysocki, 1999, p. 17).
Many incremental association studies using the balance sheet model allow for the
possibility that firms have a competitive advantage. For example, value-relevance
studies for banks recognize that bankers might earn rents on core deposits (e.g., Eccher,
Ramesh and Thiagarajan, 1996). To allow for the fact that equation (1) does not hold
with rents, some value-relevance researchers convert it to an identity by including a
goodwill term that is defined as the difference between market value of equity and net
 7:57 AM 10/6/2000 48

assets value:
MVE ≡ MVA + MVL +MVC + GW (2)
Where
GW = goodwill.
The introduction of goodwill makes equation (2) hold tautologically. It is defined as:
GW ≡ MVE-MVA-MVL-MVC
In these cases, independent variables are often included in the regression to proxy for
goodwill, but goodwill is not a separable asset, being merely the difference between
MVE and the other variables.

5.1.2 Links to accounting numbers

If the balance sheet model holds (i.e., there are no rents) the links between the
accounting numbers and the valuation model variables are relatively apparent. The
variables are the market values of assets and liabilities. It is assumed that each
accounting asset or liability number could provide information on the asset or liability’s
market value. For each asset or liability there should be an accounting number and a
market value. In practice, some assets that are separable and marketable are not recorded
as an accounting asset (sometimes for non-information reasons such as tax effects, for
example the development expense in Amir and Lev, 1996). Also an accounting asset can
be recorded for an item that is not a separable and marketable asset (i.e., purchased
goodwill). If the balance sheet model does not hold (i.e., there are rents) the links to the
accounting numbers become more difficult.

5.1.3 Implications for incremental association studies

Coefficient of component being assessed. Non-measurement studies assess the
MVC’s value-relevance by testing whether its estimated coefficient in equation (1) is
significantly different from zero. For an asset, the test might be that the coefficient is
significantly positive and for a liability that it is significantly negative.
The presence of rents could affect the sign of the coefficient of an asset or
liability. For example, consider a firm where abandonment has effectively a zero
probability. Then unless an asset’s value is correlated with the omitted rents, its
 7:57 AM 10/6/2000 49

coefficient could be zero rather than positive. If the asset value is correlated with future
cash flows the expected sign could be negative or positive. Suppose the asset price is
determined by the demand from another industry. Then an increase in that asset value
could represent higher cash outflows in the future to purchase the asset and be negatively
correlated with future cash flows.
Measurement studies typically predict that the coefficients of assets should be one
and those of liabilities should be minus one. The extent to which the coefficients differ
from one or minus one is used to assess the extent to which accounting numbers measure
the market values of assets or liabilities with error (see Barth, 1991; Barth, Beaver and
Landsman, 1996; and Eccher, Ramesh and Thiagarajan, 1996). This approach relies on
strong assumptions about the bias with which the accounting numbers measure the
underlying attributes, the correlation between the measurement errors and the underlying
attributes, and the correlation between the measurement errors and other variables in the
regression (see Lambert, 1996). Even if these conditions are met, the procedure will fail
in the presence of rents because the coefficients of assets and liabilities are not likely to
be one and minus one respectively. Equation (1) does not hold and equity value is a non-
linear function of net assets so one wouldn’t predict that the coefficients would be one
and minus one. Further, the coefficient would vary across firms with the likelihood of
abandonment.
Correlated omitted variables. Even if there are no rents, equation (1) requires the
inclusion of all asset and liability market values. Often some of those asset and liability
values are not included in the regression equation (see Lys, 1996, p. 161). As is
recognized in several studies, if the omitted values are correlated with the included
values, the estimated coefficients of the included values can be biased from their
predicted values of one and minus one. The existence of rents creates a further
opportunity for the problem of correlated variables. If no proxies are included for rents
(equation 1 is estimated), some of the included assets and liabilities can be correlated
with rents. For example, if banks invest in loans where they have informational
advantages, rents could be correlated with the market value of those loans (see the
discussion in Eccher, Ramesh and Thiagarajan, 1996, p. 85). Even if proxies are
included for rents, if those proxies do not account for all of the variation in rents and if
 7:57 AM 10/6/2000 50

included asset or liability variables are correlated with rents, the estimated asset and
liability coefficients will be biased.
Assessing the value-relevance of assets that are proposed to be included in the
balance sheet, or disclosed for the first time, illustrates the linking difficulties that arise
with both omitted assets and rents. For example, Eccher, Ramesh and Thiagarajan (1996)
assess the value-relevance of the market value of items that are currently not recorded on
the balance sheet and whose market values are not currently disclosed (OBS items).
Those items include credit-related instruments (e.g., letters of credit) for which the fair
value is not available. Eccher et al (1996) are forced to use notional values for those
credit instruments. As Eccher et al (1996) recognize, those notional values are likely to
be correlated both with the fair values of the instruments and (because they are related to
future revenues) with future cash flows. Hence, Eccher et al (1996) cannot predict a sign
for the coefficient of the credit-related instruments’ value in an incremental relevance
study and, if the coefficient is significant, cannot tell whether it is due to the instruments’
value and/or expected rents.

5.2 Earnings model

5.2.1 Valuation model
In relative association studies stock returns are often regressed on alternative
measures of earnings. The measure whose regression has the highest R2 is considered the
best performance measure or most value relevant. These studies compare income
measures within a country (e.g., Dhaliwal, Subramanyam and Trezevant, 1999,
comparing measures of comprehensive income to net income) or net income measures
across countries (e.g., Barth and Clinch, 1996). In incremental association studies, the
market value of equity is often regressed on components of earnings. For example,
Barth, Beaver and Landsman (1992) regress the market value of equity on earnings
components to assess the incremental value-relevance of pension cost components.
These studies imply earnings are related to stock market value or changes in value, but in
many cases the valuation model is not explicitly specified.
Generally, the measurement studies specify an explicit valuation model. In those
studies involving regressions of equity market value on earnings the earnings coefficient
 7:57 AM 10/6/2000 51

is expected to be 1/r, where r is the discount rate for future earnings (e.g., Barth,
Landsman and Wahlen, 1995). Similarly when the stock rate of return is regressed on
earnings components or changes in earnings components, the equivalent predicted
coefficient for earnings or earnings change before the component (deflated by opening
price) is 1/r, or close to 1/r, (e.g., Barth, 1994). In these studies, earnings are viewed as
“permanent” earnings or the “long run” earnings power of the firm and price is viewed as
capitalized earnings (see Barth, Landsman and Wahlen, 1995, p. 586).
“Permanent earnings” is just capitalized earnings converted to a perpetuity.
Permanent earnings are equivalent to the transformation of net present value to equivalent
annual cost or uniform annual cash flow (see Brealey and Myers, 1996, p. 128). As such,
it is a transformation of the estimate of value, not the underlying valuation model - it
provides no indication of the attributes that are valued. The primary valuation model is
discounted dividends. The discounted earnings model is just a re-expression of the
dividend model using the dividend payout assumption (see Beaver, 1998).
The non-measurement relative association studies are consistent with the
assumption that earnings measure (or are a transformation of) permanent income since
the criterion is R2 . The lower the error with which earnings measure permanent earnings
(a transformation of value), the higher the R2 from the regression of value on earnings.
The equality of current earnings and permanent earnings can be achieved by
assuming that the time series of future earnings follow a random walk. However, such an
assumption would be inconsistent with empirical evidence for the US. We know that
earnings changes are transient for extreme earnings, perhaps because of the abandonment
option (e.g., Hayn, 1995) or conservatism (e.g., Basu, 1997). Note also that the
transience of extreme earnings implies a non-linear relation between returns and earnings
and there is ample evidence to support that implication (e.g., Freeman and Tse, 1992).
This non-linearity is not reflected in the regressions used in the literature.

5.2.2 Links to accounting numbers

There is no equivalent to permanent income under current GAAP. Yet the
numbers employed in the earnings model (some version of earnings) in relative
association studies are assumed to represent permanent income or the methodology is
 7:57 AM 10/6/2000 52

consistent with that assumption. The use of the value-relevance earnings criterion based
on the permanent income concept as the sole criterion to set accounting standards, would
result in an earnings number that is associated with value (see section 2). But, the
earnings model provides no theory as to what should be in earnings itself, or what should
be its important components because permanent earnings is just a transformation of
value. The model provides no theory of accounting and when combined with the value-
relevance criterion, is purely a mechanical procedure for producing an earnings number
that is highly correlated with value (non-measurement studies) or is a measure of value
(measurement studies). Use of this mechanical criterion in an unfettered fashion by
standard setters could actually remove the ability of accounting information to provide
new information to capital market participants.

5.2.3 Implications for association studies

Lack of guidance for earnings and its components. Because it has no theory of
accounting, the earnings model provides no guidance to researchers (or standard-setters)
as to what numbers should be included in earnings, other than highly associated with
value or return. Lacking guidance from a theory, researchers investigate earnings
numbers or components of earnings calculated according to existing or proposed
standards. This is poses a conundrum for the value relevance literature: proposed
standards are often generated on grounds other than value-relevance (see Leftwich, 1995
for an investigation of agenda-setting for the FASB) but value relevance studies evaluate
them on the value-relevance criterion.
When the earnings model is used to determine components of earnings
(incremental association studies), the incremental association depends on the other
numbers in the regression. Because no guidance is provided as to how to sequence the
investigations of components, the sequence of investigation for the US depends on what
components the researcher chooses to include, and the sequence in which different
accounting numbers or components are considered and adopted by the FASB.
Coefficients of earnings and earnings components. The lack of consideration of
growth and abandonment option characteristics suggests incorrect predictions for the
coefficient of earnings in relative association measurement studies (e.g., the coefficient is
 7:57 AM 10/6/2000 53

unlikely to be the predicted function of the discount rate). A similar problem arises for
component studies even if the time series properties of components are taken into account
(as in Barth, Beaver and Landsman, 1992) because option problems apply to the
components as well.
Correlated omitted variables. Some earnings components (such as depreciation)
could be positively correlated cross-sectionally with net assets. Hence, they could proxy
for the omitted abandonment (and growth) options.

5.3 Ohlson model

5.3.1 Valuation model
The Ohlson model derives from the residual income valuation model, which takes
the following form:

∞
MVE 0 = BV 0 + ∑ {[E 0 (X t ) − rE 0 (BVt − 1 )](1 + r) }
−1

t=1

Where
MVE0 = market value of equity at time 0
BVt = book value of equity at time t
R = investor’s opportunity cost of capital
X = reported earnings
Et = expectation operator at time t
The model is derived from the dividend valuation model given clean surplus
accounting (change in book value of equity = earnings less dividends plus or minus
capital transactions). The model holds for any set of accounting methods as long as the
clean surplus condition holds. Changes in future earnings or changing from one set of
methods to another are offset by changes in book value. Consequently, like the earnings
model, the residual income valuation model per se provides no theory for accounting and
no practical prescription for one accounting method over another other than association
with value or ability to forecast future earnings (see Coopers & Lybrand Academic
Advisory Committee, 1997).
The residual income valuation model provides a specification of the relation
 7:57 AM 10/6/2000 54

between market value and future abnormal earnings (earnings above the required rate of
return times the beginning-of-period book value) and the current book value of equity.
But those abnormal earnings vary according to the accounting methods used and are
unlikely to equal economic abnormal returns (returns greater than the cost of capital
times the beginning-of-period market value of net assets). Further, the book value is
unlikely to be the market value of net assets.
The Ohlson model replaces the value of future abnormal earnings in the residual
income valuation model by current earnings. Ohlson (1995) derives a version of the
residual income model that can express market value as a linear function of current
earnings, dividends and book value by making assumptions about the behavior of
earnings and their relation to information in stock prices (the information dynamics of
earnings). Any test of these equations (the Ohlson model) is a joint test of the residual
income valuation model and the assumed information dynamics. So, as with the earnings
model, variation in association between earnings based on different accounting methods
and value, or between different countries’ earnings and value, could be due to variation in
the extent to which the information dynamics assumptions fit across accounting methods
or countries.
The addition of information dynamics does not provide the Ohlson model with an
ability for selecting an optimal accounting method. As with the residual income
valuation model, a potentially large number of accounting methods fit the model. All that
is added to the clean surplus requirement of the more general model is that an appropriate
information dynamics must be specified (one in which the future earnings can be
expressed in terms of current variables).
While the Ohlson model does lead to the inclusion of the book value of net equity
or net assets in the regressions, it does not allow for the existence of options. Book value
is there in order to make the equation hold, not to measure the market value of net assets,
for purposes of assessing the abandonment option. As with the residual income valuation
model, book value in the Ohlson model can be anything (as long as there are offsetting
changes in future abnormal earnings). Options will interfere with the linear relations
between market value and future earnings and book value and between market value and
current earnings, dividends and book value.
 7:57 AM 10/6/2000 55

Not only is the Ohlson model inconsistent with an abandonment option, due to the
information dynamics assumption it is also inconsistent with firms having expected rents
(expected positive net present value projects –– see Lo and Lys, 1999, pp. 13-14).

5.3.2 Links to accounting numbers

As noted above, like the earnings model, the Ohlson model has no empirical
implications for the choice of different accounting procedures. So the only implication
comes from the value-relevance literature’s methodology, not from the model: choose
the procedures that yield book value and earnings numbers that in combination are most
highly associated with market value of equity. Coopers & Lybrand’s Academic Advisory
Committee (1997) asserts that the model implies that accounting methods should be
chosen on the basis of the association of book values with intrinsic values and the
prediction of future earnings, but that implication does not flow from the model itself.

5.3.3 Implications for association studies

The implications for the Ohlson model are much the same as those for the
earnings model. The one difference in the Ohlson model-based studies, is that those
studies include a book value term that could cross-sectionally proxy for net assets value
and potentially reduce the correlated omitted variables problem (for the omission of net
assets).

5.4 Summary
The valuation models employed in the literature (value-relevance and capital
markets) have no role for accounting. The perfect and complete markets assumption that
generates the balance sheet model and the competitive capital markets assumption of the
discounted dividends model that underlies the earnings and Ohlson models assume
costless information. The valuation models supply no theory of accounting.
The assumption that accounting numbers provide information for valuation that
underlies the value-relevance literature, by itself, provides very little in the way of a
theory of accounting. It cannot explain components of income for example. The only
link between accounting numbers and valuation is that the accounting numbers somehow
 7:57 AM 10/6/2000 56

provide information on variables in the valuation. Incremental association studies using

the balance sheet model often make the link explicit via the assumption of no rents and
the assumption that individual accounting assets and liabilities numbers measure their
market values implicit in the market value of equity. The no rents assumption, however,
is likely not descriptive in many industries and exacerbates correlated omitted variable
problems.
The earnings models do not have a link to accounting earnings since permanent
earnings is merely a transformation of equity value itself. That means there is no theory
to make any predictions about the nature of earnings and their relation to value. The
Ohlson model, as employed with current earnings and book value as explanatory
variables, assumes no rents. Further, because it is simply a transformation of the
discounted dividend model using a clean surplus assumption, the model cannot
distinguish between alternative accounting systems. As long as earnings and book value
can be transformed to meet the clean surplus assumption the accounting system is
consistent with the model.
None of the models can satisfactorily address expansion and growth options.
Such options are likely to make relations between accounting variables and value non-
linear. Since all the models are estimated with linear regressions this creates problems
for predictions of the coefficients in incremental association studies.
Given these problems, even if providing inputs to valuation were the only role for
financial accounting, value-relevance, as it is currently specified, cannot provide much in
the way of predictions for accounting practice. Consequently it cannot provide much
guidance to standard setters either.

6. Conclusions and Suggestions for Future Research

The prime objective of this paper is to assess the value relevance literature’s
contribution to standard setting. While the existing value relevance literature is large, its
contribution to standard setting seems modest. A major reason is that the literature
concentrates on equity valuation. Much of the literature is motivated by an assumption
that accounting provides inputs to investors’ valuations, but the empirical tests amount to
 7:57 AM 10/6/2000 57

either associations with equity value or in many cases to equity valuation per se. This
conflicts with the FASB’s explicit denial that accounting is concerned with providing
direct estimates of value and with the nature and history of US accounting practice. Even
studies that attempt to indirectly tease out attributes the FASB considers important to
accounting numbers (such as relevance and reliability) rely on the extent to which those
attributes are reflected in equity market values. Potential differences between the
attributes reflected in stock market associations and the FASB’s definition of the
attributes (e.g., reliability or relevance to another user group) are not explored. And, the
indirect nature of the extraction of these attributes, together with the reliance on valuation
models inappropriate to most situations, make standard setting inferences questionable in
most circumstances (investigation of investment securities held by banks is perhaps one
of the most favorable set of circumstances).
Even if the value relevance literature’s tests did effectively provide evidence on
accounting’s role in providing inputs to equity investor valuation, those tests still ignore
the other roles of accounting and other forces in the determination of accounting
standards and practice. To the extent accounting standards and practice are shaped by
other roles and forces that are not perfectly correlated with the valuation role, the value
relevance literature misses key attributes of accounting. In this paper, we argue these
other forces are substantive and when we examine certain attributes of accounting
numbers, we think it is clear that at least some of these other forces are strong and
perhaps have become stronger over time. The evidence on conservatism is consistent
with that hypothesis.
Conversations with individuals currently and formerly associated with the FASB
suggest those individuals are confused about how to interpret the value relevance
evidence and how to use it in their deliberations. 14 While intuitively those individuals,
as well as academics, sense something useful must arise from knowing the degree of
association between equity valuations and accounting numbers, they find it hard to
pinpoint exactly what implications that association has for potential accounting standards.

14
While the FASB clearly tracks academic research and promotes interactions between the board and the
academic community (Beresford and Johnson, 1995), they struggle with how to use it in their deliberations
(Leisenring and Johnson, 1994).
 7:57 AM 10/6/2000 58

The points raised in this paper might partially explain why individuals associated with the
FASB have difficulty obtaining guidance from the value relevance literature.
Standard setters would be aided if accounting researchers spent more resources
investigating the many forces that shape accounting. Moreover, we believe such research
would lead to a more fully developed theory of accounting. We worry that many
researchers have begun to assume (without supporting evidence) that accounting is
predominantly concerned with equity valuation and have lost sight of the other important
roles for accounting.15 Given our concerns, we use the issues raised in this paper to
suggest interesting research topics. We believe that pursuit of the type of research
suggested would generate a more descriptive theory of accounting that would aid
academics, as well as standard setters, in understanding the forces that shape accounting.
The apparent conservatism of accounting is a phenomenon that is beginning to attract
more attention in accounting research (e.g., Basu, 1997; Ball, Kothari and Robin, 1999).
Given conservatism’s apparent pervasiveness in accounting over time and across
countries, increased research into conservatism seems likely to yield significant
improvements in understanding accounting. The current assumption of the dominance of
the equity valuation role of accounting, suggests it would be informative to investigate
whether conservatism can be explained by that role. For example, can the abandonment
option explain conservatism (see Hayn, 1995)? Variation in conservatism across
countries suggests studies to investigate the reasons for such cross-sectional variation.
We have argued that contracting (including stewardship), litigation, political
considerations, taxes and other institutional arrangements can influence the degree of
conservatism across countries. Does the influence of these factors vary across countries
in a way that explains international variation in conservatism? Can the apparent time
series variation in conservatism in US accounting, observed in section 4, be explained by
variation in these factors? The interaction of standards and practice could be investigated
using conservatism as well. Is conservatism due more to how accounting is practiced
rather than to the accounting standards enacted? Different factors suggest conservatism

15
There are various forces that might encourage that outcome. For example, with the demise of
professional accounting options in leading graduate business schools accounting faculty in those schools
have increasingly become involved in teaching valuation. It would not be surprising if faculty members
tended to adopt the view that what they teach is central to accounting.
 7:57 AM 10/6/2000 59

could be more prevalent in some areas of financial reporting than in others. For example,
the contracting and tax arguments in section 4 suggest conservatism might play a more
important role in financial statement recognition than in disclosure. This suggests a study
of the relative conservatism of recognized versus disclosed elements of financial
reporting.
Sections 3 and 4 raise other potential research topics involving non-equity valuation
roles and other forces affecting accounting and standard setting. Consider non-equity
investors (e.g., lenders). What types of accounting information are more relevant for
those investors than for equity investors? Some of those issues have been partially
investigated in the context of examining typical debt contracts (e.g., Leftwich, 1983) and
a start has been made on using accounting information to estimate the abandonment
option (e.g., Berger and Ofek, 1996). Is the form and content of the balance sheet
largely driven by the demands of these investors as opposed to equity investors? If so,
how appropriate is the balance sheet valuation model, as currently implemented, for
equity valuation?
Verifiability is also a potentially fruitful research topic. How does verifiability restrict
the opportunity set of potential standards? An examination of FASB considerations on
verifiability might provide insights into this question.
The influence of the political process on standard setting could also be studied further.
For example, can the Leftwich (1995) study on the FASB’s agenda setting be extended?
Is there any direct evidence that the balance sheet became less useful after the SEC
eliminated asset write-ups. Also, could one have predicted the political upheavals
associated with the proposed opinion on employee stock options and the hedging and
derivatives project (see Foster, 1998)? Under what circumstances do the SEC and
Congress become entangled in the standard-setting process? Is it predictable? How do
the FASB’s votes on issues reflect the political process of standard setting?
While we have concentrated on standard setting implications of this literature, many
value relevance studies have an objective beyond providing information for standard
setters. In particular, they seek to assess the usefulness of accounting numbers in equity
valuation. For example, a question addressed in Barth (1994) is whether fair value
disclosures of investment securities can be used to help determine the market value of
 7:57 AM 10/6/2000 60

banks’ equity securities conditional on the other information included in the model’s
specifications. This is a pure valuation question. While we have not assessed the overall
contribution of the value relevance literature to valuation, many issues we raise in this
paper are important for that assessment and for the general valuation literature as well.
Contributions to the valuation literature depend on the appropriateness of the valuation
models used and the links from the accounting measures to the models (see section 5), as
well as the set of conditioning variables (if any) used in the tests. If the conditioning
variables are limited in scope, the findings are likely to be less informative.
In section 5 we discuss weaknesses in the current valuation models used in
accounting research. In particular, most of the models estimated assume away the
existence of economic rents, growth and abandonment options. In addition, most of the
estimated models are linear, when there is both ample theory and empirical evidence to
support the notion that the relation between the variables in the models and value are
non-linear. Thus, another area for future research is to advance the valuation models
used in the literature, by explicitly considering rents, growth and abandonment options
and the resulting non-linear relations. Again, this is an area where some research is
taking place, but there is a surprising reliance on the models highlighted in this review,
given those models’ weaknesses.
As we have indicated, an important impediment keeping the value relevance literature
from contributing more to standard setting debates is its lack of a theory that has some
potential to explain accounting and standard setting. As we have seen, assuming
accounting involves direct valuation of equity has very little current ability or potential to
provide that explanation. Assuming that accounting provides information on inputs to
equity and other securities valuation models could, when combined with the other roles
of accounting, yield results. It will require more than just an assumption that accounting
numbers provide inputs, links between the accounting numbers and valuation models will
have to be specified in a way that provides testable implications about accounting. That
in turn will require an assumption that information (like contracting) is costly and some
way of predicting the information costs and benefits of alternative accounting regimes.
Development and refinement of a descriptive theory of accounting and standard
setting will have important implications not only for standard setting but also for the
 7:57 AM 10/6/2000 61

accounting valuation literature.16 As an example consider the relation between

accounting earnings and stock prices. It seems plausible that an accounting theory might
predict that the accounting earnings of firms with higher risk and growth measure future
cash flows with greater error and bias (see Skinner, 1993, for a contracting explanation of
this type or relation). One reason could be that the contracting use of accounting requires
verification so accounting earnings do not fully capture growth in firms’ future cash
flows. The extent to which current earnings capture future cash flows is likely to be
smaller for riskier and higher growth firms.17 If, for convenience in explanation, we
assume the measurement errors in a cross-sectional regression of returns on earnings or
changes in earnings are distributed independently of one another and of cash flows, then
the coefficients of the earnings variable will incorporate larger downward biases for
riskier and higher growth firms. Absent adjustment for this cross-sectional relation
implied by accounting theory, the researcher investigating the valuation of accounting
earnings could reach incorrect conclusions about the relation between risk and growth
and other factors affecting the earnings response coefficient (e.g., the required or market
rate of return).
Another example of how accounting theory can impact estimation of value and
earnings/value relations comes from the firm’s contractual arrangements with various
claimholders. Core and Schrand (1999) provide theory and evidence for why the relation
between earnings and stock prices will be non-linear as a function of debt indentures that
provide the debtholder the right to liquidate the firm. Thus, a non-linearity in the
earnings stock price relation is induced by the underlying contracts. This example
suggests additional research that examines how the non-valuation roles of accounting
(such as contracting) affect the relations between values and accounting measures is
warranted.

16
Consistency between accounting theory based on information costs and the valuation model would
require valuation models that incorporate the information costs. Given approximate market efficiency the
inclusion of information costs is likely to be less important in the valuation model than in the accounting
model.
17
Notice here that we are putting structure on measurement errors just as Barth (1991 and 1994) puts
structure on measurement errors. The difference is that we are offering a testable theory as to why that
measurement error arises. And, that theory suggests accounting standards are not modified to reduce that
error.
 7:57 AM 10/6/2000 62

The above illustrations of the importance of a descriptive theory of accounting

and standard setting to assist standard setters and to the earnings valuation literature
demonstrates how such a descriptive theory can help reconcile the two literatures.18 It
also reinforces our point that one cannot use the valuation literature alone to derive
standard setting implications. Given the importance of a descriptive theory of
accounting, we encourage the academic community to begin devoting more resources to
the types of questions we suggest in this section. In order to advance the accounting
literature on multiple fronts and increase the relevance of our research, we must consider
all the forces roles that affect the form and content of accounting.

18
See Watts (1992) for discussion of the implications of a descriptive accounting theory for capital markets
research, including valuation.
 7:57 AM 10/6/2000 63

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 7:57 AM 10/6/2000 70

Appendix 1
Value-Relevance Papers

Aboody, D., 1996. Market valuation of employee stock options. Journal of Accounting
& Economics 22, 357-391.
Aboody, D., Lev, B., 1998. The value relevance of intangibles: The case of software
capitalization. Journal of Accounting Research 36, 161-191.
Ahmed, A.S., Takeda, C., 1995. Stock market valuation of gains and losses on
commercial banks’ investment securities: An empirical analysis. Journal of
Accounting & Economics 20, 207-225.
Alford. A., Jones, J., Leftwich, R., Zmijewski, M., 1993. The relative informativeness of
accounting disclosures in different countries. Journal of Accounting Research
Supplement 31, 183-229.
Amir, E., 1993. The market valuation of accounting information: The case of
postretirement benefits other than pensions. Accounting Review 68, 703-724.
Amir, E., 1996. The effect of accounting aggregation on the value-relevance of financial
disclosures: The case of SFAS No. 106. Accounting Review 71, 573-590.
Amir, E., Harris, T.S., Venuti, E.K., 1993. A comparison of value-relevance of US
versus non-US-GAAP accounting measures using Form 20-F reconciliations.
Journal of Accounting Research Supplement 31, 230-264.
Amir, E., Kirschenheiler, M., Willard, K., 1997. The valuation of deferred taxes.
Contemporary Accounting Research 14, 597-622.
Amir, E., Lev, B., 1996. Value-relevance of nonfinancial information: The wireless
communications industry. Journal of Accounting & Economics 22, 3-30.
Anthony, J.H., Petroni, K.R., 1997. Accounting estimation disclosures and firm
valuation in the property-casualty insurance industry. Journal of Accounting,
Auditing & Finance 12, 257-281.
Ayers, B.C., 1998. Deferred tax accounting under SFAS No. 109: An empirical
investigation of its incremental value-relevance relative to APB No. 11.
Accounting Review 73, 195-212.
 7:57 AM 10/6/2000 71

Ballas, A., 1997. Valuation implications of the components of earnings: Cross-sectional

evidence from Greece. Unpublished working paper, Athens Greece.
Balsam, S., Lipka, R., 1998. Share prices and alternative measures of earnings per share.
Accounting Horizons 12, 234-249.
Bandyopadhay, S.P., Hanna, J.D., Richardson, G., 1994. Capital market effects of US-
Canada GAAP differences, Journal of Accounting Research 32, 262-277.
Barth, M.E., 1991. Relative measurement errors among alternative pension asset and
liability measures. The Accounting Review 66, 433-463.
Barth, M.E., 1994. Fair value accounting: Evidence from investment securities and the
market valuation of banks. Accounting Review 69, 1-25.
Barth, M.E., Beaver, W.H., Landsman, W., 1992. The market valuation implications of
net periodic pension cost components. Journal of Accounting & Economics 15, 27-
62.
Barth, M.E., Beaver, W.H., Landsman, W., 1996. Value-relevance of banks’ fair value
disclosures under SFAS No. 107. The Accounting Review 71, 513-537.
Barth, M.E., Beaver, W.H., Stinson, C.H., 1991. Supplemental data and the structure of
thrift share prices. Accounting Review 66, 56-66.
Barth, M.E., Clement, M., Foster, G., Kasznik, R., 1998. Brand values and capital
market valuation. Review of Accounting Studies 3, 41-68.
Barth, M.E., Clinch, G., 1996. International accounting differences and their relation to
share prices: Evidence from U.K., Australian, and Canadian firms. Contemporary
Accounting Research 13, 135-170.
Barth, M.E., Clinch, G., 1998. Revalued financial tangible, and intangible assets:
Associations with share prices and non market-based value estimates. Journal of
Accounting Research 36, 199-233.
Barth, M.E., McNichols, M.F., 1994, Estimation and market valuation of environmental
liabilities relating to superfund sites. Journal of Accounting Research Supplement
32, 177-209.
Bartov, E., 1997. Foreign currency exposure of multinational firms: Accounting
measures and market valuation. Contemporary Accounting Research 14, 623-652.
 7:57 AM 10/6/2000 72

Beaver, W.H., Christie, A.A., Griffin, P.A., 1980. The information content of SEC
accounting series release No. 190. Journal of Accounting & Economics 2, 127-
Beaver, W.H., Dukes, R.E., 1972. Interperiod tax allocation earnings expectations, and
the behavior of security prices. Accounting Review 47, 320-418.
Biddle, G.C., Bowen, R.M., Wallace, J.S., 1997. Does EVA beat earnings? Evidence on
associations with stock returns and firm values. Journal of Accounting &
Economics 24, 301-336.
Black, E.L., 1998. Life-cycle impacts on the incremental value-relevance of earnings and
cash flow measures. Journal of Financial Statement Analysis 4, 40-56.
Bodnar, G.M., Weintrop, J., 1997. The valuation of the foreign income of US
multinational firms: A growth opportunities perspective. Journal of Accounting &
Economics 24, 69-97.
Chan, K.C., Seow, G.S., 1996. The association between stock returns and foreign GAAP
earnings vs. earnings adjusted to US GAAP. Journal of Accounting & Economics
21, 139-158.
Chaney, P.K., Jeter, D.C., 1994. The effect of deferred taxes on security prices. Journal
of Accounting, Auditing & Finance 9, 91-116.
Cheng, C.S.A., Liu, C., Schaefer, T.F., 1997. The value-relevance of SFAS No. 95 cash
flows from operations as assessed by security market effects. Accounting Horizons
11, 1-15.
Choi, B., Collins, D.W., Johnson, W.B., 1997. Valuation implications of reliability
differences: The case of nonpension postretirement obligations. Accounting
Review 72, 351-383.
D’Souza, J., Jacob, J., Soderstrom, N.S., 2000. Nuclear decommissioning costs: The
impact of recoverability risk on valuation. Journal of Accounting & Economics 29,
forthcoming.
Davis-Friday, P.Y., Rivera, J.M., 2000. Inflation accounting and 20-F disclosures:
Evidence from Mexico. Accounting Horizons 14, 114-135.
Dhaliwal, D., Subramanyam, K.R., Trezevant, R., 1999. Is comprehensive income
superior to net income as a measure of firm performance? Journal of Accounting &
Economics 26, 43-67.
 7:57 AM 10/6/2000 73

Eccher, E.A., Ramesh, K., Thiagarajan, S.R., 1996. Fair value disclosures by bank
holding companies. Journal of Accounting & Economics 22, 79-117.
Ely, K., Waymire, G., 1999. Intangible assets and equity valuation in the pre-SEC era.
Unpublished working paper. University of Iowa.
Fields, T.D., Rangan, S., Thiagarajan, S.R., 1998. An empirical evaluation of the
usefulness of non-GAAP performance measures in the REIT industry. Review of
Accounting Studies 3, 103-130.
Francis, J., Schipper, K., 1999. Have financial statements lost their relevance? Journal
of Accounting Research 37, 319-352.
Gheyara, K., Boatsman, J., 1980. Market reaction to the 1976 replacement cost
disclosures. Journal of Accounting & Economics 2, 107-125.
Givoly, D., Hayn, C., 1992. The valuation of the deferred tax liability: Evidence from the
stock market. Accounting Review 67, 394-410.
Gopalakrishnan, V., 1994. The effect of recognition vs. disclosure on investor valuation:
The case of pension accounting. Review of Quantitative Finance & Accounting 4,
383-396.
Gopalakrishnan, V., Sugrue, T.F., 1993. An empirical investigation of stock market
valuation of corporate projected pension liabilities. Journal of Business Finance &
Accounting 20, 711-724.
Graham, R.C., Lefanowicz, G.C., Petroni, K.R., 1998. Value-relevance of fair value
disclosures for investments in securities accounted for under the equity method.
Unpublished working paper, Michigan State University.
Harris, M.S., Muller, K.A., 1999. The market valuation of IAS versus US-GAAP
accounting measures using Form 20-F reconciliations. Journal of Accounting &
Economics 26, 285-312.
Harris, T.S., Lang, M., Moller, H.P., 1994. The value relevance of German accounting
measures: An empirical analysis. Journal of Accounting Research 32, 187-209.
Harris, T.S., Ohlson, J.A., 1987. Accounting disclosures and the market’s valuation of
oil and gas properties. Accounting Review 62, 651-670.
Henning, S.L., Stock, T., 1997. The value-relevance of goodwill write-offs.
Unpublished working paper, Southern Methodist University.
 7:57 AM 10/6/2000 74

Hirschey, M., Richardson, V.J., Scholz, S.W., 1998. Value-relevance of nonfinancial

information: The case of patent data. Unpublished working paper, University of
Kansas.
Joos, P., Lang, M., 1994. The effects of accounting diversity: Evidence from the
European Union. Journal of Accounting Research Supplement 32, 141-175.
Lev, B., Sougiannis, T., 1996. The capitalization, amortization, and value-relevance of
R&D. Journal of Accounting & Economics 21, 107-138.
Nelson, K.K., 1996. Fair value accounting for commercial banks: An empirical analysis
of SFAS No. 107. Accounting Review 71, 161-182.
Petroni, K.R., Wahlen, J.M., 1995. Fair values of equity and debt securities and share
prices of property-liability insurers. Journal of Risk and Insurance 62, 719-737.
Pope, P.F., Rees, W., 1993. International differences in GAAP and the pricing of
earnings. Journal of International Financial Management and Accounting 4, 190-
219.
Rees, L., Elgers, P., 1997. The market’s valuation of nonreported accounting measures:
Retrospective reconciliations of non-U.S. and U.S. GAAP. Journal of Accounting
Research 35, 115-127.
Rees, L., Stott, D., 1999. The value-relevance of stock-based employee compensation
disclosures. Unpublished working paper, Texas A & M University.
Shevlin, T., 1991. The valuation of R&D firms with R&D limited partnerships.
Accounting Review 66, 1-21.
Venkatachalam, M., 1996. Value-relevance of banks’ derivatives disclosures. Journal of
Accounting & Economics 22, 327-355.
Vincent, L., 1997. Equity valuation implications of purchase versus pooling accounting.
Journal of Financial Statement Analysis 2, 5-20.
Vincent, L., 1999. The information content of funds from operations (FFO) for real
estate investment trusts (REITs). Journal of Accounting & Economics 26, 69-104.
Whisenant, J.S., 1998. Does fundamental analysis produce more value-relevant
summary measures? Unpublished working paper, Georgetown University.
 Table 1
Value-relevance papers classified by methodology and motivation
Methodology Standard-Setting Motivation
Marginal
Relative Incremental Information
No. Author(s) Journal Year Association AssociationMeasurement Content Intertemporal Explicit Implicit
1 Aboody JAE 1996 1 1
2 Aboody & Lev JAR 1998 1 1
3 Ahmed & Takeda JAE 1995 1 1
4 Alford, Jones, Leftwich & Zmijewski JAR 1993 1 1
5 Amir AR 1993 1 1
6 Amir AR 1996 1 1
7 Amir, Harris & Venuti JAR 1993 1 1 1
8 Amir, Kirschenheiter & Willard CAR 1997 1 1 1
9 Amir & Lev JAE 1996 1 1 1
10 Anthony & Petroni JAAF 1997 1 1
11 Ayers AR 1998 1 1
12 Ballas WP 1997 1 1 1
13 Balsam & Lipka AH 1998 1 1 1 1
14 Bandyopadhyay, Hanna & RichardsonJAR 1994 1 1 1
15 Barth AR 1991 1 1 1
16 Barth AR 1994 1 1 1
17 Barth, Beaver & Landsman JAE 1992 1 1
18 Barth, Beaver & Landsman AR 1996 1 1
19 Barth, Beaver & Stinson AR 1991 1 1
20 Barth, Clement, Foster & Kasznik RAS 1998 1 1 1
21 Barth & Clinch CAR 1996 1 1
22 Barth & Clinch JAR 1998 1 1
23 Barth & McNichols JAR 1994 1 1
24 Bartov CAR 1997 1 1
25 Beaver, Christie & Griffin JAE 1980 1 1
26 Beaver & Dukes AR 1972 1 1
27 Biddle, Bowen & Wallace JAE 1997 1 1 1
28 Black JFSA 1998 1 1
29 Bodnar & Weintrop JAE 1997 1 1 1
30 Chan & Seow JAE 1996 1 1
31 Chaney & Jeter JAAF 1994 1 1
32 Cheng, Liu & Schaefer AH 1997 1 1
33 Choi, Collins & Johnson AR 1997 1 1 1
34 D'Souza, Jacob, Soderstrom JAE 2000 1 1 1
35 Davis-Friday, Rivera AH 2000 1 1
36 Dhaliwal, Subramanyam & TrezevantJAE 1999 1 1
37 Eccher, Ramesh & Thiagarajan JAE 1996 1 1 1
38 Ely & Waymire WP 1999 1 1
39 Fields, Rangan & Thiagarajan RAS 1998 1 1 1
40 Francis & Schipper JAR 1999 1 1
41 Gheyara & Boatsman JAE 1980 1 1
42 Givoly & Hayn AR 1992 1 1
43 Gopalakrishnan RQFA 1994 1 1
44 Gopalakrishnan & Sugrue JBFA 1993 1 1 1
45 Graham, Lefanowicz & Petroni WP 1998 1 1
46 Harris & Muller JAE 1999 1 1 1 1
47 Harris, Lang & Moller JAR 1994 1 1 1
48 Harris & Ohlson AR 1987 1 1 1
49 Henning & Stock WP 2000 1 1
50 Hirschey, Richardson & Scholz WP 1998 1 1
51 Joos & Lang JAR 1994 1 1 1
52 Lev & Sougiannis JAE 1996 1 1
53 Nelson AR 1996 1 1 1 1
54 Petroni & Wahlen JRI 1995 1 1 1
55 Pope & Rees JIFMA 1993 1 1 1
56 Rees & Elgers JAR 1997 1 1
57 Rees & Stott WP 1999 1 1 1
58 Shevlin AR 1991 1 1 1
59 Venkatachalam JAE 1996 1 1 1
60 Vincent JFSA 1997 1 1 1
61 Vincent JAE 1999 1 1 1 1
62 Whisenant WP 1998 1 1 1
TOTAL 15 53 13 7 7 54 8
Journal Abbreviations
ABR = Accounting and Business Research JAE = Journal of Accounting & Economics
AER = American Economic Review JAL = Journal of Accounting Literature
AFE = Applied Financial Economics JAR = Journal of Accounting Research
AF = Accounting and Finance JBF = Journal of Banking and Finance
AH = Accounting Horizons JBFA = Journal of Business Finance and Accounting
AQAFA = Advances in Quantitative Analysis of Finance & Accounting JEB = Journal of Economics and Business
AR = Accounting Review JREPM = Journal of Real Estate Portfolio Management
BAF = Bank Accounting and Finance JFSA = Journal of Financial Statement Analysis
CAR = Contermporary Accounting Research JIFMA = Journal of International Financial Management & Accounting
FAJ = Financial Analyst Journal JRI = Journal of Risk and Insurance
FASB = Financial Accounting Standards Board MA = Management Accounting
IJA = International Journal of Accounting RAS = Review of Accounting Studies
JAAF = Journal of Accounting, Auditing and Finance RQFA = Review of Quantitative Finance & Accounting
WP = Working Paper (included only if publication not found)
 Table 2
Comparison of conservatism of US income numbers over time
by reporting regime,1927-1993

Average coefficients from yearly cross-sectional regressions of earnings on contemporaneous returns for different reporting regimes (Ely & Waymire Data),
coefficients from pooled cross-sectional regressions of earnings on contemporaneous returns with dummies for different reporting regimes (Basu, 1997),
coefficients from pooled cross-sectional regressions of earnings on contemporaneous returns (Ball, Kothari & Robin, 1999)

Xt/Pt-1 = α0 + α1DRt + β0Rt+ β1DRtRt

EARNINGS REGRESSION OPERATING EARNINGS REGRESSION

Mean coefficient of Mean coefficient of
Loss Dummy* Loss Dummy*
Dummy Return Return Dummy Return Return
α1 β0 β1 α1 β0 β1
Conservatism Conservatism
ELY & WAYMIRE DATA
Average of individual year regressions
Subperiod Reporting regime
1927-41 Prestandard-setting, low litigation 0.00 0.11** 0.09* -0.09 0.15** -0.09
(0.48) (5.57) (2.24) (-.93) (5.37) (-1.29)
1942-46 Price controls, standard-setting, low litigation 0.07 0.60** -0.32 0.07 2.29** -1.53
(1.28) (8.16) (-.98) (0.04) (5.69) (-1.05)
1947-50 Standard-setting, low litigation 0.03 0.33** 0.01 0.05 0.71** -0.16
(1.39) (6.54) (0.10) (1.30) (6.36) (-0.55)
1951-53 Price controls, standard-setting, low litigation 0.03 0.22** 0.07 0.09 0.49** 0.05
(2.24) (5.38) (1.66) (1.89) (5.64) (-0.55)
1954-66 Standard-setting, low litigation 0.00 0.08** 0.06* 0.01 0.18** 0.08*
(0.51) (6.78) (2.61) (1.34) (6.52) (2.30)
1967-75 Standard-setting, high litigation 0.03* 0.11** 0.05** -0.02 0.08** 0.08*
(2.13) (5.58) (3.62) (1.43) (3.39) (2.42)
1976-82 Standard-setting, litigation 0.03* 0.14** 0.16** 0.06 0.26 0.02
(2.13) (6.49) (3.40) (0.68) (0.06) (1.59)
1983-93 Standard-setting, high litigation 0.02 0.00 0.43** 0.03* 0.08** 0.32**
(0.89) (0.63) (7.47) (2.30) (3.19) (5.32)
1963-66 Standard-setting, low litigation 0.00 .06** 0.04 0.03 0.19* 0.09
(0.73) (4.67) (1.34) (1.38) (3.62) (1.78)
Full period
1927-93 .02** 0.14** 0.10** 0.00 0.36** -0.06
(3.44) (14.99) (7.77) (2.85) (13.87) (3.45)

BASU (1997)
Pooled cross-sectional regressions with regime dummies
1963-66 Standard-setting, low litigation 0.00 0.03** 0.01
(0.01) (4.74) (0.93)
1967-75 Standard-setting, high litigation 0.02 0.07 0.19
1976-82 Standard-setting, litigation -0.01 0.03 0.19
1983-90 Standard-setting, high litigation 0.03 0.03 0.40

EARNINGS BEFORE EXTRAORDINARY ITEMS

BALL,KOTHAR & ROBIN (1999)
Pooled cross-sectional regressions
1985-90 Standard-setting, high litigation ? 0.03** 0.29**
(6.14) (26.79)
1991-95 Standard-setting, high litigation ? 0.03** 0.33**
(6.54) (22.14)

t-statistics in parentheses. For the Ely & Waymire data the t-statistics are for the mean coefficient. No t-statistics are available for the last three Basu periods
because the coefficients are obtained from aggregating reported coefficients.

Ely & Waymire Data. Sample of 100 firms drawn randomly each year in the period 1927-1993 that met two criteria: I) stock price data available from CRSP Monthly
Price File for 29 months from February of the prior year through June of the subsequent year; and 2) four-digit SIC code between 1000 and 3999. Earnings are from
Compustat or Moody's Industrial Manuals. Earnings data are not available for 30 of the 6700 firm years and those observations are not replaced. As a result the
yearly number of observations varies from 97-100 with most of the missing data occurring pre-1951.

Basu's sample consists of 43,321 firm year observations from 1963-1990. Basu estimates a pooled regression with dummies for the additional effects in various
subperiods. We aggregate the coefficients to produce coefficients comparable to the Ely & Waymire data regressions.

The Ball, Kothari & Robin samples include 11,978 firm years for the 1985-90 period and 9,247 for the 1991-95 period. They estimate pooled regressions.

Xt is the firm earnings per share for year t, Pt-1 is the price at the beginning of year t, For the Basu data earnings are adjusted for market earnings.
Earnings is before extraordinary items for Ball, Kothari & Robin
DRt is a dummy variable equal to 1 if Rt <0 and zero otherwise.
Rt is the rate of return on the firm stock for year t. Ely & Waymire measure the return over 16 months, fiscal year plus four months. ; Basu measures the return over
the 12 months beginning month four of fiscal year and adjusts for the market return; Ball, Kothari and Robin measure the return over the fiscal year
The test for conservatism is whether the slope coefficient for the last term is significantly positive.