THE RELEVANCE OF VALUE

John Goodwin*
La Trobe University
K.R. Sawyer
University of Melbourne
K. Ahmed
La Trobe University
Value is a relative term. The value of a thing means the quantity of some other thing,
or of things in general, which it exchanges for.
John Stuart Mill,
Principles of Political Economy

I. INTRODUCTION
Accounting value relevance is a concept that has admitted a number of definitions and
measures. Lev (1989) asserted that the relevance of accounting value was characterised by the
quality of accounting information. For Lev, earnings quality was measured by the coefficient
of determination in a regression of market returns on earnings. The strength of association
between market returns and earnings is the basis of most measures of value relevance. For
example, Collins et al (1997) and Lev and Zarowin (1999) both used the coefficient of this
association (the earnings association coefficient) to estimate value relevance. Chang (1998)
suggested the variance of the log of the value-price ratio as a measure of value relevance, with
value determined from an earnings-based valuation model. In some cases, for example Chang
(1998), the association between earnings and market returns is assessed with a lag rather than
contemporaneously, reflecting different rates at which information is impounded. And in some
cases, the variability in market returns is controlled for by forming portfolios sorted
exogenously, with the association between earnings and returns then assessed across portfolios
(see for example Francis and Schipper (1999) and Nwaeze (1998)).
* Corresponding author: John Goodwin, School of Business, Latrobe University. Bundoora, Victoria,
Australia. Ph: 61-3-9479 1229
E-mail: A.Goodwin@latrobe.edu.au

In all of the above measures of value relevance, it is the exchange of market value for
accounting information that constitutes accounting value relevance. However, the multiplicity
of definitions suggests that the theory of this exchange is not well specified. In part, this
ambiguity arises because the theory has been determined from a set of empirical studies. This
is not uncommon in the development of a theory. For example, in his development of the
efficient markets hypothesis, Fama (1970) noted that the empirical work on market efficiency
had preceded its theory. Famas efficient markets theory (EMH) provides inference as to a
possible theory of value relevance. His theory, that prices reflect information, depends on a
classification of information. Thus, weak form efficiency corresponds to an information set
consisting of historical prices, semi-strong form efficiency to an information set of all publicly
available information (including earnings announcements), and strong form efficiency to an
information set of both public and private information. When he revisited the efficient markets
hypothesis in 1991, Fama conceded that a better definition of efficiency was Jensens whereby
prices reflect information up to the point where the marginal benefits of that information do not
exceed its marginal costs. (Jensen (1978)). Regardless of the definition, tests of market
efficiency test the dependence of prices on types of information. The heterogeneity of the
information is important.
Increasingly, information that is not recognized in the financial statements is being
tested for its value relevance. For example, Barth (1994) tests for the value relevance of the
fair value of investments and Hughes (2000) tests for the value relevance of proxies of air
pollution. Macroeconomic information, which is often the basis of tests of market efficiency,
can also be assessed for its value relevance. This suggests that there is some convergence
between the EMH, as a theory of information, and value relevance, as a theory of information.
But in value relevance studies, information is filtered through the financial statements. The
information set is conditional on the accounts. The conditioning of information is an important
component of value relevance studies. Information is conditioned by the principles of
accounting used, whether unbiased, conservative or aggressive, and by the rules invoked. That
is, the standards of the Financial Accounting Standards Board. It is the application of
principles and rules that changes the conditioning of the information. And it is this
conditioning that distinguishes a value relevance study from a market efficiency study.
Like tests of market efficiency, tests of value relevance are dependent on a
classification of information. Clearly, the weak, semistrong and strong form classification of

Fama, based on price history, public and private information, is inappropriate. A more refined
classification, which incorporates the conditioning of information by the accounts, is required.
One classification, adopted in the present paper, is to categorize information as either
recognized in the financial statements, disclosed in the notes of the financial statements but not
recognized, public information not in the financial statements, and private information. This
classification is adopted for two reasons. First, it reflects the importance of the public
disclosure of information, just as in the EMH. When information becomes publicly available,
it provides important signals to all market participants. We therefore expect some difference
between the value relevance of public and private information. Secondly, recognition of
information may confer some difference in terms of the reliability of information, in addition
to providing a signal to market participants. In classifying information, we follow Fama in
formalizing the heterogeneity of information, and the possible heterogeneity of its effects. We
thereby establish an hypothesis which we designate the Efficient Accounting Hypothesis .
The Efficient Accounting Hypothesis that we propose is designed to order tests of value
relevance, analogous to the ordering in the EMH. First, tests of weak- form value relevance,
which test the price-relevance of recognized information, are discussed. Secondly, tests of
semistrong- form value relevance, which test the price-relevance of public information, either
recognized, disclosed, or neither recognized or disclosed, are considered. Tests of strong- form
value relevance, which test the price-relevance of both public and private information, are then
proposed. As for the EMH, our classification of value relevance tests preserves the ordering
implied by the nomenclature. Strong-form value relevance implies semistrong-form which
implies weak-form. As most of the existing tests of value relevance test the value relevance of
recognized information, most of the existing studies are then weak-form value relevance
studies.
The correspondence between price efficiency and value relevance is not restricted to
the classification of information. There are four other issues. First, as identified by Fama
(1991), tests of the EMH are joint tests of the process generating prices and the efficiency of
the market.

Price endogeneity is important in the testing of price efficiency, and price

endogeneity is important in the testing of value relevance. To test value relevance, a price or
returns process must be specified. In most of the existing tests of value relevance, the price
process is unspecified. Often, prices are assumed to be efficient and, following Ohlson (1995),
to be determined by a present value relation of expected abnormal earnings. In the present
paper, we assume a general pricing process that depends on the arrival of information, and how
that information is filtered by the financial statements. The evolution of prices then depends
3

on both information arrival, on accounting principles and rules, and on the formation of
expectations.
Secondly, we include the possibility that there is market inefficiency. In a number of
recent studies, most notably Aboody, Hughes and Liu (2000), value relevance is tested in the
presence of market inefficiency. As a consequence, the specification of the price process
adopted in the present paper encompasses a test for both market efficiency and value
relevance. The specification separates the testing of value relevance and market efficiency.
The encompassing framework which we employ permits the interaction of market efficiency
and value relevance, but relaxes the dependence of value relevance on market efficiency.
Thirdly, we contend that while market efficiency studies are tests of how prices
impound information, value relevance studies are tests of how prices impound information
through the filter of the financial statements, that is, conditional on the accounts. Necessarily,
this implies that a value relevance study involves a two-step procedure. In the first stage,
information is transmitted to and filtered by the accounts. At the second stage, the accounting
information is transmitted to the markets. This process is recursive but, because it is likely the
errors are correlated in both stages, it is also simultaneous. We therefore assert that the process
governing information, financial statements and prices follows a two-step-algorithm:
X t ,t +1 k

(1a )

Rt ,t +1 X t , t +1 k

(1b)

where k represents information of type k, Xt,t+1 an accounting measure such as earnings or

comprehensive income, and Rt,t+1 the market returns over a long period horizon t,t+1, typically
one year. It is this two-step procedure which distinguishes the approach in the present paper
from many value relevance studies which consider conditioning of the form
Rt , t +1 X t , t +1

(2)

The conditioning in the recursive system (1) is sensitive to accounting principles and
rules and this affects value relevance. Conservatism, which is defined as asymmetric
recognition of bad news and goods news in earnings (Basu (1997)) implies that bad news is
recognised in earnings earlier than good news. In general, conservatism reduces value relevance
because the market impounds all relevant information not just bad information [Holthausen and
Watts (2001)]. Matching, the principle of recording expenses in the same period as when the

revenues generated are recognized, often increases value relevance, particularly in relation to
R&D (Lev and Zarowin (1999)).
In assessing value relevance, cognisance of the error in the pricing process in (1) is
important. As acknowledged in other studies, for example, Kothari and Sloan (1992),
measurement error is fundamental to a value relevance study. In the present paper, we permit
two types of error. First, one error arises as a measurement error representing the difference
between the markets assessment of value and the accountants measure of value for recognised
and disclosed information. There is a second type of error, attributable to non-value-based
trading. Value relevance, like market efficiency studies, are sensitive to the same issues which
have led to the emergence of behavioral finance, namely the market heuristics which become the
determinants of prices, and which attenuate value relevance.
Finally, by aligning value relevance with the EMH, we emphasise the testing of
coefficients of expected and unexpected information. Pricing efficiency is tested by testing
that expected information does not explain market returns, but that unexpected information is a
significant explanator. It is the significance of the coefficients of expected and unexpected
information that matters, not the goodness of fit of the pricing process. Necessarily, as in the
EMH, it is the empirical significance levels (the P-values) associated with the tests of expected
and unexpected information that matters, not the R-squared from the pricing process (1b), or
(2), nor the magnitude of the coefficients in the recursive pricing process (1a) and (1b), or (2).
The significance of these coefficients is affected by accounting principles and by accounting
rules, and is necessarily conditioned by the type of information.
The theory of value relevance that we propose in Sections II and III of this paper
therefore has its foundations in the EMH. Analogous to the EMH, it is based on an assumption
of heterogeneous information arrival, analogous to the EMH it is a joint test of value relevance
and a process of price determination. And analogous to the EMH, it permits market
inefficiency. However, in contrast to the EMH, it is a theory based on conditional information,
conditioned by the financial statements which embody the accounting principles and rules.
Value relevance then becomes a joint test of market efficiency, of an endogenous pricing
process, of the conditioning of the financial statements, and of value relevance. Section II of
the paper develops our theory of the microstructure of value relevance. In Section III, we
propose the Efficient Accounting Hypothesis, and in Section IV, we consider some of the
empirical implications of the theory proposed in Section II.

II THEORY OF VALUE RELEVANCE

Value relevance represents the association between the information impounded in the
accounts, and the information impounded by the market. The extant theories of value
relevance invoke three assumptions that are critical to their testing. First, they assume markets
are efficient, typically semi-strong form efficient. Secondly, they assume a present value
relation in which market prices are determined by accounting information. Finally, they
assume that, as a null hypothesis, over infinite horizons economic goodwill measured by the
difference between the market value of equity and the book value, converges to zero.
In formalizing a theory of value relevance, we relax each of these assumptions. The theory
exposited is a theory of information transmission, first to the accounts, and then to the markets.
Our theory of value relevance becomes a joint test of the product of the two transmission
mechanisms. Necessarily, it is a microstructure approach rather than the aggregate approach of
most value relevance studies. The theory has the following characteristics
1. It is a theory of information and, in particular, information microstructure. Existing models
of value relevance test the aggregate association between market prices and earnings, book
values or a variant thereof. The theory proposed tests the association between market
prices and the determinants of earnings or book values. The disaggregation of accounting
information permits the testing of the value relevance of various components, such as
intangibles, and the testing of information not typically used in value relevance studies, for
example, non-financial information. The theory which we propose is based on the
assumption that information is heterogeneous. In Section III, we develop an Efficient
Accounting Hypothesis consistent with Famas EMH.
2. It is also a theory that permits the joint testing of market efficiency and value relevance.
Existing theories of value relevance assume that market prices reflect all information.
Necessarily, the existing tests for value relevance are conditional on an assumption of
efficiency. We relax this assumption so that market efficiency and value relevance are
tested jointly. As a result, it is possible for value irrelevance to result from market
inefficiency, rather than accounting inefficiency.
3. It is a theory of how the accounts filter information. In particular, this permits the testing of
accounting rules and their importance in determining value relevance. Existing theories of
value relevance typically assume the present value relation, and that accounting rules are
unbiased.

We begin with a simple model and invoke the following assumptions.

Assumption 1: Information arrival k
We assume that the information k arrives during the year t,t+11 at random intervals. Ohlson
(1995) and Hand and Landsman (1998) assume that information is homogeneous. We assume
the information to be heterogeneous (indexed by k), and to have heterogeneous market
efficiency and value relevance. The information transmission is represented by a line diagram:
Figure 1: Heterogeneous Information Arrival
______________t________________tk______________t+1____________________
Et (Xt,t+1)

Etk( k) k

so that the k-th arrival of information k occurs at tk during t,t+1. We assume that the
information k generates a separable effect (from other information) on both the balance sheet,
and on the market value. This is consistent with the notion of different levels of value
relevance for different levels of information; see for example Lev and Sougiannis (1996) and
Nwaeze (1998).
Assumption 2: Accounting Measure Xt,t+1
We consider the value relevance of information, k , as it is transmitted through the financial
statements. Let Xt,t+1 be some aggregate measure of the financial statements of the period
t,t+1. Typically, Xt,t+1 is earnings during t,t+1. But in some studies, comprehensive income
defined as earnings plus change in dirty surplus is used to assess value relevance. It is possible
to use other, less aggregate, measures of Xt,t+1 to assess value relevance; for example,
operating cashflows. Traders form expectations of accounting information Et (Xt,t+1), at the
beginning of the year. Prior to tk , traders form expectations Etk( k) relating to k. The
information k then arrives and is impounded into the financial statements.
Assumption 3: Value Relevance of (X, k)
The arrival of the information k generates two effects
(i)

An effect on the aggregate accounting measure Xt,t+1 , and

(ii)

An effect on the market value, measured by the effect on the return Rt,t+1 over the
period.

The value relevance of the information k transmitted through Xt,t+1 will then depend on the
two arguments, the information k and the accounting measure Xt,t+1 .

Assumption 4: Recursive Structure

Market efficiency studies test the direct effect of the arrival of information k on returns Rt,t+h
in short intervals t,t+h around the information arrival. We assert that value relevance tests the
recursive effect of the arrival of information k first on Xt,t+1, and then through Xt,t+1 on the
long horizon return Rt,t+1 during (t,t+1). We summarize this recursive structure in Figure 2.
Figure 2: Recursive Structure of Value Relevance
k

Rt,t+1
Xt,t+1

(X, k)

It is simple to note that unanticipated changes in accounting information can be decomposed in

terms of the arrival of heterogeneous information during the year. Formally,

X t ,t +1 k Et ( X t ,t +1 ) = Et ( k ) Et ( X t , t +1 )
k

+ ( k Et ( k ))
k

+ X t ,t +1 k k

(3)

This equation asserts that information that is not anticipated at the beginning of the year can be
decomposed into three terms comprising the formation of expectations of the information
arrival, the unexpected component of that information, and the effect of the information postarrival on accounting information. Value relevance studies attempt to measure the effect of all
three terms on market prices. Market efficiency studies, usually event studies, measure the
effect of the unexpected component of information on market prices.
Assumption 5: Possible Market Inefficiency
The typical assumption of value relevance is that prices are efficient, that is, that prices reflect
all available information. However, Aboody et al (2000) consider the possibility of value
relevance in a possibly inefficient market. The value relevance theory that we develop
1

In some studies the period is defined as a 15- month interval.

8

depends on a formalization of the concept of market efficiency, but applied to a flow of

information over a period of time.
Consider the arrival of information with market value k at time t and its impact on returns in
the intra-year interval t,t+h. The efficient markets hypothesis requires that in the model
Rt ,t + h = 0 + 1k Et ( k ) + 2k ( k Et ( k )) + ut
k
k

1k = 0 and 2 k 0

(4)

(5)

so that no trading system based on k can earn excess returns. Possible market inefficiency is
evidenced not only by a non-zero value for 1k, but by the dynamics of future returns which
interact with the timeliness proposition in value relevance.
When information is aggregated across a given year, we have:
K
K
Rt ,t +1 = 0 + 1k Et ( k ) + 2k ( k Et k ( k )) + ut
k =1
k =1

(6)

Inefficiency will be detected by non-zero values for 1k.

Assumption 6: Value Relevance Measure
The value relevance of (X, k) relates to how the information k is transmitted recursively
through Xt,t+1 into long period returns Rt,t+1 as in Figure 2. We formally measure the value
relevance of (X, k) using the returns generating process
K
Rt ,t +1 = 0 + 1Et ( X t ,t +1 ) + 2k ( X t , t +1 k Et (X t ,t +1 )) + ut
k =1

( 7)

Equation (7) asserts that returns over the year Rt,t+1 are dependent on prior expectations of the
accounting measure Et (Xt,t+1), and on information arrival k but only as it is filtered through
accounting measure Xt,t+1. As before, when markets are efficient, we expect 1 to be zero.
Value relevance refers to the relevance of the information k, as it is filtered through
accounting information Xt,t+1. Information becomes value relevant when 2k is non-zero.
Comparing (6) and (7) shows that value relevance is similar in design to the concept of market

efficiency, except the conditionality is from k to the accounts and then to the market.
Essentially, value relevance assesses the transmission of information k into both accounting
information and market information, and tests whether this relationship is recursive. The
transformation of the market efficiency hypothesis into the value relevance hypothesis requires
the conditionality of accounting information Xt,t+1 on k to be specified. This conditionality
depends on accounting principles, accounting rules, and the measurability or diffuseness of the
information.
Assumption 7: Accounting Principles and Rules
We assume the existence of accounting principles P1 and accounting rules P2 that affect the
measurement of information k by the financial statements. In particular, we assume that
(i)

The principles P1 can either be unbiased, conservative or aggressive.

(ii)

The rules P2 are the more than 100 (40) accounting standards of the FASB (AASB), and
other rules that impact on the financial statements.

We denote by k (P1, P2 ) the information measured under principle P1 and rule P2 .

10

Assumption 8: Accounting Measures and Information

The accounting measure Xt,t+1 is assumed to depend on expectations formed prior to the given
year Et (Xt,t+1), on information in the current year k , and on an unobservable error vt.

X t ,t +1 k = Et ( X t , t +1 ) + 1k k + vkt

(8)

The coefficient 1k is assumed to then be dependent on the principles P1 and rules P2 used in the
formation of the financial statements.
When equation (8) is inserted into equation (7), we find that:
K
K
Rt ,t +1 = 0 + 1Et ( X t , t +1 ) + 2k 1k k + 2k v kt + ut
k =1
k =1

(9)

Equation (9) defines the evolution of market returns. It asserts that in a market which is
possibly inefficient, returns during a given year are generated by expected accounting
information Et(Xt,t+1), by the arrival of new measurable information k as chanelled through
the accounts, and by information which is in the accounts, but not attributable to k. Equation
(9) permits the testing of both market efficiency and value relevance. In particular:
1.

Market efficiency of accounting information

The market is efficient with respect to accounting information if 1 is zero and 2k is non-zero.

2.

Value relevance of information k

The value relevance of information k is measured by significance of the product of

(1)

2k, which is the market coefficient associated with k and

(2)

1k, the coefficient which measures the filtering of k by the accounts.

If either 2k or 1k are zero, then the information k will not be value relevant in the sense that
when it is filtered through the accounts, it does not affect market value. The information k
may still affect market value, but not through accounting information. In this sense, value

11

relevance becomes a test for the relevance of information in determining market value through
the accounts.
3.

Value relevance of accounting information Xt,t+1

The value relevance of accounting information is measured by the significance of

K

(1) 2 k 1k and
k =1
K

(2) 2 k
k =1

The value relevance of accounting information is then related to the aggregate value relevance
of individual information k, and the aggregate value relevance of vk. The term vk represents
information in the accounts that is priced, but is not attributable to k.
In the theory of value relevance that we have proposed, value relevance and market
efficiency are not separable. They are jointly determined by testing the evolution of returns in
equation (9), but as part of the recursive system of equations (8) and (9). Value relevance is
then determined as the product of the accounting filter coefficient 1k and the efficiency
coefficient 2k. Value relevance can then be compared with a direct test of market efficiency of
the information k in equation (6).
Because the coefficient 1k depends on the principles P1 and rules P2 used in the
formation of the financial statements, so too does the value relevance. In emphasising the role
of the accounting coefficient 1k in equation (8), our theory is not dissimilar from that
proposed by Easton, Shroff and Taylor (2000) who assume a factor which captures the
rescaling of unexpected returns by the accounting system. Clearly the measure of value
relevance we suggest depends on the rules used by the system to incorporate, for example, an
unexpected increase in rental expenses. The theory of value relevance proposed does not
assume that accounting rules are unbiased. Rather, it is possible to test between for the value
relevance effects under different rules or different conventions.
In emphasising the role of information, the theory is not dissimilar to the role of
information proposed by Ohlson (1995). Ohlson (1995) assumes that abnormal earnings are
generated by:

12

X ta,t 1 = X ta 1,t + t + 1, t
+

t = t 1 + 2,t

(10a )
(10b)

where Xa t,t+1 is abnormal earnings and t is information arrival during (t,t+1). Ohlson (1995)
assumes that information follows an autoregressive process, and is embedded into accounting
information through the recursive structure in (10a) and (10b). Value relevance is then tested
using the present value relation. Ohlsons (1995) assumption of an autoregressive structure for
information appears to be unnecessarily restrictive, particularly if information is measurable.
Ohlson also assumes information to be homogeneous, so that
there is no differentiation across different types of information k .
In Section III, we consider the formalization of this theory of value relevance by
considering the heterogeneity of information.
III.

THE EFFICIENT ACCOUNTING HYPOTHESIS

While the principle of capital market efficiency had long been recognized, for example
in a study of martingale pricing of Samuelson (1965), it was Famas empirical survey of 1970
that established the notion of market efficiency as a theory of information. As LeRoy (1989)
asserted, when information is regarded as the resource of asset markets, the efficient market
hypothesis (EMH) is simply a restatement of the Ricardian theory of comparative advantage.
Competitive price equilibria are determined by the interaction of traders with different
information endowments to the point where relative information differences have negligible
advantage. In 1970, Fama defined efficiency in terms of prices fully discounting information.
Fama (1970) identified three sufficient conditions for efficiency, zero transactions costs, zero
costs of information acquisition, and a consensus belief of all traders. Clearly, this was an
extreme form of the hypothesis and, in his revisitation of the EMH in 1991, Fama adopted the
Jensen (1978) definition that prices reflect information to the point where the marginal benefits
of acting on information (the profits to be made) do not exceed the marginal costs. Fama
(1991) had therefore converged to a Ricardian view.
By regarding prices as conditioned on information, Fama (1970) was able to consider
the importance of information heterogeneity. He introduced the now familiar trichotomy of
weak-, semistrong- and strong- to classify efficiency studies. Weak-form efficiency related to

13

information embedded in an assets price, semi-strong efficiency to all publicly available

information, including the asset price, and strong efficiency to all public and private
information. The advantage of identifying information in this way was twofold. First, due to
the mathematics of conditional expectations, the ordering is transitive. Strong-form efficiency
implies semistrong-form efficiency which in turn implies weak-form efficiency. In other
words, the ordering, as the nomenclature suggests, reflects the strength of the market
efficiency. The minimum hurdle for an asset market is then weak-form efficiency. A second
advantage relates to the implications for the study of information transmission. By classifying
information, we logically classify studies of information transmission in asset markets. An
event study of the release of macroeconomic information is then regarded differently from a
study of the changes in the directors shareholdings.
In tests of the EMH, information is assumed to be an exogenous determinant of an
equilibrium asset pricing model in which prices are endogenous. Necessarily, a test of the
EMH is conditional on the type of information, and necessarily it is a joint test of efficiency
and the asset pricing model. The importance of information and information heterogeneity to
the EMH cannot be overstated. Paradoxically, in studies of value relevance, the role of
information, of information heterogeneity and of market efficiency are rarely mentioned.
Typically, a value relevance study assumes market efficiency, that prices are endogenously
determined by some unspecified process, and that information is implicit in the price
determination. Hand and Landsman (1998), in their discussion of tests of the Ohlson (1995)
model, allude to the implicit assumptions of the many value relevance studies which have
resulted from the Ohlson (1995) model, including Collins, Maydew and Weiss (1997) and
Francis and Schipper (1999). These assumptions are that prices are efficient, that prices are
determined by the present value relation of expected abnormal earnings, that abnormal
earnings are generated by an AR(1) process of information dynamics and that, as a maintained
hypothesis, accounting rules are unbiased so that limiting values of economic goodwill
converge to zero. Of course, variants of these assumptions, such as a different process for the
evolution of information, will still permit a value relevance study. As a consequence, a value
relevance study is necessarily a joint test of market efficiency, of price determination, of
accounting rules and of information transmission. Logically, as for the EMH, a theory of value
relevance becomes a theory of information. And, as for the EMH, the heterogeneity of that
information becomes relevant.
The realization that prices may not be efficient and that information is heterogeneous
has begun to emerge in value relevance studies. Lev and Sougiannis (1996) find an association
14

between the capitalization of R&D and future stock returns, suggesting either systematic
misspricing of R&D intensive stocks or the presence of an additional risk factor. Barth,
Beaver and Landsman (2001) argue that markets need not be efficient for valid standardsetting inferences to apply. Rather, it is sufficient for prices to reflect a consensus belief of
traders, one of the three sufficient conditions proposed by Fama (1970). Similarly, Holthausen
and Watts (2001) assert that a requirement for value relevance studies is that markets are
reasonably efficient, which suggests that value relevance may still apply in the presence of
some market inefficiency. In general, it has been common to assume that asset pricing errors
are smaller than the errors in accounting measurement; for example in one of the tests used in
Barth (1994), prices are posited as true variables, and accounting measures as variables with
error. One response to possible market inefficiency is to adjust market prices for the
correlations between future returns and current accounting data. A study which adopts this
approach is Aboody et al (2000) who examined whether market inefficiency could explain the
decline in value relevance in a longitudinal study. They find some interaction between value
relevance and price inefficiency.
That information is heterogeneous, and that value relevance may apply to information
not measured in the balance sheet has begun to be acknowledged in recent studies. Barth
(1994) finds that in a study of banks market valuation, disclosed fair values of banks
investment securities were value relevant. Amir and Lev (1996) show that in a study of the
wireless communications industry, a nonfinancial measure of market share has value
relevance. And Hughes (2000) finds that nonfinancial measures of air pollution are value
relevant for high-polluting electric utilities. It is clear that studies of value relevance are not
limited to studies of cash and other recognized transactions. They extend also to disclosed but
not recognized information, to nonfinancial information, and to private information just as in
studies of market efficiency. Information which is not recognized in the accounts may become
value relevant through various mechanisms, often rather indirect. For example, the information
may change expectations and thereby affect both the balance sheet and market prices. In an
earnings study in 1981, Foster finds that earnings releases by other firms in the same industry
affect a given firms price. By indicating industry conditions or market share, such releases
may also affect the firms accounts through changed expectations. Indirectly, such information
becomes value relevant.
The EMH provides a clue as to how to classify information used in value relevance
studies. In the EMH, the efficiency ordering (weak-, semistrong- and strong-) relates to
whether the information is in the market price, and whether the information is public
15

information. These two criteria determine the threshold between weak- and semistrong-, and
semistrong- and strong- efficiency. The theory of value relevance proposed in Section II above
tests the price-relevance of information as it is transmitted through the accounts, that is
conditional on the accounts. Analogously to the EMH, we define a value relevance ordering
related to the heterogeneity of information. We consider four types of information
1. Information that is recognized in the financial statements.
2. Information that is disclosed but not recognized in the financial statements.
3. Information that is neither recognized nor disclosed in the financial statements, but
is public information.
4. Private information.
The term recognized is used to mean information reported in the accounts that satisfies tests for
relevance and reliability. As Davis-Friday, Folami, Liu and Mittelstaedt (1999) assert, the
Statement of Financial Accounting Concepts No. 5 FASB 1984 , para. 6 defines recognition as
The process of formally recording or incorporating an item into the financial
statements of an entity as an asset, liability, revenue, expense, or the like. Recognition includes
depiction of an item in both words and numbers, with the amount included in the totals of the
financial statements.
Examples of recognized information include cash transactions (cash sale, payment for
new equipment), accrued transactions (credit sales and purchases, provisions). Earnings and
book values largely comprise transactions information, so that existing value relevance tests
are largely tests of the price-relevance of transactions information. Under generally accepted
accounting principles (GAAP), all transactions-based information is recognized in the period
the transaction occurs. For example, a credit sale increases revenue and assets usually when
the sales transaction occurs. Of course this is subject to reasonable certainty requirements
about the realization of future cash flows. It is also the case that non-transactions-based
information reflecting value changes may also be recognized in earnings or as part of dirty
surplus, subject to prevailing accounting rules and GAAP. For example, under AASB 1041
Revaluation of Non-Current Assets, unrealized changes in non-current asset values must be
recognized when the asset is written down but when the asset is written up, recognition is
discretionary. Foreign exchange holding gains can be recognized either in earnings or dirty
surplus under AASB 1012 Foreign Currency Translation, depending on the nature of the
transaction. When asset revaluations and foreign exchange holding gains are recognized in
dirty surplus, the value relevance of earnings and the value relevance of comprehensive income
will almost certainly differ.
16

The recognition of intangible assets is particularly important in value relevance studies.

In general, only intangible assets acquired via external transaction are recognized. For
example, a cash payment to acquire a patent can be capitalized under Australian GAAP.
Capitalization and amortization of R&D usually improves the matching of revenues and
expenses with a consequent increase in the value relevance of earnings [Lev and Zarowin
(1999)]. Ceteris paribus, Australian earnings are therefore expected to have higher value
relevance than in regimes where intangibles are not recognized.
By unrecognized disclosed information, we mean financial and non-financial
information which is not recognized in the accounts. As Davis-Friday, Folami, Liu and
Mittelstaedt (1999) contend, the SFAS No. 5 (para. 9) does not provide a precise definition of
disclosure, but like Davis-Friday et al, we assume it means any depiction which is not
recognized. Examples include holding gains and losses, and fair value disclosures, which are
disclosed in the notes of the financial statements, but not recognized.
By public information that is not disclosed, we mean information that is publicly
available, but not recognized in the financial statements, or disclosed in the notes of the
financial statements. Examples include earnings releases of other firms, macro-economic
information releases, changes in expectations and changes in a firms CEO. Analogously to
Fama (1970), we refer to private information as information that is not publicly available.
Examples include the private information of insiders and informed traders.
Distinguishing information as recognized, disclosed, public but not recognized or
disclosed, and private is important to establishing an ordering of value relevance.
We call this ordering the Efficient Accounting Hypothesis (EAH). We define
(i)

Tests of weak -form value relevance relating to information recognized in the accounts.

(ii)

Tests of semistrong -form value relevance relating to information that is either

recognized, disclosed or public information that is not disclosed public information,
that is, information which is either recognized, disclosed or public information which is
not disclosed in an accounting sense.

(iii)

Tests of strong -form value relevance relating to both public and private information.
This ordering is summarized in Table 1 below.

17

Table 1 :
Classification of Value Relevance
Weak form

Recognised Information
Cashflows

Transactions

Accruals

(Recognized in Earnings)

(1) Discretionary accruals

(2) Non-discretionary accruals
(1) Asset revaluations

Non-transactions

(2) Foreign exchange gains/losses

(Recognized in Dirty Surplus)

(3) Prior-period adjustments

Semistrong form

Public Information

Recognized Information
Disclosed Information
Public Information
(not recognized or disclosed)
Strong form

Fair values of financial instruments in notes

Market share
Macroeconomic information
Pollution measures
Public and Private information

There is some evidence that recognition matters in terms of value relevance. The
FASB contends that disclosure and recognition are separable (SFAS No. 106, para. 164).
Davis-Friday, Folami, Liu and Mittelstaedt (1999) find some evidence that recognized pension
retiree benefit liability has higher value relevance than disclosed pension retiree benefit
liability. Their finding amplifies the contention of Bernard and Schipper (1994) that
recognition and disclosure may lead to different stock price effects due to investors
inappropriately undervaluing disclosed amounts or due to recognition conferring greater
reliability on the information. Conversely, Holthausen and Watts (2001) suggest that
verifiability of recognised information can impede value relevance as a result of measurement
error. Many prior studies have examined the question as to whether recognition and disclosure
have equivalent value relevance, including Landsman and Ohlson (1990), and Imhoff, Lipe
and Wright (1993). Harper, Mister and Strawser (1987), in an experimental setting, find that

18

the value relevance of recognized and disclosed pension liabilities diverge. As a consequence,
the assumption that recognition defines a threshold between weak- and semistrong-form value
relevance appears to be empirically defensible. The assumption that public and private
information confer different levels of value relevance is consistent with the EMH. Weak-form
should then be regarded as the minimum form of value relevance, and the most widely tested
form of value relevance. However, studies of semistrong-form value relevance do exist as
illustrated in Table 2 (Appendix). In this table, existing studies of value relevance are
classified in terms of weak-, semistrong- and strong-form. Within each classification there can
be varying degrees of value relevance. In Section IV below, we consider the empirical
implications of the theory of value relevance.
IV.

IMPLICATIONS FOR EMPIRICAL RESEARCH

In Section II, we proposed a recursive model for the estimation of value relevance. For
a given information arrival t,t+1 during the period t,t+1, estimation of value relevance entails
estimating the system of equations derived from (8) and (9) and given by
X t ,t +1 t , t +1 = Et ( X t ,t +1 ) + 1 t , t +1 + vt
Rt , t +1 = 0 + 1Et ( X t , t +1 ) + 21 t , t +1 + 3vt + ut

(11)
(12)

Value relevance will be determined from the product 21. There are a number of attendant
issues. First, Et (Xt,t+1) must be estimated. The simplest assumption is a nave expectations
model, so that
Et ( X t , t +1 ) = X t 1,t

(13)

Secondly, the measure of value relevance depends on both X and . We need to

operationalize both X and to estimate value relevance. For X, there are a number of
possibilities, including earnings and comprehensive income. However, it is also possible to
use a valuation measure for X, as foreshadowed by Hand and Landsman (1998), or a
disaggregated measure of the accounts such as operating cashflow. The operationalization of
is less straightforward. In semistrong-form studies, such as the release of macroeconomic
information, it will be measured as in tests of the EMH. That is, in terms of the information
surprise. Other semistrong studies can be similarly conducted; for example, information
pertaining to resource discovery announcements of the given firm, the earnings releases of
19

other firms, information about market share, changes in regulations and other nonfinancial
information can usually be measured.
In weak-form studies, the operationalization of may be contaminated by the level of
aggregation of the information. As becomes more aggregated, so collinearity problems
emerge. When is equal to X itself, and nave expectations (13) are used, we revert to the
existing value relevance studies, so that equation (12) becomes
Rt , t +1 = 0 + 1 X t 1,t + 2 ( X t ,t +1 X t 1,t ) + ut

(14)

In this equation, efficiency is tested by testing that 1 is zero, that is, that last periods
value of X has no effect on returns in this period. Value relevance is tested by testing that 2
is non-zero, that is that earnings change affects returns. Estimation of (14) constitutes an
aggregate weak-form value relevance study. Clearly, we also need to conduct other weak-form
studies. In the study of intangibles, for example, we can use measures of R&D to estimate the
information component . The measure of used will depend on the purpose of the study,
but also on the accounting principles and rules under study. In Table 3 (appended), we
provide an illustration of the combinations of X and for classifications of accounting rules
and information. The importance of this Table is that it shows that a value relevance study is
dependent on X, , and the principles and rules (P1 and P2 in Section II). Value relevance can
then be determined for all combinations of X and .
The third issue associated with equations (11) and (12) is the estimation of the two
equation system. When the covariance between the errors vt and ut is zero, the system is fully
recursive, so that equation (11) can be estimated first and the predictions and residuals from
this equation can be inserted into equation (12). That is, we estimate the second equation as
Rt ,t +1 = 0 + 1Et ( X t ,t +1 ) + 21 t ,t +1 + 3vt + ut

(15)

Estimation of equation (15) generates the familiar generated regressors problem (Pagan
(1984)), so common to tests of the EMH.
A final issue associated with equations (11) and (12) relates to the testing for value
relevance. In aggregate value relevance studies (equation 14), we test for market efficiency by
testing that 1 is zero. We test for value relevance by testing that 2 is non-zero. Aggregate
value relevance is measured by the significance of this test, that is by the P-value. Consistent
with tests of the EMH, it is logical to use the empirical significance levels because it allows

20

for comparability across different sample sizes, and different research designs. In value
relevance studies dependent on an accounting measure X and information , we first estimate
equation (11) and then equation (15). In equation (15), we test for market efficiency by testing
that 1 is zero. We test for value relevance by testing that 2 is non-zero. The value relevance
of (X, ) is measured by the significance of the test on 2, that is the P-value of this test.
Again, consistent with tests of the EMH, we can then compare the value relevance across
different sample sizes, different research designs, and different combinations of X and .
In summary, the empirical methodology which is a corollary of the theory of value
relevance in Section II is based on
1. For an aggregate value relevance study with nave expectations, estimate equation (14)
and test for market efficiency by testing that 1 is zero. Test for value relevance by testing
that 2 is non-zero. The value relevance of X is determined by the P-value of the test on 2
.
2. For a value relevance study based on an accounting measure X and information , we
first estimate equation (11) by ordinary least squares and then equation (15) by ordinary
least squares. In equation (15), we test for market efficiency by testing that 1 is zero, and
test for value relevance by testing that 2 is non-zero. The value relevance of (X, ) is
determined by the P-value of the test on 2 .
3. Comparison of the value relevance for various combinations of X and .

21

V.

CONCLUSION

In this paper, we have proposed a theory of value relevance based on a theory of

information. This theory has its foundations in the efficient markets hypothesis. It is
based on a theory of heterogeneous information arrival, and analogous to the EMH,
becomes a joint test of market efficiency, value relevance and a process of price
determination. The theory proposed is based on conditional information, conditioned
by the financial statements. As a consequence, to implement the theory, a recursive
procedure is proposed which first estimates the effect of information on the financial
statements, and then estimates the transmission of this effect to market values. The
theory and empirical implications of the theory distinguish between aggregate value
relevance studies and studies based on both accounting measures X and information .
In assuming heterogeneity of information, we permit a classification of value relevance
studies into weak-form, semistrong-form and strong-form value relevance, similar to
the classification used by Fama (1970) in the EMH. And analogous to Famas
classification, it has a similar ordering in terms of the strength of value relevance.

22

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28

TABLE 2
Selected Value Relevance Studies Classified by Accounting Variables (X) and Information Examined ()
X
1. Weak-Form Value Relevance studies
1.1 Cash Flows
Dechow (1994)
Cheng, Liu and Schaefer (1997)

Operating cash flows, Earnings

Estimated operating cash flows and Earnings
Operating, investing, financing cash flows and
earnings

Accruals
Operating Cash Flows

Lev (1989)
Easton and Harris (1991)
Easton, Harris and Ohlson (1992)

Earnings change
Earnings level and earnings change
Earnings

Warfield and Wild (1992)

Earnings

Length of measurement window

Length of measurement window and Recognition
practice

Easton, Eddey and Harris (1993)

Hayn (1995)

Property, plant and Equipment upward revaluations

Earnings

Chan and Seow (1996)

US GAAP

Lev and Sougiannis (1996)

Basu (1997)

Earnings and book value

Earnings

Collins, Maydew and Weiss (1997)

Earnings & book value

Ayers (1998)

Deferred Tax amounts

Chang (1998)

Earnings and Book Value

Nwaeze (1998)
Lev and Zarowin (1999)

Earnings and book value

Earnings, operating cash flow and book value

Black (1998)
1.2

Firm life-cycle stages

Earnings and Balance Sheet Amounts

Information in Losses & Profits

Information between Foreign GAAP earnings
versus foreign GAAP earnings reconciled to US
GAAP
R&D
Good news & bad news
Intangible Assets, Small firms, losses, one-time
items
Difference between deferred Tax amounts under
SFAS 109 versus APB 11
Accruals, Intangibles, extraordinary items, returns
variability of firms operations, difference
between firms growth rate and cost of equity
capital,
Regulation of utility industry profits
R&D and the rate of business change

29

Francis and Schipper (1999)

Ely and Waymire (1999a)
Ely and Waymire (1999b)
Ali and Hwang (2000)
Brown, Lo and Lys (2000)
Amir and Regev (2000)
Barth and Clinch (1998)
Dhaliwal, Subramanyam and Trezevent (1999)
Chen and Dodd (2001)
Aboody, Hughes and Liu (2001)

Earnings, book value, cash flows and other

fundamental variables
Earnings and book value
Earnings
Earnings, operating cash flows, accruals and book
value for manufacturing firms
Earnings and book value
Residual earnings and book value
Tangible and Intangible Non-current Asset
revaluations
Earnings and comprehensive income
Earnings, residual income and EVA
Earnings and book value

Intangibles
Different Standard-setting bodies
Intangibles
Various country specific factors
Scale effects
Trading methods and ownership concentration
Source of the valuation
Market Inefficiency

2. Semi-Strong-Form Value Relevance Studies

Clinch and Magliolo (1992)

Oil and gas industry firms proved reserve

disclosures

Barth (1994)

Banks investment securities at historical cost

Barth and Clinch (1996)

US GAAP earnings

Bryan (1997)

Cash flows, earnings, earnings change, SG&A

expenses, book value
Financial statement variables

Rees and Elgers (1997)

US GAAP earnings and book value

Graham, Lefanowicz and Petroni (1998)

Book Value of investments in associate entities

Recognised liability for retiree benefits other than
pensions
Book value
Earnings

Amir and Lev (1996)

Davis-Friday, Folami, Liu and Mittelstaedt (1999)

Hughes (2000)
Lundholm and Myers (2000)

Reliability level
Fair values and gains/losses of banks investment
securities Differences between domestic and US GAAP
earnings for UK, Australian and Canadian firms
Market share measures in the wireless
communications industry
MD & A note disclosures
Difference between foreign earnings and book
value and US GAAP earnings and book value
Fair values of investments in associate entities
Disclosed Fair Value of retiree benefits other than
pensions
Toxic Omissions
Voluntary Disclosures

3. Strong-Form Value Relevance Studies

30

TABLE 3: Classification of by rules that prescribe recognition and/or

measurement and disclosure of (1) weak-form information (2) semi-strong-form
information and (3) Strong-form information
Weak-Form
Earnings,
Rule /
Info type

Assets &
Liabilities

Dirty
Surplus

Semi-strong

Strong Form

Form
Financial

Disclosure of

Nonfinancial

Financial

Nonfinancial

policies

Public Information

Financial Reporting Rules

Recognition
and
measurement

of Revenues
Disclosure of
Revenues (eg
Segments)
Disclosure of
Expenses (eg
cost of sales)
Disclosure of
fair values
(eg
derivatives)
Disclosure of
non-financial
information
(eg market
share)
Disclosure of
Financial
Information
(eg other
firms
earnings)
Private
Information

31