Abstract
Capital markets research in accounting began with inquiries into the relation between equity return and accounting earnings. The collective efforts made by numerous researchers over the past four decades or so have produced a vast body of work on this topic, which is commonly known as the “ERC” (earnings response coefficient) literature. In this chapter, we firstly give a brief account of this research and evaluate it in the context of the return model developed in Chap. 9. Previously, Lev (1989) and Kothari (2001), and others have surveyed and evaluated this literature at its various stages, but not in relation to a specific theoretical model.
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Notes
- 1.
A concurrent study by Beaver (1968) examines the impact of earnings reports on return volatility and trading volumes, both of which are beyond the scope of this discussion.
- 2.
A premise for this type of event study is that the market at least partially reacts to the information in the earnings report. However, it is not necessary that such a reaction be fully efficient. In other words, researchers can still obtain qualitative results that are consistent with a priori predictions even if the market over- or under-reacts to the news from the event.
- 3.
The concept is adapted from “the permanent income hypothesis” advanced in the macroeconomics literature (see for example Kormendi and Lipe 1987). However, permanent income as defined in economics is a future-oriented concept whereas accounting income is derived from past transactions. Their distinctly different orientations make it questionable as to whether the former concept can be taken as a suitable benchmark to characterize the latter one. In particular, given that a typical firm’s course of operations may evolve along many different directions due to the inherent and evolving uncertainty of the business environment, it is unclear how an accounting system can produce a measure of permanent income on the basis of past transactions.
- 4.
- 5.
Generally speaking, it is overly simplistic to treat the difference between market value and book value (u t ) as a random noise. In essence, this difference, known as unrecorded goodwill, represents what a firm contributes to investors, and determining the amount of value creation is at the heart of the valuation exercise.
- 6.
There appear to be two technical flaws in the derivations of Easton and Harris (1991). Firstly, they initially treat V t as cum-dividend value but then switch its meaning to ex-dividend value after bringing d t into the equation. Secondly, after taking changes of the value function, they retain d t in its original (unchanged) form.
- 7.
Some of the studies discussed below also touch on using price levels (versus returns) as the dependent variable.
- 8.
An exception is Ohlson and Shroff (1992), who incorporate (unspecified) “other” information in their linear dynamic, thus giving rise to other information as an additional factor in explaining returns. However, they do not elaborate on the source of this other information nor how it affects earnings generation.
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Zhang, G. (2014). An Evaluation of the Return-Earnings Research. In: Accounting Information and Equity Valuation. Springer Series in Accounting Scholarship, vol 6. Springer, New York, NY. https://doi.org/10.1007/978-1-4614-8160-7_10
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