Accounting Standard-Setting Organizations and Earnings Relevance: Longitudinal Evidence from NYSE Common Stocks, 1927-93

by

Kirsten Ely (Emory University) and

Gregory Waymire (University of Iowa)

Current Draft: April 1998

Key Words: Accounting standards; capital markets, earnings. JEL Classification: G18, M41, N22, N82.

1 We want to thank George Benston, Bill Cready, Ron King, Carla Hayn, Paul Irvine, Baruch Lev, Grace Pownall, Gord Richardson, Paul Simko, workshop participants at NYU, UCLA, Washington (St. Louis), and Emory and an anonymous referee for their helpful suggestions on prior drafts of this paper. Generous financial support for this research was provided by the Goizueta Business School of Emory University.

2 1.0 Introduction In this paper we report evidence on the relevance of earnings for valuation of NYSE common stocks from 1927 - 93. For each sample year, we select a random sample of 100 NYSE firms (excluding transportation firms, financial institutions, and public utilities) and measure the strength of association between earnings and stock returns (the adjusted R2 of a cross-sectional regression of 16-month stock returns on annual earnings changes and levels - see Lev [1989]). Based on a time series analysis of this measure, we investigate whether earnings relevance has increased following: (1) the empowerment of the Committee on Accounting Procedure (CAP) in 1939 as the first U.S. standard-setting body, and (2) subsequent reorganizations of the standard-setting process which led to the establishment of the Accounting Principles Board (APB, 1959-73) and the Financial Accounting Standards Board (FASB, 1973-Present). We focus on earnings relevance since income measurement and disclosure has been a primary (although not exclusive) focus of accounting policymakers throughout the period covered by our study. In the early 1930s, when the AIA (forerunner of the AICPA) recognized the need for policies which required the disclosure or standardization of accounting methods, they emphasized the cardinal importance of income as explained by the fact that the value of a business is dependent mainly on its earning capacity (see AIA [1934, p.9]). Over 40 years later, the FASB in SFAC1 adopted a similar view when it concluded that: (1) an objective of setting standards is to enhance the relevance of accounting data, and (2) the primary focus of financial reporting is on

3 earnings and its components (see FASB [1978]). Consistent with this, earnings is seen as a primary determinant of share prices by the financial community.1 We examine NYSE firms both because data are available for these firms over the lengthy time series we examine and these firms were the primary target of the Securities Exchange Act of 1934 under which private-sector standard-setting bodies have derived their authority.2 Our longitudinal approach allows us to track the time series behavior of earnings relevance for NYSE common stocks from a regime without accounting standards (pre-1939) through the formation of the CAP as well as subsequent reorganizations that led to the establishment of the APB and FASB. Because one of the AIAs early goals was to enhance the quality of accounting data for assessing earning capacity, we hypothesize an increase in earnings relevance following the CAPs empowerment. We test for increased earnings relevance following subsequent reorganizations since the objective of each reorganization was to improve on the existing standard-setting body. While standard-setters may believe that enhancing relevance is desirable, there can be significant impediments to achieving such a goal. Informational relevance is likely a complex, multidimensional attribute and standard-setters may not reach consensus on

Accounting earnings is regularly forecasted by financial analysts, its use in summary valuation measures is widespread (e.g., price-earnings ratios), and it is typically one of the first items reported in prominent financial press outlets such as The Wall Street Journal when firms financial results are disclosed. The primary importance of earnings in equity valuation has long been emphasized in texts on security analysis and equity valuation (see Graham and Dodd [1934] and Palepu, Bernard, and Healy [1996]). Monthly returns data are available for NYSE stocks in machine-readable form extending back to the mid-1920s. Income statement data are available on COMPUSTAT back to the mid-1950s and Moodys manuals provide extensive accounting data over the entire period covered by our study. The Securities Exchange Act of 1934 also applied to firms traded on the Curb Exchange (forerunner of the American Stock Exchange), but the total market value of these stocks was small relative to the NYSE (see Bernheim and Schneider [1935]). Federal securities law mandating public disclosure was not extended to OTC markets until the 1960s.
2

4 which specific methods will enhance relevance (see Joyce, Libby, and Sunder [1982] and Dye and Verrecchia [1995]). Second, the relevance of accounting data may be influenced by changes in the economic environment beyond the standard-setters control (see Lev [1996]).3 Hence, they may play a continual game of catch-up where new standards are required merely to keep pace with changing external circumstances. Finally, standardsetting is a political process (see Watts and Zimmerman [1978] and Miller and Redding [1988]). As such, standard-setters may be required to trade-off relevance against the need to satisfy multiple constituencies with conflicting interests. These (and other) factors could work against our finding increased earnings relevance following empowerment of the CAP and subsequent reorganizations of the standard-setting process. Our analyses provide little evidence to suggest that the mean and median adjusted R2 (as well as its trend) from yearly returns-earnings regressions are significantly higher following empowerment of the CAP in 1939 and subsequent reorganizations leading to creation of the APB and FASB. We find weak evidence of a higher median during the CAPs tenure (1939-59) compared to the Pre-CAP era (1927-38), but this result is not robust under alternate specifications of our primary tests where either yearly rank regressions are used, losses are excluded from the sample, or operating income is used in lieu of net income in the yearly regressions. Differences in means and medians are not significant in comparisons across four successive time periods: Pre-CAP (1927-38), CAP (1939-59), APB(1960-73), and FASB (1974-93).

For example, the AICPAs Jenkins Committee concluded that the relevance of financial statements has declined in recent years due to changes in the business environment (see AICPA [1994]). The studies by Collins, Maydew, and Weiss [1997], Francis and Schipper [1996] and Lev [1996] all provide evidence on this issue.

5 We also estimate yearly models where stock price is regressed against earnings and book value since Collins, Maydew, and Weiss (CMW) [1997] and Francis and Schipper (FS) [1996] use this model in longitudinal analyses of the relevance of financial statement data from the mid-1950s to the early 1990s. The evidence in CMW and FS indicates that the combined relevance of earnings and book value has increased during this period while the incremental relevance of earnings (book value) has declined (increased) over the same period. Their results raise the possibility that tests focused solely on earnings may understate the impact of standard-setters since new standards can have an impact on the balance sheet as well as the income statement. Results from tests examining incremental earnings relevance in price regressions are consistent with our earlier results based on returns regressions: we find no evidence indicating that the valuation relevance of earnings has significantly increased since the initiation of U.S. standard-setting in 1939. Consistent with evidence in CMW and FS, we document a highly significant increase in the combined relevance of earnings and book value during the FASBs tenure compared to the APB era which is driven by increased incremental relevance of book values. However, this increase in combined relevance is largely the artifact of abnormally low combined relevance in the APB era. For instance, the combined relevance of earnings and book value is the lowest in our sample period during the years of the APBs tenure (1960-73) and the combined relevance of earnings and book value in the FASB era is not significantly different than that observed during the Pre-CAP and CAP periods. In sum, our evidence provides only weak support for the hypotheses that earnings relevance is higher following the introduction of U.S. accounting standard-setting bodies

6 and subsequent reorganizations of the standard-setting process. However, it should be stated at the outset that our analysis is based entirely on broad tests of association and we cannot offer causal inferences about economic factors which underlie these weak findings. We offer some suggestions for future research in the concluding section of this paper in the hope that further analyses will produce a clearer understanding of our findings. The rest of the paper is organized as follows. We present our hypotheses in section 2. Section 3 describes sample selection and test design. Empirical evidence is reported in section 4 and the paper is summarized in section 5.

2.0. Hypotheses Congress established the SEC in 1934 and granted it authority to determine both the accounting methods and disclosures required for corporate financial reports. The SEC delegated the establishment of accounting principles to the private sector in 1938 (see Cooper and Robinson [1987]). One year later, the American Institute of Accountants (AIA) reorganized an existing committee to form the Committee on Accounting Procedure (CAP) and empowered it to develop accounting policy pronouncements (see Zeff [1984, pp. 453-8]).4 The CAP was replaced in 1959 by the Accounting Principles

Limited efforts to develop accounting principles were attempted prior to establishment of the SEC but these had little impact on most firms. In 1917 the AIA worked with the Federal Trade Commission to develop a set of accounting and auditing guidelines, but firms were not required to follow these guidelines (see Moonitz [1970]). The AIA also worked with the NYSE to develop a set of five basic principles in the early 1930s (see Carey [1969, p. 176]). These were not immediately adopted by NYSE firms since changes to existing listing arrangements can be made only when firms issue new securities (see Shultz [1936] for the history of NYSE listing agreements in the pre-SEC era).

7 Board (APB). The APB was replaced in 1973 by the Financial Accounting Standards Board (FASB). We investigate two primary hypotheses related to the establishment and subsequent reorganizations of the U.S. accounting standard-setting process. The first is whether earnings relevance is higher following the establishment of the CAP in 1939. Tests of this hypothesis are directed towards comparing earnings relevance in a regime with accounting standard-setting bodies to one where no such bodies exist. The second hypothesis concerns whether subsequent reorganizations of the standard-setting process in 1959 and 1973 are followed by higher earnings relevance. Tests of this hypothesis compare earnings relevance under the APB and FASB with earnings relevance under their respective predecessors - i.e., the APB (1960-73) is compared to the CAP (1939-59) and the FASB (1974-93) is assessed using the APB as a benchmark. The motivation for our first hypothesis stems from the view that standard-setting bodies seek to enhance the relevance of accounting data to financial statement users (see Dyckman [1988] for a discussion of alternative views of accounting standards). Prior to 1939, two ways of enhancing relevance through standard-setting were debated (see AIA [1934, p. 7]). The first does not alter existing practice, but provides information on alternative methods employed in practice and requires disclosure of the methods used by a firm. The CAPs approach to standard-setting resembled this approach (see Zeff [1984, pp. 453-8]). The second was one where the standard-setter selects a single method to be used by all companies. This is the approach followed later by the APB and FASB.

8 While the CAP did not advocate major changes to existing practice, their activities could still increase the relevance of earnings for equity valuation. Early texts on security analysis suggest that comparing earnings across firms was difficult due to the lack of disclosure of accounting methods (see Graham and Dodd [1934, pp. 350-5]). If the CAP increased investors knowledge through expanded disclosure of accounting methods, then cross-firm comparisons would be facilitated and it is less likely that firms could misstate earnings in a manner which would not be detectable. In turn, investors would (all else equal) place greater emphasis on earnings in valuing corporate equity.5 Hence, we test our first hypothesis comparing earnings relevance under the CAP to that observed in the pre-CAP period (1927-38). We test this hypothesis against a onetailed alternative which permits rejection of the null only if earnings relevance is higher during the CAP era compared to the Pre-CAP period. We also test this hypothesis by comparing earnings relevance in the Pre-CAP period with that observed for all years in our sample period where a standard-setting body exists (i.e., 1939-93). In both cases, a one-tailed alternative is used since it is difficult to envision circumstances under which a standard-setter would actively seek to reduce the relevance of accounting information to financial statement users. As noted at the outset, the objective of improving relevance is one which has been consistently stated by policymakers (see AIA [1934] and FASB [1978]).

Financial historians have argued that early 20th century investors placed far greater emphasis on dividends than earnings in equity valuation because earnings were subject to manipulation (see Baskin and Miranti [1997, pp. 188-99]). Sivakumar and Waymire [1993] report evidence indicating that announcements of dividend changes by NYSE industrials during 1905-10 are associated with larger magnitude stock price changes than announcements of annual earnings changes.

9 Our second hypothesis is whether reorganizations of the standard-setting process leading to establishment of the APB in 1959 and the FASB in 1973 are followed by periods of increased earnings relevance. Both reorganizations were intended to address three issues about the standard-setting process first raised by critics of the CAP in the 1950s (see Zeff [1984, pp. 458-62]). First, the CAP did not adopt accounting principles that could enhance comparability by reducing diversity in accounting practice. Second, they did not develop a theoretical framework to direct the selection among alternative accounting methods. Such a framework may enhance a standard-setters ability to write relevance-enhancing standards by providing a more focused, proactive strategy for standard-setting that is linked to specific objectives such as enhanced relevance. Third, the CAP failed to win corporate support for their pronouncements while maintaining independence. Obtaining support from multiple constituencies may be important to avoid passing watered down standards that have little effect on the quality of accounting information. The APB adopted a more normative approach to standard-setting than the CAP and succeeded in reducing the diversity of practice in some areas. This was accomplished, in part, by making it more difficult for firms to use methods of accounting other than those sanctioned by the standard-setter. In the mid-1960s, the AICPA began requiring that auditors disclose departures from APB Opinions in their reports or in the footnotes to the financial statements (see Davidson and Anderson [1987, p. 118]). If this reduction in diversity of accounting practice made earnings data reported by firms more comparable, we would expect that earnings relevance would be greater under the APB than under the CAP.

10 At the same time, the APB failed to address two of the three criticisms that had been raised about the CAP. While the APB attempted to write a conceptual framework, they did not successfully complete this task (see Davidson and Anderson [1987, p. 117]). Also, despite having adopted more extensive due process procedures than the CAP, delays in writing accounting rules for business combinations (APB Opinions 16 and 17) combined with intense pressure from industry groups led some to question whether the APB could remain independent while reaching consensus on new standards which win the support of multiple constituencies.6 The reorganization which created the FASB was the result of continuing dissatisfaction over these two issues. The AICPA formed two committees to separately examine the conceptual underpinnings of accounting and the organization of the standardsetting process. The Trueblood Committee was charged with studying the objectives of financial reporting in the hopes of making further progress towards a conceptual framework. The Wheat Committee, charged with studying the institutional processes used to establish accounting standards, recommended a major restructuring of the standardsetting process (see Recommendations of the Study on the Establishment of Accounting Principles, Journal of Accountancy [1972]). The FASB built on the final report of the Trueblood Committee (see AICPA [1973]) in its own Conceptual Framework project.7 Under their Conceptual Framework,

Unlike the CAP, the APB distributed exposure drafts of proposed opinions and held public meetings with industry groups (see Zeff [1984, p. 462]).
7

See FASB [1991] for the text of the six Statements of Financial Accounting Concepts comprising their Conceptual Framework. There has been debate on the effectiveness of the FASBs Conceptual Framework (see Dopuch and Sunder [1980] and Daley and Tranter [1990]).

11 one primary objective of the standard-setting process is to enhance the relevance or usefulness of accounting information to financial statement users (see SFAC1).8 The stated purpose of the FASBs framework is, in part, to provide a basis for selecting among alternative methods to enhance informational relevance. Using this framework as a basis, the FASB has continued the APBs attempt to reduce diversity in accounting practice. This approach was further legitimized by the SEC in 1973.9 The restructuring recommended by the Wheat Committee led to the FASB being structured differently than the APB on some dimensions that may affect its ability to promulgate relevance-enhancing standards. The FASB was established independently of the AICPA (both the APB and FASB were part of the AICPA) and its membership represents a broader set of constituency groups.10 The FASB also has fewer members (seven vs. over 20 for both the CAP and APB) and these members serve full-time (CAP and APB members retained full-time careers outside their role as standard-setters). These structural changes were intended to help board members identify issues pertinent to multiple constituencies, maintain independence from previous employers, and resolve disagreements.
8

The definition of relevance in the FASB Conceptual Framework is more narrow than the one we employ. They view relevance as determined jointly by informational predictability, feedback ability, and timeliness. We study the broader notion of information usefulness to financial statement users as defined by the association between information and prices (see Lev [1989]). Our definition is consistent with that employed in other recent studies by Collins, Maydew, and Weiss [1997], Francis and Schipper [1996], and Lev [1996] on changes in the relevance of accounting information over time.
9

SEC Accounting Series Release No. 150 asserts that FASB standards have substantial authoritative support and should be used by firms in preparing financial statements submitted to the SEC under federal securities laws.
10

Seats on the FASB are allocated to a broader group of constituencies which include academics, preparers, and users of financial statements. The FASB also has adopted far more extensive due process procedures for evaluating proposed standards than the APB. Miller and Redding [1988, pp. 31-82] provide a description of the organizational structure and processes of the FASB.

12 While it is difficult to assess the effectiveness of these structural changes, the FASB has survived longer and issued more pronouncements than either the CAP or APB. Through the end of 1993 (the final year in our sample period), the FASB had promulgated 117 Standards (an average of 5.5 from 1974-1993). In contrast, the CAP wrote 51 Accounting Research Bulletins (average of 2.4 per year from 1939-59) and the APB penned 31 Opinions (average of 2.2 per year). 11 If the FASBs Conceptual Framework and process changes increase the likelihood of promulgating relevance-enhancing standards, then the relevance of earnings will be higher under the FASB than the APB. We test our second hypothesis by comparing earnings relevance under the APB and FASB with their respective predecessors. As with our first hypothesis, we test against a one-tailed alternative permitting rejection of the null only when relevance is higher than under the prior standard-setting organization. In other words, we assess whether earnings relevance is higher under the APB than the CAP and for the FASB compared to the APB. We may be unable to reject either our first or second null hypothesis since the ability of standard-setters to write relevance-enhancing standards can be limited for several reasons. First, the underlying relation between accounting standardization and informational relevance may be complex. For instance, Dye and Verrecchia [1995] develop a theoretical model which shows that the impact of limiting accounting discretion on the value of accounting data will depend on the nature of conflicts both between managers and shareholders (the internal agency problem) as well as current and future

11

The FASB average is higher, in part, due to a high number of pronouncements during the four years between 1979 and 1982. Excluding the 47 Standards adopted in this period, the average for the FASB would drop to 4.4 per year (which is still approximately twice the average annual number of pronouncements by the CAP and APB together).

13 shareholders (the external agency conflict). Also, even if all parties had identical incentives, experimental evidence suggests it is not a straightforward task for standardsetters to unambiguously identify accounting rules that will result in more relevant accounting information (see Joyce, Libby, and Sunder [1982]). Second, some have recently argued that the information in financial reports is becoming less relevant (in relative terms) to investors due to increased complexity of the business environment. This view led the AICPAs Jenkins Committee to recommend development of an expanded model of business reporting which places greater emphasis on forward-looking and nonfinancial information (see AICPA [1994]). Lev [1996] presents a similar argument and provides some evidence consistent with this conjecture. The effect of environmental change (beyond the standard-setters control) which erodes the relevance of accounting data is that standard-setters may need to write new standards at an accelerating rate merely to maintain the overall relevance of accounting data at existing levels. If these effects exist, any improvements in relevance from new standards may be offset by an underlying negative trend caused by environmental change.12 Finally, standard-setting is a political process where competing constituencies attempt to influence the process towards the adoption of rules which favor their self interest (see Watts and Zimmerman [1978] and Miller and Redding [1988]). Competing political interests will reduce the standard-setters ability to adopt relevance-enhancing standards. Moreover, the effect of political pressure could actually be heightened by the

In addition to Lev [1996], Collins, Maydew, and Weiss [1997] and Francis and Schipper [1996] also provide evidence suggesting that the association between earnings and prices has eroded in recent years. These latter two studies document that the declining relevance of earnings in recent years has been offset by increased relevance of balance sheet data. We address this issue in section 4.

12

14 use of elaborate due process procedures (such as those used by the FASB) as lengthy debate results in delays in adoption of new standards or weakens the standards eventually adopted. One example of this would be the FASBs standard on accounting for stock options which took several years to complete and differed markedly in final form from the initial exposure draft (see Loomis [1988]).

3.0. Sample Selection, Data, and Methodology For each of the 67 years during 1927-93 (inclusive), we randomly select 100 NYSE companies from the CRSP Monthly Price File that meet the following criteria: (1) the firm has monthly common stock price data available for the 29 months from February of the prior calendar year through June of the subsequent calendar year, and (2) the firms four-digit SIC code is between 1000 and 3999. The first criterion is imposed to insure sufficient data to estimate the stock return variables used in our empirical tests. The second criterion excludes railroads, utilities, and financial institutions, all of which are subject to regulatory processes that can influence their earnings numbers. Data on firms annual earnings are collected from either COMPUSTAT or Moodys manuals on industrial securities. All data from before 1950 have been manually collected from Moodys. When COMPUSTAT data are not available for a firm in the post-1950 period, we collect data applicable to that firm-year observation from Moodys.
13

13

We did not condition the selection of firms on COMPUSTAT data availability since the coverage of firms is considerably thinner in the 1950s than today. Only 47% of the firms entering our samples for

15 We found no usable earnings data for 30 of 6,700 firm-year observations. To maintain consistency of the random selection process, we did not replace these observations. More of the missing observations occur in the pre-1951 period (preCOMPUSTAT) than in the post-1950 period (18 vs. 12). There are no more than three missing observations in any given year. Of these 30 cases, two observations are missing because we cannot find information for the firm in either COMPUSTAT or Moodys. Changes in fiscal year-end account for 18 of these observations and insufficiently detailed disclosures account for ten. Our primary tests examine the explanatory power of yearly cross-sectional regressions of 16-month market-adjusted stock returns on annual earnings changes and levels.14 We use both earnings changes and levels since the inclusion of levels improves specification of the earnings-return relation (see Easton and Harris [1991] and Ali and Zarowin [1992] for evidence and Ohlson and Schroff [1991] for theory). The marketadjusted return equals the difference between the firms return over this interval and the return on the CRSP equally-weighted index of NYSE stocks. For each of the 67 years in our sample period, we estimate the following cross-sectional model: ri = 0 + 1 Ei + 2 Ei + i

(1)

the years 1950-59 have data available on COMPUSTAT. The percentage of firms in our sample with data on COMPUSTAT increases with time. For example, the percentage of firms with COMPUSTAT data available are 50, 92, 95, and 99 in 1960, 1970, 1980, and 1990, respectively. 14 If reporting lags are substantially longer in the early part of our sample period, a bias could be introduced in favor of our alternative hypotheses by the use of a return measurement interval that did not allow for the full incorporation of earnings information into prices. The effect of such a bias is likely of second-order magnitude, at best. For example, Sivakumar and Waymire [1993] document an average reporting lag of nearly 11 weeks for NYSE firms in 1905-10 compared to average lags of nine and six weeks respectively for 1960 and 1974 reported by Givoly and Palmon [1982]. Hence, the use of a 16month return measurement interval will likely include the actual earnings announcement date for most of our sample firms, even for early years in our sample period.

16 where ri = 16-month market-adjusted return for firm i measured from the first month of the fiscal year through the end of the fourth month after the fiscal year end, Ei = change in annual earnings for firm i scaled by the beginning of period market value, Ei = annual earnings for firm i scaled by the beginning of period market value, and i = residual term. We examine the adjusted R2 (i.e., the proportion of the market-adjusted return associated with annual earnings) as a measure of earnings relevance (see Lev [1989]). Because returns are measured over a 16 month interval, the adjusted R2 reflects a statistical association rather than the degree to which investors actually use earnings in establishing equity values. Inspection of the data indicates the existence of some extreme observations that likely constitute outliers. We eliminate from the sample 79 observations where either the dependent variable or one of the independent variables in eq. (1) is six or more standard deviations away from the mean for that variable in the yearly sample to which the observation applies.15 After excluding these 79 observations and the 30 cases with no useable earnings data, the final sample on which our subsequent analyses are based includes 6,591 firm-year observations.

15

This loss of 79 observations represents 1.2% of the total 6,670 observations for which data are available. These observations are not clustered in a particular period; the number of observations excluded in each period is: 15 (Pre-CAP, 1927-38), 22 (CAP, 1939-59), 19 (APB, 1960-73), and 23 (FASB, 1974-93).

17 Estimation results for eq. (1) using the 67 yearly samples indicate a mean (median) adjusted R2 of .185 (.169) and the measure is positive in all 67 years. Using an F-test, the overall regression is significant at the .10 level in 65 (97%) years.16 Consistent with prior research, the mean and median coefficients are positive for both independent variables. Earnings level coefficients are positive and significant at the .10 (.05) level in 45 (41) years compared to 37 (30) years for earnings changes. These estimation results suggest that earnings is a significant factor in explaining cross-sectional return variation for our yearly samples and this effect is present for virtually all years in our sample period.

4.0. Empirical Evidence 4.1. Primary Results Panel A of table 1 shows the mean and median adjusted R2 based on yearly estimation of eq. (1) for 1927-93 partitioned into four sub-periods: Pre-CAP (1927-38), CAP (1939-59), APB (1960-73), and FASB (1974-93). The test statistics (either a tstatistic for the means or a Wilcoxon z-statistic for medians) shown under the CAP, APB, and FASB means and medians are used in one-tailed tests for differences relative to their respective predecessor regimes. The statistics under the means and medians for the All

16

Without eliminating extreme observations, the mean (median) adjusted R2 is .142 (.118) and the overall regression is significant at the .10 level in only 56 years. We selected a six standard deviation cutoff because this was the point at which improvement in model performance (as measured by the number of years where the regression was significant) was largely exhausted and the overall loss of data from imposing the deletion rule remained small. For example, using a three (two) standard deviation rule would have resulted in 64 (64) significant years and the overall loss of observations would have been N = 294 (593).

18 Bodies period (1939-93) apply to a one-tailed comparison with the Pre-CAP period (1927-38). _______________________________ Insert Table 1 About Here _______________________________

Our first hypothesis (in alternative form) is that earnings relevance is higher following empowerment of the CAP in 1939. This hypothesis is tested by comparing the mean and median adjusted R2 in the Pre-CAP period (1927-38) with either: (1) the CAP period (1939-59), or (2) the entire period covered by U.S. standard-setting bodies (193993). Our second hypothesis (in alternative form) is that earnings relevance will be higher following establishment of the APB (FASB) in 1959 (1973). We test this hypothesis by comparing adjusted R2 levels in: (1) the APB period with those of the CAP period, and (2) the FASB era to those during the APBs tenure. These comparisons provide only weak support for our first alternative hypothesis. During the CAP era, the median adjusted R2 equals .2312 compared to .1570 in the PreCAP period (a Wilcoxon test rejects the null of equal medians at the .05 level). No other test of means or medians permits rejection of either null hypothesis at the .10 level. Hence, the evidence in panel A does not support the hypothesis that relevance is significantly higher after the reorganizations creating the APB and FASB, but there is weak support for higher earnings relevance in the CAP era compared to the Pre-CAP era. One limitation of the tests in panel A is that they do not capture changes in earnings relevance that occur throughout a given standard-setting bodys tenure. To

19 illustrate, the assertion that standard-setters can enhance earnings relevance assumes that each new standard improves the quality of accounting earnings and makes these data more relevant to investors. If this is true, then earnings relevance should be increasing during the standard-setting bodys tenure as it promulgates new standards - i.e., the effect of new standards on earnings relevance should be cumulative. Moreover, if the standard-setting body in place improves on the prior regime, the upward trend in relevance over its tenure should be greater than that associated with the prior regime. To investigate this possibility, we estimated the following time series model which allows for an upward trend in earnings relevance during a standard-setting bodys tenure: ARSQt = 0 + 1 t + 2 Dt t + ut where ARSQt = adjusted R2 of cross-sectional regression of market-adjusted returns on earnings levels and changes for year t, t = trend variable equal to one for 1927, two for 1928, and so forth, and Dt = dummy variable assuming a value of one under the regime hypothesized to have increasing relevance and zero otherwise. (2)

Eq. (2) is estimated for our first test of hypothesis one using data from the 33 years during 1927-59. For this test, Dt assumes a value of one for all years between 1939 and 1959 inclusive. If earnings relevance is increasing during the CAPs tenure beyond the rate during the pre-CAP period, then 2 will be positive. In the test comparing the Pre-CAP period to the period covered by all bodies during 1939-93, Dt assumes a value of one (zero) for all years 1939 and beyond (during 1927-38). In testing hypothesis two, we

20 estimate eq. (2) over either: (1) the 1939-73 period to compare the APB with the CAP, or (2) over the 1960-93 period in comparing relevance under the APB and FASB. Trend model results are shown in panel B of table 1. None of the four estimates of 2 is significant at the .10 level or better based on a one-tailed t-test.17 These results do not indicate an upward trend in earnings relevance for periods following the CAPs empowerment or subsequent reorganizations leading to establishment of the APB and FASB. As a diagnostic test, we also replicated the tests in table 1 using yearly rank regressions to estimate eq. (1). In these tests, we are unable to reject either null hypothesis at the .10 level. The mean (median) adjusted R2 based on yearly rank regressions during each of the four periods is: Pre-CAP: .2586 (.2852); CAP: .2798 (.2711); APB .2526 (.2400); and FASB: .2309 (.2263). Likewise, none of the coefficients on the trend model in eq. (2) is significant at the .10 level when the yearly adjusted R2 values are based on rank regressions. Hence, the result in panel A that the median adjusted R2 is higher in the CAP era is not robust to the use of rank regressions. The means and medians from yearly adjusted R2 estimates in table 1 may be influenced by only one or two years - i.e., an individual years estimate may be noisy since it is based on no more than 100 observations. Hence, we also estimated eq. (1) where observations are pooled across time to estimate a single regression for each of the four
17

Following Francis and Schipper [1996], we also estimated each trend model including an additional independent variable to control for stock market volatility for the year in which the dependent variable (adjusted R2) is measured. This variable was computed as the standard deviation for the 12 monthly returns on the CRSP equally-weighted market index for the calendar year. This variable is not significant in either model used to test hypothesis one in panel B of table 1, but it is positive and significant (at .05 level for two-tailed test) in both models used to test hypothesis two. However, inclusion of this variable

21 sub-periods (Pre-CAP, CAP, APB, and FASB). The adjusted R2 estimates from these regressions are generally consistent with the results reported in panel A of table 1. For these pooled regressions, the adjusted R2 increases from .1197 in the Pre-CAP era to .1625 in the CAP period, but declines to .1427 in the APB era and .1047 during the FASBs tenure.18 We also investigated whether the time series behavior of the earnings relevance measure differs for firms categorized by their relative size measured as the market value of common equity at the beginning of the fiscal year. Firms were ranked on this measure (within years) and split into two groups at the median. Firms above (below) the median size are included in the group of relatively large (small) firms for that year. This test did not reveal significant differences in the adjusted R2 levels across standard-setting regimes for alternative samples defined by relative firm size.19

4.2. The Impact of Losses and Nonrecurring Items We next investigated the impact of losses on our results since recent research suggests that losses exhibit a weaker association with stock returns than positive earnings (see Hayn [1995]). In a longitudinal study during 1953-93, Collins, Maydew, and Weiss

does not alter inferences about the trend coefficient 2; in no case is this coefficient significant at the .10 level.
18

We tested for regression homogeneity between the Pre-CAP and CAP periods using a Chow test. This test rejected at the .05 level, but this result should be interpreted cautiously since the Chow test will reject either because of differences in explanatory power or differing coefficients between the two models.
19

The median adjusted R2 for relatively large firms is: .2269 (Pre-CAP); .2189 (CAP); .1129 (APB); and .1206 (FASB) compared to .1546 (Pre-CAP); .2114 (CAP); .2074 (APB); and .1471 (FASB) for the relatively small firms. The increase in the small firms median from the Pre-CAP to the CAP era is not significant at the .05 level (Wilcoxon Z-statistic equals 1.25). Inferences are identical when hypotheses are tested on means for these sub-samples.

22 (CMW) [1997] find that yearly measures of the relevance of accounting data are lower when more firms report losses. The inclusion of loss observations could bias our tests in either direction depending on their relative incidence in the four different time periods we examine. For instance, the comparison indicating a higher median adjusted R2 in the CAP period relative to the Pre-CAP period could be due to a higher frequency of losses in the Pre-CAP period. Likewise, other tests failing to reject the null of increased earnings relevance under subsequent standard-setting bodies could be due to a higher incidence of losses in the later periods used in these comparisons. The data in panel A of table 2 indicate that both the incidence and severity of losses is relatively high in both the Pre-CAP and FASB periods. In the Pre-CAP era, 26.0% (304 of 1,171) of the earnings observations are losses and 13.2% of the observations entering our yearly samples in the FASB era are losses. In contrast, only 4.6% and 4.7% of the observations for the CAP and APB periods, respectively, are losses. The far right column of panel A shows the mean and median values of net income scaled by beginning-of-year market value of equity for each of the four periods using loss observations only. The mean (median) loss in the Pre-CAP sample of -.405 (-.185) is the most negative of the four periods followed by -.235 (-.126) for the FASB sample.20 These data suggest that the inclusion of loss observations in the sample may influence the results of tests which examine the Pre-CAP and FASB eras.

20

The higher incidence of losses in the Pre-CAP era is not surprising since this period covers the Great Depression of the early 1930s. Macroeconomic research indicates that aggregate corporate earnings is a leading indicator of cyclical changes in macroeconomic conditions (see Hall [1990, pp. 23-5]).

23

_______________________________ Insert Table 2 About Here _______________________________

Panel B of table 2 shows replications of the tests in panel A of table 1 after excluding losses for comparisons of: (1) the Pre-CAP and CAP periods, and (2) the APB and FASB periods. The differences between the Pre-CAP and CAP periods mean and median adjusted R2 levels are not significant at the .10 level. This suggests that the significant difference in medians between these periods reported in table 1 is not robust to the exclusion of losses from the sample. Excluding losses from the sample does not alter inferences about the relative levels of earnings relevance under the APB and FASB.21 CMW also provide evidence indicating that yearly measures of informational relevance are lower when the incidence of nonrecurring items is higher. The impact of nonrecurring items on our results will depend on the magnitude of these items and their directional impact on earnings. Items which are larger in absolute terms will have a greater dampening effect on the adjusted R2 from the cross-sectional earnings-return model. Also, nonrecurring items which reduce earnings should dampen the strength of association between earnings and returns further since they increase the probability of a bottom-line loss.

21

We also replicated all other tests previously reported in table 1 excluding losses. No conclusions, other than those concerning differences in medians between the Pre-CAP and CAP periods, were altered by excluding losses.

24 To avoid problems created by nonrecurring items, we also replicated our tests using operating income in lieu of net income in the yearly cross-sectional returns regression model. As with the analyses excluding losses, no significant increases in earnings relevance across the sub-periods were detected. Using operating income in the yearly regressions, the mean (median) adjusted R2 equals .1761 (.1161) in the Pre-CAP period compared to .1868 (.1642) for the CAP sample. Neither the difference in the means nor the medians between the Pre-CAP and CAP periods is significant at the .10 level. Likewise, no other replication of the tests in table 1 using operating income permitted rejection of either null at the .10 level. 22

4.3. Tests on the Relevance of Earnings and Book Value We also replicated our tests using an alternative yearly regression model where stock price is regressed against earnings per share and book value per share. Both CMW and FS use this model in longitudinal analyses of financial statement relevance from the mid-1950s to the early 1990s and find that: (1) the combined relevance of earnings and book value is increasing during this period, and (2) the incremental relevance of earnings (book value) is declining (increasing) over this period. Their results suggest that tests

22

Estimation of the trend model in panel B of table 1 comparing the relevance of earnings under the PreCAP and CAP periods also did not reject the null for hypothesis one when using operating earnings in the yearly models.

25 such as ours may understate the impact of standard-setters since new accounting standards can also affect the relevance of balance sheet data as well as earnings.23 The following cross-sectional model is estimated for each of our 67 yearly samples:

Pi = 0 + 1 Ei + 2 BVi + ui where

(3)

Pi = cum-dividend price of common stock of firm i at the end of the fourth month following the firms fiscal year end, Ei = the annual earnings for firm i divided by the number of common shares outstanding, BVi = the book value for firm i divided by the number of common shares outstanding, and ui = residual. We estimate eq. (3) using only firm-year observations which have passed a six standard deviation filter on the dependent and independent variables similar to that imposed in determining the yearly samples used in our returns tests. In total, 6,631 firmyear observations enter the yearly samples used for analyses based on eq. (3).24

23

We do not mean to imply that extending our tests to include book value is the only possible extension to our tests. Other possibilities would be to investigate the valuation relevance of income statement and balance sheet components or the supplemental information disclosed in footnotes. We focus on book value because it (like earnings) is a convenient summary measure from a principal financial statement and the results in CMW and FS suggest it may be important in longitudinal tests of the type we conduct.
24

From the original 6,700 firm-year observations, we eliminate 30 observations due to lacking earnings data and another six due to lacking balance sheet data. The application of the six standard deviation cutoff results in the loss of an additional 33 observations.

26 Following CMW, we use yearly estimates of eq. (3), along with univariate regressions of either earnings or book value against price, to obtain measures of the combined relevance of earnings and book value as well as measures of the incremental relevance of earnings and book value. The combined relevance measure is the adjusted R2 of eq. (3). The incremental relevance of earnings (book value) equals the change in adjusted R2 from adding earnings (book value) to a univariate price regression with only book value (earnings) included initially as an independent variable. Stated alternatively, the incremental relevance of earnings (book value) equals the adjusted R2 of eq. (3) less the adjusted R2 from of a univariate regression of price against book value (earnings). Table 3 provides summary information on the estimation of eq. (3) for the 67 yearly samples. Two points are noteworthy. First, the explanatory power of the yearly price regressions is generally higher than the returns regression estimated earlier. The mean (median) adjusted R2 of eq. (3) (shown in the row labeled the regression with both E & BV) equals .4408 (.4619) compared to .185 (.169) for the returns regression.25 This is due in part to the levels specification of the regression; the mean (median) adjusted R2 from a univariate regression of price against earnings equals .3791 (.3764), which is over twice as large as the explanatory power of the returns regression. _______________________________ Insert Table 3 About Here _______________________________

Yearly estimates of eq. (3) provide a rejection of the null of no explanatory power at the .001 level using an F-test in all 67 years.

25

27 Second, the earnings variable is more strongly associated with stock price than book value. The earnings (book value) coefficient is positive and significant at the .05 level in 65 (35) years. Also, the mean and median incremental relevance measures for earnings exceeds those of book value and the explanatory power of univariate regressions based solely on earnings exceed those of book value. These results indicate the importance of earnings for equity valuation and support our focus on earnings, at least as a starting point for our sample and the time period we examine. Table 4 shows mean and median relevance measures based on yearly estimates of eq. (3) for the various time periods examined in our earlier tests. This table is laid out similar to panel A of table 1 in that test statistics under the means and medians for the CAP, APB, and FASB correspond to a comparison with the predecessor regime. The test statistics applicable to the entire period of standard-setting bodies apply to a comparison with the Pre-CAP period. _______________________________ Insert Table 4 About Here _______________________________

Four aspects of the results shown in table of 4 are worthy of mention. Note first that the results on incremental earnings relevance are generally consistent with the evidence based on yearly returns regressions. In only one comparison are the mean and median higher for the latter period being compared. The mean (median) incremental earnings relevance equals .2281 (.2204) in the APB period compared to .1840 (.1909) in the CAP era. These differences are not significant at the .10 level. Hence, these tests

28 provide no evidence that earnings relevance in the CAP period is higher than in the PreCAP period. This is consistent with prior checks on the returns results; the finding of higher median earnings relevance for the CAP period in table 1 is not a robust result. Second, the results are consistent with evidence reported in CMW and FS suggesting that the combined relevance of earnings and book value have increased during the FASB era because of increases in the incremental relevance of book value. The mean (median) combined relevance in the FASB era equals .4691 (.4707) compared to .3422 (.3009) in the APB period. These differences are significant at the .001 (.01) level for a test of equal means (medians). The mean and median incremental relevance for book value in the FASB period are also significantly greater than identical measures in the APB era at the .001 level. Also consistent with CMW and FS, incremental earnings relevance in the FASB era (mean of .1115 and median of .0992) is lower than in the APB era. These differences would be highly significant in both cases under the application of twotailed tests.26 Third, the highly significant results on the combined relevance measure during the FASB era are an artifact of relatively low combined relevance during the APB era rather than abnormally high combined relevance in the FASB era. For instance, if two-tailed tests were applied to the mean and median combined relevance in the APB era, both of these measures would be significantly lower (at least at the .05 level) than the mean and
26

Also consistent with the evidence in CMW and FS, the combined relevance means and medians in the APB and FASB eras increase when losses are excluded and differences across eras remain significant (although at lower levels). Excluding losses, the mean (median) combined relevance in the FASB era is .5038 (.5022) compared to .4153 (.4375) in the APB era. Both the differences in mean and median across these periods are significant at the .05 level for a one-tailed test (t-statistic = 1.86 and Wilcoxon z-statistic = 1.66). Excluding losses does not have a uniform effect of increasing the mean and median combined

29 median for the CAP era. Consistent with this, we applied identical significance tests in comparing the FASB period against either the Pre-CAP or CAP periods on the combined relevance measure. These results (not reported in a table) indicate no significant differences between the FASB era and these earlier periods in terms of mean and median combined relevance of earnings and book value. Finally, a somewhat counterintuitive result in table 4 is the relatively strong association between prices and accounting data in the period prior to the establishment of U.S. standard-setting bodies. On all three relevance measures, we find no evidence of increased relevance in the 1939-93 period compared to the Pre-CAP era. For all comparisons, the mean and median relevance measure in the Pre-CAP exceeds that in the 1939-93 period and in the case of incremental earnings relevance, this difference is of sufficient magnitude that it would be significant under a two-tailed test at the .001 level. As a final check on the results, we also replicated the tests in table 4 using yearly rank regressions. None of the combined relevance tests permit rejection of either null hypothesis at the .10 level. The mean (median) combined relevance is.5280 (.5388) in the Pre-CAP era, .5557 (.5718) in the CAP era, .5063 (.5067) in the APB era, and .5621 (.5524) in the FASB era. None of the inferences about incremental relevance of earnings are changed by the use of rank regressions. The incremental relevance of earnings using rank regressions falls significantly in the CAP and FASB eras and shows a significant increase in the APB era while the incremental relevance of book value falls in the APB era but increases in the FASB period. The median incremental relevance of earnings (book value) is .3837 (.0283) for the Pre-CAP era, .2551 (.0138) in the CAP era, .3383 (.0002)

relevance measure across time periods. For example, the mean (median) in the Pre-CAP era falls from

30 for the APB period, and .2187 (.0391) in the FASB era. Mean incremental relevance measures show a similar pattern.

5.0. Summary of Results and Suggestions for Future Research Our objective in this paper has been to examine the time series behavior of the valuation relevance of earnings for yearly samples of NYSE common stocks during 192793. For each of these 67 years, we measure the relevance of earnings as the adjusted R2 of a cross-sectional regression model of 16-month market-adjusted returns on annual earnings changes and levels. Our empirical tests investigate whether earnings relevance is higher following: (1) empowerment of the Committee on Accounting Procedure (CAP) as the first U.S. accounting standard-setting body in 1939, and (2) subsequent reorganizations of the standard-setting process leading to creation of the Accounting Principles Board (APB) in 1959 and the Financial Accounting Standards Board (FASB) in 1973. The evidence we report provides only limited support for the hypothesis that earnings relevance is materially higher after either empowerment of the CAP or subsequent reorganizations of the standard-setting process. We find evidence of higher earnings relevance in the CAP era (1939-59) compared to the prior 12 years (1927-38) when the median adjusted R2 of the yearly returns regression model is examined. However, this result is not robust; these differences become insignificant when losses are excluded from the sample or operating income is used in the yearly regressions in lieu of

.4839 (.5261) as reported in table 4 to .4528 (.4530) when losses are excluded.

31 net income. Other tests based on yearly returns regressions do not yield differences across periods in explanatory power that differ significantly at conventional levels. We extend these tests by estimating regressions models which incorporate summary measures from both the income statement and the balance sheet. Following Collins, Maydew, and Weiss (CMW) [1997] and Francis and Schipper (FS) [1996], we estimate yearly cross-sectional regressions where price is the dependent variable and both earnings and book value are included as independent variables. The results from these tests are consistent with our returns results in that the incremental relevance of earnings does not exhibit significant increases following empowerment of the CAP and reorganizations creating the APB and FASB. However, in tests examining the time series of the combined relevance of earnings and book value for equity valuation, we find a significant increase during the tenure of the FASB (1974-93) compared to that of the APB (1960-73). These findings are consistent with the evidence in CMW and FS showing an upward trend in combined relevance from the mid-1950s through the early 1990s. For our yearly samples of NYSE stocks, these results appear attributable to the abnormally low combined relevance of earnings and book value during the APBs tenure; when combined relevance during the FASB era is compared against either the Pre-CAP or CAP eras, differences are not significant at conventional levels. Our analysis is based on broad tests of association and, as such, should be interpreted with caution. Because the nature of our tests does not permit causal inferences, additional research is necessary to obtain a clearer interpretation of our findings. We suggest further research in two related areas. First, additional research

32 could examine the impact of specific standards on the relevance of accounting data. Such analyses could replicate our tests for firms identified as experiencing material financial statement effects associated with the adoption of new accounting standards. Second, more research is needed on how other factors influence the valuation relevance of accounting data. As one example, some have suggested that increased investor utilization of the balance sheet in recent years is due to increased takeover activity (see Cottle, Murray, and Block [1988, p. 595]). Additional research could investigate the relative importance of earnings and book value in valuing the equity of takeover target firms.

33 References AICPA Study Group, 1973, Objectives of financial statements, AICPA, New York, NY. AICPA Special Committee on Financial Reporting, 1994, Improving business reporting A customer focus, Journal of Accountancy (Supplement). Ali, A. and P. Zarowin, 1992, The role of earnings levels in annual earnings-returns studies, Journal of Accounting Research (Autumn): 286-96. American Institute of Accountants (AIA), 1934, Audit of corporate accounts, American Institute of Accountants, New York, NY. Baskin, J. and P. Miranti, 1997, A history of corporate finance, Cambridge University Press, Cambridge, England. Bernheim, A. and M. Schneider, eds., 1935, The security markets: Findings and recommendations of a special staff of the 20th Century Fund, Twentieth Century Fund, New York, NY. Carey, J., 1969, The rise of the accounting profession: From technician to professional, 1896-1936, AICPA, New York. Collins, D., E. Maydew, and I. Weiss, 1997, Changes in the value-relevance of earnings and book values over the past forty years, Unpublished working paper, University of Iowa, March. Cooper, W. and I. Robinson, 1987, Who should formulate accounting principles? The debate within the SEC, Journal of Accountancy: 137-40. Cottle, S., R. Murray, and F. Block, 1988, Graham and Dodds security analysis, Fifth Edition, McGraw-Hill, New York, NY. Daley, L. and T. Tranter, 1990, Limitations on the value of the Conceptual Framework in evaluating extant accounting standards, Accounting Horizons 4:15-24. Davidson, S. and G. Anderson, 1987, The development of accounting and auditing standards, Journal of Accountancy: 110-27. Dopuch, N. and S. Sunder, 1980, FASBs statement on objectives and elements of financial accounting: A review, The Accounting Review 55: 1-21. Dyckman, T., 1988, Credibility and the formation of accounting standards under the Financial Accounting Standards Board, Journal of Accounting Literature 7: 1-30.

34 Dye, R. and R. Verrecchia, 1995, Discretion vs. uniformity: Choices among GAAP, The Accounting Review 70: 389-416. Easton, P. and T. Harris, 1991, Earnings as an explanatory variable for returns, Journal of Accounting Research 29: 19-36. Financial Accounting Standards Board (FASB), 1978, Statement of Financial Accounting Concepts # 1, FASB, Stamford, CT. Financial Accounting Standards Board (FASB), 1991, Statements of financial accounting concepts, Irwin, Homewood, IL. Francis, J. and K. Schipper, 1996, Have financial statements lost their relevance?, Unpublished working paper, University of Chicago, February. Givoly, D. and D. Palmon, 1982, Timeliness of annual earnings announcements: Some empirical evidence, The Accounting Review 57: 486-508. Graham, B. and D. Dodd, 1934, Security Analysis, McGraw Hill, New York, NY. Hall, T., 1990, Business cycles: The nature and causes of economic fluctuations, Praeger Publishers, New York, NY. Hayn, C., 1995, The information content of losses, Journal of Accounting and Economics 20: 125-53. Joyce, E., R. Libby, and S. Sunder, 1982, Using the FASBs qualitative characteristics in accounting policy choices, Journal of Accounting Research 20: 654-75. Lev, B., 1989, On the usefulness of earnings and earnings research: Lessons and directions from two decades of empirical research, Journal of Accounting Research Supplement: 153-92. Lev, B., 1996, The boundaries of financial reporting and how to extend them, Unpublished working paper, New York University, May. Loomis, C., 1988, Will FASBEE pinch your bottom line?, Fortune (December 16): 93108. Miller, P. and R. Redding, 1988, The FASB: The people, the process, and the politics, Irwin, Homewood, IL. Moonitz, M., 1970, Three contributions to the development of accounting principles prior to 1930, Journal of Accounting Research 8: 145-55.

35 Ohlson, J. and P. Schroff, 1992, Changes versus levels in earnings as explanatory variables for returns: Some theoretical considerations, Journal of Accounting Research 30: 21026. Palepu, K., V. Bernard, and P. Healy, 1996, Business analysis and valuation, Southwestern Publishing, Cincinnati, Ohio. Recommendations of the Study on the Establishment of Accounting Principles, Journal of Accountancy (May 1972): 66-71. Shultz, B., Stock exchange procedure, NYSE Institute, New York, NY. Sivakumar, K. and G. Waymire, 1993, The information content of earnings in a discretionary reporting environment: Evidence from NYSE industrials, 1905-10, Journal of Accounting Research 31: 62-91. Watts, R. and J. Zimmerman, 1978, Towards a positive theory of the determination of accounting standards, The Accounting Review 53: 112-34. Zeff, S., 1984, Some junctures in the evolution of the process of establishing accounting principles in the U.S.A.: 1917-1972, The Accounting Review 59: 447-68.

36 Table 1 Results of Hypothesis Tests for Increased Earnings Relevance Across Alternative Accounting Standard-Setting Regimes Based on Regressions of 16-Month Market-Adjusted Returns on Annual Earnings Changes and Levels for Yearly NYSE Industrial Samples, 1927-93 Yearly Model: ri = 0 + 1 Ei + 2 Ei + i A: Comparisons of Mean and Median Adjusted R2 Pre-CAP CAP APB FASB 2 2 2 (1927-38) (1939-59) (1960-73) (1974-93)2 .1879 .2285 .1755 .1453 (0.87) (-1.55) (-0.82) .1570 .2312 .1331 .1393 ** (1.93) (-1.90) (0.63) All Bodies (1939-93)2 .1847 (-0.08) .1806 (0.73)

Mean Adj. R2 (t-statistic)3 Median Adj. R2 (z-statistic) 3

B: Comparison of Adjusted R2 Trends Time Series Model: ARSQt = 0 + 1 t + 2 Dt t + ut 4 Periods Being Compared 1 (t-statistic) 2 (t-statistic) Tests of Hypothesis 1 Pre-CAP vs. CAP .0086 -.0057 Estimation Period: 1927-59 (0.93) (-0.78) Pre-CAP vs. CAP-FASB Estimation Period: 1927-93 Tests of Hypothesis 2 CAP vs. APB Estimation Period: 1939-73 APB vs. FASB Estimation Period: 1960-93 -.0007 (-0.11) -.0006 (-0.10)

-.0024 (-0.69) -.0020 (-0.44)

-.0001 (-0.07) -.0000 (-0.02)

1. ri equals the 16-month market adjusted return on security i, Ei equals the change in annual earnings scaled by beginning of period price for security i, and Ei equals the level of annual earnings scaled by beginning of period price for security i. The regression model is estimated using cross-sectional data for yearly samples of NYSE common stocks for each of the 67 years between 1927 and 1993, inclusive. 2. This column shows the mean or median adjusted R2 of the yearly returns regression model estimated separately for each year in the time period shown in the first column. 3. The test statistics apply to a test of differing mean or median relative to the prior regime for the CAP, APB, and FASB periods. For the period covered by all bodies, these test statistics apply to a comparison with the Pre-CAP period. 4. The trend model is estimated for the time period shown in the first column. ARSQt equals the adjusted

R2 of the yearly returns regression model estimated using data from year t, t equals one in the first year of the estimation period, two in the second year and so forth, and Dt equals one (zero) during the period covered by the latter (former) of the two periods being compared, and ut is the residual for year t. * Significant at the .05 level for a one-tailed test. ** Significant at the .01 level for a one-tailed test. *** Significant at the .001 level for a one-tailed test.

37 Table 2 Results of Empirical Tests Examining the Impact of Losses on Tests of Increased Earnings Relevance Across Alternative Standard-Setting Regimes for Yearly Sample of NYSE Firms, 1927-93 A: Incidence and Magnitude of Losses Across Different Standard-Setting Regimes Period Pre-CAP (1927-38) CAP (1939-59) APB (1960-73) FASB (1974-93) Sample Size 1,171 2,068 1,379 1,973 # (%) Losses1 304 (26.0%) 95 (4.6%) 65 (4.7%) 260 (13.2%) Mean (Median) Loss/MVE2 -.405 (-.185) -.129 (-.085) -.115 (-.070) -.235 (-.126)

B: Select Mean and Median Adjusted R2 Levels After Excluding Losses Yearly Model: ri = 0 + 1 Ei + 2 Ei + i 3 Mean Adjusted R2 Median Adjusted R2 Losses Losses Losses Losses 4 5 4 Hypothesis 1 Excluded Included Excluded Included5 (1) Pre-CAP (1927-38) .2004 .1879 .1494 .1570 (2) CAP (1939-59) .2442 .2285 .2268 .2312 Difference (2) - (1) .0438 .0406 .0774 .0742 T-Statistic 0.82 0.87 Wilcoxon Z-Statistic 1.22 1.93** Hypothesis 2 (1) APB (1960-73) (2) FASB (1974-93) Difference (2) - (1) T-Statistic Wilcoxon Z-Statistic

.2044 .1712 -.0332 -0.69

.1755 .1453 -.0302 -0.82

.1880 .1399 -.0581 -1.00

.1331 .1393 .0062 0.63

1. This column shows the number and percentage of firm-year observations within a given period where net income is negative. 2. This column shows the mean and median net income scaled by beginning-of-year market value of equity for all firm-year observations within a given period where net income is negative. 3. ri equals the 16-month market adjusted return on security i, Ei equals the change in annual earnings scaled by beginning of period price for security i, and Ei equals the level of annual earnings scaled by beginning of period price for security i. The regression model is estimated using cross-sectional data for yearly samples of NYSE common stocks for each of the 67 years between 1927 and 1993, inclusive. 4. This column shows the mean and median adjusted R2 of yearly returns regressions for a given time period estimated using only firm-year observations where net income is positive. 5. This column shows the mean and median adjusted R2 of yearly returns regressions for a given time period estimated using all firm-year observations. These summary statistics were previously reported in panel A of table 2. * Significant at the .05 level for a one-tailed test. ** Significant at the .01 level for a one-tailed test. *** Significant at the .001 level for a one-tailed test.

38 Table 3 Summary Statistics on Adjusted R2 and Coefficient Estimates from Regressions of Stock Price on Annual Earnings and Book Value for Yearly NYSE Industrial Samples, 1927-93 Yearly Model: Pi = 0 + 1 Ei + 2 BVi + ui
1

A: Mean and Median Relevance Measures (Across All Years)

Measure Regression with both E & BV (Combined Relevance) Univariate Regression with E Univariate Regression with BV Incremental Relevance of E Incremental Relevance of BV Mean .4408 Median .4619

.3791 .2454 .1954 .0333

.3764 .2420 .1821 .0101

B: Distribution of Yearly Earnings Coefficients

# (%) Years > 0 67 # (%) Years > 0 & P<.053 65

# Years 67

Mean 4.784

Median 4.583

C: Distribution of Yearly Book Value Coefficients

# (%) Years > 0 59 # (%) Years > 0 & P<.053 35

# Years 67

Mean .247

Median .200

1. Pi equals the stock price of security i at the end of the fourth month following month of the fiscal year end, Ei equals the annual earnings per share of security i, and BVi equals the book value per share of security i. The regression model is estimated using cross-sectional data for yearly samples of NYSE common stocks for each of the 67 years between 1927 and 1993, inclusive. 2. The incremental relevance of earnings (book value) for year t equals the adjusted R2 of the yearly price regression with both earnings and book value included as independent variables less the adjusted R2 of a univariate regression with only book value (earnings) included as an independent variable. 3. Refers to the frequency of cases that the coefficient is positive and a t-test of the significance of the coefficient rejects at the .05 level or better using a two-tailed t-test.

39 Table 4 Summary Statistics on the Combined and Incremental Relevance of Earnings and Book Value Across Alternative Accounting Standard-Setting Regimes Based on Regressions of Stock Prices on Annual Earnings and Book Value of Equity for Yearly NYSE Industrial Samples, 1927-93 Yearly Model: Pi = 0 + 1 Ei + 2 BVi + ui 1 Comparisons of Mean and Median Relevance Measures All Pre-CAP CAP APB FASB Bodies (1927-38)2 (1939-59)2 (1960-73)2 (1974-93)2 (1939-93)2 Incremental Relevance of E3 Mean .3169 .1840 .2281 .1115 .1689 (t-statistic)4 (-3.71) (1.30) (-4.34) (-4.78) Median .3389 .1909 .2204 .0992 .1588 (z-statistic) 4 (-3.09) (0.76) (-3.69) (-3.88) Combined Relevance of E & BV3 Mean (t-statistic) 4 Median (z-statistic) 4 Incremental Relevance of BV3 Mean (t-statistic) 4 Median (z-statistic) 4

.4839 .5261

.4549 (-0.68) .4619 (-0.73)

.3422 (-2.53) .3009 (-2.27)

.4691 (3.02)*** .4707 (2.22)**

.4314 (-1.30) .4540 (-1.41)

.0738 .0382

.0205 (-2.37) .0150 (-1.40)

.0098 (-1.42) .0021 (-1.18)

.1338 (3.16)*** .1092 (3.20)***

.0590 (-0.45) .0185 (-0.70)

1. Pi equals the stock price of security i at the end of the fourth month following month of the fiscal year end, Ei equals the annual earnings per share of security i, and BVi equals the book value per share of security i. The regression model is estimated using cross-sectional data for yearly samples of NYSE common stocks for each of the 67 years between 1927 and 1993, inclusive. 2. This column shows the mean or median relevance measure from the price regression model estimated separately for each year in the time period shown in the first column. 3. The combined relevance of earnings and book value in year t equals the adjusted R2 from the crosssectional regression of price against earnings and book value per share. The incremental relevance of earnings (book value) equals the combined relevance measure less the adjusted R2 from a univariate regression including only book value (earnings) as an independent variable. 4. The test statistics apply to a test of differing mean or median relative to the prior regime for the CAP, APB, and FASB periods. For the period covered by all bodies, these test statistics apply to a comparison with the Pre-CAP period. * Significant at the .05 level for a one-tailed test. ** Significant at the .01 level for a one-tailed test. *** Significant at the .001 level for a one-tailed test.