JOURNALOF

ELSEVIER

Journal of Accounting and Economics 24 (1997) 39 67

Accounting
&Economids

Changes in the value-relevance of earnings and book

values over the past forty years
Daniel W. Collins a, E d w a r d L. M a y d e w b'*, Ira S. Weiss b
a College of Business Administration, University oflowa, Iowa City, 1A 52242, USA
b Graduate School of Business, University of Chicago, 1101 East 58th Street, Chicago, IL 60637, USA

Received 1 September 1996; received in revised form 1 September 1997

Abstract
This paper investigates systematic changes in the value-relevance of earnings and book
values over time. We report three primary findings. First, contrary to claims in the
professional literature, the combined value-relevance of earnings and book values has not
declined over the past forty years and, in fact, appears to have increased slightly. Second,
while the incremental value-relevance of 'bottom line' earnings has declined, it has been
replaced by increasing value-relevance of book values. Finally, much of the shift in
value-relevance from earnings to book values can be explained by the increasing frequency and magnitude of one-time items, the increasing frequency of negative earnings,
and changes in average firm size and intangible intensity across time. 1997 Elsevier
Science B.V. All rights reserved.
JEL classification." G10; G38; M41
Keywords: Capital markets; Financial reporting

I. Introduction

This paper investigates changes in the value-relevance of earnings and book

values over the past forty years. Our inquiry is motivated by recent research on
the value-relevance of earnings and book values and related claims from the
professional community. There appears to be a widespread impression that
historical cost financial statements have lost their value-relevance because of
*Corresponding author. Tel.: + 1 773 702 9478; fax: + 1 773 702 0458; e-mail: ed.maydew@
gsb.uchicago.edu.
0165-4101/97/$17.00 1997 Elsevier Science B.V. All rights reserved
PI1 S0 1 65-4 1 01 ( 9 7 ) 0 0 0 1 5-3

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D. I'K Collins et al. / Journal o f Accounting and Economics 24 (1997) 39-67

wholesale changes in the economy. In particular, many claim that the shift from
an industrialized economy to a high-tech, service-oriented economy has rendered traditional financial statements less relevant for assessing shareholder
value. These claims are embodied in the recent report of the AICPA Special
Committee on Financial Reporting, 1994 (the 'Jenkins committee 1994') and in
numerous articles in the professional literatureJ However, the validity of these
claims needs to be subjected to empirical scrutiny. 2
Consistent with these claims of a loss in value-relevance, Lev (1997) and
Ramesh and Thiagarajan (1995) report a steady decline in the value-relevance of
earnings over time. Similarly, Amir and Lev (1996) find that earnings, book
values, and cash flows are largely irrelevant on a stand-alone basis when valuing
firms in the intangible-intensive cellular telephone industry. In addition, studies
by Basu (1997), Elliott and Hanna (1996), and Hayn (1995) suggest that negative
earnings and nonrecurring items can adversely affect the value-relevance of
earnings. These studies also find that in recent years firms have become increasingly likely to report negative earnings and nonrecurring items, which also
suggests a decline in the value-relevance of earnings across time.
However, the same factors contributing to a decline in the value-relevance of
earnings could cause an increase in the value-relevance of book values. Recent
empirical studies suggest that book values take on increased importance relative
to earnings when earnings are negative or contain nonrecurring items (Barth et
al., 1997; Berger et al., 1996; Burgstahler and Dichev, 1997; Collins et al., 1997;
Jan and Ou, 1995). Two explanations (which are not mutually exclusive) have
been given for these findings: (1) book values serve as a better proxy for future
earnings when current earnings contain large transitory components, and
(2) book values serve as a proxy for the firm's abandonment option. Taken as
a whole, this research suggests that the value-relevance of earnings and book
values move inversely to one another, and that if the value-relevance of earnings
has decreased over time then the value-relevance of book values should have
increased.
We investigate the value-relevance of earnings and book values over time
using a valuation framework provided by Ohlson (1995), which expresses price
as a function of both earnings and book value of equity. We estimate yearly
cross-sectional regressions for a 41 year period spanning 1953 to 1993 and use
R 2 a s the primary metric to measure value-relevance. Then, using a technique
described in Theil (197l) and applied by Easton (1985), we decompose the
combined explanatory power of earnings and book values into three components: (1) the incremental explanatory power of earnings, (2) the incremental

1 See, for example, Elliott and J acobson (1991), Jenkins (1994), Rimerman (1990), and Sever and
Boisclair (1990).
2 Schipper (1994).

D.W. Collins et al. / Journal o f Accounting and Economics 24 (1997) 39 67

41

e x p l a n a t o r y p o w e r of b o o k values, a n d (3) the e x p l a n a t o r y p o w e r c o m m o n to

b o t h e a r n i n g s a n d b o o k values. T h e c o m m o n c o m p o n e n t t a k e s into a c c o u n t
that, to s o m e extent, e a r n i n g s a n d b o o k values act as substitutes for each o t h e r
in e x p l a i n i n g prices, while they also function as c o m p l e m e n t s b y p r o v i d i n g
e x p l a n a t o r y p o w e r i n c r e m e n t a l to one a n o t h e r .
C o n t r a r y to assertions from the professional c o m m u n i t y , we find t h a t the
c o m b i n e d value-relevance of e a r n i n g s a n d b o o k values h a s n o t declined over the
p a s t 40 years and, in fact, a p p e a r s to have increased slightly. This result is
consistent with the general conclusions of Ely a n d W a y m i r e (1996) a n d F r a n c i s
a n d S c h i p p e r (1996), w h o find n o consistent evidence t h a t value-relevance has
declined over time. 3 W e do, however, find t h a t the value-relevance of ' b o t t o m
line' e a r n i n g s has declined o v e r time, h a v i n g been r e p l a c e d by an increased
value-relevance of b o o k values. 4
W e next investigate possible e x p l a n a t i o n s for the o b s e r v e d t e m p o r a l shift in
e x p l a n a t o r y p o w e r from e a r n i n g s to b o o k values. First, we e x a m i n e w h e t h e r the
i n c r e a s e d i m p o r t a n c e of intangible-intensive firms can explain this shift. W e find
t h a t the increasing frequency of intangible-intensive firms d o e s n o t e x p l a i n
changes in the c o m b i n e d value-relevance of earnings a n d b o o k values across
time; however, this increase in frequency does p a r t i a l l y explain the shift in
v a l u e - r e l e v a n c e from e a r n i n g s to b o o k values.
Next, we d o c u m e n t t h a t the value-relevance of e a r n i n g s ( b o o k values) decreases (increases) when firms r e p o r t n o n r e c u r r i n g items o r negative earnings. 5
W e also r e p o r t a striking increase in b o t h n o n r e c u r r i n g items a n d negative
e a r n i n g s over the p a s t forty years a n d find t h a t these increases e x p l a i n at least
p a r t of the shift in value-relevance from e a r n i n g s to b o o k values. F i n a l l y , we
p r o v i d e evidence t h a t the p r o p o r t i o n of s m a l l e r firms in the C o m p u s t a t d a t a files
has increased over time, a n d d e m o n s t r a t e t h a t the i m p o r t a n c e of e a r n i n g s
relative to b o o k values in v a l u a t i o n is inversely related to firm size.

3 Lev (1997) and Ramesh and Thiagarajan (1995) report that earnings response coefficients have
declined across time. Our results may, at first, seem at odds with theirs. However, those papers
examine only earnings whereas our paper examines earnings and book values. In fact, we find
analogous results when examining earnings only. Further, we note two important differences
between our study and theirs. First, both Lev's paper and Ramesh and Thiagarajan's paper focus on
the total explanatory power of earnings, while our study examines the value-relevance of earnings
and book value incremental to one another. Second, Lev focuses on the information content of
earnings (reactions to earnings announcements) while ours focuses on value-relevance (associations
with earnings and book values). Information content could decrease across time as nonaccounting
information becomes more timely. At the same time the value-relevance of accounting information
might be constant or even improving.
4 By 'bottom line' earnings we mean earnings that include discontinued operations, extraordinary
items, and special items.
s We use "nonrecurring items' and 'one-time items' interchangeably in the paper. Both refer to
discontinued operations, extraordinary items, and special items.

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D.W. Collins et al. / Journal o f Accounting and Economics 24 (1997) 39-67

In sum, our evidence suggests that intangible intensity, nonrecurring items,

negative earnings, and firm size explain the temporal shift in the relative
importance of earnings and book values in valuation. Once we control for these
factors, there is little evidence of a systematic change in the value-relevance of
earnings and book values over the past 40 years.
The rest of the paper proceeds as follows. Section 2 outlines recent research
findings that suggest explanations for temporal changes in the value-relevance
of earnings and book values. Section 3 discusses the valuation model and the
technique used to decompose the explanatory power of earnings and book
values into their common and incremental components. Section 4 describes the
sample and the sample selection criteria. Section 5 presents evidence that the
value-relevance of earnings and book values has changed across time. Section 6
provides explanations for the temporal changes in the value-relevance of earnings and book values, while Section 7 concludes.

2. Factors affecting the value-relevance of earnings and book values

When viewed as a whole, recent research suggests at least four factors that
are likely to contribute to changes in the value-relevance of earnings and
book values over time: (1) the increased importance of service and technologybased firms that invest in intangibles; (2) the frequency and magnitude of
nonrecurring items; (3) the incidence of negative earnings; and (4) the growing
number of small firms on Compustat. Each of these factors is discussed in detail
below.
2.1. Investment in intangibles and its' effect on the value-relevance of
earnings and book values

Lev (1997) and Amir and Lev (1996) argue that financial accounting information is of limited value to investors when valuing service and technology-based
companies that invest in intangibles (e.g., research and development, human
capital, and brand development). While intangibles may contribute to the
market values of these entities, current accounting rules only record intangible
assets in limited circumstances (i.e., purchased intangibles). Consequently, financial accounting information may not be very useful when assessing the values of
companies with large amounts of unrecorded intangibles. Consistent with this
concern, Amir and Lev (1996) find that earnings, book values, and cash flows are
largely irrelevant on a stand-alone basis when valuing companies in the cellular
telephone industry. If these findings generalize to other intangible-intensive
industries, then as the incidence of these firms increases over time we would
expect a temporal decrease in the value-relevance of earnings, book values, or
both. A priori, we have no prediction of how the accounting treatment of

D.W. Collins et al. / Journal of Accounting and Economies 24 (1997) 39-67

43

intangibles might affect the relative importance of earnings and book values
over time.

2.2. Nonrecurring items and the value-relevance of earnings and book values
Elliott and Hanna (1996) demonstrate that the market places less weight on
special items than on earnings before special items. This is consistent with
special items representing 'low quality' or transitory income items. Empirically,
most nonrecurring items are losses (Elliott and Hanna, 1996; Maydew, 1997).
Basu (1997) finds that bad news has less impact on prices than good news and
that failing to take into account this differential impact can lead to lower RZs.
This suggests that the value-relevance of 'bottom-line' earnings should be
decreasing in nonrecurring items. Finally, Elliott and Hanna (1996) document
an increasing propensity of firms to report special items across time. Together,
this evidence indicates that nonrecurring items could provide at least a partial
explanation for an observed decline in the value-relevance of earnings across
time.
Nonrecurring items could also affect the value-relevance of book values
across time. It is reasonable to expect that firms divesting themselves of noncore
lines of business and firms in financial difficulty report nonrecurring items more
frequently than other firms. If abandonment value is more salient in these types
of firms, and if abandonment value is associated with increasing value-relevance
of book values, one would expect the value-relevance of book values to be
increasing in nonrecurring items. Finally, regardless of the reason why firms
report nonrecurring items, these items are likely to be more transitory than
earnings before nonrecurring items ('core' earnings). Decreased persistence can
lead to less weight on earnings and more weight on book values in the relation
between price, earnings, and book values (Ohlson, 1995).

2.3. Negative earnings and the value-relevance of earnings and book values
Hayn (1995) documents that firms reporting negative earnings have smaller
earnings response coefficients than firms reporting positive earnings. She hypothesizes that this is because shareholders always have an option of liquidating
the firm and, as a result, negative earnings cannot persist indefinitely. She also
presents evidence that the frequency with which firms report negative earnings
has increased over time.
Basu (1997) examines the role of conservatism in accounting, explaining that
in conservative accounting systems firms must incorporate bad news into
earnings more readily than good news. Because of this asymmetric treatment of
bad and good news, earnings declines (or losses) are much more transitory than
earnings increases. Basu finds that failing to allow for different slopes on good
and bad news reduces the ability of earnings to explain returns. Moreover, Basu

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D.W. Collins et al. / Journal o f Accounting and Economics 24 (1997) 39-67

also argues that there has been an increase in the measured degree of conservatism in recent years. 6 Combined with Hayn's results, these findings suggest that
the increased frequency of negative earnings over time could contribute to the
temporal decline in the incremental value-relevance of earnings.
Further, several papers report direct cross-sectional evidence that valuerelevance shifts from earnings to book values when earnings are negative or as
firms face financial distress (Barth et al., 1997; Burgstahler and Dichev, 1997;
Collins et al., 1997; Jan and Ou, 1995). These results are consistent with a
firm's abandonment value becoming more relevant for assessing shareholder
value as the firm experiences losses or financial distress. If book values are more
closely associated with firms' abandonment values than are earnings (Berger et
al., 1996; Burgstahler and Dichev, 1997), then as abandonment becomes more
likely so will the incremental explanatory power of book values relative to
earnings.
2.4. Firm size and the value-relevance of earnings and book values
Previous research suggests that book values take on increased importance in
valuation when (1) current earnings do not provide a good proxy for future
earnings or (2) the firm faces an increased likelihood of abandonment or
liquidation. We posit that firm size is related to both these possibilities.
Smaller firms are more likely to include start-up companies whose value is
driven by their future earnings growth potential (i.e., abnormal earnings) than by
current earnings realizations. Moreover, Hayn (1995) shows that smaller firms
are more likely to report losses than are larger firms. 7 Consequently, their
earnings persistence is lower which, according to the Ohlson valuation framework, leads to increased importance of book values relative to earnings in
valuation. We also expect that smaller firms face a greater likelihood of encountering financial distress or of failing than do larger firms. Therefore, for reasons
cited earlier, investors may place greater weight on book values as a proxy for
abandonment or liquidation value when valuing smaller companies. This alone
would not explain changes in the value-relevance of earnings versus book values
over time unless there were systematic changes in the proportion of smaller firms
represented in the sample. In fact, as we will demonstrate, we find that the
proportion of small firms in the Compustat database has increased over time as
its coverage expanded to include smaller NASDAQ firms.

6 Basu cites recognition requirements for previously off-balance sheet liabilities such as pensions,
post-retirement health benefits and environmental liabilities, as potential explanations for this
increase.
7 One potential explanation for this is that larger firms are better diversified and, therefore, are
better able to shield themselves from losses when there are downturns in the economy.

D.W. Collins et al. /Journal o f Accounting and Economics 24 (1997) 39 67

3. Valuation model and

R2

45

decomposition technique

The value of a firm's equity can be expressed as a function of its earnings and
b o o k value (Ohlson, 1995): s
Pit = ~o + ~lEit + ~2BVit + 8it,

(1)

where Pit is the price of a share of firm i three months after fiscal year-end t, E , is
the earnings per share of firm i during the year t, BV, is the b o o k value per share
of firm i at the end of year t, and air is the other value-relevant information of
firm i for year t orthogonal to earnings and b o o k value.
To compare the explanatory power that earnings and book value have for
prices, we decompose total explanatory power into three parts: (1) the incremental explanatory power of earnings, (2) the incremental explanatory power of
b o o k value, and (3) the explanatory power c o m m o n to both earnings and book
value. This decomposition is used in Easton (1985) and is derived theoretically
by Theil (1971). Let
Pi, = )8o + ~lEit -~ '~it

(2)

Pit = 7o + 'ylBVit -I- Git.

(3)

and

The coefficients of determination from Eqs. (1)-(3) are denoted R 2, R 2, and

/~3z respectively. Then /i 2 --/~2 = / ~ v represents the incremental explanatory
power provided by b o o k value (incr BV), and / ~ 2 _ R2 = R2 represents the
incremental explanatory power provided by earnings (incr EARN). The remaini n g / i 2 - / i 2 - R2v = / i 2 represents the explanatory power c o m m o n to both
earnings and b o o k value ( C O M M O N ) .
We use this R 2 decomposition to investigate whether the value-relevance of
accounting information has changed over time. Specifically, we examine
whether the incremental explanatory power of earnings and book value for
prices has changed over time, and if so, why the relationship may have changed.
O u r tests regress g 2 (TOTAL), R~ (incr EARN), a n d / ~ v (incr BV) on a timetrend variable as follows:
/~2 = ~bo + q~ITIME, + et,

(4)

80hlson's model includes a term (1 + r,)/r, for discounting the earnings. Maydew (1993) finds
that allowing discount rates to vary across firms does not significantly improve the explanatory
power of the model.

46

D.W. Collins et al. / Journal of Accounting and Economics 24 (1997) 39 67

where T I M E = 1. . . . . 41, c o r r e s p o n d i n g to the years 1953 1993. 9 T h e incremental e x p l a n a t o r y power is said to have decreased (increased) over time if
~blis significantly negative (positive). Later in the paper, we re-estimate the a b o v e
regression after a d d i n g variables that c o n t r o l for t e m p o r a l changes in i n t a n gibles, n o n r e c u r r i n g items, negative earnings, a n d firm size. W e e x a m i n e whether
these a d d i t i o n a l controls are significant in explaining the changes in e x p l a n a t o r y
power a n d whether they render the t i m e - t r e n d variable insignificant.

4. Sample selection
The sample is selected from the period 1953-1993 using the following criteria:
(i) a n n u a l earnings, b o o k value, a n d share i n f o r m a t i o n are available o n the
1994 Compustat Primary, Secondary, and Tertiary, Full Coverage, and Research
Annual Industrial Files; 1
(ii) security price a n d the factor to adjust for stock splits a n d dividends are
available o n the C e n t e r for Research a n d Security Prices (CRSP) M o n t h l y
Returns File for the last day of the third t r a d i n g m o n t h after the firm's fiscal
year-end; a n d
(iii) total assets a n d stockholders' equity are b o t h greater t h a n zero.
The selection process yields 119,389 firm-year o b s e r v a t i o n s for N Y S E , A M E X
a n d N A S D A Q firms. 11 T o control for the effects of extreme values, we remove
o b s e r v a t i o n s that are (1) in the top a n d b o t t o m one-half percent of either
e a r n i n g s - t o - p r i c e or b o o k v a l u e - t o - m a r k e t value, (2) in the o n e - h a l f percent of
firms with the most extreme values of o n e - t i m e items as a percent of income, a2
a n d (3) identified as outliers in the regressions. 13 T o m a i n t a i n c o m p a r a b i l i t y
across tables a n d figures, all tests in the p a p e r are based o n the same final sample
of 115,154 firm-year observations.

9 RegressingR2S o n a time variable was also used in Francis and Schipper (1996). We control for
first-order autocorrelation in the residuals using a generalized least-squares approach developed by
Prais and Winsten (1954) and described by Greene (1990).
10Annual earnings are defined as net income (Compustat item 172). Book value is defined as total
assets (6) total liabilities (181) for the years prior to 1966, and as common equity (60) after 1965.
This is because Compustat's common equity was not available until 1963, and it contained many
missing values until 1966.
11Our sample begins in 1953 because total liabilities (Compustat data item 181), which is
necessary to compute book value of equity, does not contain data for our firms prior to 1953.
12We use the absolute value of one-time items as a percent of net income before one-time items.
13To control for outliers, we remove from all of our tests any observation that has a studentized
residual greater than four standard deviations from zero in any yearly regression of price on
earnings, price on book values, or price on earnings and book values.

D.W. Collins et al. / Journal o f Accounting and Economics 24 (1997) 39 67

47

Table 1
Descriptive statistics for firm-year observations for the years 1953 1993"

Variable b

Mean

Standard
deviation

Lower
quartile

Median

Upper
quartile

Price (P)
Earnings (E)
'Core' earnings (CORE)
Book value (BV)
"One-time' items (ONE)

17.583
1.289
1.321
12.653
- 0.032

17.018
1.899
1.847
12.861
1.003

5.125
0.129
0.128
3.600
0.000

12.750
0.952
0.958
8.720
0.000

24.750
2.173
2.172
17.839
0.000

"The n u m b e r of firm-year observations with necessary data on C o m p u s t a t and C R S P is 115,154

after deleting the following: (1) observations in the top or bottom one-half percent ranked on
earnings-to-price or book value-to-market, (2) observations in the top one-half percent of the
absolute value of one-time items value as a percent of net income before one-time items, and (3)
observations with studentized residuals greater than four standard deviations from zero in any
yearly regression of price on earnings, price on book values, or price on earnings and book values.
bp is the price of a share of finn i three m o n t h s after year-end t. E is the earnings per share of firm
i for year t. C O R E is the earnings per share less one-time items per share of firm i for year t. BV is the
book value per share of finn i at year-end t. O N E is the 'one-time' items per share of firm i for year
t (specifically, extraordinary items + discontinued operations + special items).

Table 2
Correlation a m o n g independent and dependent variables a

Variable b

Price
(P)

Earnings
(E)

Price (P)
Earnings (E)
'Core' earnings (CORE)
Book value (BV)
'One-time' items (ONE)

1.000
0.675
0.681
0.683
0.024

0.766
1.000
0.857
0.718
0.316

"Core'
earnings
(CORE)
0.773
0.902
1.000
0.720
- 0.219

Book value
(BV)
0.773
0.766
0.774
1.000
0.033

One-time
items
(ONE)
0.017
0.182
- 0.082
0.018
1.000

"The n u m b e r of firm-year observations is 115,154. Pearson correlations are in the bottom-left cells
and Spearman correlations are in the upper-right cells. D u e to the large sample size, all of the above
are significant at the 0.0001 level.
bp is the price of a share of firm i three m o n t h s after year-end t. E is the earnings per share of firm
i for year t. C O R E is the earnings per share less one-time items per share of firm i for year t. BV is the
book value per share of firm i at year-end t. O N E is the 'one-time' items per share of firm i for year
t (specifically, extraordinary items + discontinued operations + special items).

Tables 1 and 2 present descriptive statistics and correlations for the sample.
The variables C O R E and O N E are used later in the paper and are included for
completeness. The variable O N E reflects the firms' one-time (nonrecurring)
items, including special items, discontinued operations, and extraordinary

48

D.W. Collins et al. / Journal of Accounting and Economics 24 (1997) 39-67

items. 14 CORE, representing the firms' earnings from continuing operations, is

defined as earnings before one-time items. We expect the C O R E component of
earnings to be less transitory than the O N E component and use this expectation
in later tests.
Table 1 reveals that, on average, one-time items reduce net income and are
relatively small compared to 'core' earnings ( - 0 . 0 3 2 vs. 1.321 per share,
respectively). The upper right (lower left) hand side of Table 2 contains the
Spearman (Pearson) correlation coefficients. As expected earnings and book
value are positively correlated with price and with each other. One-time items
are positively correlated with earnings, since they are included in earnings.
One-time items are also negatively correlated with 'core' earnings. This finding
is consistent with their use as an income smoothing device.

5. Changes in the value-relevance of earnings and book values over time

Table 3 summarizes the yearly cross-sectional regressions of Eqs. (1)-(3).
Earnings and book values are significant at better than the 1% level in almost
every year. The adjusted R 2 for the pooled cross-sectional time-series regression
indicates that earnings and book values jointly explain about 54% of the
cross-sectional variation in security prices. Rather than report 41 sets of coefficients, t-statistics, and R2s, for the sake of brevity Table 3 reports simple
averages of the yearly cross-sectional regressions over three 10-year periods and
one 11-year period.
Fig. la and Fig. lb show the trend in common and incremental explanatory
power of earnings and book values across time. The figures differ only in the
presentation of the incremental and common explanatory power. In Fig. la
the various RZs a r e 'stacked' on one another so that they collectively add up
to the total explanatory power of Eq. (1). The darkest-shaded region represents
the incremental explanatory power of earnings; the next darkest represents the
incremental explanatory power of book values; and the lightest-shaded region
represents the explanatory power common to both earnings and book values.
By definition, these sum to the total explanatory power of both variables. While
this representation has advantages, it is difficult to visually evaluate when the
stacked variables (i.e., incremental earnings and book values) are changing over
time. Fig. lb clarifies this by presenting the two incremental RZs and the total
R 2 unstacked.

14The term 'one-time' should not be interpreted too strictly. We recognize that some firms
report one-time items in several consecutive years. We only use the term as a convenient way of
describing items of income that are likely to be more transitory than income from continuing
operations.

1,659.5

3,885.9

5,525.2

115,154

1963-72

1973-82

1983-93

Pooled

3.41
(132.15)

3.44
(34.89)

3.22
(33.55)

8.22
(26.27)

9.31
(16.32)

al

0.16
(5.39)

0.00
(0.18)

0.54
(141.94)

0.92
(56.66)

0.31
(21.12)

a2

0.536

0.754

0.604

0.511

0.502

(A)
(Adj. R 2

6.04
(310.07)

7.13
(81.39)

4.67
(70.56)

9.09
(40.09)

9.28
(21.46)

bl

0.455

0.567

0.555

0.498

0.90
(316.89)

1.30
(100.57)

0.69
(61.85)

0.78
(26.03)

0.60
(10.75)

0.466

0.684

0.492

0300

0.203

Adj. R 2

0.499

(C)

Adj. R 2

el

(B)

0.070

0.070

0.112

0.212

0.299

incr EARN

(A)-(C)

0.081

0.186

0.049

0.014

0.004

incr BV

(A~(B)

BV is the book value per share of firm i at year-end t. P is the price of a share of firm i three months after year-end t. E is the earnings per share of firm i for
year t.

Notes: Coefficient estimates are based on ordinary least-squares estimation. The table reports the average of the coefficient estimates and t-statistics from
the yearly cross-sectional regressions T-statistics are in parentheses.

444.8

Average
firms
per yr.

Pit = Cot + c l t B V i t + '~it

Pit = ao, + altEit + a2tBVit + eit

1953-62

Years

Models:

Average of yearly cross-sectional regressions of price on earnings and book value

Table 3

txa
4~

g~

D.W. Collins et al. / Journal of Accounting and Economics 24 (1997) 39-67

50

r~Common

lncr Earn

Iner BV

0.80
0.70
0.60
0.50
0.40
0.30
0.20
0.10
0.00

(a)

year

TOTAL

----~

IncrEARN

" " - IncrBV

0.80
0.70
0.60
0.50
0.40
0.30
0.20
0.10
0.00

(b)

year

Fig. 1. (a) Yearly cross-sectional regressions showing the c o m m o n and incremental explanatory
power of earnings and book values (stacked). In each year, three cross-sectional regressions are run.
Price is regressed on (1) earnings, (2) book values, and (3) both earnings and book values. The
incremental explanatory power of book values (lncr BV) is the explanatg3~ power, R 2, from
regression (3) less the R 2 from regression (1). The incremental explanatory power of earnings
(Incr EARN) is the R 2 from regression (3) less the R 2 from regression (2). The explanatory power
c o m m o n to both earnings and book values (Common) is the remaining explanatory power. (b)
Yearly cross-sectional regressions showing the total and incremental explanatory power of earnings
and book values (unstacked). The total explanatory power (TOTAL) is the R z from the yearly
cross-sectional regressions of price on both earnings and book values.

D.W. Collins et al. / Journal of Accounting and Economics 24 (1997) 39 67

51

F r o m i n s p e c t i o n of Fig. 1b it is clear t h a t the i n c r e m e n t a l e x p l a n a t o r y p o w e r

of e a r n i n g s has declined over time, while the i n c r e m e n t a l e x p l a n a t o r y p o w e r of
b o o k values has increased over time. Regressing the RZs on a t i m e - t r e n d
v a r i a b l e (Eq. (4)) reveals that these changes are significant (t = - 10.071 a n d
5.097, respectively). C o n t r a r y to claims m a d e in the p r o f e s s i o n a l literature, the
c o m b i n e d e x p l a n a t o r y p o w e r of e a r n i n g s a n d b o o k values has a c t u a l l y increased over the p e r i o d (t = 1.896). 15

6. Explaining the temporal change in the value-relevance of

earnings and book values
6.1. The cross-sectional effects o f intangible intensity, one-time items,
negative earnings, and firm size
In this section we lay the g r o u n d w o r k for later tests by d o c u m e n t i n g h o w the
i n c r e m e n t a l e x p l a n a t o r y p o w e r of e a r n i n g s a n d b o o k values v a r y with intangible intensity, o n e - t i m e items, negative earnings, a n d firm size. At this p o i n t we
are n o t yet c o n c e r n e d with w h e t h e r these factors are c h a n g i n g across time;
r a t h e r we s i m p l y seek to d o c u m e n t h o w each of these items is r e l a t e d to the
v a l u e - r e l e v a n c e of e a r n i n g s a n d b o o k values.
A m i r a n d Lev (1996) p r o v i d e evidence t h a t u n r e p o r t e d intangibles cause
t r a d i t i o n a l historical cost financial s t a t e m e n t s to be less i n f o r m a t i v e with respect
to share prices. In c o n t r a s t to their findings, P a n e l A of T a b l e 4 suggests t h a t in
o u r s a m p l e the overall e x p l a n a t o r y p o w e r of earnings a n d b o o k values is slightly
h i g h e r for i n t a n g i b l e - i n t e n s i v e firms t h a n for n o n i n t e n s i v e firms (0.567 vs.
0.540). 16 P a n e l A also shows t h a t i n t a n g i b l e - i n t e n s i v e firms have slightly lower
i n c r e m e n t a l R2s from earnings c o m p a r e d to n o n i n t e n s i v e firms (0.057 vs. 0.072),
a n d h a v e slightly higher i n c r e m e n t a l RZs from b o o k values (0.092 vs. 0.086).
P r i o r research suggests t h a t earnings ( b o o k values) have less (more) e x p l a n a t o r y p o w e r for firms with o n e - t i m e items relative to those w i t h o u t o n e - t i m e

5As evidenced in Table 3, the coefficients on earnings decrease over time while the coefficients for
book values increase. This is consistent with the changes in explanatory power shown in Fig. la and
Fig. lb, and is revisited in Section 6.3.
6 Note that intangible intensity does not refer to the presence of large amounts of recorded
intangibles because the concerns raised in the literature relate more to unrecorded intangibles.
Consequently, we define firms as intangible intensive when their production functions likely contain
large amounts of unrecorded intangibles. We recognize that any such classification is somewhat ad
hoc. We define intangible-intensive as being firms in the two-digit SIC codes 48 (electronic
components and accessories), 73 (business services), and 87 (engineering, accounting, R&D and
management related services); and three-digit SIC codes 282 (plastics and synthetic materials), 283
(drugs), and 357 (computer and office equipment).

17,441

Intangible-intensive

72,789

42,365

Without one-time items

With one-time items

Panel B: One-time items

97,713

2.28
(67.99)

4.60
(118.67)

4.05
(47.85)

3.30
(123.30)

a~

Pit = Co A- clBVit 4- cit

Pit = bo + blEit + ~;,

0.70
(129.56)

0.39
(72.96)

0.84
(60.96)

0.53
(135.18)

a2

P . = ao + alEit + a2BVit + eit

Not intangible-intensive

Panel A: Intangible intensive b

Models:

0.559

0.528

0.567

0.493
0.384

6.79
(266.29)
5.01
(162.49)

1.33

0.475
7.87
(125.56)

0.92
(210.26)

0.88
(237.53)

(134.77)

0.88
(293.71)

0.454

5.87
(285.30)

0.511

0.437

0.510

0.469

R2

0.540

(c)

Rz

R2

C1

(B)

(A)
b,

Table 4
Regressions of price on earnings and book value for various portfolio combinationsa

0.048

0.091

0.057

0.072

(A)-(C)
incr EARN

0.175

0.035

0.092

0.086

(A)-(B)
incr BV

21,779

Negative earnings

30,853

10,267

11,512

With one-time items and

E > 0

Without one-time items and

E < 0

With one-time items and

E < 0

-0.23
( - 5.04)

- 0.32
( - 5.87)

3.82
(64.79)

5.48
(108.13)

- 0.30
( - 8.95)

4.85
(125.17)

0.74
(95.34)

0.53
(69.72)

0.52
(67.05)

0.28
(43.50)

0.66
(119.40)

0.37
(74.46)

0.486

0.379

0.536

0.486

0.450

0.503

- 1.76
( - 31.55)

- 1.84
( - 30.73)

6.81
(165.03)

7.24
(235.83)

- 1.85
( - 46.30)

7.12
(289.73)

0.080

0.084

0.469

0.471

0.090

0.473

0.76
(104.03)

0.55
(78.72)

0.89
(166.52)

0.83
(200.04)

0.68
(132.89)

0.86
(259.77)

0.485

0.376

0.473

0.390

0.448

0.420

0.001

0.002

0.063

0.096

0.002

0.083

0.406

0.294

0.068

0.016

0.360

0.030

aT-statistics are in parentheses.

blntangible-intensive industries: (SIC codes: 282 plastics and synthetic materials; 283 drugs; 357 computer and office equipment; 367 electronic
components and accessories; 48 communications; 73 business services; 87 engineering, accounting, R & D and management related services)
cPositive (negative) earnings are those firm-year observations for which 'core' earnings is greater than (less than) 0.

62,522

Without one-time items and

E > 0

Panel D: Combinations

93,375

Positive earnings

Panel C: Profitability ~

54

D.W. Collins et al. / Journal of Accounting and Economics 24 (1997) 39 67

items. Panel B of Table 4 presents results consistent with this expectation. The
incremental explanatory power of earnings is approximately one-half the level in
firm-years with one-time items as in those without one-time items, 0.048 and
0.091, respectively. Even more dramatic is the difference in the incremental
explanatory power of book values. For firm-year observations with one-time
items, book values have an incremental explanatory power over four times
larger than those without one-time items, 0.175 and 0.035, respectively. '7
We also expect that book values become more value-relevant and earnings
less so as firms experience negative earnings. In Panel C of Table 4 we verify
these findings in our sample. Like one-time items, firm-years with negative
earnings have a lower incremental explanatory power of earnings (0.002) compared to firms with positive earnings (0.083). Similarly, the incremental explanatory power of book values is higher in firm-years with negative earnings (0.360)
than it is in firm-years with positive earnings (0.030). ~s
Panel D presents the four combinations of firm-year observations with
positive/negative earnings and with/without one-time items. The far-right columns give the incremental explanatory power of earnings and book values for
each combination. Earnings provide the most incremental explanatory power
for firms with positive earnings and no one-time items (0.096), while book values
provide the least explanatory power (0.016). Both earnings and book values
contribute about the same incremental explanatory power for firms with onetime items and positive earnings (0.063 and 0.068, respectively). The largest
change comes from negative earnings. Firm-years with negative earnings and no
one-time items derive most of their incremental explanatory power from book
values (0.294) and little from earnings (0.002). Finally, the combination of
negative earnings and one-time items produces the biggest shift to book values.
The incremental explanatory power provided by book values is over four
hundred times that of earnings (0.406 and 0.001, respectively) for these firmyears.
Fig. 2 presents further evidence of the effect of one-time items and negative
earnings on the value-relevance of earnings and book values, as well as evidence
of firm size effects. In Fig. 2a-Fig. 2c, we form decile portfolios based on certain
characteristics and examine how the total and incremental explanatory power of

1v This difference can be observed in the coefficients as well. The coefficient on earnings in Eq. (1)
for firms without one-time items is over twice as large as those with one-time items (4.60 vs. 2.28).
The coefficient on book values is 0.39 for firm-years without one-time items, while it is 0.70 for
firm-years with one-time items.
' S T h e coefficients on earnings and book values have a pattern consistent with these results.
Firm-years with negative earnings have larger coefficients on book values than firm-years with
positive earnings (0.66 and 0.37, respectively). The coefficient on earnings is smaller for firm-years
with negative earnings than firm-years with positive earnings ( - 0.30 and 4.85, respectively).

D.W. Collins et al. / Journal of Accounting and Economics 24 (1997) 39-67

55

0.60

0.50

'".

0.40

TOTAL
~ I n c r BV
" Incr EARN

0.30

/
/

0.20

0.10

. . . . .

""

"

-,..~

ql ~-

-m

~'

0.00

l)eciles (I is no one-time items, 10 is

(a)

highest

one-time

10

items)

0.90

TOTAL
--lncrBV

0.80

-0.70

1" "

"

!
~

Incr EARN [

0.60

0.50
0.40

0.20

0.00 ~
1
(b)

"

,, , ,

(~

10

Deciles (1 is lowest 'core' EJP, 10 is highest 'core' E/P)

Fig. 2. (a) Pooled cross-sectional time-series regressions of portfolios formed by decile of one-time
items as a percent of net income. Portfolios are formed by computing one-time items as a percent of
net income before one-time items for each firm-year observation. Ten equally sized portfolios are
formed based on this criterion with portfolio 1 (10) having no one-time items (the highest value of
one-time items). The observations are then pooled cross-sectionally and over time and the regressions are run as in Table 3 to obtain the total explanatory power of both earnings and book values
(TOTAL), the incremental explanatory power of book values (Incr BV), and the incremental
explanatory power of earnings (Incr EARN). (b) Pooled cross-sectional time-series regressions of
portfolios formed by decile of 'core' earnings-to-price. Portfolios are formed in the same way as (a),
except the metric used is 'core' E/P instead of one-time as percent of net income.
earnings and book values varies across the portfolios. We test whether the
incremental explanatory power varies across the portfolios by regressing the
incremental R2s on the decile rankings and examining the t-statistic for DECILE, which takes on values 1-10.
/ ~ = ~ 0 + ~ b l D E C I L E j + ej.

(5)

56

D.W. Collins et al. /Journal of Accounting and Economics 24 (1997) 39-67

0.60
[
0.50

TOTAL

[ - - --lncrBV

AgN i

0.40

\
\

0.30

0.20

0.10

0.00

(c)

6
7
Deciles (1 is lowest MVE, I0 is highest MVE)

10

0.25

0.20

~ 0.15
0.10

0,05

0.00

(d)

4
5
6
7
Deeiles (1 is Iow~t MVE, 10 is highest MVE)

10

Fig. 2. (c) Pooled cross-sectional regressions of portfolios formed by decile of inflation-adjusted

market value of equity (MVE). Portfolios are formed in the same way as (a) and (b), except the metric
used is inflation-adjusted market value of equity. Inflation-adjustment is done by using the consumer price index for all urban consumers (CPI-u) from the Economic Report of the President. The
base year is the average of 1982-1984. (d) Frequency of abandonment: portfolios formed by decile of
inflation-adjusted market-value of equity (MVE). A firm is considered 'abandoned' in the first year
that it is no longer listed on either Compustat or CRSP (excluding 1993 - the last year of the sample).
Portfolios are formed in the same way as (c), again using inflation-adjusted market value of equity.

I n Fig. 2 a w e f o r m p o r t f o l i o s o f f i r m - y e a r o b s e r v a t i o n s b a s e d o n o n e - t i m e
i t e m s as a p e r c e n t o f n e t i n c o m e . Specifically, w e c o m p u t e o n e - t i m e i t e m s as
a percent of 'core' earnings for each firm-year observation, and form ten
portfolios based on this criterion. Portfolio one has firm-year observations with
no one-time items and portfolio ten has firm-year observations with the largest

D.W. Collins et al. / Journal o f Accounting and Economics 24 (1997) 39 67

57

magnitude of one-time items as a percent of 'core' earnings. Since more than

50% of the firm-year observations have no one-time items, portfolio one has all
these firm-year observations. The other nine portfolios each have an equal
number of observations.
Fig. 2a shows that the incremental explanatory power of both earnings and
b o o k values is quite low for the portfolios with zero or a low amount of one-time
items. The majority of the explanatory power is c o m m o n to both b o o k values
and earnings. The incremental explanatory power for book values increases
(almost monotonically) in the magnitude of one-time items (t = 6.620). As
one-time items increase, the incremental explanatory power of earnings decreases (t = - 6.534). For portfolios nine and ten, nearly all the explanatory
power derives from b o o k values. Combined with the results in Panel B of
Table 4, this evidence indicates that one-time items are associated with a shift in
value-relevance from earnings to book values.
In Fig. 2b we classify firms into deciles based on their rankings of 'core'
earnings to price. Firms in the tenth decile have the largest ratio of 'core'
earnings to price, while firms in the first decile have the lowest. Since 19% of the
sample has negative earnings, the first two deciles are almost entirely composed
of these firms. Consistent with the results in Panel C of Table 4, Fig. 2b shows
that firm-years with negative earnings derive almost no incremental explanatory
power from earnings; instead, b o o k values provide nearly all of the explanatory
power. The t-statistic for the regression of incremental R z on decile ranking is
insignificant for earnings (t = 0.405) and significantly negative for b o o k values
(t = - 2.163). It is interesting to note that the incremental explanatory power of
earnings appears to peak around decile four and then steadily decline over
larger deciles. Furthermore, the incremental explanatory power of b o o k values
appears to increase in the tenth decile. This finding is consistent with high 'core'
earnings to price firms having lower earnings persistence than the average
profitable firm. It also suggests that removing one-time items is not a perfect
control for low-persistence items in income.
Fig. 2c presents results for deciles based on firm size. Because we are pooling
firms over a 41 year period, it is important to control for differences in price
levels across time. Accordingly, we rank firms based on inflation-adjusted
market value of equity. 19 The results confirm that firm size is related to the
value-relevance of earnings and b o o k values. The total explanatory power of
earnings and b o o k values declines as one moves from the smallest firms in decile
one to the largest firms in decile ten (t = -18.342). Consistent with our
expectations, the incremental explanatory power of book values (earnings)
declines (increases) with firm size (t = - 6.563 and t = 2.037, respectively).

~9 W e use the c o n s u m e r price index for all u r b a n c o n s u m e r s as the m e a s u r e of inflation.

58

D.V~ Collins et al. / Journal of Accounting and Economics 24 (1997) 39-67

As we discussed earlier, other papers have documented an increased valuerelevance of book values and decreased value-relevance of earnings for abandoning firms. In Fig. 2d we present the frequency of a b a n d o n m e n t across
inflation-adjusted size deciles. Abandonment is defined as occurring if the firm
ceases to have information on both C o m p u s t a t and CRSP. 2 It is evident that
a b a n d o n m e n t is much more prevalent for small firms than for large firms.
Viewed together, Fig. 2c and Fig. 2d suggest that firm size proxies for the ex
ante probability of abandonment, which is consistent with our finding that book
values (earnings) are more (less) value-relevant for small firms.
Overall, the results in Fig. 2 indicate that one-time items, negative earnings,
and firm size are all associated with variation in the value-relevance of earnings
and book values. If these factors vary systematically across time, then they may
explain the shift in value-relevance from earnings to b o o k values shown in
Fig. 1.
6.2. Temporal changes in intangible intensity, one-time items,
neyative earnings, and f i r m size

In this section we investigate whether the factors described in the prior section
have varied systematically over the past 40 years. We assess whether the factors
are changing over time by regressing them on the time-trend variable discussed
earlier, T I M E .
Fig. 3a reveals that the percentage of C o m p u s t a t firms operating in intangible-intensive industries has increased steadily over the last 40 years. As shown,
the percentage of firms in intangible-intensive industries has increased from 7%
in 1953 to 21% in 1993.
In Fig. 3b we examine whether there have been temporal changes in the size
of one-time items for firms in our sample. Fig. 3b presents the average magnitude of one-time items as a percentage of net income before one-time items. The
increase is rather dramatic, with the cross-sectional average increasing fourfold
from 1953 to 1993 (t = 7.146). Similar results, not reported, can be obtained by
simply examining the percentage of firms reporting one-time items in any given
year. The increasing frequency and magnitude of one-time items across time is
consistent with the results in Fig. 1, which demonstrates a shift in incremental
explanatory power from earnings to b o o k values.
In Fig. 3c we present the percentage of firms in each year that report negative
earnings before one-time items. Overall, the proportion of firms with negative
earnings increased over the past 40 years (t = 5.470), from a low of about 2% in
1953 to a high of about 30% in the mid-to-late 1980s. The increasing frequency

20A firm may no longer be recorded on Compustat and CRSP for a variety of reasons including,
for example, liquidation, merger, and going private.

59

D.W. Collins et al. / Journal o f Accounting and Economics 24 (1997) 39 67

0.25

0.20

0.15

~, 0.10
0.05

0.00

(a)

year
0.80

0.70

: =0 0.80
Q

" "

0.50

~ g

0.40

0.30

[~.

0.20
0.10
0.00

(b)

E I

year

Fig. 3. (a) Percentage of firms in intangible-intensive industries by year. Any firm in one of the
following SIC codes is considered intangible intensive: 282 plastics and synthetic materials; 283
drugs; 357 computer and office equipment; 367 electronic components and accessories; 48 c o m m u n ications; 73 business services; 87 engineering, accounting, R & D and m a n a g e m e n t related services. (b)
Mean absolute value of one-time items as a percentage of'core' net income by year. One-time items
as a percent of net income is Ione-timel/l'core' net incomel, where one-time items = discontinued
operations + extraordinary items + special items, and 'core' net income is net income excluding
one-time items

of negative earnings over time is consistent with the shift in value-relevance that
we documented in Fig. 1. Note that because we define earnings as negative only
when 'core' earnings is less than zero, this result is not caused by the increased
frequency of one-time items such as asset write-offs or restructurings.

60

D.W. Collins et al. / Journal (?./'Accounting and Economics 24 (1997) 39 67

0.35

--41-- loss finns 1

0.30
0.25

==

0.20

==

0.15
0.10
0.05
0.00

(c)

yea r

I--II--- mean I
14

~=I

13

12

(d)

year

Fig. 3. (c) Frequency of firms in sample reporting losses by year. Percentage of firms in each year
that report losses before one-time items (i.e. firm-years with 'core' net income < 0). (d) The average
size of firms by year. The natural log of the mean inflation-adjusted market value of equity of sample
firms by year. Inflation adjustment is done using the consumer price index for all urban consumers
(CPI-u) from the Economic Report of the President. The base year is the average of 1982-1984.

Finally, in Fig. 3d we report changes in inflation-adjusted average firm size

across time. Overall, the average size of firms in our sample appears to be
decreasing across time (t = - 1.936), consistent with the broadening coverage
of Compustat. The average sample firm is largest in 1959, after which size
declined until a low was reached in 1974 at less than one-fourth of the level in
1959. Since 1974, the average inflation-adjusted size of firms on C o m p u s t a t has
increased moderately.

D.W. Collins et aL /Journal of Accounting and Economics 24 (1997) 39-67

61

Overall, the results in Fig. 3 indicate that the percentage of firms in intangible-intensive industries, the average magnitude of one-time items, the
frequency of negative earnings, and average firm size have all experienced
systematic changes in the past 40 years in directions consistent with the changes
in the value-relevance of earnings and book values. The next section more
formally tests whether the changes documented in Fig. 3 can explain the
changes in the value-relevance of earnings and book values.

6.3. Explaining temporal variation in the value-relevance of earnings and

book values
In this section, we tie together the results of the prior sections to determine
whether the observed shift in value-relevance from earnings to book values can
be explained by changes in the proportion of intangible-intensive firms, the
average magnitude of one-time items, the frequency of negative earnings, and
changes in average firm size. To do so, we include proxies for these four factors
as independent variables in the earlier regression of incremental R 2 on a timetrend variable:
/ ~ = q~o + q~TIMEt + qb2INT + q~3ONE* + q54LOSS, + ~bsSIZE, + ~,,

(6)
where TIME is 141, corresponding to the years 1953-1993, INT is the percentage
of firms in intangible-intensive industries, ONE* is the mean absolute value of
one-time items as a percent of'core' net income of all sample firms in year t, LOSS is
the percentage of sample firms in year t that have negative 'core' net income, and
SIZE is the natural log of the average inflation-adjusted market value of equity of
sample firms in year t.
We examine what effect, if any, including INT, ONE*, LOSS, and SIZE has on
the significance of TIME.
The results, presented in Table 5, indicate that including the above variables
renders T I M E insignificant at explaining temporal variation in total R 2 and the
incremental R 2 provided by earnings, and weakly significant at explaining the
incremental R 2 provided by book values. 21 Further, one-time items, negative
earnings, intangible-intensity, and firm size are all significant in explaining variation
in explanatory power in at least one regression. Contrary to assertions in the
financial press, the proportion of firms operating in intangible-intensive industries
does not reduce the combined explanatory power of earnings and book values.

21 These results are robust to including a time-squared variable to account for possible nonlinearities
in the time trend. We also find evidence of first-order serial correlation in the time-series regressions,
which is not unexpected. We correct for this serial correlation using the method developed by Prais and
Winsten (1954) and described by Greene (1990).

41

41

41

41

0.045
1.799)
0.468
1.847)

0.468
(7.431)
2.513
(4.731)

0.323
(18.108)
- 0.288
( - 1.244)

((-

ao

- 0.007
10.071)
0.001
( - 0.697)

(-

0.005
(5.097)
- 0.004
( - 1.839)

0.005
(1.896)
0.001
(0.116)

TIME
al

- 0.422
( - 0.903)

1.247
(2.505)

0.206
( - 0.190)

1NT
a2

- 0.218
( - 3.033)

0.174
(2.378)

- 0.601
(3.541)

ONE*
a3

0.053
(0.271)

0.295
(1.403)

1.298
(2.846)

LOSS
a4

0.046
(2.779)

0.027
(1.480)

- 0.138
( - 3.653)

SIZE
a5

0.931

0.880

0.896

0.804

0.636

0.686

Adj. R 2

bThe dependent variables are (1) the R 2 from the yearly regressions of price on earnings and book values, (2) the incremental R 2 of book value, and (3) the
incremental R 2 of earnings.

aT-statistics are in parentheses. Variable definitions: TIMEr is the t is 1 for year 1953, and increases by one for each additional year. INT~ is the percentage of
firms in year t that are in intangible-intensive industries (SIC codes: 282 plastics and synthetic materials; 283 drugs; 357 computer and office equipment; 367
electronic components and accessories; 48 communications; 73 business services; 87 engineering, accounting, R & D and management related services). O N E * is
the mean of the absolute value of one-time items as a percent of'core' net income for firms in year t. LOSSt is the percentage of finns that have 'core' net income
< 0 in year t. SIZEt is the natural log of the mean inflation-adjusted market value of equity of firms in year t. All of the above regressions were corrected for
first-order autocorrelation in the residuals using a generalized least-squares approach developed by Prais and Winsten (1954) and described in Greene (1990).

(3) Incremental earnings R 2

(2) Incremental book value R z

41

(1) Total R z
41

Dependent variable b

R { = ao + alT1ME, + azlNTt + a3ONE* + a4LOSSr + asSIZE~ + ~

Regressions of total R 2, incremental book value R 2, and incremental earnings R 2 on time-trend variable and various yearly characteristics of the sample"

Table 5

',~

b.

D.W. Collins et al. / Journal of Accounting and Economics 24 (1997) 39-67

63

In the first regression of total R 2, T I M E is positive (t = 1.896) when it is the only

explanatory variable; however, it becomes insignificant when the control variables
are included (t = 0.116). Except for the coefficient on intangibles (INT), which is
predicted to be negative, we have no predictions for the signs of the control
variables in the regression of total R 2 of earnings and book values. As noted above,
the coefficient on I N T is insignificant (t = - 0.190). The coefficient on O N E * is
negative and significant (t = - 3.541), indicating that increases in one-time items
reduces the overall ability of earnings and book values to explain price. The
coefficient on LOSS, however, is positive and significant (t = 2.846), while the
coefficient on SIZE is negative and significant (t = - 3.653).
In the regression of the incremental R 2 of book values, T I M E is positive and
strongly significant when it is alone (t = 5.097), however it becomes slightly negative
and only marginally significant when the other control variables are included
(t = - 1.839). The coefficient on I N T is positive and significant (t = 2.505), indicating that book values have actually become more value-relevant as the percentage of
firms in intangible-intensive industries has increased. The coefficient on O N E * is
positive and significant (t = 2.378), as predicted. This finding is consistent with
increased reporting of one-time items increasing the value-relevance of book values.
The coefficients on LOSS and SIZE are positive as predicted, but are insignificant
(t = 1.403 for LOSS and 1.480 for SIZE).
The last set of regressions in Table 5 seeks to explain variation in the incremental
explanatory power provided by earnings. When time is the sole explanatory
variable, it is negative and strongly significant (t = -10.071), consistent with
claims of the declining value-relevance of earnings across time. After the control
variables are included, however, the coefficient on T I M E becomes insignificant
at conventional levels (t-- -0.697). The coefficient on I N T is insignificant
(t = --0.903). As predicted, the coefficient on O N E * is negative and significant
(t = -3.033), which is consistent with one-time items being more transitory
and thus reducing the value-relevance of earnings. The coefficient on LOSS is
insignificant (t =0.271). The coefficient on SIZE is positive and significant
(t = 2.779).
Besides incremental R2s, one could use coefficients to gauge changes in the
value-relevance of earnings and book values. We next examine intertemporal
changes in the coefficients on earnings and book values and investigate whether we
observe a similar pattern as we observed with the incremental RZs, and whether the
same variables able to explain changes in explanatory power can explain changes in
coefficients. Table 6 presents the results of re-estimating Eq. (6) with the coefficients
on earnings and book values as the dependent variables. These results are generally
consistent with the earlier results that used incremental RZs as the measure of
value-relevance. The value-relevance of earnings (book values) appears to have
decreased (increased) across time before controlling for changes in intangibles,
one-time items, losses, and firm size. After controlling for these items, the time-trend
variable is no longer significant.

41

41

0.210
2.362)
1.790
2.125)

9.399
(7.140)
- 38.559
( - 4.365)

((-

ao

- 0.175
( - 3.345)
0.093
(1.266)

0.026
(7.291)
0.000
( - 0.035)

TIME
al

- 33.812
( - 2.007)

2.778
(1.654)

INT
a2

- 6.246
( - 2.759)

0.521
(2.060)

ONE*
a3

5.870
(0.847)

1.384
(1.948)

LOSS
a~

3.594
(5.703)

0.106
(1.776)

SIZE
a5

0.948

0.892

0.935

0.889

Adj. R:

bThe dependent variables are (1) the coefficients on book values from the yearly regressions of price on earnings and book values, and (2) the coefficients on
earnings from the same regression.

"T-statistics are in parentheses. Variable definitions: TIMEr is the t is 1 for year 1953, and increases by one for each additional year. INTt is the percentage of
firms in year t that are in intangible-intensive industries (SIC codes: 282 plastics and synthetic materials; 283 drugs; 357 computer and office equipment; 367
electronic components and accessories; 48 communications; 73 business services; 87 engineering, accounting, R & D and management related services).
ONE* = mean of the absolute value of one-time items as a percent of'core' net income for firms in year t. LOSSz is the percentage of firms that have 'core' net
income < 0 in year t. SIZEt is the natural log of the mean inflation-adjusted market value of equity of firms in year t. All of the above regressions were corrected
for first-order autocorrelation in the residuals using a generalized least-squares approach developed by Prais and Winsten (1954) and described in Greene
(1990).

(2) Coefficient on earnings

41

(1) Coefficient on book value

41

Dependent variableb

Coefficientr = a0 + alTIMEt + azINTt + a3ONE* + a4LOSS + asSIZE~ + ~t

Regressions of coefficients on time-trend variable and various yearly characteristics of the sample"

Table 6

~,e
~'e

~'

D.W. Collins et al. / Journal o f Accounting and Economics 24 (1997) 39-67

65

Overall, Tables 5 and 6 indicate that there has been a shift in value-relevance of
accounting numbers from earnings to book values over time before controlling
for changes in intangible intensity, one-time items, negative earnings, and firm
size. Controlling for these factors explains much of the shift in value-relevance
of earnings and book values across time. Further, we find no evidence of a
deterioration in the combined value-relevance of earnings and book values across
time.

7. Conclusions and future research

This paper investigates systematic changes in the value-relevance of earnings and
book values over time. Our analysis is motivated by recent claims that conventional
historical cost financial statements have become less value-relevant over time. We
report three primary findings. First, contrary to claims in the professional literature,
the combined value-relevance of earnings and book values has not declined over the
past forty years and, in fact, appears to have increased slightly. Second, while the
incremental value-relevance of 'bottom line' earnings has declined, it has been
replaced by increasing value-relevance of book values. Finally, much of the shift in
value-relevance from earnings to book values can be explained by the increasing
significance of one-time items, the increased frequency of negative earnings, and
changes in average firm size and intangible intensity across time. In summary, our
empirical evidence suggests that claims that the conventional historical cost accounting model has lost its value-relevance are premature.
The analysis in this paper raises a number of questions for future research. First, it
is not clear whether the changes in value-relevance we document are due to changes
in GAAP or due to 'real' economic changes. Second, the effects of variation in the
value-relevance of earnings and book values across industries and changes in
industry composition across time have not been fully explored. If earnings and book
values have differing value-relevance across industries, then changes in the proportion of firms in each industry will affect inferences, like ours, that are based on yearly
cross-sectional regressions. Finally, we cannot be certain that the variables used to
explain intertemporal changes in value-relevance are causally linked to changes in
value-relevance, or whether some unknown underlying economic phenomenon is
responsible for variation in both our dependent and independent variables.

Acknowledgements
We thank Ray Ball (the editor), Bill Beaver (the referee), Kevin Den Adel, Marty
Butler, Mike Doran, Jere Francis, Paul Hribar, Arthur Kraft, Renee Price, Bill
Swartz, Hong Xie, and workshop participants at Iowa State University and the
University of Missouri for useful comments. Dan Collins appreciates the financial

66

D. ~l~ Collins et al. /Journal o f Accounting and Economics 24 (1997) 39 67

s u p p o r t f r o m the College of Business at the U n i v e r s i t y of Iowa. E d M a y d e w

appreciates the financial s u p p o r t f r o m the F M C faculty research fund at the
U n i v e r s i t y of Chicago. Ira Weiss appreciates the financial s u p p o r t f r o m the U n i v e r sity of C h i c a g o G r a d u a t e S c h o o l of Business.

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