Disaggregated Accounting Data as Explanatory Variables for Returns

JAMES A. OHLSON* STEPHEN H . PENMAN**

1. Introduction and Summary

Modem market-based accounting research rarely refers to the elaborate concepts dictating the preparation of financial reports. The research does not explicate the reasons for the relevance of accounting data in valuation, and it depends only on the broad notion of "accounting data facilitates investors' assessments of firms' future cash flows." The popular construct of unexpected eamings, which researchers employ to explain retums, by contrast, is irrelevant to the practicing accountant who implements accounting principles. A more traditional way of looking at accounting recognizes the process as one of measurement. That is, the analysis of transactions leads to line items in the financial statements, which in tum aggregate into the "bottom line" numbers: (net) eamings and book value (net worth). These two summary measures achieve preeminent status by serving as primary indicators of a firm's value. However, the disclosures of the line items clearly suggest that the accountant is aware of the insufficiency of eamings and book values as determinants of values. This paper incorporates a measurement perspective in addition to an information perspective to understand how accounting data relate to security retums.' Eamings (and book values) derive from line items, and these line items may have differential valuation implications because investors perceive differential measurement errors. Hence, aggregation is not generally satisfied unless the measurement errors in the line items are relatively insignificant. The latter could occur for long reporting periods, as is suggested by the notion that a firm's lifetime eamings are measured without error. In any event, the language of accounting provides some straightforward hypotheses conceming the realizations of line items and retums. Revenues are "good," whereas expanses are "bad," and retums should respond accordingly. MoreGraduate School of Business, Columbia University **Walter A. Haas School of Business Administration, University of California, Berkeley 1. A measurement perspective on accounting line items and security values can be found in Barth (1991) and Barth, Beaver, and Wolfson (1990). While their work is similar in spirit to ours, the empirical issues and specifications differ substantially.

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over, in the absence of measurement errors, one can simply deduct the expenses from the revenues without loss of infonnation; that is, the disaggregation of eamings into line items does not enhance the explanatory power of regressions with retums as a dependent variable. The empirical results developed in this paper emanate from the above measurement perspectives on accounting. We evaluate empirically how disaggregated accounting data explain retums. We focus on regressions with retums as dependent variables and various components of eamings (gross margin, operating expenses, depreciation expense, tax expense, other income/expense items, and extraordinary/unusual line items) as independent variables to show the sufficiency of aggregation as one lengthens the retum interval. That is, for long retum intervals (10 years), the estimated coefficients associated with the various line items have approximately the same magnitudes. The signs are also correct; income items have positive (estimated) coefficients, whereas expense items have negative coefficients. Given the stmcture of the model, one can thus assert that the empirical evidence supports the notion that the market treats all line items as equivalent if they are measured over long periods. This empirical outcome illustrates Paton's (1963) concept of the "cash flow illusion": A dollar of depreciation expense is basically no different from a dollar of wage expense, except that the former is more difficult to measure for short periods. The empirical evidence we present is remarkably consistent with this idea of economic equivalence in line items. The study also explores empirically the differential measurement problems related to the eamings components by invoking the standard errorsin-variables perspective on estimated coefficients.^ We hypothesize that the coefficients associated with income components that are traditionally considered difficult to measuredepreciation and tax expenses, in particular do have relatively lower coefficients for the shorter retum intervals as compared to other, less problematic, income items. Only as the measurement interval lengthens can we expect a reduction in differences of the coefficient magnitudes. The results support this hypothesis as well. The empirical analysis goes beyond an evaluation of the disaggregation of the income statement into summary line items. We also consider intertemporal eamings disaggregation by analyzing the degree to which subperiod eamings contribute to the explanation of retums. The subperiod eamings may not satisfy additivity in the regression. In the extreme, one can hy2. We do not model errors-in-variables econometrics formally, an apparent deficiency in this research. Future work may usefully be directed toward this issue. Barth (1991) provides insights as to how errors-in-variables econometrics can be exploited when one relates accounting line item measurements to market values.

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pothesize that the eamings prior to the final year in the retum interval are irrelevant, except in so far as these eamings influence eamings in the final year of the retum interval. Thus, we compare the explanatory power of (1) aggregate eamings for the entire retum interval versus (2) eamings for only the last year of the retum interval. The former model develops from Hick's concept of (economic) eamings, that is, eamings measure the change in (market) value, whereas the latter concept develops from eamings as an indicator of a stock of value (see Black [1980] in particular). The results show that these two models explain retums ahout equally for the shorter retum intervals (2 to 5 years). For longer retum intervals (10 years), the Hicksian approach appears to have somewhat higher explanatory power. Thus, overall, the results suggest that there is some truth to both of the ideas that eamings (1) serve as a measure of changes in values and (2) serve as a measure of a stock of value. Finally, we also report on results that relate to the book value, and its subcomponents, as explanatory variables for retums. The results demonstrate that the book value by itself does not explain retums to the same extent as aggregate eamings for the shorter retum intervals. This difference, however, essentially ceases as one lengthens the retum interval. We further observe that the disaggregation of book value into balance sheet components does not improve the model's explanatory power. Thus, in contrast to the disaggregation of the income statement, there appears to be less material information content in the individual balance sheet summary items.

2. Basic Methodology and Modeling

Within the literature that examines how accounting data explain retums, Lipe's (1986) study appears to have been the first to be concemed with the general role of summary line items in the income statement. Lipe uses a traditional unexpected realizations framework for one-year retum periods. This specification in its simplest form reduces to a model in which the changes in the line items determine the independent regression variables. Other studies using similar information content constmcts have followed, with mixed results (Raybum [1986], Wild [1991], and Wilson [1987]). The approach to the specification of independent variables in this research differs from the above-mentioned papers. We make no attempt to model (un)expected realizations of accounting data by identifying their timeseries dynamics or analysts' expectations. Instead, we rely on two recent studies by Easton and Harris (1991) and Easton, Harris, and Ohlson (1991). Their work uses the levels of (aggregate) eamings, scaled by price at the beginning of the retum interval, as the generic independent eamings variable

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explaining retums. The conceptual foundation for this specification is Hicksian in the following sense. Economic eamings measure the value added, and, under ideal circumstances, the eamings for any given period should explain the change in a firm's market value. As Easton, Harris, and Ohlson (1991) note, these "ideal circumstances" occur if (and essentially only if) the differences between the market value and book value at the beginning and end of the period remain the same (see below). To express formally the Easton, Harris, and Ohlson (1991) model, we use the following notation: Pj, = firm/s market value at the end of year t, Xj, = firm/s eamings for year t,
T

AXjT - 2 Xjt = firm/s aggregate eamings for years 1 through T.

1=1

Further, define YjT = {PjT - Pjo)/Pjo = firm/s market retum over T years, exclusive of any dividends, ZjT = AXJT/PJO = fimi/s aggregate eamings for years 1 through T normalized by market value at the beginning of the retum interval. The Easton, Harris, and Ohlson (1991) cross-sectional regression model can now be expressed by + ^jr, (D

where a^ and Pr are the regression parameters and e^r is a random disturbance term. The subscript T has been appended to the regression parameters to explicate that the regression applies to varying retum intervals. The above model disregards any dividends paid. Easton, Harris, and Ohlson (1991) discuss how one develops altemative modifications of YJT and ZjT to factor in the dividends for the various years dj,. Given that dj, 9^ 0 for some year t, 0 < t ^ T, the model in eq. (1) makes no theoretical sense in a setting of certainty. Referring to such settings, one simple modification of ZjT considers [S(JC,, - dj,)]/Pjo rather than (Sx,,)/P;o- We use both specifications, but provide results only for the former case. At any rate, the exclusion/inclusion of dividends in YJT and ZJT does not materially affect the empirical results, even when one applies the more elaborate schemes used in Easton, Harris, and Ohlson (1991). The Easton, Harris, and Ohlson (1991) paper motivates the above regression primarily by referring to a Hicksian perspective on eamings.

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557

Hicks' concept of (economic) eamings suggests that eamings measure the increment in a firm's value. Thus, one can expect a high correlation between Yjr and Z,^ provided that the differences between a firm's market and book value is relatively small or remains roughly the same across dates. To be precise, if Pj^ - BYjr = Pjo - BV^, where BV,, denotes the book value at date t, then one can put a^ = 0, 3^ = 1, and e^^ = 0 because Yjr = Z,r if one further assumes regular "clean-surplus" accounting, BV.T^ = AX^r + BV,o. A substantially different way of looking at "ideal" eamings views eamings for the current period (such as the current year) as an indicator of the firm's value. This concept of economic eamings has been advocated by Black (1980), in particular. In this case, ideally, />,, = Kx,,, where A T is a constant (Black [1980] suggests it should be 10). It follows that the regression in eq. (1) is misspecified, and one obtains a better model by regressing y,r on x,VP,o rather than^ on AXJJJPJQ. The two approaches differ in terms of intertemporal eamings disaggregation. In the Hicksian case, all eamings are simply aggregated over time (no disaggregation), whereas in the Black case one disaggregates eamings to consider only the last year's eamings. Which of the two specifications best explains retums accordingly depends on the usefulness of altemative disaggregations of accounting data. A subsequent section reports on the empirical results that bear on this issue. The above discussion disregards the fact that one usually specifies regressions explaining retums by referring to the more "modem" concept of

unexpected eamings. That is, retums should reflect only new, or unexpected,
information observed by the market during the retum interval. However, Easton, Harris, and Ohlson (1991) recognize that one can interpret the model of eq. (1) to conform with the unexpected eamings concept. We next reconsider and expand on their analysis in terms of some recent results from Ohlson (1991). Ohlson (1991) shows that in the absence of any anticipated dividends over the interval (0, T), one can approximate a firm's market value at date 0 by using the formula , (2)

where p equals one plus the cost of (equity) capital. Thus, for T large, one obtains Vl = PQ- (Ohlson also shows that one can have cases without approximation error, even when T = \). Using expression (2), and the approximation Vl ~ Po, it follows that
3. Kothari and Sloan (1991) regress retums on XJT/PJO for varying return intervals. However, their motivations for examining this regression appear to be quite different from ours.

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(3)

that is, ZjT approximates unexpected eamings in a ratio form (rather than the usual difference form). If one restricts pj to be the same across firms, then the model of eq. (2), combined with eq. (3), has a straightforward interpretation: The market "buys" future eamings, and the ratio of realized eamings to expected eamings explains the market retum. Of course, the empirical validity of this scenario hinges critically on the market's horizon. In theory as well as in reality, one cannot presume that the approximation Vl = = Po works effectively for horizons (T) of only a few years. It follows that the variable Z,^ may not adequately measure the ratio of realized eamings to expected eamings for relatively short retum intervals. In that case, the estimated slope coefficient p^ will be lower for short intervals as compared to long intervals. Referring to the work by Ohlson (1991), one can focus no less on future expected book value than on expected eamings. Specifically, Ohlson considers the formula Wl ^ p - % ( B V , ) , (4)

and shows that Wl ~ Po for large T. Expression (4) differs from eq. (2) in its discounting of a future expected stock of value rather than a future expected rate of value creation. Equation (4) and the approximation Wj ~ Po motivates a second regression model: YjT = Por + P.72,'r + e,r, (5)

where Z,V = BWJT/PJO and por are Pir are the regression parameters. Similar to the above discussion motivating the regression of eq. (1), one interprets BWjr/Pjo as an approximation of realized book value relative to expected book value (scaled by a constant), and the realization of unexpected book value thus explains retums. Estimations of the regressions of eqs. (1) and (5) raise questions conceming the degree to which they are misspecified. We argue that most, if not all, of these issues can be investigated by disagreggating the eamings and book value variables into their subcomponents. Thus, we work with the premise that the absence of measurement error in the independent variables requires that disaggregation does not improve on the explanatory power of the model. Measurement errors in the independent variables arise potentially because the implied market horizon, T years, is too short, or alternatively, the market perceives deficiencies in some acceptable accounting principles. These aspects are investigated by varying the duration of retum

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559

interval and by disaggregating each of the independent variables into related vectors of independent variables based on components of eamings and book values. Section 3 discusses altemative schemes of disaggregating the independent variables in eqs. (1) and (5).

3. Disaggregation Schemes
This section considers altemative disaggregations of the variables ZjT = AXjjJPo and Z}r = BYjjJPjo in the models of eqs. (1) and (5), respectively. The eamings variable Z,^ permits disaggregation along three dimensions (disaggregation 1, 2, and 4 below), whereas the book variable Z}r permits disaggregation along one dimension (disaggregation 3 below): 1. intertemporai disaggregation of AXT, 2. the disaggregation of AXr into summary line items from the income statement, 3. the disaggregation of BV^ into summary line items from the balance sheet, and 4. the disaggregation of AXr into the first differences in summary line items in the balance sheets at date 0 and date T. The implementation of these disaggregation schemes are discussed next. We further state some testable hypotheses. First, consider disaggregation 1, the intertemporai disaggregation of eamings. In its most general version, for a retum interval of T years such a disaggregation is specified by
T

Yjr = ttr + 2 3*r(V^yo) + ^JT-

(6)

This model reduces to eq. (1) if, and only if, p.^ equals ^rfork = 1 , . . . , r, and Pr is the parameter in eq. (1). Further, note that by comparing eq. (1) to the special case when P^^ = 0 for it = 1,. . . , 7 - 1,
Yjr = ar + ^rAXjr/Pjo) + ^JT, (7)

one can evaluate whether the Hicksian concept of income works better than the concept of annual eamings as a value indicator. The next section supplies the results for T equal to 2, 5, and 10 years. Given the multicollinearity of the independent variables in eq. (6), we do not compare eq. (6) to eq. (1) in its full generality. Instead, we consider the following special cases: For r = 10 years:

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9

(i) (ii) For r = 5 years:

E ^jiJPjo and XjJPjo,

5
10

(8) (9)

Z ^jiJPjo and

^ ^J<JPJO-

(iii)

S Jcy/'yo and x,5/P,o.

*=i

(10)

The specifications in eqs. (8) and (10) evaluate the degree to which the explanatory power increases if one includes eamings for the years that preceded the last year of the retum interval. That is, these two regressions can be compared with the related bench marks as specified by the model of eq. (7). An evaluation of eq. (9) bears on the degree to which accounting eammgs satisfy the Hicksian concept of eamings. That is, the null hypothesis equates the coefficients associated with the two independent variables, in which case the model in eq. (9) reduces to eq. (1). Hence, just as eqs. (8) and (10) rely on eq. (7) as a bench mark, eq. (9) relies on eq. (1) as a bench mark. Second, we disaggregate AXJT/PJO into summary line items in the income statement for retum intervals of 1, 2, 5, and 10 years. In an initial, very simple, model we consider only three independent variables: 1. eamings (for T years) before depreciation expenses, 2. depreciation expense, and 3. total dividends declared. In a more elaborate regression, the summary line items consist of the following six income statement variables and aggregate dividends, for a total of seven independent regression variables: 1. gross margin (for T years), as calculated by sales minus cost of goods sold; 2. operating (periodic) expenses, that is, selling and administration expenses; 3. depreciation and amortization expenses; 4. total tax expenses; 5. all other income items, except for extraordinary or unusual items; 6. extraordinary and unusual items; and 7. total dividends declared. This regression with seven independent variables reduces to eq. (1) if all of the line items lack information content. That is, eq. (1) obtains in

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56]

case the estimated coefficients have (approximately) the same magnitudes with the correct signs. We hypothesize that such a configuration of the estimated coefficients becomes more transparent for the longer retum intervals. This outcome reflects the idea that while some line items may have larger measurement errors than some other items, for long retum intervals such potential measurement errors diminish. Thus, we hypothesize that long retum intervals effectively eliminate measurement errors in all of the individual line items, and aggregate eamings explain most of the variation in security retums. We further investigate the measurement error issue by examining the coefficients for the shorter retum intervals. Accounting theory generally suggests that some line items pose greater measurement problems than others. In particular, one may hypothesize that depreciation and tax expense measurements have greater errors than the other line items. In such a case, it follows that the coefficients associated with depreciation and taxes should be lower (and possibly have incorrect signs) as compared to those coefficients that relate to the other independent variables. Of course, consistent with the discussion in the previous paragraph, only for the longer retum intervals can one expect the differences in coefficient magnitudes to be immaterial. Third, we consider an evaluation of the book value model of eq. (5) and its disaggregation into summary balance sheet items. The model in eq. (5) has not been estimated previously in the literature. Initially, we therefore compare the explanatory power of the book value model to the bench mark

(aggregated) Hicksian model of eq. (1) and the model of eq. (7) in which
last year eamings serve as a value indicator. We hypothesize that the book value model works distinctly worse than these two models retum for shorter intervals, but this differential in explanatory power should diminish as one expands the retum interval. The disaggregation 3 relates to summary line items in the (net) book value at the end of the retum interval (year T). In examining this case, we consider three assets categories, and two liability categories, for a total of five independent variables: 1. 2. 3. 4. 5. working capital; property, plant, and equipment, net of accumulated depreciation; other assets; deferred tax liability; and long-term debt and preferred stock.

Fourth, we consider the disaggregation 4, which focuses on changes in summary balance sheet items. In contrast to disaggregation 3, this scheme relates to a disaggregation of the aggregate eamings (adjusted for dividends)

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EXHIBIT 1 Variable Definitions

Pd Pr X, D,
1/ If

= = = =

Share price at beginning of windows Share price at end of windows, time T Net income (eamings) for year / Dividend for year t
/p \* T p "X/P * O)'' 0

yiD

/p

^_ /)

\IP

XT = XrlPo = Earnings for the final year in the window, deflated by price at beginning of window

IC, BCi ICB, Br

= = = =

Income statement component ilPo Balance sheet component HPQ Balance sheet change component i of net income/Po Book value of common equity at TlPo

In the notation in the tables, the normalization by Po is implicit.

over various retum intervals. We use the same balance sheet categories as in the previous case, except that we take the differences at the beginning and end of the retum interval. However, we also include a "plug" to ensure that the net increase in the book value in fact equals aggregate eamings minus aggregate dividends. (The latter procedure is necessary because the clean-surplus relation is not always satisfied).

4. Summary of Results
4.1 Data and Methodology

We estimate the regressions by extracting data from the Compustat Annual and Research Files for the years 1970 through 1987. Exhibits 1 and 2 summarize the data items and variable definitions that enter into the various estimations. Each cross-sectional regression aligns calendar time. That is, the data includes only December 31 firm-year (FY) end firms, and, in each regression, the calendar periods for retums and eamings are identical for all firms. Moreover, to fully exploit the data we use a moving window approach. It follows that a specific observation may enter several regressions. To illustrate, consider model (1) for 10-year windows. We first estimate model (1) for the 1970-79 period: Yjr = (Ppg - Pj69)/Pj^ and AX^T =
79

eamings^,. In the second regression, we estimate model (1) using data

( = 70

for the 1971-80 period. The process continues moving forward in time to yield a total of nine regressions estimating eq. (1) for windows of 10 years.

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EXHIBIT 2 Component Line Items

Income (ICJ Component gross margin (sales - cost of goods sold) 2 OPEX operating expense 3 DEPR depreciation and amortization 4 TAX all taxes 5 OTHER all other items except extraordinary items 6 XI extraordinary items 7 D dividends 1 GM i i 1 WC 2 3 4 5 Balance Sheet (BC, and ICB,) Component working capital

PPE property, plant equipment OA other assets DEFTAX deferred taxes OLPS other liabilities and preferred stock income-dividends A owners' equity (for balance sheet component of income only)

6 PLUG

All components are normalized by Po and this feature is implicit in the notation in the tables.

An identical sequencing procedure is applied when we estimate the shorter windows. Of course, the number of estimated regressions increases as the length of the window decreases. Exhibit 3 summarizes the number of estimations for each window, and the number of firm-years. By dividing the latter with the former, one obtains the average number of observations used in a regression with a specific retum interval length. (For example, the average number of observations for two-year windows equals 25 769/17 = 1,516). Data availability influences the number of observations in the regressions. Firms with less than 10 years data contribute observations only for the shorter windows. Data availability also slightly reduces the data set when the regressions require balance sheet line items. These aspects could affect the comparability of regressions as one varies the windows and the specification of the independent variables. However, none of the suppleEXHIBIT 3 Data Availability
Window No. of Estimations 18 17 10 9 Number of firms is slightly less for balance sheet component analysis. No. of Firm-Years 28,986 25,769 18,274 9,068

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TABLE 1 Regression Results: Aggregated Earnings and Final Year's Earnings

Window Panel A 1 2 5 10 Panel B 1 2 5 10 a b t(b) Mean R^ Mean Spearman Corr. (Y^rJir)

.077 .151 .354 .474 .050 .089 .373 1.292

.872 .956 1.183 1.702 .869 1.714 3.010 5.030

13.65 16.85 23.24 27.54 13.59 19.82 23.56 24.25

.11 .16 .29 .43 .11 .21 .29 .36

.41 .52 .67 .78

.43 .62 .73 .76

Panel A: >'jT = a ^h b AX,r + eirPanel B: >'L = a -y b X:r + n

mentary tests that control for the data comparability across specifications suggest the occurrence of material biases. The regression results we report make only an attempt to capture the general tenor of the data and how these relate to various hypotheses. The tables that follow supply the averages over the regressions for the estimated coefficients, /^^ and r statistics. We do not report on statistical analyses that bear on the overlapping data sets issue. Nor do we report on various specification issues such as the effects of outliers. Although such matters must

be considered to make precise statistical discriminations across hypotheses,

we emphasize that the results overall show considerable robustness. The fiavor of the regressions reported on have not been biased by "picking the right regressions" out of the many that were estimated. Of course, even though such robustness is present, the results must be interpreted with caution. The latter applies especially when we are concerned with the statistical significance of increased R^ and statistical equivalence in estimated coefficients. We make inferences based on the average across regressions, but we see no reasons why this procedure should lead to significant distortions when one interprets the results.
4.2 Inter-Temporal Disaggregation

Panels A and B in Table 1 present results for the bench mark "Hicksian" and "Black" regressions, eqs. (1) and (7), respectively. Both sets of results show increasing R^ as one expands the retum interval. The Panel A results replicate Easton, Harris, and Ohlson (1991). It is apparent that the two

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5^5

TABLE 2 Regression Results: Time Disaggregation of Earnings

T Panel A 5 10 Panel 8 10 ''' b, ^^ Kb,) ::t(b,) _ MeanR' Mean Spearman Con. (Actual. Fitted)

.398 .434 .629

.860 1.189 .830

2.273 3.686 2.000

13.54 15.15 5.56

17.15 16.88 26.35

.33 .49 .45

.70 .81 .79

Panel A: Yfr = a + b, AX^r - , + bj(jr + WJT. Panel B: Yjr = a + b, AX^, + b. AX,,,, + ,,. AXjT - , is total eamings minus dividends for the window minus the last year's eamings for the window. AXj5 is eamings minus dividends for the first five years of 10-year window. AXjsio is eamings minus dividends for the last five years of 10-year window.

models have almost identical explanatory power for retum intervals of five years or less. However, this rough equivalence in model performance ceases for long retum intervals; 7 = 10 yields /?' of 43 versus 36 percent, respectively. The latter conclusion should perhaps be qualified, because the Black model performs only slightly worse than the Hicksian model if one considers Spearman's rank correlations for {Yj-^, Yjj) rather than the usual R^ (76 versus 78 percent). The results suggest overall that neither model dominates the other in a clearcut fashion. Table 2, Panel A, shows that the Black model, eq. (7), is unambiguously

misspecified since aggregate eamings prior to the final year are almost as
important as the final-year eamings. For T = 5 the two (average) t statistics equal 13.54 and 17.15, respectively, and for r = 10 the two t statistics equal 15.15 and 16.88. For the relatively long retum intervals, at least, one cannot conclude that the Hicksian model is a garbled version of the Black model and works only because pre-final-year eamings have a high correlation with final year eamings. Even so, we note that the improvement on the benchmark Black model, eq. (7), is relatively marginal if one focuses on the change in R^. As one may surmise from the above results, the data no less reject statistically equally weighted aggregation in subperiod eamings inherent in the Hicksian eamings concept. Table 2, Panel B, supplies the relevant results. This table considers the estimations of the regression of eq. (9), which is based on partitioning 10 years of eamings into two subperiods of 5 years each. The (average) coefficient associated with second subperiod of eamings is significantly larger as compared with the first subperiod (2.00 versus .830). The same conclusion applies if one looks at the related (av-

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TABLE 3 Regression Results: Disa^regation of Earnings into "Cash Fiow" and Depreciation
= a + Ci (AX+ DEPR),T + CzDEPf

T + eJT Mean Spearman Corr.

Window 1 2 5 10

c, .924 .973 1.126 1.677

C2

Mean R-' -.521 -.369 -.385 -.989 .14 .20 .33 .45

(yjr.yjr)

.oai
.038 .059 -.059

-.451 -.559 -.818 -1.611

.43 .54 .69 .79

erage) t statistics (26.35 versus 5.56). Nevertheless, this difference should not be overemphasized since the increase in R^ is not ovedy impressive: The restricted, equal-coefficient, model of eq. (1) has an R^ of 43 percent, whereas the unrestricted model of eq. (8) has an R^ of 45 percent. We summarize the results of the intertemporai eamings disaggregation as follows. First, the difference between the Hicksian and Black models is of no significance for shorter retum intervals. Only for long retum intervals can one suggest that the Hicksian model has superior explanatory power. Second, one can improve on the Hicksian as well as the Black model by recognizing that they constitute rather special cases in their treatment of subperiod eamings. The Hicksian model places equal weights on each subperiod's eamings, whereas Black's model puts all the weight on the final year's eamings, but the data reject both restrictions as too extreme. Third, while both models are clearly misspecified, they also serve as useful empirical bench marks because the increases in R^ due to relaxations in restrictions on subperiod eamings are relatively immaterialon the average only a few percentage points.
4.3 Income Statement Disaggregation

Estimations of the model based on only three independent variables eamings before depreciation, depreciation, and dividendsdemonstrate usefully the thrust of the results conceming income statement disaggregation. Table 3 provides the estimations of such regressions for various retum intervals. The coefficients associated with the three variables have the correct signs (positive, negative, and negative) for all retum intervals. This finding is, of course, reassuring. Further, as predicted, the depreciation coefficient is much less than the eamings before depreciation coefficient for the shorter retum intervals. But the percentage difference in the two coefficients shrinks

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as one lengthens the retum interval. In case of a 10-year interval we note that, rather remarkably, the two coefficients are practically identical. This result serves as a powerful illustration of Paton's (1963) concept of the "cash flow illusion." Depreciation expense may involve considerable measurement problems for relatively short periods, but this expense item is no less "real" than other "cash expenses." The negative coefficient associated with the depreciation variable occurs in spite of the variable having a positive correlation with the retum variable. This negative coefficient thus depends on a positive correlation between the eamings before depreciation and depreciation variables. The point highlights that estimated valuation coefficients cannot be inferred from naive statistical concepts focusing on how individual line items correlate with the dependent variable. The joint distribution of individual line items is of no less importance. Needless to say, this aspect applies as well when one considers more elaborate models explaining retums. Tuming to the more extensive eamings disaggregation model with seven independent variables, the results are much the same except that the tax expense coefficient has incorrect signs for retum intervals of 5 years or less (see Table 4). Thus, we note that depreciation and tax expenses have lower (or incorrectly signed) coefficients for the 5 years or less retum intervals, consistent with the traditional perception that these items pose particularly vexing measurement problems. In sharp contrast, the coefficients for gross margin and operating expenses are relatively large, and they also approximate each other to a surprising degree for every retum interval including the 1-year interval. We also note that for retum intervals of 10 years the disaggregation of eamings adds little explanatory power. Overall, the coefficients have approximately the same magnitudes, and the line item model explains 48 percent of the variation in retums as compared to 43 percent for the bench mark Hicksian model, which applies when the line items aggregate. This difference in correlations is even smaller if we consider the Spearman rank correlations between (Yj,Yj) rather than the R^: 79 versus 78 percent (on the average).
4.4 Balance Sheet Disaggregation

We initially consider the aggregated book value model of eq. (5) and compare it to the Hicksian model of eq. (1) and the Black model of eq. (7). Table 5, in conjunction with Table 1, shows that the Hicksian and Black models dominate the book value model for the shorter retum intervals of one and two years. These differences are statistically significant. However, as predicted, for the longer retum intervals of 5 and 10 years there are

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TABLE 5 Regression Results: Final Book Value

Yjr = a + ^Bjr + Pjr Window 1 2 5 10 a -.023 -.095 -.494 -.926 .138 .314 .920 1.535

KP) 6.80 8.42 8.19 6.65

m
8.42 13.76 24.59 29.23

Mean Spearman Corr. Mean R^ .05 .12 .33 .47 .19 .34 .60 .75

practically no differences in the three bench mark models. The R^ is actually somewhat larger for the book value model (47 percent) as compared with the (second best) Hicksian model, eq. (1), (43 percent) when T = 10. But this difference is not statistically significant, and the comparison reverses if one instead considers Spearman rank correlations. Overall, the three bench mark models are strikingly similar in their explanatory power of retums, especially for the "intermediate length" retum interval of 5 years. Looking at the results for the disaggregated book value model. Table 6 shows that the signs of the estimated coefficients are always the ones

predicted by accounting concepts. We also observe a gradual increase in

the absolute values of the coefficients when the retum interval is lengthened. This pattem differs little from the one found for the eamings model with summary line items for the income statement. We interpret the results similarly: the longer the retum interval, the sharper is the discriminatory power of the accounting data. In this context, we further note that disaggregation of the book value has only a marginal effect on the explanatory power when TABLE 6 Regression Results: Disaggregation of Book Value into Balance Sheet Components
Yjr = a + 2J d,BC,,r + p>

a Window 1 2 5 10 -.021 -.097 -.476 -.947

d, (WC) .155 .349 .929 1.513

I
(PPE) .115 .275 .854 1.399 (OA) .139 .337 1.080 1.907

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(DEFTAX) -.068 -.196 -.536 -1.036

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(OLPS) -.127 -.296 -.947 -1.512 Mean R' .07 .14 .34 .49

Mean Spearman Corr. (Y,T,Yjr) .24 .37 .62 .76

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the retum interval is 10 years. The unrestricted model has an R^ of 49 percent, versus an R^ of 47 percent for the restricted model. The results are also, to a remarkable degree, consistent with the notion that the accounting measurement of "deferred tax liabilities" is inherently more complex than the measurement of most other assets and liabilities. The coefficient associated with the deferred tax liabilities variable is always the lowest one, regardless of the retum interval. We finally observe that the coefficients associated with the relatively unproblematic items, working capital and long-term debt, closely approximate each other for all retum intervals. For a 10-year interval they are virtually identical (1.513 and - 1.512, respectively). As one perhaps would suspect, the aggregation principle works effectively for working capital and long-term debt.

4.5 The Disa^regation of Earnings into Changes in Balance Sheet Items The results are predictable and consistent with those previously reported. As Table 7 shows, all of the estimated coefficients have the correct signs,

regardless of the retum intervals. With only minor exceptions, the coefficients also increase motorically with the retum interval. The deferred tax
liability coefficient has the lowest absolute magnitu4e, except for one-year retum intervals. Perhaps most striking, the estimated coefficients have absolute magnitudes that closely approximate each other, even for short retum intervals.'* For T = 10 years, the disaggregated model has an R^ of 52 percent versus 43 percent for the restricted, bench mark, Hicksian model. This difference in explanatory power virtually ceases if one instead focuses on the Spearman rank correlations of (r,,f,) for the two models (79 versus 78 percent). Thus, curiously, the income statement components model in Table 4 has the same (average) Spearman correlation as the changes in balance sheet model (79 percent) for 7 = 10. Only for the shorter retum intervals (T < 5) does the income statement components model outperform the changes in balance sheet components model.
4. The issue of how measurement errors in balance sheet line items affect their related estimated coefficients has an additional twist that differs from the case of the income statement. The possibility of conservative accounting increases the estimated coefficients and thereby potentially reduces the effects due to errors in measurements. In the extreme one can visualize equivalence in estimated coefficients across line items for short intervals, even though the line items have differential measurement error: the latter errors may be (precisely) offset by the degree to which the valuation rule for each line item is conservative. This scenario is, of course, ruled out when one is concerned with the income statement items (at least if one imposes a clean surplus reconciliation).

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5. Condnding Remarks
This paper has examined how disaggregated accounting data explain retums. The development of statistical hypotheses was based on simple ideas: ideal concepts of eamings (the "Hicksian" and "Black" models), the structure of accounting (aggregation in line items and the clean surplus reconciliation), and, more broadly, issues of measurement (some line items in the income statement are more difficult to measure than others). Although our general approach clearly lacks a formal conceptual framework that integrates the informational and measurement perspectives on accounting data, we believe the results are quite compelling. Three aspects of the empirical findings seem particularly noteworthy. First, the estimated effect of a line item on retums depends on whether the line item is an income item (positive) or an expense item (negative). The signs of the estimated coefficients are generally correct, the only exceptions occurring for the more problematic line items (e.g., taxes) when the retum intervals are short. Second, consistent with a naive errors-in-variables perspective on the line items, the estimated coefficients are generally much lower for those line items that are problematic from an accounting measurement perspective (e.g., depreciation versus gross margin). Third, the line item coefficients converge in their (absolute) values as one lengthens the retum interval. This result is particularly interesting since it demonstrates the asymptotic sufficiency of eamings as an explanatory variable for retums: eamings components are measured with increasing accuracy as one lengthens the measurement interval, and thus their aggregation property becomes more workable.

REFERENCES Barth. M. E. 1991. "Relative measurement errors among pension asset and liability measures." The Accounting Review 66 (July): 4 3 3 ^ ^ 3 . Barth, M. E.. W. H. Beaver, and M. A. Wolfson. 1990. "Components of bank eammgs and the structure of bank share prices." Financial Analysts Journal XLVI (May/June): 53-60. Black, F. 1980. "The magic in earnings: Economic eamings vs. accounting eamings." Financial Analysts Journal (November/December): 19-24. Easton, P. D., and T. S. Harris. 1991. "Eamings as an explanatory variable for retums. Journal oJ Accounting Research (Spring): 9-36. Easton, P. D., T. S. Harris, and J. A. Ohlson. 1991. "Accounting eamings can explam most of secunty retums: The case of long event windows." Journal of Accounting and Economics, forthcoming. Kothari, S. P., and R. Sloan. 1991. "The price-eamings, lead-lag relation and eamings response coefficients." Unpublished paper, Rochester, N.Y.: University of Rochester. Lipe, R. C. 1986. "The infomiation contained in the components of eamings." Journal of Accountmg Research 24 (Supplement): 37-64. Ohlson, J. A. 1991. "Eamings, book values, and dividends in security valuation. Unpublished paper. New York: Columbia University. Paton, W. A. 1963. "The 'cash-flow' illusion." The Accounting Review XXXVIII (Apnl): 243-251.

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Raybum, J. 1986. "The association of operating cash flow and accruals with security retums." Journal of Accounting Research 24 (Supplement): 112-133. Wild, J. J. 1991. "Stock price informativeness of accounting numbers: Evidence on eamings, book values, and their components." Unpublished paper, Madison: University of Wisconsin. Wilson, G. P. 1987. "The incremental information content of the accrual and funds components of eamings after controlling for eamings." The Accounting Review LXII (April): 293-322.