The Boundaries of Financial Reporting and How to Extend Them (Digest Summary)

The authors establish that the usefulness to investors of accounting data has declined
during the past 20 years. The authors investigate the statistical relationship between
earnings and returns for each of the years from 1977 through 1996. Earnings and the
one-year change in earnings explain 6–12 percent of the variability of returns in
the first 10 years (1977–1986), decreasing to 4–8 percent in the
1987–96 time period. A regression of the annual R²s on
a time variable indicates that the decrease is statistically significant. The authors
also examine two other accounting variables—cash flows and book values—and
find similar results: a declining usefulness of each over the time period.

The authors apply the same tests to a subset of 1,300 companies that were in the sample
for the full time period. Relative to the entire sample, earnings information for the
subset had greater explanatory power for each of the sample years, indicating that
earnings are more informative for companies with a long operating history. Nevertheless,
the explanatory power for this subset experienced a statistically significant decrease
over the 20-year period.

The authors hypothesize that an increase in the rate of change of business experienced by
a company is related to the decline in accounting usefulness. To measure the rate of
change, the authors construct 10 equal-sized portfolios based on value of equity.
Whenever a company moved from one portfolio to another, a portfolio switch occurred. The
authors construct a measure of portfolio switching that reflects the magnitude and
frequency of change. For portfolios established on both book value and market value, the
switching increased significantly over the 1977–96 time period.

The authors divide the companies into two portfolios based on portfolio switching:
“high-change” and “no-change” portfolios. Tests indicate that
the greater the portfolio switching, the greater the decrease in information over time.
In fact, the no-change portfolio did not experience any decrease in informational
usefulness. R&D appears to be a substantial contributor to the rate of change in
that high-change companies experienced a much larger change in R&D intensity than
did low-change companies.

The authors submit two proposals aimed at enhancing informational usefulness. Currently,
expenditures on intangible assets, such as R&D and employee training, are expensed
because of the uncertainty regarding the realization of prospective benefits. Because
the passage of time reduces the uncertainty about the success of the project, the
authors propose that accountants capitalize expenditures on intangible assets, including
all project expenditures previously expensed.

The authors also recommend a systematic restatement of financial reports. As the results
of expenditures on intangibles materialize, accountants would restate financial reports
to reflect the results. For example, once a project passes a feasibility test, the
financial reports would be restated by capitalizing previous expenses. The authors
expect that some people will argue that the restated information is no longer relevant
to decision making, but the authors see the restatements as functioning much like the
GDP revisions and believe that the revision process would provide new information to
investors.

The authors conclude that the social consequences of the decline of usefulness of
financial information are tied to the ability of investors to obtain the information at
no added cost. The authors acknowledge that researchers have not fully explored the
social cost resulting from inadequate accounting data; however, the information
available indicates that the lack of information does impose costs on investors.