Accounting Research and Theory

(22 April 2018)

ACCOUNTING RESEARCH :

Relevance Lost,
Relevance Regain?
Ho Yew-Kee
Associate Provost (SkillsFuture & Staff Development)
Professor of Accounting
Singapore Institute of Technology

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 Accounting Research and Theory
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What is the one most important

discovery in accounting
research in the last 30 years?

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Other Ancillary Questions

• Do practicing accountants understand the

construct and theory from our research?
(What’s new?)

• How does this knowledge help to make

accounting more relevant and useful?
(So What?)

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More Critical Questions

• Can academic accountants be accused of

losing their grip of reality?

• Would the practice world be willing to pay

for our discovery?

• Will the world miss us even with all our

publications?

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Philosophy of Research

What is research and what are the end goals?

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Inventing Reality : Physics as a Language

Gregory, B. 1988.
(pages v-viii, 1-3, 5-18, 193-201)

What is research and what are the end goals?

a. Discovering new knowledge

b. Modelling the real world

c. Describing the world / observed phenomena

d. Inventing a new language

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Inventing Reality : Physics as a Language

Gregory, B. 1988.
(pages v-viii, 1-3, 5-18, 193-201)

Research as Inventing a New Language

Page 2 : ...it seems fair to say that we live in a world structured, at least to some degree, by
language.

Page 3 : …we view science as the uncovering of an already-made world

Page 3 : …history of physics as the evolution of a language – as the invention of new

vocabularies and new ways of talking about the world.

Page 3 : …realism in painting is largely a convention. A physicist is no more engaged in

painting a “realistic” picture of the world than a “realistic” painter is. For a
physicist, a realistic picture is far too complex to be useful as a tool, and physics is
about fashioning tools.

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 Accounting Research and Theory
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Inventing Reality : Physics as a Language

Gregory, B. 1988.

Three Views of Research

Page 195: Three umpires:

1) “I call ‘em the way I see ‘em”
2) “I call ‘em the way they are!”
3) “They ain’t nothin’ until I call ‘em!”

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Inventing Reality : Physics as a Language

Gregory, B. 1988.

Research is Discovering New Things

Page 196:
The hallmark of the conversation of science is the
willingness to allow the agreement or disagreement
between predictions and observations to determine
whether physicists are satisfied with the theory they have
or whether they try to build a new theory – that is,
whether they continue to talk about the world in one way
or change to another.

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Inventing Reality : Physics as a Language

Gregory, B. 1988.

Research is Storytelling
Page 198:
Language tells us what the world is made of, not because language
somehow accurately captures a world independent of language, but
because it is the heart of our way of dealing with the world. When we
create a new way of talking about the world, we virtually create a new
world. This observation is no more profound, nor any less profound,
than saying that the questions we ask determine, not the content of the
answers we will get, but what will count as an answer.
Page 198:
A story does not have intrinsic value; it has value only to the extend that
it serves a purpose, and the stories of physics have served their purposes
very well indeed.
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Inventing Reality : Physics as a Language

Gregory, B. 1988.

New language in Physics: New language in Accounting:

• Polarities • Debits and Credits
• Electromagnetic radiation • Depreciation, Amortization
• Atoms and quarks • Fair Value
• Thermodynamics • Impairment
• Spacetime • Journal Entry
• Relativity • Type 1, 2 & 3 Values
• Elementary quantum of action • Hyperinflation accounting
• Fecundity of space • Agricultural accounting
• Quantum field theory • Conservatism, Consistency
• W, Z fields • Finance or Capital Lease
• Superstrings • Mark-to-Market

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What is research and what are the end goals?

• Describing observed phenomena with language

• Discovering new knowledge by using language

• Prescribing policies and actions to make the

world a better place.

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Core Questions in Research

• What’s New?
• So What?

Professor Shyam Sunder (1944 - ) Yuji Ijiri (1935 - 2017)

James L. Frank Professor of Accounting, Robert M. Trueblood University Professor
Economics, and Finance of Accounting and Economics
Yale School of Management Carnegie Mellon University

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The Association between Earnings and

Returns: A Comparative Study between
China and US Stock Markets

Vincent Chen (NUS/SAC)

Yew Kee Ho (NUS/SIT)

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Motivations

• Understanding the role of earnings in valuation is a

fundamental research topic in accounting and finance
research (e.g., Ball and Brown, 1968)

• Studying the earnings-return relation provides both

practical and academic implications for practitioners
and researchers (Kothari, 2001)

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Motivations (cont’d…)
• Prior studies examine the earnings-return relation and
establish the relation between:
– Earnings change and stock returns (e.g., Beaver et al., 1980; Beaver
et al., 1987)
– Unexpected earnings and unexpected stock returns (e.g.,
Kornmendi and Lipe, 1987; Collins and Kothari, 1989)

• Easton and Harris (1991) extend this line of the

literature by showing that earnings levels variable is
an explanatory variable for stock returns

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Motivations (cont’d…)
• In this study, we compare the earnings-return relation
between China and US stock markets

• Specifically, we:
– Replicate Easton and Harris (1991) in 1968-1986 in the US
market

– Extend Easton and Harris (1991) in 1998-2011 in the US

market to the Chinese market and compare findings between
China and US stock markets

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Ball, R., and P. Brown. 1968.

An Empirical Evaluation of Accounting Income Numbers.
Journal of Accounting Research 6(2):159-178.

Basic Objectives
• To assess the usefulness of existing accounting income
numbers by examining their information content and
timeliness.
• Annual income numbers provide about 50% of all
information about an individual firm.
• Income report does not rank highly as a timely medium
as 80% to 90% of its content is captured by more
prompt media.
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Ball, R., and P. Brown. 1968.

An Empirical Evaluation of Accounting Income Numbers.
Journal of Accounting Research 6(2):159-178.

• 261 firms from 1957 to 1965

• December year end fiscal period
• Monthly returns
• Variable 1 – Net income (Regression)
• Variable 2 – EPS (Regression)
• Variable 3 – EPS (Naïve model)
• 0 = Announcement month
• Three portfolios:
 Positive income forecast errors
 Overall
 Negative income forecast errors
• Downward drift of negative income forecast
errors

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 Accounting Research and Theory
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Ball, R., and P. Brown. 1968.

An Empirical Evaluation of Accounting Income Numbers.
Journal of Accounting Research 6(2):159-178.

Critical Development in the 1960s

• CAPM
• Event study methodology
• Efficient Capital Market Hypothesis (EMH)
• Theoretical development in finance and economics
(particularly positive economics)
• Changes in regulations (eg. Quarterly Reporting)

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The Earnings-Return Relation

• Development from the book value model:
– For a firm i,
Pt = BVt + ut (1)
ΔPt = ΔBVt + ut’ (2)
ΔBVt = A t – dt (3)

Substitute (3) into (2):

ΔPt = A t – d t + u t’ (4)
ΔPt + dt = A t + u t’ (4’)

Divide (4’) by Pt-1:

( ΔPt + dt ) / Pt-1 = At / Pt-1 + ut’’ (5)

P = Price BV = Book Value A = Earnings d = Dividends

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Research Design
• Relative explanatory power of earnings:
Rjt = αt0 + α t1Ajt / Pt-1 + ϵjt  Level Model

Rjt = φt0 + φ t1ΔAjt / Pt-1 + ϵjt  Changes Model

• Incremental explanatory power of earnings:

Rjt = γt0 + γt1Ajt / Pt-1 + γ t2ΔAjt / Pt-1 + ϵjt  Incremental Model

• Prior-period earnings and stock returns:

Rjt = θt0 + θt1Ajt-1 / Pt-1 + εjt  Lag Model

• The association between UE and UR:

CARjt = ψt0 + ψ t1Ajt / Pt-1 + ψ t2ΔAjt / Pt-1 + ϵjt  CAR Model
P = Price BV = Book Value A = Earnings d = Dividends
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Overview of Findings
Comparison of the Explanatory Power
of E and ΔE based on R2 or incremental R2

Model Ret = ƒ(E) Ret = ƒ(ΔE) Ret = ƒ(E) + ƒ(ΔE) CAR = ƒ(E) + ƒ(ΔE)
(Level Model) (Changes Model) (Incremental Model) (CAR Model)

Earnings Variable E ΔE E ΔE E ΔE

US: 1968-1986 Yes > Yes Yes > Yes Yes Yes

US: 1998-2011 Yes < Yes No < Yes No Yes

China: 1998-2011 Yes = Yes Yes = Yes No Yes

Yes – the Explanatory variable is significant

> Greater explanatory power; < Lesser explanatory power
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Sample
• For our US sample, data is collected from COMPUSTAT and
CRSP
– Two US samples:
• the 1968-1986 period (for replication), which includes
28,781 firm-year observations; and
• the 1998-2011 period (for the comparative analysis), which
consists of 45,913 firm-year observations

• For the China sample, we collect information from CSMAR

– The final sample covers 16,656 firm-year observations from
1998-2011

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A Validation of the US Stock Markets:

1968 - 1986

Replication of Easton and Harris (1991)

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Incremental
Model

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CAR
Model

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A Comparative Study between China and

US Stock Markets: 1998-2011

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Level
Model

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Changes
Model
US Firms Chinese Firms

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Incremental
Model

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Incremental
Model

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CAR
Model

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CAR
Model

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R2 Comparison – USA versus China

USA China
35% 35%

30% 30%

25% 25%

20% 20%

15% 15%

10% 10%

5% 5%

0% 0%

Level Change Level Change

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R2 Comparison
Level Comparison Change Comparison
40% 40%

35% 35%

30% 30%

25% 25%

20% 20%

15% 15%

10% 10%

5% 5%

0% 0%

USA China USA China

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Lessons Learnt

• For the period 1998 to 2011, there continued to be a positive

relationship between returns and earnings and changes in
earnings. This suggests a strong convergence in best
practices.

• For both markets, changes in earning is a more stable

explanatory variable when its comes to explaining returns.

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More Critical Questions

• Are academic accountants asking and answering

the relevant questions? (Usefulness of their
research)

• Are we really contributing to the practice of

accounting or are we just creating knowledge
which is understood by fellow academic
accountants only? (ie. We have the answers but
we are not sure what is the question?)

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