Another blog piece from a Doctoral Consortium Student (Dina F El-Mahdy from Virginia Commonwealth University).  Enjoy!–RJB

I came across Holthausen and Watts’s (2000) working paper on SSRN and I find it a good starting point to open a discussion on the usefulness of value relevance research to the standards’ setters. This working paper was prepared for the Journal of Accounting & Economics Conference held on April 28-29, 2000 and it incorporates multi-facets on the implications of value relevance research to the ongoing deliberations of the Financial Accounting and Reporting Standards.

Value relevance research is a stream of research started by the seminal work of Ball and Brown (1968) and Beaver (1968). It investigates the association between accounting numbers and stock price performance for the sake of better understanding the usefulness of accounting numbers to different constituencies such as investors, standards’ setters, stakeholders and others. According to Holthausen and Watts’s (2000), value relevance research is classified into three main themes:

  1. Relative association studies. These studies test the association between stock price performance and different measures of bottom line numbers such as alternative measures of EPSs, earnings versus book value measures, or earnings levels versus earnings changes.
  2. Incremental association studies. These studies test the incremental explanatory power of accounting numbers among other set of variables. This stream of research hypothesizes that if the coefficient of accounting numbers are different from zero then the accounting numbers possess incremental explanatory power over other predictor variables.
  3. Marginal information content studies or event study methodology. It tests the response of the stock prices to the release of new information set to the market using returns windows. The authors document that only 11% of the value relevance research follows the event study methodologies and 94% of value relevance research are association studies.

The authors focus on the association studies in their descriptive analysis. However, ignoring the implications of event study methodologies to the standards’ setters in this working paper is unwarranted since this stream of research is of benefit to both the standards’ setters and real world. Event Studies can be simply used to test whether new Financial Accounting and Reporting Standards achieve its desired outcomes.

The authors conclude that the value added from value relevance research to the standards’ setters is very modest. They attributed this low usefulness of value relevance research to a number of factors discussed below.

  • First, the underlying theory of the value relevance research is not a descriptive solid theory. The Efficient Market Hypothesis (EMH) is usually the underlying theory in value relevance research. The EMH contends that the arrival of new information to the market is instantaneously reflected in the contemporaneous stock price. In general, the authors argue that there is a lack of connection between theory and accounting.
  • Second, value relevance research lacks the explanation and logic underlying its assumptions. For example, research that test whether net income or comprehensive income is more associated with firm performance is not of relevance to the standard setters because there is no financial accounting standards showing interest in this comparison between net income versus comprehensive income.
  • Third, in addition to the lack of theory, explanations, and logic underlying value relevance research, there is an evidence of mismatch between FASB objective and accounting role. For example, the primary objective of accounting information, according to FASB, is to provide relevant and reliable information to different constituencies. These two criteria of relevance and reliability mean that the accounting numbers ought to be associated with a value or simply useful for equity valuation and this does not mean that this association is of value to the standard setters. On the other hand, the accounting role is equity valuation by providing estimates of value or transformations of value. Overall, the authors argue that value relevance research focuses on equity investors, valuation of equity securities, and assumes that stock prices adequately represent equity investors’ use of information in valuing equity securities. However, the tests of relevance and reliability teased from stock prices do not necessarily reflect reliability as defined by FASB statements.

Based on Holthausen and Watts’s working paper, one can raise an intriguing question: what can be done to increase the usefulness of value relevance research to the standards’ setters? In my opinion, we should start by developing our own accounting theories that must evolve from the primary objective of the Financial Accounting and Reporting Standards. Having the Positive Accounting Theory (PAT) over the last four decades was the major contribution that underlies the accounting literature since the late 1960s and enriched the value relevance research. Nevertheless, the world has changed significantly over the last four decades and these changes call for a new accounting theory that cope with the worldwide economical, political, and environmental changes. The business environment has experienced many changes along with a noticeable increase in investment costs such as: restructuring costs ‘merger and acquisition’, Research and Development (R&D) expenditures, investment in information technology, brands, and human resources. Moreover, international accounting standards’ convergence, globalization and institutionalization in stock exchanges alter the firm’s products, risk exposure, operation, economic conditions, and market values.

We need an accounting theory that goes beyond merely describing the actual accounting practices because these actual accounting practices are affected by the surrounding economical, environmental, social and political factors. For example, the actual accounting practices in an era of expansion differ from those in an era of recession. In an era of expansion, we usually notice that the business environment is moving towards deregulation and more relaxation of provisions and this would reduce the transaction costs and hence the cost of capital. On the other hand, in an era of recession, arising partially from increased fraud and corporate failure, we find the business environment is moving in the opposite direction with more issued provisions such as the Sarbanes Oxley Act in 2002. The issuance of a new provision sometimes entails more costs or leads to unfavorable consequences such as increased restatements, litigation risk, board turnover, and audit fees. These unfavorable implications of new provisions might lead to imprecise risk and return measures. I find describing the actual accounting practices in a constantly moving business environment requires a more elastic accounting theory that takes into consideration these never ending changes. We need an accounting theory that stresses market discipline, reduces management discretionary behavior, and provides a fair assessment of risk and return measures. Having such an elastic accounting theory would achieve the objective of the financial accounting reporting as stated by FASB: “The primary role of financial reporting is to furnish the investor and lender with information useful to assess the prospective risk and returns associated with an investment”(FASB [1976, pp. 3-4].