‘Journal of Accounting Research Vol A7 No.2 Autumn 1998 Printed in USA Have Financial Statements Lost Their Relevance? JENNIFER FRANCIS AND KATHERINE SCHIPPER* 1. Introduction ‘This paper addresses the concern that financial statements have lost a nificant portion of their relevance to investors.! This concern and its implications for financial accountants, standard-setters, educators, and auditors have given rise to a number of research and policy initiatives whose common goal is to improve financial reporting by altering the current financial reporting model.” Our purpose in this paper is nat to comment on the specifics of any suggestions for changes in the financial “Duke University, This research was supported by the Institute of Professional Account. ing, the Graduate School of Business of the University of Chicago, and the KPMG Peat Marwick Foundation, We appreciate the comments and suggestions of two anonymous re- viewers, Nicholas Dopuch, workshop participants at Chicago, Emory, Harvard, North Texas, and from Andrew Alford, Eli Amir, Dennis Beresford, Charles Boynton, John Elliott, Rabert Elliott, Trevor Harris, Robert Herz, Edmund Jenkins, Deen Kemsley, Peter Knutson, Rich- ard Leftwich, James Leisenring, Baruch Lev, Barry Lewis, Jung Liv, Barbara Merino, Krishna Palepu, and Mark Zmijewski, We also thank Dennis Oswald for excellent research assistance. "Section & discusses this concern, the various ways it has been expressed, and same alternative ways of making the concern operational, We focus on the relevance of finan- ial statement information to inuettors for valuation purposes, ignaring the stewardship uses, 6f accounting information, ignoring the relevance of accounting information (and any changes therein} to other users, such as creditors, unions, or managers, and ignoring ether possible uses by equicy investors (e.g., assesting risk) 2-These initiatives include several academic research projects, the A/CPA Special Com: mittee on Financial Reporting [1994} and its recommendations, the business reporting project of the Finaneial Accounting Standards Board, and the Intangibles Research Center at New York University, a9 Gopyright ©, Indiituie of Profesional Azcounting, 1909320 JOURNAL OF ACCOUNTING RESEARCH, AUTUMN 1999 reporting model; rather our goal is to discuss and test some of the em- pirical implications of the claim that financial statements have lost their relevance over time. We believe our study is pertinent to discussions of proposals for changing financial reporting because the analysis includes a discussion of various operationalizations of the construct “value rele- vance.” This study adds empirical discipline to practical debates over the function of financial reporting by putting forward empirical measures to calibrate the value relevance of reported numbers under the current reporting system; then if changes are proposed (or implemented) for the financial reporting system, there is an empirical basis for assessing whether those changes alter value relevance. We operationalize value relevance in. uwo ways, both of which we be- lieve are consistent with the concern as it has been expressed by others. Our first measure of relevance is the total return that could be earned from foreknowlédge of financial statement information.) Our second measure is based on the explanatory power of accounting information for measures of market value: the ability of earnings to explain annual arket-adjusted returns; and the ability of earnings and book values of assets and liabilities to explain market values of equity, We measure a Joss of relevance as a decrease over time either in the returns that could be earned from foreknowledge of financial statement information or i the explanatory power of accounting information. Both measures are applied to broad samples of exchange-listed and NASDAQ firms, over the period 1952-94.4 The returns-based approach to assessing relevance has been applied in other contexts, beginning with the Ball and Brown [1968] portfolio re- turns tests of the information content of earnings ina pooled time-series cross-section sample and more recently the Alford et al. [1993] eross- sectional tests of the value relevance of earnings in 16 different countries compared (oa sample of U.S. firms. Our version of the approach is use to answer the question: Would investments based on financial statement information earn progressively less over time? The explanatory power approach (in particular, the contemporaneous returns—earnings test) follows directly from Ley's [1989] discussion of the ability of earnings to explain returns as the appropriate measure of the usefulness of account: 1 While we focus on earni the stmmary measure im the financial seater alse perform tests hased on assets aiid liabilities, book values of equity, cash flaws, and a comprehensive measure based on earnings andl nonearnings Financial statement informa: tion shown te be value relevant in some contests (Ley and Thiagarajan {1993]) ‘Collins, Maydew, and Weiss (1997) andl Hly ancl Waymire [1999] abo investigate over time changes in J's, Among other measures, Chang (7999] examines the variance af the log ratio of abnormal earnings-basedl intrinsic value to stock price, He argues that this metric: is superior te the RY measure because iC is based on % multiplicative, rather than an ad- itive, crror assumption. His remlts show_a significant decrease over time ve rele= ‘vance; further tests attribute the difference in his results (relative to this paper and Collins, Maydew, and Weiss [1997]) co the choice of error assumptionHAVE FINANCIAL STATEMENTS LOST THEIR RELEVANCE? 321 ing information. If the relevance of financial statement information has declined over time, we expect to observe a decline in its ability to ex plain the cross-sectional variation in security returns, Relatedly, follow- ing research which models the market value of equity as a function of asset and liability book values, we expect that if the relevance of balance sheet information has declined over time, the ability of these variables to explain market equity values will also decline. OF the two approaches to measuring relevance, we favor the portfolio returns tests because they control for changes in the volatility of market returns over time; the explained variation tests de not. Depending on the source of the returns volatility, failing to control for it could affect the interpretation of results. For example, if the absolute amount of value- relevant information in financial statements is (truly) constant through time, but the volatility of market returns is increasing for reasons that cannot be traced to information sources, the explained variation tests will be biased toward the result that relevance is decreasing over time This is because a greater portion of the variability in the dependent vari- able (market-adjusted returns or market values) will be unexplained by accounting infornvation. In fact, as explained in section 4, we do find that the variability of market returns has been increasing over the sample period. Some observers have attributed the putative decline in the relevance of financial reporting to the increase in relative importance of technol- ogy-based industries for which the current reporting model is alleged to be particularly ill-suited, If this is the case, we expect that any decline in relevance would be most apparent in high-technology industries, where the disparity between what is value relevant to investors and what is in- cluded in financial statements is potentially the widest. To investigate this possibility, we repeat our analyses on two samples of firms selected because they belong cither to high-technology industries (such as phar- maceuticals, computers, and telecommunications) or to industries (such as grocery stores, wood and paper products, and railroads} where, argu- ably, technological change and related omissions of value-relevant infor- mation from the financial statements are less prevalent. The results of our tests show a decline in the relevance of earnings information, and an increase in the relevance of balance sheet and book value information, over our sample period. These results are broadly con- sistent with other research examining the value relevance of financial information (¢.g., Collins, Maydew, and Weiss [1997], Ely and Waymire [1999], Lev and Zarowin [1999], and Chang [1999]).? We observe no consistent differences either in the relevance of earnings, or over time changes in the relevance of earnings, between high- and low-technology firms. Although we find some evidence that balanee sheet information 5 An exception is Chang's finding of « decrease in the value relevance of earnings and book values322 JENNIFER FRANCIS AND KATHERINE SCHIPPER explains a significantly higher portion of the variability in prices for low~ technology firms than for high-technology firms, we observe significant increases over time in the explained variability of this relation for both samples of firms.® Taken as a whole, we view the results as providing mixed support for one of the claims associated with the formation of groups charged with finding ways to improve financial reporting. Our tests do not, however, speak to the question of a current and future threat of loss of relevance. The results, therefore, do not imply that efforts to improve financial reporting are inappropriate. Indeed, be- cause our results indicate that perfect foreknowledge of earnings would allow a user to carn about half of all the returns available in a typical year, there appears to be ample scope for increasing the market share of financial information by increasing its value relevance. Whether this market share can or should approach 100%—that is, whether it makes sense to aspire to a financial reporting system which yields information that completely subsumes all information used by investors—is a ques- tion that lies outside the scope of this analysis. Section 2 discusses the claim that financial statements have lost thei relevance to investors, links this claim to the statistical tests we perform, and summarizes related research, Section 3 describes the two-approaches we take to measuring the decline in relevance and the data we use. Sec- tion 4 reports the results of applying both the portfolio tests and the explained variation tests to the full sample and to the samples of high- technology and low-technology firms. Section 5 concludes the paper, 2. Value Relevance of Audited Financial Statements We begin by summarizing our understanding of calls for changing the financial reporting model and of research which either investigates the claim of reduced value relevance or makes recommendations for addressing the problem-of reduced value relevance (section 2.1). We then describe various empirical interpretations of the construct value relevance (section 2.2), in the context of the discussion in section 2.1. Section 2.8 describes how we construct tests of changes over time in value relevance. 2.1 CONCERNS ABOUT THE FINAN: PROPOSALS FOR CHANGE IAL REPORTING SYSTEM AND. Concerns about decreased value relevance of financial reporting and suggestions for changing the reporting model have come primarily from To the extent that aur high- and law-technology samples differ primarily along the tli- niension of unrecorded intangible assets, our finding of few systematic differences betwee the exo groups is not consistent with results.reported by Collins, Maydew, and Weiss [1997] and Lev and Zarowin {1999}. both of which report that various proxies for the economic importance of unrecorded intangible assets are associated with decreased relevance of fi- nancial informationHAVE FINANCIAL STATEMENTS LOST THEIR RELEVANCE? 323 academic and practicing accountants.” Some of the concerns expressed about the current reporting model (and, by implication, the recom- mendations for change) focus on the content of whatis reported: for ex- ample, it has been. asserted that the current reporting model does not appropriately recognize and measure the economic assets deployed to cre- ate shareholder value. This situation might result either because account- ing standards and practices have remained stagnant while business has changed, or because accounting standards and practices have changed in ways that diverge from providing value-relevant information, or both, Regardless of the cause, the view that the current accounting model has become less useful in terms of what is reported has been expressed, for example, in @ disctission of anditing (similar themes are echoed in Jenkins (1994, p. 80] and Rimerman [1990, p. 79) ange part of the immediate problem [with the market vitality of the audit) is the lim ined usefulness of today’s financial statements. They do not, for example, reflect infor- mation-age asscts, such as information, capacity for innovation, and human resources Asa consequence. they have been a declining proportion of the informabon inpaus 10 investors’ decision making. That translates into a declining share of the information marketplace dor auditors (and, for that mader, financ statements as central to investors’ decisionmaking as they were thirty jears ago, there would be relatively little concern over the vitality of the audit. (Elliote [1995].) | accountants). Were financial Academic research has-also addressed the content issue. For example, Collins, Maydew, and Weiss [1997] conclude that both the increased re- porting of losses and one-time or special items and the increased eco- nomic importance of unreported intangible assets contributed to their finding of a decreased value relevance of earnings and increased rele- vance of balance sheets. Ley and Zarowin [1999] attribute their finding of decreased relevance of financial information to both the increased importance of unreported intangible assets and the failure of the finan- cial reporting model to keep pace with and reflect the increased rate of change in the business environment (e.g. as evidenced by deregulation and innovation). They view losses and special items not as causes but rather as symptoms of the decline in earnings relevance In terms of suggesting changes in what is reported, Amir and Lev (1996, p. 26] conclude their study of the wireless communications in- dustry by recommending that “the required disclosure of new and value relevant variables [such as customer churn rates] should be considered and the accounting rules governing income measurement and asset valuation ... in this industry should be modified.” Lev and Zarowin [1999] call not only for the capitalization of certain intangibles but also for the systematic and continual restatement of financial statements ter Theis interesting that the security analysts interviewed by the AICPA Special Commitee oh Financial Reporting and the AJMA generally did not raise concerns about the (ack ot ) relevance of financial statements, rather they propased certain changes in financial re port- ing rules (cg. inchiding segment data in the quarterly reports)4 JENNIFER FRANCIS AND KATHERINE SCHIPPEI reflect the resolution of uncertainty which existed when the original statements were issued, Other concerns expressed about, and recommendations for chang- ing, financial reporting seem to address the issue of when information is reported, specifically the timeliness of financial reporting and the extent (© which competing information preempts financial statement information.® In a comment which subsumes both content and timeli- ness issties, Elliott and Jacobson [1991, p. 54] assert: “The U.S. financial accounting model[’s] .. . periodic, historical, cost-based financial state ments served the bygone industrial era well but are not sufficient for evaluating information-era companies.” These concerns and recommendations can be grouped into three cat egories. each of which could at least in principal be pursued indepen- dently of the others. First, there is the option of addressing the content issue by altering what is reported without changing the frequency of reports; this option seems ta be consistent with Amir and Lev’s recom- mendations, with some of the recommendations of the AICPA Special Committee on Financial Reporting, and with certain FASB activities (e.g, requiring that certain postemployment benefits be measured and disclosed: requiring disclosure of the cast of compensation paid in the form of stock options; undertaking a project on business reporting)” Second, the timeliness issue might be addressed in isolation by reporting the currently required information more frequently, e.g., every month More frequent reporting reduces the likelihood that other information sources could preempt financial reports, thereby increasing the reports! value relevance. Third, the perspective of the information reported could be changed by requiring, say, continually restated financial statements {as suggested by Lev and Zarowin [1999]) or forecasted financial state- In this context, timeliness is the ability of financial statements to-capture valve-relevant events in the same time period as they are reflected in share returns, Qne reason GAAP financial staterients lack timeliness is the emphasis placed on objectivity andl verifiability, on of certain future economic benefits. On the other hand, these qualities. combined with the audit function, impose a credibility- both of which mitigate against early recogni nhancing discipline on other information disclosed during a reporting period, That is, he canlirmatory role of financial statements ericouirages the disclosisre of mote tiinely valite relevant iiformation, thas adding to the supply of what appear lobe competing information sources. Hence, the more timely information sourcesand the financial statements.are cam- plements not substitutes "iy and Waymire (1999) provide a direct test of whether the FASHs efforts hy ‘creased the value relevance of financial information, relative to the benchmark provided by its predecessar groups (the Committee on Aceaunting Procedure and the Accounting Fria ciples Board), While they nd no evielenee that earnings relevance has increased since the founding of the FASB, they find significant increases in the combined value relevance of earnings and book values since the inception of the FASB: In contrast, Chang [1999] pro- videyeviddence of decreased value relevance of’ accruals in the post-FASE period. an indirect indication that one key component of boch book values and earnings has nor increased in. value relevance.HAVE FINANCIAL STATEMENTS LOST THEIR RELEVANCE? 32 ments, without changing what is reported or its frequency. As with fre- quency of reporting, the greater the “look ahead” value of financial reports, the smaller the chance they will be preempted by other infor- mation sources and the greater their value relevance to investors. Assessing Which of these options, alone or in combination, would do the most to increase the value relevance of financial reports would re- quire benchmarking the current system using an agreed-upon measure of value relevance, implementing the proposed changes, and then re- measuring value relevance. In the next section, we propose several ways of operationalizing value relevance and discuss why we believe our inter- pretation offers the clearest insights on value relevance as it relates to the above concerns. 2.2 ALTERNATIVE INTERPRETATIONS OF V2 UE RELEVANCE, We consider four passible interpretations of the construct value rele- vance. Interpretation 1 is that financial statement information leads stock prices by capturing intrinsic share values toward which stock prices drift, Value relevance would then be measured as the profits generated from implementing accounting-based trading rules. This interpretation can be found in, for example, Ou and Penman (19890; 19895] and Har- ris and Ohlson [1990]. We do not use this interpretation in our analyses both because we de not believe it is the basis for suggestions to change the financial reporting model and because implementing the interpreta- tion necessitates assuming that prices do not reflect intrinsic values but accounting numbers do, Tests carried out under this assumption require numerous adjustments for (or heroic assumptions about) shifts in risk over time, and results typically are confounded by allegations that the researchers failed to adjust appropriately for risk in implementing trad- ing rules. Under Interpretation 2, financial information is value relevant if it contains the variables used in a valuation model or assists in predicting those variables. Thus, the value relevance of earnings for a discounted dividend valuation model, or a discounted cash flow valuation mode discounted residual income model, might be measured by the ability of carnings to predict future dividends, future cash flows, future earnings, or future book values. We do not use Interpretation 2 in our analyses be- cause the predictive ability criterion is only indirectly related to the ¢on- cerns of those who are criticizing the current financial reporting model Interpretations 3 and 4 are based on value relevanee as indicated by a statistical association between financial information and prices or returns Under Interpretation 3, the statistical association measures whether in- Vestors actually use the information in question in setting prices, so value relevance would be measured by the ability of financial statement in- formation to change the total mix of information in the marketplace. terpretation implies that value relevance is measured in terms of implying that value-relevant information changes stock prices ora326 JENNIFER FRANCIS AND KATHERINE SCHIPPER: because it causes investors to revise their expectations. Implementing In- terpretation 3 in an empirical setting requires taking account of the inked concepts of timeliness and expectations formation. To see this, suppose it was found that earnings announcements do not move stock prices very much, This might be because the earnings themselves are mostly irrelevant noise or because the earnings are almost fully antici- pated by investors in the sense that nearly all the information they con- tain has been impounded in stock prices before the earnings are released. In the limiting case, earnings are perfectly predictable and there is no price response when they are announced. Earnings can be predicted by investors using past financial statement information (see, e-g., Ou and Penman [19894; 19896]) and/or other in- formation, including various disclosures made by, for example, managers, analysts, and government agencies. We argue that many of these disclo- sures would cease if financial statements were issued more frequently.!” To put this another way, the perceived importance to investors of finan- cial information drives at least some portion of the disclosure activity that preempts disclosures of the financial information itself. To the e7 tent that earnings predictions become more sophisticated and accurate over time, the news content of the earnings announcement per se will be reduced. This does not imply, however, that investors are uninter- ested in carnings: they may he so interested that they have developed complex and highly accurate mechanisms for predicting them or have suceceded in inducing managers and others to issue more timely earn- ings information to improve these predictions, We believe that Interpretation $ confounds the question of whether investors care about the content of the financial statements with the limeliness/predictability of that information, We are unable to design an empirical-archival study which controls far ane concept while mea- suring changes ever time in the other; absent such controls it is difficult to draw inferences about whether a deficiency in the content of finan- cial reports or the greater timeliness/ predictability of competing infor- mation makes financial statements less useful to investors, A statistical association between accounting information and market values or returns, particularly over a long window, might mean only that the accounting information in question is correlated with information used by investors (Interpretation 4).!! Under this view, value relevance is "We do: not analyze the teehni¢al and ather obstacles to shortening the reporting in- terval; our purpose here is simply to note What might be some effects of doing so. "IE the statistical association berween) returns (prices) and financial information is de- creasing over time, itis hard (o argue that the value relevance of the information is increas- ing. However, the statistical association can increase (because the financial information is correlated with ether information that is being increasingly used by investors) even if in vestors are using less of the financial information itself.HAVE FINANCIAL STATEMENTS LOST THEIR RELEVANCE> 327 measured by the ability of financial statement information to capture or summarize information, regardless of source, that affects share values. This interpretation (which is the one we use) does not require that finan- cial statements be the earliest source of information, It is consistent with the value relevance of financial reports stemming from cither the content of the financial statements themselves or a settling-up role (discussed in n. 8), in which the audited financial statements discipline other, more timely information disclosures such as management earnings forecasts, An alternative to the informational framework for our association tests is to use a valuation framework, The discounted residual income model, which describes intrinsic values as the sum of current book value and the infinite sum of furure expected earnings in excess of the cost of capital, might seem to be particularly well suited for this purpose be- cause the model uses accounting numbers directly (as opposed to using dividends or cash flows), In a valuation framework, shifts in value rele- vance would be assessed by testing for shifts in the ability of residual- income-based estimates of intrinsic value to approximate observed market values.!® Assessing value relevance based on discounted residual income valuation, Chang [1999] concludes that the combined r ings and book values has decreased over time, 2.3 CONSTRUCTING TESTS FOR CHANGES IN VALUE RELEVANCE Consistent with Interpretation 4 we use long-window (15-m« folio tests and explained variation ( th) port: 2) in long-window regressions as ‘our statistical association metrics. These metrics meastire value relevance as the portion of total returns that could be earned from financial state ment information and by the percentage of cross-sectional Variation in yeturns or market values explained by financial statement information ‘We calculate both the R® and total portfolio return metrics for the fiscal years 1952-94 and use three approaches to test for a decline in each metric. First, we test for a general decline over the entire sample period us- ing both OLS and rank regressions. The latter imposes no particular functional form on the relation of the value relevance metrics to time, whereas the former imposes a linear relation, The rank regression ap- proach has the particular advantage of capturing a nonlinear decline in yalue relevance which might be confined to only one subperiod of our sample period. While the commentators on declining value relevance do not specify the exact period over which the alleged decline has occurred, 2 Assessments of valuc relevance based on valuation models necessitate assuming market values and intrinsic values measure the same. construct, and they confront the surement iswe of developing a proxy for expected future residual income over an inelefinive hhorizon. This measurement issue is direetly related to the predictive ability criterion which ‘underlies our Interpretation 2 of the value relevance construct,328 0 JENNIFER FRANCIS AND KATHERINE SCHIPPER the relatively recent origin of the debate suggests that whatever decline exists may be confined to, or particularly prominent in, the later years in our sample.!8 Second, given arguments that one key cause for declin~ ing value relevance of financial information is the way the accounting model accommodates innovation, we test for declines in value relevance for subsamples of high- and low-technology firms. Finally, to address concerns that changes over time in sample composition may influence the results, our third approach tests for relevance for NYSE firms only, SDAQ firms only, and firms with data available for all years.4 Our analyses take the form of tests for the sign but not the magnitude of slope coefficients in regressions of value relevance metrics on time metrics, Evidence consistent with a decline in value relevance would be provided by reliably negative slope coefficients, while evidence inconsis- tent with declining value relevance might take the form of either reliably positive slope coefficients (indicating an increase in value relevance over lime) or coefficients which are not reliably different from zero. In the latter case, a failure to reject a null hypothesis of no association between a value relevance metric and a time metric provides the evidence of changes in relevance, raising questions af the power of the test. The power of our tests isa function of our empirical interpretation of value relevance, the value relevance metrie we use (long-window port folio Yeturns versus long-window explained variability), and the empirical specifications estimated, In particular, the rank regression specification is often viewed as having lower power than a specification which imposes a particular functional form for the estimation. Since we have no cor ceptual or other basis for favoring one functional form over another, the rank regression provides a reasonable compromise between power and the risk of imposing an incorrect functional form. To assist in interpret- ing the rank regression results, we also provide OLS results and results from a regression which specifies a particular nonlinear relation between lime and the value relevance metric.!" "tn fact, while some might predict that the initial eflarts of the Accounting Principles Board (APB) and the FASB Io tighten the cules and reduce the number of allowable alter natives might have inereased value celevance. Ely and Waymire (1990) fine evidence that the relevance of earnings did not increase during the efforts of either the APor the FASB, but the combined relevance of carnings plus book yalucs did, while Chang [1999] reports evidence oF decreased value tetevance of aceruals in the post-FASB era "14 fonrth potential Lest would segment the sample in terms of before sind after a shift in the development and tive af information technology as a productive asset. We do not undertake this test berate we have not been able to identify any objective basis for chous- ing a vear when this shift occurred. "We thank an anonymous referee for suggesting this particular nonlinear specifica: tion, which includes an intercept, time, andl time squaredHAVE FINANCIAL STATEMENTS LOST THEIR RELEVANCE? 329 As previously noted, we favor the portfolio tests over the explanatory power tests because the former control for changes in the variability of returns and the latter do not.!" However, it might be argued that value relevance consists of explaining a reasonably high and constant percent- age of the total variation in returns, regardless of shifts in that yariation We believe this argument has greater empirical content when returns vari- ability that is not explained by financial reporting information is driven by information which at least in principle is competing with financial statement information for market share (e.g., analyst foreeasts and re- ports), We are not aware of any evidence to support the view that i creased returns volatility (which we document in section 4,2) is due to competing information sources, Instead there is some evidence which Suggests that a substantial portion of the variability of returns is not explained by news events, To illustrate, Mitchell and Mutherin [1994] report correlations between news announcements on the Dow Jones News Wire and three measures of market activiry; trading volume (correla- tion is 367), absolute value of market returns (correlation is 055), and summed absolute value of firm-specific returns (correlation is .112).!7 While these correlations are highly statistically significant, they do not indicate that news is the primary explanator of market activity. 3. Measuring Changes in Value Relevance 3.1 PORTFOLIO M EASURES The first measure of relevance (the “portfolio measure”) focuses on the market-adjusted returns which could be earned based on foreknowledge of accounting information during 1952-94. The marketadjusted return on security j, R,y, is defined as the compound (with dividend) return minus the return on the equally weighted market portfolio. To enhance comparability of our results with those of Alford etal, [1993], all returns are computed over the 15 months beginning in the first month of the firm's fiscal year. We compute the 15-month marketadjusted returns to five hedge portfolios formed on the basis of accounting information: 1. SIGN-SEARN,, refers to the hedge portfolio formed om the basis of the sign of the change in earnings before extraordinary items in year f, EARN,, Specifically, we take long positions in stocks when WW Ayother reason some might favor the portfolio teturns tests, at least when the market metric is equity market value (as opposed (6 returns), is a concer that R? in a regression fof equity marker yalue on accounting variables is sensitive to firm size, with larger firms having an inappropriately disproportionate influence, Chang [1909] points out that this concern is problematic when the sample distributions differ through time F-The paper uses a varicty of specifications to test for a relation between various mea- sures of market activity and news, including specifications which control for the impor- tance of the news announcements Inferenses are robust across these specifications.330 JENNIFER FRANCIS AND KATHERINE SCHIPPER AEARN,, = EARN, ,- EARN, is positive; we take short positions in stocks when AEARN;, is negative This portfolio approximates the approach to- assessing the usefulness of earnings information developed by Ball and Brown [1968]. This measure extracts only the sign of earnings changes from thé total available information in financial statements, ignoring magnitudes of changes and non- earnings information. 2. AEARN, refers to the hedge portfolio formed on the basis of the sign and magnitude of AEARN, . Specifically, we rank firms each year by the change in earnings (deflated by beginning-of-year mar- ket value) and form an equally weighted hedge portfolio that is Jong in stocks with the highest 40% of AEARN,, and short in the lowest 40%. This measure, which is similar to that used in a cross- country comparison by Alford et al, [1993], considers both the sign and the magnitude of the earnings change, 3. ACASH, refers to the hedge portfolio formed on the basis of the percentage change in cash flows (as a percentage of beginning- of-year market yalue).!® Following Lev and Thiagarajan [1993] we mcasure cash flows as net income before extraordinary items plus depreciation and amortization expenses plus deferred tax expense plus minority interest, less the change in working capital. We rank firms each year by ACASH; ; and take long positions in stacks with the highest 40% of ACASH, ,and short positions in the lowest 40%. 4. RATIOL, refers to the hedge portfolio formed on the basis of fun- damental values derived using Lev and Thiagarajan’s [1993] fi- nancial ratio model. Specifically, for each year in the sample with available data, we estimate the following regression: o Ri = Gout E ahelhe + 80 a where Ft, = value of financial signal k for firm jin year 1!9 We ex- amine the ten signals included in Lev and Thiagarajan's [1993] reduced model Returns to the ACASF hedge portfolio can be viewed asa lower bound on the value rele evance of accrual accounting information. Subsequent tests show that the returns wo hedge porifolias based on accrual accounting information (such as AEARN) are 2$ times the returns to AGASH, suggesting thar the value relevance of accrual accounting is significant. "We estimate the financial signal coefficients within sample (i.c., coefficients from year (data are used te form portfolios based on year fratios). This approach abstracts, ax much as possible, from the effects of predicting the appropriate coefficients for a given set of ra- tios, It doesnot, however, take aecount of either estimation error in the estimated relation or changes over time in which ratios are most likely to be value relevant. From previous research (e.g:, Ow and Penman [1984q; 19894) and Hoithausen and Lareker (1982]) itap- pears there may be substantial over time instability in the relation between particular sets fof accounting ratios and share recuensHAVE FINANCIAL STATEMENTS LOST THEIR RELEVANCE? 331 5. RATIO2,refers to the hedge portfolio formed on predictions based on the following returns—book value and earnings regression: Rie = You? Ty AEARN,. + to,cBARN; «+ 74 BV; + Gp (2) where &;, = the cumulative market-adjusted return on security j over the 15 months ending § months following the end of fiscal year & AEARN, .= firm j’s earnings before extraordinary items in year tminus its annual earnings in year t~ 1, deflated by the market value of equity at the end of fiscal year ¢~ 1; EARN) -=firm j's earn- ings before extraordinary items in year ¢ deflated by the market value of equity at the end of fiscal year t~ 1; BY, ,= per share book value of firm j's equity jat the end of fiscal year t, Using the yearly coefficient estimates, we rank the observations in year (on the basis of their predicted values of the dependent variable, R,;, The RATIO2 hedge portfolio takes long positions in the highest 10% of the predicted values and short positions in the lowest 40%,2° For each accounting-based hedge portfolio and year, we also compute the market-adjusted returns to a perfect foresight returns-based hedge portfolio. This portfolio takes long (short) positions in the stocks in each accounting-based hedge portfolio with positive (negative) 15-month market-adjusted returns, The market-adjusted recurn on this rewurns- based hedge portfolio in year ¢is denoted RET/, where H denotes the type of accounting hedge portfolio, We scale the accounting-based hedge portfolio returns in year ¢by RET (0 control for time-series differences in the variation in market-adjusted returns.2! The resulting scaled me sures describe the proportions of all information in security returns that are captured by the accounting-based measures. We also calculate a RATIOS measure, based on the regression of returns on earn, ings. change in earnings, asscts, and Habilties. Results (not reparted) are similar to those ‘obtained using RAT/O2 Another possibility, which we do not examine, isa hedge portfolio ‘based on perfect foreknowledge of rem on equity (AROE). Chang [1999] reports a significant over time decrease in the returns to the ARGE bedge portfolia. This result is con+ sistent with the decline in returns documented for our RATIO2 hedge portfolia, which, like the AROE measure, captures both earnings and book values. In their analysis of across-countty differences in perfect foresight earnings-hased hedge returns (analogous to our AEARN hedge portfolio). Alford et al. (1999) scale by perfect foresight semurns to control for across-country differences in the variability of marketadjusted returns. Their perfect foresight returns portfolio ranks firms based on their 15-month market-adjusied rettans and forms an equally weighted hedge portfolio that is long in the highest 40% and short in the lowest 40%, We adopt a similar procedure to contral for differences in the vartability of market-acljusted recurtts over time, Our per- fect foresight returns portfolio differs from Alford et al’s, however, in that we take posi- tions only in the stocks ineluded in the accounting hedge portfolio. and we take long (shart) positions in stocks with positive (negative) returns. As discussed in section 44, the results are not driven by this specification.382 JENNIFER FRANCIS AND KATHERINE SCHIPPER 3.2 EXPLANATORY POWER OF ACCOUNTING INFORMATION FOR MARKET MEASURES Our second approach to measuring relevance examines three con- temporaneous relations between market value measures and accounting nformation, The first relation investigates the ability of earnings to ex- plain market-adjusted returns (“earnings relation”); the second exam- ines the ability of assets and liabilities to explain market equity values (“balance sheet relation”); and the third examines the ability of book values and earnings to explain market equity values (*book value & earn- ings relation”). The earnings relation we estimate follows Easton and Harris [1991], wherein we regress market-adjusted security returns on the change in earnings and the level of earnings (both before extwaor- dinary items), Specifically, we estimate the following regression for each year in our sample period: : Ris = Por * Pi ABARN), (+ py .EARN, (+ Yr (3) The second relation we estimate is based on a firm's equity at time ¢ being equal to its assets at (minus its liabilities at time & MVj¢ = my + ASSETS, ; + 1p, LIABS, p+ B5,, (4) where MV), = per share market value of the equity securities of firm j at the end of fiscal year & ASSETS, = per share book values of firm j's total assets at the end of fiscal year f and LIABS,, = per share book value of firm j’y total liabilities at the end of fiscal year Because data on the book yalue of total liabilities (Compustat data item #181) are not available for any of our sample firms prior to 1953, we estimate (4) for each of the subsequent years 1 The third relation is:* MV je = bay + 81 Ba 19 BARN, + 8h (3) To ensure that the results of estimating expressions (3), (4), and (3) are not sensitive to extreme observations, we eliminate the extreme 1% of each variable and remove any observations which the Belsley, Kuh, and Welsch [1980] diagnostics indicate are influential observations (stu- dentized residual greater than 3 or Cook's D statistic greater than 1) 3.3 SAMPLE The (full) sample consists of all firm-year observations with available CRSP and Compustat data. The CRSP data files contain monthly return nts of this model have been used by many researchers. e.g., Barth and MeNich- ols (19195) #8 We are grateful to Trevor Harris for suggesting this specification. [i has been used in a cross-sectional research design by, for exainple, Barth, and Landsman [1996] in a time-series research design by, for example, Collins, Maydew, and Weiss [1997], who obtain results that are qualitatively similar to ours.HAVE FINANCIAL STATEMENTS LOST THEIR RELEVANCE: 338 data on both market indices and New York Stock Exchange listed firms sinee 1925; American Stock Exchange listed firms were added in July 1962; and NASDAQ traded firms were added in December 1972, The ear- liest year for which we have Canpestat data is 1950, Because the cash flow portiolio requires two years of lagged data, we begin the sample with the 1952 fiscal year, Our sample ends with 1994 The number of securities in the hedge portfolios differs over time— most notably sample size mcreases with the inclusion of NASDAQ firms in fiseal year 1974—as well as across the hedge portfolios formed within a given year, For example, the second column of table 1 shows that the number of securities in the SIGN-AEARN hedge portfolio ranges from 893 in 1952 to 4.831 in 1994. The number of secu the AEARN hedge portfolio and the ACASH hedge portfolio (not reported) is about 80% of the number in the SIGN_AEARN hedge portfolio (recall that the AEARN and ACASH portfolios exclude the middle 20% of observations). The RATIO? portfolio contains between 1,460 and 1,884 securities each year between 1974 and 1994, while the RATIQ2 portfolio contains be tween 274 and 3,624 securities over 1953-94. Hes: AL Resilts This section reports the restilis of portfolio returns tests (section 4.1), explained variability tests (section 4.2), tests conducted on samples of high-technology and low-technology firms (section 4.3), and sensitivity checks (section 4.4). 4.1 PORTFOLIO TEST RESULTS: each year, table 1 shows the mean market-adjusted return to each accounting hedge portfolio (denoted %) and the proportion of the market- adjusted return (0 the returns-based hedge portfolio explained by each accounting measure (denoted % mkt}. The average market-adjusted return across the entire sample period is about 14% for the SIGN_AEARN port- folio, compared to 20% for the AFARN portfolio, 6% for the ACASH part- folio, 17% for the RATIOL portfolio, and 18% for the RATIO2Z portfolio, The “ mid results indicate that about 45% of the total perfeet foresight re- turns are available to investors with advance knowledge of the sign of the earnings change; knowing both the sign and magnitude of the earnings change yields, on average, 59% of the total available return. In contrast, knowledge of the change in cash flows (ratio signal) earns 18% (52%) of these returns?! Knowledge of book value of equity plus the level and change in earnings (RAT/O2) earns about 61% of total perfect foresight returns, The average values of the Sout remen mesic for the AEARN hedge portfolio are comparable to the range (49% wo 50%) reparted by Alford et al: for U.S, firms,JENNIFER FRANGIS AND KATHERINE SCHIPPER 4 = ssp Sl goss ozs Ful Rast wes gel BFS 699 GL ORS os SSL REET 1e9 ORT Fes'T £89) SLL ORe'T 969 BOR BOTT £09 ost OOr'T Slt oLe Be0'T TL9 SLL 996 09 68s OIG Fes o9%L OCH ; VEL 894, BIL gr SIL Bah ol URL £OL re vst eal PEL a8 wit % 8 con, wbo-zeat yunyy’ 1 aTaVvi335 HAVE FINANCIAL STATEMENTS LOST THEIR RELEVANCE: wat aL vet sana sb sash a6" she‘ uge'F zee'P ‘ope'F eat Le0'r “oFo'r tos’ R0'e 6r0's se" oas's sae'e 85's ons SIAMVAV-NDI RL6L 2u60336, VNIFER FRANCIS AND KATHERINE SCHIPPER 90.0 5 800 + 100 0 50.0 ae 40.0 30.0 + 20.0 10.0 00 LPP EPP LE LLP LE SH FIG, 1, -EAURN' 9 mk ‘To investigate whether the marketadjusted returns to the accounting- based hedge portfolios have declined over time, we estimate equation (6a) for each of the mA! measures reported in table 1 (figures | and 2 depict this relation for the AFARN and RATIO2 measures, respectively): Se talily Po + By tv, (6a) where (refers to the sample year; ¢= 1 1952 1994. Table 2 reports coefficient estimates (significance levels) for the raw (i.e., the OLS) regression of equation (6a), and for the rank regression which replaces the values of the dependent and independent variables by their ranks. Relative to the raw (OLS) regression, the rank regression allows for unspecified nonlinearities in the relation between Simké and un nd, because it uses only ranks of Variables, it eliminates the influ- ence of outliers. We also report in table 2 coefficient estimates and sig- nificance levels for the following nonlinear specification: 43 corresponds to years Jomkt, = By + ByO+ BoP y,. (66) Consistemt with the average portfolio returns noted in table 1, the in- tercepts in the raw regression results indicate that perfect foreknowl- edge of accounting information earns between 17% and 66% of perfect foresight returns, depending on the type of accounting information used. We observe significant (at the .00 level) declines in the returns toHAVE FINANCIAL STATEMENTS LOST THEIR RELEVANCE’ 337 80.0 70.0 60.0 a 400 300 4 200 1009-$————_—— 0.0 PEP PP ESE SLE EHP S Fi. 2— RATIO? % mkt TABLE ? ‘Tasty of Over Fre Differences in Market-Adjasted Returns fo Accounting: Based Helge Portfulins, 19528" eRetwrne Defloted ly Perfect Fonsight Returns) Raw [Rank] Regression Results! Pocifol Po fy fh Regression Results? Tao COO 7 (15 37 (00) [-0.2087 6.19) AEARN 4.662 (HIF “0.0092 00) 0.8101 00) HOSS. 4.8) -0.0002 (08) [-.5651 (.00)) ACASH O74 (AHI) 0.0004 (67) O.214 4,00) MHS (16) 4.000] (.12) [0.0858 (.72)) RATION 0.588 (AM) N54 (00) O77 4.00) —0.0040 (87) 0.0001 (7: [-0.7889 (,00)) RATION OGTR) 0.0082 (00) 0,602 ¢.00) =0,.0012 4,73) a.6000 [-0.4859 (,00)) Tahle | Tor deseriptions of the accounting hedge ponalion MWe repure coefficient exiaates ‘significance levsi} for raw [eamh] regressions: Seay = fy © Hye + vy Where % wf 6 the market-tdjusted retura on the noted aecourting>-based heelge portfolin in year f deflated by the returns to the revuraebused portiole in year fj and t= 1... 4) corresponds tv the sample years 1952... 1994, The rank regression replaces the Yalues of the dependent snd! independent Variables wih shetr vans. Hecité the fatercept in the rank regession ia jose the average the ranka, we do not report it. We al report cocthiciont estimates (significance levels for Ihe rave regression: SSmbt, = By +0 +P:388° JENNIFER FRANCIS AND KATHERINE SCHIPPER three of the five accounting-based hedge portfolios (AEARN, RATIOL, and RATJO2) but not to either the S/GN-AEARN or the ACASH port- folios. Results for the nonlinear OLS regression (equation (65)) indicate no statistically reliable change in Yomkt over time and one statistically re- liable change in the rate of change (for the AEARN portfolio). These re- sults indicate that for some financial statement metrics there has been a statistically reliable decline in value relevance. Figures 1 and 2 give a sense of the nonlinearity of this decline and the volatility of the account- ing—retums relation, for the AEARN and RATIO2 measures. 4.2 EXPLANATORY POWER OF ACCOUNTING INFORMATION Table 3 reports estimated coefficients and explained variation by year for expressions (3), (4), and (5). The number of securities in the annual regressions ranges from 377 in 1952 to nearly 4,500 in 1994. For the earnings relation, all slope coefficients are significant at the .001 level; the adjusted R's of the yearly models range from 5% to 46%, with the earnings variables explaining an average of 22% of the variation in mar- ket-adjusted returns, For the balance sheet relation, all slope coefficients are significant at the .O1 level, and their signs are generally consistent with investors placing: a positive (negative) Weight on the book value of the firm's assets (liabilities), The adjusted R's of the yearly balance sheet models range from 6% to 68%: on average, the book values of assets and liabilities explain 41% of the variation in equity market values. For the book value & earnings relation, the average coefficient estimates indi- cate that $1.00 of book value (earnings) corresponds to $0.25 ($6.70) of market value. While the yearly coefficient estimates deviate considerably from these averages (for example, the coefficient on book value ranges between -0.13 and 0.97), the explained variation of this model is more stable, with an average of 62% and a range of 47% to 78%. Figures 3, 4, and 5, which display the over time patterns of the ex- plained variability measures, show a distinct decrease (increase) in the adjusted AR? from the earnings relation (balance sheet relation) and a less obvious upward trend in the adjusted K* from the book yalue & earnings relation. We test the significance of these over time patterns by estimating the following raw and rank regressions: ADP-RY = 8g + 88+ E, (7a) ADJ-RE = 09 + 040+ Ogi? +E, (70) Turning first to the results for the earnings relation (table 4), we see that the intercept in the raw regression indicates that after controlling for time, the level and change in earnings explain on average 31% of the variability in market-adjusted returns each year; there is also a significant {at the .00 level) decrease in explained variation over time. The estimated magnitude of this decline (as indicated by the raw regression results) is about 4% per year; over 43 years, this implies an average decline of ahout 17 percentage points,HAVE FINANCIAL STATEMENTS LOST THEIR RELEVANCE? 339 TABLE 3 Gontemporensous Reiasions bedeaeen Market andt Accounting Mesures, 1952-049 Baok Valve & Earnings Relation Balance Sheet Relation Earnings Relation nb “BEARN EARN Adj RE ASSETS BABS Ad) REV EARN adj 37 139 Ti 0.87 da nla nia ale ava nla 383183088 O12 O31 1b 0,88 OGL 507 48 399 072-248 O45 097 0,88 ogo 8.97 0.61 AIL LAS 1.07 049-037 0.20 m2 868 0,65 44 2101.85 025 012 Old $009,050.89 445 4501.08 “003 0.16 oo6 796 O57 47. 0142.38 “0.02 0.10 -9.03 1089 O58 4840179072 0.00 008-08 115 Oe 509 2688.15 0.15 0.060 0.09 10.58 O47 585 «105210 “0.07 017-011 1881 058 825 1304.66 019 019-015 1050.68 1968100214 2.09 -0.30 0.40 000 1241076 16d 1180.97 0.45 0.00 1188 O74 1965 «1914 «8031.38 oat 0.07 120371 ee a) 033-008 908 O59 Io67 1,375 2491.60 0.38 100 10.85.87 19681408 3.90 2.06 0.28 OM 1017 0.54 1969159) 3.02 $46 0.22 005 B84 050 1970 1,680 0.98485, 0.38 O1s 784 0,56 177521488 a9 O08 859° 0.58 19721850 1.85818 052-008 9.76 1731911 Ler 1.68 0.36 002 611 OB 1974 303K 0.16 0.96 45 O18 0.58 197) 3,174.85 O48 49 024 061 1976 3,188 0.33 ORR 56 024 070 1977 S216 048 OI O57 0.29 0.78 197880769 52 O10 69 1979 809.764 OAT 07 0.68 1980 3.084 O5E 088 ol 004 1981 31840858286 49 0.20 62 1982 3.394 0.98 OHNE 047 0.59 19833449047 5H O16 0.56 0.65 W8t 3,788 O82 8 048 07% 1985 3,777.13 TF RO 0.78 073 1086 3,798 02062 089 cr en 071 1988 4.06117 79.18 078 1989 8,957.20 078.18 081 074 1990 8.946 025 OL O18 0.67 170 1901844 Be sh06 oat 0.66 1902 4,089 0.82085 (0.08 0.90 0.65 1903 4,999 044 50.11 097 06s 19944493 0.37 OH O.16 078 0.65 Average 110138082 0.70 0.64 025 0.62 We report dhe coefficient estimates for the following reavessions, rail separately for each year Earnings relation: = poy + 01yAEARNG. + py EARN ps7 Xp Balance sheet relation BWV = Nyy + ASSETS 5 + me LEABS, +6, Book value & earnings velation: MU, = Byet By BV i+ FepEARN, + 8, there ft, = the cumulative market adjusted return on security jever the 15-month period ending 8 months following fiscal year (; AEARN,, = firm j'-carningr before extraordinary items ih year [minus At earnings in year !~ 1, deflated by the mur Ket value of equity at the beginning of fiscal year 1: BARN, = firm J's earnings before extranreinary items in year ¢ deflated by the maskerwalie of equity atthe beginning of year f; AV, = the per share market value of firm js equity securities atthe fend of fiscal year f: ASSETS (JABS), = the per share book value of firm j's asset (Viabilitcs) at the ead of fiscal year ¢;and 2V;,= dhe per share book value of equity for fem j atthe end of fiscal year. The row labeled average shows the mean of the -yelrly Coefficient estimaics and the. yearly pdjunted R's mis the number of obscrvations uscd to eatimate the earnings relation. ‘The sample sixéa.ave similar for both the balance sheet relation and the book value & earnings relation,3400 JENNIFER FRANCIS AND KATHERINE SCHIPPER 0.30 os 0.40 035 0.30 02s 0.20 bas 0.0 bos 9.00 CLEP HOPE LEE LO ESS Fic. 8 —Earnings relation adjusted R2 PES KL OSHS PLS Fic. 4—Balance sheet relation adjiniwed R2 0.90 5 (88 $a 070 + 0.60 + 0.50 + os — 0.39 —__— 9.20 <——______ °8 000 ms PPP PKS L EL LP HESS Fic. §.—Book value & earnings refation adjusted AtHAVE FINANCIAL STATEMENTS LOST THEIR RELEVANCE? 341 TABLE 4 ver Tione Changes in the Ability of Accounting Enfirrmadéon to Explain Variation in Mavhet Measures, 125284 Dependent Variable: Raw [Rank] Regression Results ‘Raw Regression Resulix Adjusted 0 a) ay 8 e Earnings Relation @312(00)—-W.0041 (00) 0272 (00) GOOIE 7) _—H.ONOT | Oa [-0.6280 (00)] Balance Sheet Relation 0.119 4,00) Q,0154 (,00) 0.082 (07) 0.0186 (,00) 0.0001 6.27) (0.883 (.00)) Book Value & 01545 (.00) 0,087 ¢.00) 0.558 (,00) 0.0019 (.64) 0.0000 (.665 Earnings Relation 10.5380 (009) WW FepOrt coctficlent estimatex Giguifiance levels) (or raw [re the adjusted explained Yarlation of the returny~earnings eyeesi [egfenions of ADIRE=Ry = 8))> Sy where ADE vt year #(or the ajiaied explained variation of the bab the book value & een for year th; al = inice sheet relation for-year (or the adjusted explained variation « 1, a8) cbriesponds to ibe astuple yeuis LOS. 1004. We also tepir regression: ADL RP = ty +), + BE + 8, igs el eaafviene 10 {significant levels) fee the rate Tn contrast to the decline in the ability of earnings 10 explain market- adjusted returns, the results of estimating (7a) using the éxplained variation either of the balance sheet relation or of the book value & earnings relation as the dependent variable show no evidence of a de- cline in value relevanee—in fact, if anything, there has been an increase. Both the raw and rank regressions (but not the nonlinear OLS specifi- cation) indicate an increase in the adjusted Rs of both the balance sheet nd the book value & earnings relations {significant at the .00 level), On average, the estimated magnitude of this increase is about L3% per year (about 57% over the sample period) and about .37% per year (about 15.5% over the sample period) for the balance sheet and book value & earnings relations, respectively. ‘As previously noted, changes over time in the volatilit turns, unrelated to the absolute usefulness of accounting information to investors, could induce the appearance of over time changes in the rel- evance of accounting information as measured by explained variation, even if there is no change in the absolute amount of information.?* When the absolute amount of yalue-relevant information in financial statements is held constant, increasing (decreasing) market returns volatility biases the explained variability tests toward a finding of declining (increasing) relevance. ‘To test for an inerease in market volatility, we computed the variability of 15-month returns for the equally weighted and value-weighted market portfolios for each year, 1952-94, and regressed these volatility measures of market re- #8.Ay discussed im sectidn 2, an altemative approach ix to define the over time bench- mark for value relevance as the ability of ikancial statement information to account for or explain a constant percemiage of total returns, regardless of the level or volaulity of thove returns, and regardless of Whether the volatility is eaused by identifiable information sources ar something else,$42 JENNIFER FRANCIS AND KATHERINE SCHIPPER on time, We find.a significantly positive (at the ,08 level) slope coefficient for both portfolios (results not tabulated). We conclude that increases in the volatility of market returns during our sample period could cause the decline in the portion of the total variability in market-adjusted returns explained by the level and the change in earnings, perhaps also account- ing for the mixed results we find using the explained variability metrics. 4.3. HIGH-TECHNOLOGY VERSUS LOW-TECHNOLOGY STOCKS ‘The claim that financial statements have lost their relevance may seem most applicable to high-technology firms, where financial statements allegedly fail to recognize certain items whose expected future cash flows are relevant to investors. One frequently cited example is R&D expenditures, which are expensed as incurred, so firms which invest heavily in RED will show no corresponding (intangible) asset. As an- other example, Amir and Lev [1996] argue that an important cause of the depressed earnings of cellular companies is the expensing of intan- gibles related to customer acquisition and brand development. Because the number of high-technology firms increased considerably over our sample period, it is possible that any documented decreases in value rel- evance of accounting information are due to the increasing influence in our sample of high-technology firms for which accounting information is largely value irrelevant To investigate whether financial statements of high-technology stocks are less value relevant than those of other firms, we compare the value relevance of accounting information for samples of high- and low-tech- nology firms, chosen based on previous research and on our priors about the extent to which accounting practices would (would not) generate unrecorded intangible assets, The high-technology sample (see table 5) includes firms in the computer, electronics, pharmaceuticals, and tele- communications industries. The low-technology sample does not include all industries which are unlikely to have unrecorded intangible assets. Rather we selected enough low-technology industries to generate roughly equal-size portfolics of securities for the high- and low-technology sam- ples over the sample period, While we were reasonably successful through the early 19805 (ie., the number of securities in the two portfolios does not differ by more than 100 over 1950-81), the number of high-technol- ogy firms increased significantly after this time. In the later portions of our sample period, the high-technology portfolios contain two to three times as many firms as the low-technology portfolios. To assess whether our classification of high- and low-technology indus- tries captures the construct of unrecognized assets, we compare the RED spending and market-to-book ratios of the two samples. Market-to-book ratios have been used in prior research as a proxy for unrecognized in tangible assets, and R&*D spending as a percentage of total assets is in- tended to capture investments in unrecorded intangible assets. For eachHAVE FINANCIAL STATEMENTS LOST THEIR RELEVANCE? 348 TABLE § Industries Included in High- and Low-Teehnology Samples* High-Technology Industries 283 Drtigs 357 Computer and Office Equipment 360 Electrical Machinery and Equipment, Excluding Computers 361 Electrical Transmissions and Distribution Equipment 362 Electrical Industrial Apparatus 363 Household Appliances 364 Electrical Lighting and Wiring Equipment 365 Household Audio, Video Equipment, Audio Receiving 366 Communication Equipment 367 Electronic Components, Semiconductars 368 Computer Hardware (Including Mini, Micro, Mainframes, Terminals; Discs, Tape Drives, Scanners, Graphics Systems, Peripherals, and Equipment) 481 Telephone Gommunications 737 Computer Programming. Software, Data Processing 87% Research, Development, Testing Services Low-Technology Industries 020, Agricultural Products—Livestock 160 Heavy Construction, Excluding Building 170 Construction—Special Trade 202 Dairy Products 220 Textile Mill Products 240 Lumber and Wood Products, Excluding Furniture 245 Wood Buildings, Mobile Homes 260 Paper and Allied Products 300 Rubber and Miscellaneous Plastics Products 307 Miscellaneous Plastics Products S24 Gement Hydrautic 991 Blast Furnaces and Stecl Works 356 General Industrial Machinery and Equipment 371 Motor Vehicles and Motor Vehicle Equipment 399 Miscellaneous Manufacturing Industries 401 Railroads 421 Trucking, Courier Services, Excluding Air 440 Water Transportation 451 Scheduled Air Transportation, Air Courier S41 Grocery Stores WWE reporl the three-digit SlOcodes and the Wanbey of the Industries included in the high. and low technology samples. Industries are selected for inclusion in the high- (lon-} technology sample bane on whether Firmein the industry are likely (nr likely) to have siguificant unrecorded intangible assets, year and in total, firms in the high-technology sample spent significantly (at the .10 level) more on R&D asa percentage of total assets than the firms in the low-technology sample. The across-year results indicate that on average high-technology firms invest 9.2% of total assets in RED, compared to 0.8% for low-technology firms (difference significant at the .0001 level). In all years, the market-to-book ratio of the high-technol- ogy firms exceeds that of the low-technology firms (at the .01 level orFRANCIS AND KATHERINE SCHIPPER TABLE 6 Comparison of the Market-Adjusted Returns to Avcounting-Based Hedge Portfolios for the Fligh- and Low-Fechriology Samples, 1932-040 (Returns Deftated by Perfect Fotesigh! Returns) ‘Panel A: Average, Over Time, Hedge Portfolio Returns! Average “mike Hedge Portfolio High-Tech LawTech Difference ‘SIGN_AFARN 47 419.7 2.0 (5a EARN 591 60.6. 15 (58) AGASH B45 74 (,00) RATION 56.0 0.5.91) siniaiad 620 6.9 (70 Hedge Portfolio an SHGNLSEARN 0519.00) 0.0081 (13) 0.0008 (58) [0.2098 ¢.08)] —_ [-9.0058 (.96)] AEARN O16 (0 0.0014 [-0.g806 (1 2) -0.0002 (88) LAD E 5] (0.0509 (.67)] 2.88 1,09) ACASH 0.198 (00) 0.0004. 1.73), @.0013. (32) {-0.0692 (,60)] {0.1187 (95) 13) 31.10) 2 RATION OH0E 00) 0.0092 (10) AROMAT (11) 0.04 95) [-O.2541 (157) [0.8856 .15)) 0.00 4,99) RATIOR 0.565 (00) 0.0026 (04) 0,005 be ig hedge portfolios, 20 11) 05) } SSce lallle I [or descriptions of the account "Panel A reports the avera arketasjusted reuera te each accennting pur ifolia Gellated hy thr renirns te the porte rns portfolin} for the high- and dhe jow-technol: The lar Fight column sports a Ktcal of the equality of the average snark igh and lowstech nology hedge pordiohins pots cactlirient estimates (sigmiReance levels) far raw [rank] regressions OF Senile, = hy r+ by where Gomis, ip the marketadjisted rein on the nested account by the return to the Feturns-based hedge portfolio in ywar ¢ }tochnalogy ineatsry, O otherwise; and 2= 1... 48 carresponds i = AMM» Ing-biaed hedge pon GH, (LOW, the sample y better). A comparison of the across-year average market-to-book ratios of the two samples shows that the average market-to-book ratio is 3.18 for high-tech firms versus 1.57 for low-tech firms, difference significant at the 0001 level, Overall, we interpret these results as indicating that the samples of high- and low-technology firms differ along the dimen- sion (unrecorded assets) we had hoped to capt Table 6, panel A summarizes the results of constructing the account- ing-based hedge portfolios on the samples of high- and low-technology firms, For each portfolio and sample, we report the mean (across all sam-HAVE FINANCIAL STATEMENTS LOST THEIR RELEVANCE? 345, ple years) market-adjusted return deflated by perfect foresight return ( Yomk¢). Except for the AGASH portfolio, which earns 17% for high-tech- nology firms versus 24% for low-technology firms (difference significant atthe .00 level), these results indicate litle difference in the mean hedge portfolio returns for high- versus low-technology firms. We conclude that these cross-sectional tests do not support the notion that financial state- ment information és consistently less value relevant for high-technology firms than for low-technology firms Cross-sectional tests do not speak to the possibility that a failure to cope with an increasing pace of change and innovation might have in- duced a relatively more pronounced deterioration in the value rele- vance of financial statements of high-technology firms, To investigate whether there has been a decline in the relevance of accounting infor- mation for high-technology firms and whether this decline is greater than the change (if any) experienced by low-technology firms, we esti= mate the following equation: Go mkt; = hg + 4 HIGH, 1+ AgLOW, 1+ 5, (3) where HIGH,, (LOW,,) = 1 if i= high (ow) technology portfolio, 0 otherwise. The results of estimating (8), reported in panel B of table 6, are con- sistent with, but less significant than, the full sample results reported table 2. While we continue to observe significant declines in the Toast returns to high-technology hedge portfolios based en RATIO2, the full sample cleclines for the AEARN portfolio and the RATIO! portfolio are less pronounced, Comparison of the rank regression coefficients for the SIGN_AFARN, AEARN, and ACASH returns shows some evidence that these returns decline at faster rates for high-technology firms than for low-technology firms. There are no statistically reliable differences in the raw OLS coefficient estimates. We also repeat the analyses of the explained variation tests on th samples of high- and low-technology firms. If accounting information less relevant for the former than for the latter, we expect to observe lower explained variability for the high-technology sample: Panel A of table 7 summarizes the results of estimating equations (3), (4), and (5): here we report the average, across all years, adjusted explained variation for each of the three relations by sample. F-statistics (reported in the fi right column) shaw no difference in the ability of earnings to explain the returns of high- and low-technology firms, for both samples, the average explained variability is about 23%, Results for both the balance sheet relation and the book value & earnings relation show, however, that the dependent variables explain significantly (at the .01 level) more of the variation in market equity values for low-technology firms than for high- technology firmsER FRANCIS AND KATHERINE SCHIPPER TABLE 7 Comparison of the Ouer Time Changes in the Ability of Accounteng Information to Explain Variation in Market Measures for the High and the Low-Techaology Samples, 1952-94 Panel A: Average, Over Time, Adjusted R?# Dependent Variable: Adjusted R® HighTech Low-lech Difference Earnings Relation 023 0.00 (83) Balance Sheet Relation 0.43 -0.07 (.00) 0.65 0.08 (.01) Book Value & Earnings Relation Pane! B: Over Time Differences in Adjusted et! Rav [Rank] Regression Results Dependent Variable: Adjusted: R® Ko x Xy Px, =% ‘Earnings Relation 3285 (00) -0.0045 (00) 00038 (00) 0.67 (a9) [-0.5199 (.00)] [0.3744 (.00)] 2.20 (14) Balance Shéet Relation 0.0766 (00) 0.0141 (00) 0.0187 (.00) 0.25 (Gy {0.7820 (.00)] [0.8051 ¢.00)] 0.12.73) Book Val & 5871600) 0.0022 4.05) 0.0088 (.00) #96 (.09) Earnings Relati [0.2476 (45) [0.4094 (.00)]_ 2.27 (14) For the high- and low-rechnology sanaples, pi explained variatinn for each of the models estimate ee far right colin shows Patatsien (sie nificance levels) for whether the adjusted R's difer the highsteehnology and Inwtechnology simples, "In pane! B. we eeport coetliclent estimates (significance hevels) for raw [rank] regressions af: AD, Rij ny + RAUCH, «= f* K:LOW, 2 1% &, « where ADR’ = the adjusted explained sarlation of the variation of the balance sheet ar book value & (LOW, () = 110 the returns—earnings felatian is 9 corresponds to the sam- ie whether i) =. relurms-cornings regression (or the adjusted exp carnings Fegzessian} for year ¢ for portfobo #: Hii estimated. on the igh: (taw-) teebaology sample, 0 otherwise and (= 1 ple yoary 1952... 1044, We also report the Festanistics (significance levels) ‘To explore the time-series patterns of explained variability for high- and low-technology firms, and to provide evidence on whether the abil- ity of accounting information to explain returns has declined more for high-technology firms than for low-technology firms, we estimate expres- sion (12) and test for the equality of «, and xy. ADJ-R®) = Ko + ¥ HIGH,» (+ RgLOW; 2 04+ Bie co) Consistent with a decline in the ability of earnings to explain high-tech- nology firms’ market-adjusted returns, the results in pane B of table 7 show that xj is reliably negative (at the .00 level), We obtain similar, albeit weaker, results for the low-technology sample. Fests do not reject (at the .10 level) the hypothesis that the ability of earnings te explain mar- ket-adjusted returns has declined the same for high- and low-technology stocks. Tests of the changes over time in the explained variability of the balance sheet relation show no evidence of a decline in the ability ofHAVE FINANGIAL STATEMENTS LOST THEIR RELEVANCE? 347 assets and liabilities to explain market equity values for either technology sample. Consistent with the full-sample results, this relation has strength= ened for both the high- and low-technology firms over the past 40 years {significant at the .00 level). Finally, the explained variability of the book value & earnings relation is inereasing through time for both samples, and there is some evidence that the increase is larger for low-techhnology firms, In summary, we view the results of the portfolio returns tests and ex- plained variation tests as providing mixed support for the view that financial starements are less relevant for high-technology firms than for low-technology firms, and marginal evidence supporting a claim of a greater decline over time in the relevance of the financial statements of high-technology firms. We do not believe, therefore, that evidence of a decline in the value relevance of financial information can be attributed solely, or even primarily, to the increasing number and importance of high-technology firms in the economy, 4.4 SENSITIVITY CHECKS Our first sensitivity check examines the behavior of Semi and ad- justed AY over time for three subsamples: all NYSE firms, all NASDAQ firms, and firms with available data for all sample years, The NYSE sam- ple contains 393 to 1,419 firms per year and spans 1952-94; the NASDAQ sample contains 1,124 to 2,866 firms and covers 1974-94. There are 130 firms (all NYSE) with data necessary to calculate all variables (with the exception of RATIO!) for all sample years 1952-94.29 We repeat our main tests on each of these samples and summarize the findings in table 8. ‘The results are generally consistent with the results documented for the full sample, with the exception that the explained variability of the book value & earnings relation increases over time for firms with data for all years but not for the NYSE sample or the NASDAQ sample. We also assess the sensitivity of the results to alternative specifications including: (1) using raw versus market-adjusted returns; (2) cumula returns over 12 months versus 15 months; (3) examining wo alternative specifications of the perfect foresight returns portfolio;=* (4) using 10%, 20%, and 30% cutoffs rather than the 40% cutoffs for constructing the accounting hedge portfolios; and (5) using an absolute benchmark rather than a relative benchmark to construct the AEARN portfolio—we take long (short) positions in stocks with earnings changes in year f greater ‘of the 130 firms with 2 Our tests far RATIOL for this sabsainple are based on the subset the data neeessary ta estimate equation (1) ‘The two specifications are the returns portfolio tse in Alford e1 al, [1995] and a perfect foresight hedge portfolio based on geing long (short) in the top (bottom) 80% of the stocks included in the accounting hedge portfolioJENNIFER FRANCIS AND KATHERINE SCHIPPER 348 (a0) 2980 Von[eA yoo (00°) Zoro (oo?) $6000 (LO). 2L0T—MONtIay rays soUM peg {(00") soa50-1 (00) EO 00°) Saga" (ow) stoo'0- SY VONSNIY [EY ARYL AINSAY Worsailiog [yarN] Mey egy Manag smaty sues luo suuaid BvaSYN (00° HOS O- Koo") FL00°0~ (oo) 929°0 (Wo) ogso cOLLVY )) BEA al | 6L000- (00') ¢F9°0 yess o (0) sro (oo') 280 LOLLY L(g") 1290'0-1 [ese gez0" (59°) Go00O- Hsvov (no) r1E-0, (00°) a62¢'0-1 foo) ReOW0- (00) O10 (oo) gaa'o Nuva (08") 826 p00 nr) SEO ‘a a Sunsay woNsaNaIy | 4w9p Aao4y SULLY OMS VaudHAVE FINANCIAL STATEMENTS LOST THEIR RELEVANCE? 349 than 10% (less than -10%). Except for some results which show no sig- nificant (or a significantly positive) over time relation with respect to earn s information, the results are very similar to those reported, We also examine the behavior over time of the unsealed accounting hedge port- folio returns, %. For all hedge portfolios, the % metric shows significant (at the .05 level or better) increases over 1952-94. Finally, we examine the sensitivity of the results to two econometric is« sues. We control for heteroscedasticity in the balance sheet and book value & earnings relations by estimating these regressions after applying a log transformation to the variables. The resulting adjusted R's (not reported) exhibit the same time-series patterns documented in tables 3 and 4, We also test and adjust for autocorrelation in the variables of interest. For the mkt measures, Durbin-Watson statistics generally do not reject the null hypothesis of no autocorrelation; when they do re- ject (usually in favor of small amounts of positive autocorrelation), we take first-differences of the variable and examine the behavior of this wansformed variable over time. In general, the first differences results indicate no over time relations for any of the portfolie returns, For the adjusted R® measure, Durbin-Watson tests reject the null hypothesis of no autocorrelation (in favor of positive autocorrelation) for the balance sheet model and the book value & earnings model, We find no serial correlation in the adjusted Rs of the earnings relation, We examine the over time behavior of the first-differences of the adjusted #'s from the balance sheet and book value & earnings models and find no significant pattern in the ability of these accounting measures to explain market values over time, 5. Conclusion This study investigates the popular claim that financial accounting information has become less value relevant over time, specifically over the period 1952-94. Our analyses show that returns to perfect foresight trading strategies based on the sign and magnitude of earnings, on the level and change in earnings and book values, and on an assortment of fundamental signals have decreased over our sample period, However, returns based on cash flows and (just) the sign of earnings have not changed significantly over time. Our tests indicate that the explanatory power of earnings levels and changes for returns has significantly de- creased over time. In contrast, our test of the explanatory power of book values of assets and liabilities (alone or combined with earnings) for market equity values provides no evidence of a decline in the explained variability of the balance sheet relation or the book value and earnings relation—in fact, we usually find the opposite. ‘To the extent our statistical tests favor the null hypothesis of no change in relevance (so failure to reject the null may be driven by low power),350 JENNIFER FRANCIS AND KATHERINE SCHIPPER greater weight should be placed on results which reject this hypothesis. ‘These results include declines in the returns to several of the accounting- based hedge portfolios, a decline in the ability of earnings to explain re- turns, and increases in the ability of assets and liabilities, and earnings and book values, to explain market equity values. Overall, we interpret our results as providing mixed evidence on whether financial reports have lost relevance over the 1952-94 period. Because claims of decreased value relevance are often phrased ina way which implies that the decrease should be greatest for high-technology stocks, and because of the increased numbers of these firms over our sam- ple period, we repeat the first and second analyses for subsamples of firms in high-technology industries and compare the results to those obtained for firms in low-technology industries, Results for these two samples are similar to the findings for the full sample, suggesting that high-technol- ogy firms have not experienced a greater decline in relevance than low- technology firms. We infer from these results that even though certain types of assets are not included in the current accounting model, and current GAAP requires expensing not capitalization of certain expendi- tures expected to yield future benefits, reported earnings continue to summarize value-relevant corporate activities to approximately the same extent for both high-technology and low-technology firms. Our tests do not rely on assumptions about whether market agents fully extract all the information available in financial statements, just that there haye been no systematic differences in this behavior over time, Our tests also do not speak to the question of whether the [eve of value rele- vance in financial statement information is undesirably low. Rather the results bear only on the question of whether there has been a change in value relevance. Thus, our results have no implications for whether re- sources should be devoted to changing the financial reporting model nor do our tests shed any light on which specific pieces of financial statement information—other than earnings, cash flows, assets, and liabilities—are used, by which investors, and how.?* While our tests are not designed to comment on the source of any changes in value relevance, future work could examine possible explana- tions for documented changes and, in doing so, develop more powerful tests of changes in the value relevance of financial reports, Analyses ex- ploring other interpretations of value relevance (such as those described "We believe that behavioral approaches might be particularly appropriate for such in- vestigations. For example, Bouwman, Frishkoff, and Frishkoff [1995] use protocol analyses ‘of the investment screcning decision to analyze what specific types of accounting informa- Won (eg.. sales, leverage ratios, segment data) and nonaccounting information (e.g., stock price, a general description of the company) are used in each stage of the decision. De- pending on which stage of the decision process is considered, GAAP financial information accounts for as much as 62% and as little as 98% of the information usageHAVE FINANCIAL STATEMENTS LOST THEIR RELEVANCE? 351 in section 2) would also add to our understanding of the decision use- fulness of financial statements to investors.2* REFERENCES Atroap, A= J: Jones; R. Lerrwici: azo M. Zwyewsks, “The Relative Informativeness of ‘Accounting Disclosures in Different Countries” journal of Accounting Research Supple» ment 1993); 183-295. AmteRICAN INSTITUTE OF CERTIFIED PuBtic ACCOUNTANTS. SPECIAL COMMITTEE ON FINANCIAL REPORTING. 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Journal of Accorentaniey (April 1990); 79, 82-85Copyright of Journal of Accounting Research is the property of Wiley-Blackwell and its content may not be copied or emailed to multiple sites or posted to a listserv without the copyright holder's express written permission. However, users may print, download, or email articles for individual use.