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Ball And Brown Essay

1324 words - 6 pages

lustrated by the argument that income numbers cannot be defined sub- stantively, that they lack "meaning" and are therefore of doubtful utility.' The argument stems in part from the patchwork development of account- * University of Chicago. t University of Western Australia. The authors are indebted to the participants in the Workshop in Accounting Research at the Univer- sity of Chicago, Professor Myron Scholes, and Messrs. Owen Hewett and Ian Watts. 1 Versions of this particular argument appear in Canning (1929); Gilman (1939); Paton and Littleton (1940); Vatter (1947), Ch. 2; Edwards and Bell (1961), Ch. 1; Chambers (1964), pp. 267-68; Chambers (1966), pp. 4 and 102; Lim (1966), esp. pp. ...view middle of the document...

What is at issue is the fact that an analytical model does not itself assess the significance of departures from its implied measurements. Hence it is dangerous to conclude, in the absence of further empirical testing, tha~t a lack of substantive meaning implies a lack of utility. An empirical evaluation of accounting income numbers requires agree- ment as to what real-world outcome constitutes an appropriate test of use- fulness. Because net income is a number of particular interest to investors, the outcome we use as a predictive criterion is the investment decision as it is reflected in security prices.3 Both the content and the timing of existing annual net income numbers will be evaluated since usefulness could be im- paired by deficiencies in either. An Empirical Test Recent developments in capital theory provide justification for selecting the behavior of security prices as an operational test of usefulness. An im- pressive body of theory supports the proposition that capital markets are both efficient and unbiased in that if information is useful in forming capital asset prices, then the market will adjust asset prices to that information quickly and without leaving any opportunity for further abnormal gain.4 If, as the evidence indicates, security prices do in fact adjust rapidly to new information as it becomes available, then changes in security prices will re- 2 Canning (1929), p. 98. 8 Another approach pursued by Beaver (1968) is to use the investment decision, as it is reflected in transactions volume, for a predictive criterion. 4 For example, Samuelson (1965) demonstrated that a market without bias in its evaluation of information will give rise to randomly fluctuating time series of prices. See also Cootner (ed.) (1964); Fama (1965); Fama and Blume (1966); Fama, et al. (1967); and Jensen (1968).
EMPIRICAL EVALUATION OF ACCOUNTING INCOME NUMBERS 161 fleet the flow of information to the market.' An observed revision of stock prices associated with the release of the income report would thus provide evidence that the information reflected in income numbers is useful. Our method of relating accounting income to stock prices builds on this theory and evidence by focusing on the information which is unique to a particular firm.6 Specifically, we construct two alternative models of what the market expects income to be and then investigate the market's reac- tions when its expectations prove false. EXPECTED AND UNEXPECTED INCOME CHANGES Historically, the incomes of firms have tended to move together. One study found that about half of the variability in the level of an average firm's earnings per share (EPS) could be associated with economy-wide effects.7 In light of this evidence, at least part of the change in a firm's in- come from one year to the next is to be expected. If, in prior years, the in- come of a firm has been related to the incomes of other...

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