2.

2 Nonrecurring items and the value-relevance of earnings and book values

Elliott and Hanna (1996) demonstrate that the market places less weight on special items than on earnings
before special items. This is consistent with special items representing 'low quality' or transitory income
items. Empirically, most nonrecurring items are losses (Elliott and Hanna, 1996; Maydew, 1997). Basu
(1997) finds that bad news has less impact on prices than good news and that failing to take into account
this differential impact can lead to lower RZs. This suggests that the value-relevance of 'bottom-line'
earnings should be decreasing in nonrecurring items. Finally, Elliott and Hanna (1996) document an
increasing propensity of firms to report special items across time. Together, this evidence indicates that
nonrecurring items could provide at least a partial explanation for an observed decline in the value-
relevance of earnings across time.

Nonrecurring items could also affect the value-relevance of book values across time. It is reasonable to
expect that firms divesting themselves of noncore lines of business and firms in financial difficulty report
nonrecurring items more frequently than other firms. If abandonment value is more salient in these types
of firms, and if abandonment value is associated with increasing value-relevance of book values, one
would expect the value-relevance of book values to be increasing in nonrecurring items. Finally, regardless
of the reason why firms report nonrecurring items, these items are likely to be more transitory than
earnings before nonrecurring items ('core' earnings). Decreased persistence can lead to less weight on
earnings and more weight on book values in the relation between price, earnings, and book values
(Ohlson, 1995).

2.3 Negative earnings and the value-relevance of earnings and book values

Hayn (1995) documents that firms reporting negative earnings have smaller earnings response
coefficients than firms reporting positive earnings. She hypothesizes that this is because shareholders
always have an option of liquidating the firm and, as a result, negative earnings cannot persist indefinitely.
She also presents evidence that the frequency with which firms report negative earnings has increased
over time.

Basu (1997) examines the role of conservatism in accounting, explaining that in conservative accounting
systems firms must incorporate bad news into earnings more readily than good news. Because of this
asymmetric treatment of bad and good news, earnings declines (or losses) are much more transitory than
earnings increases. Basu finds that failing to allow for different slopes on good and bad news reduces the
ability of earnings to explain returns. Moreover, Basu also argues that there has been an increase in the
measured degree of conservatism in recent years. 6 Combined with Hayn's results, these findings suggest
that the increased frequency of negative earnings over time could contribute to the temporal decline in
the incremental value-relevance of earnings.

Further, several papers report direct cross-sectional evidence that valuerelevance shifts from earnings to
book values when earnings are negative or as firms face financial distress (Barth et al., 1997; Burgstahler
and Dichev, 1997; Collins et al., 1997; Jan and Ou, 1995). These results are consistent with a firm's
abandonment value becoming more relevant for assessing shareholder value as the firm experiences
losses or financial distress. If book values are more closely associated with firms' abandonment values
than are earnings (Berger et al., 1996; Burgstahler and Dichev, 1997), then as abandonment becomes
more likely so will the incremental explanatory power of book values relative to earnings.
2.4 Firm size and the value-relevance of earnings and book values

Previous research suggests that book values take on increased importance in valuation when (1) current
earnings do not provide a good proxy for future earnings or (2) the firm faces an increased likelihood of
abandonment or liquidation. We posit that firm size is related to both these possibilities.

Smaller firms are more likely to include start-up companies whose value is driven by their future earnings
growth potential (i.e., abnormal earnings) than by current earnings realizations. Moreover, Hayn (1995)
shows that smaller firms are more likely to report losses than are larger firms. 7 Consequently, their
earnings persistence is lower which, according to the Ohlson valuation framework, leads to increased
importance of book values relative to earnings in valuation. We also expect that smaller firms face a
greater likelihood of encountering financial distress or of failing than do larger firms. Therefore, for
reasonscited earlier, investors may place greater weight on book values as a proxy for abandonment or
liquidation value when valuing smaller companies. This alone would not explain changes in the value-
relevance of earnings versus book values over time unless there were systematic changes in the
proportion of smaller firms represented in the sample. In fact, as we will demonstrate, we find that the
proportion of small firms in the Compustat database has increased over time as its coverage expanded to
include smaller NASDAQ firms.

3. Valuation model and 2 decomposition technique

The value of a firm's equity can be expressed as a function of its earnings and book value (Ohlson, 1995):

=0 +1 +2 +
where is the price of a share of firm three months after fiscal year-end t , , is the earnings per
share of firm during the year t , , is the book value per share of firm at the end of year t, and air is
the other value-relevant information of firm for year t orthogonal to earnings and book value.

To compare the explanatory power that earnings and book value have for prices, we decompose total
explanatory power into three parts: (1) the incremental explanatory power of earnings, (2) the
incremental explanatory power of book value, and (3) the explanatory power common to both earnings
and book value. This decomposition is used in Easton (1985) and is derived theoretically by Theil (1971).
Let

= 0 + 1 +
And

= 0 + 1 +
The coefficients of determination from Eqs. (1)-(3) are denoted 2 , 22 and 32 respectively.
Then 2 22 = 2
represents the incremental explanatory power provided by book value (incr BV),
2 2 2
and 3 = represents the incremental explanatory power provided by earnings (incr EARN).
The remaining 2 2 2
= 2 represents the explanatory power common to both earnings and
book value (COMMON).

We use this 2decomposition to investigate whether the value-relevance of accounting information has
changed over time. Specifically, we examine whether the incremental explanatory power of earnings and
book value for prices has changed over time, and if so, why the relationship may have changed. Our tests
regress 2 (TOTAL), 2 (incr EARN), and
2
(incr BV) on a timetrend variable as follows:

2 = 0 + 1 +
where TIME = 1 . . . . . 41, corresponding to the years 1953 1993. 9 The incremental explanatory power is
said to have decreased (increased) over time if ~blis significantly negative (positive). Later in the paper,
we re-estimate the above regression after adding variables that control for temporal changes in
intangibles, nonrecurring items, negative earnings, and firm size. We examine whether these additional
controls are significant in explaining the changes in explanatory power and whether they render the time-
trend variable insignificant.

4. Sample selection

The sample is selected from the period 1953-1993 using the following criteria:

i. annual earnings, book value, and share information are available on the 1994 Compustat Primary,
Secondary, and Tertiary, Full Coverage, and Research Annual Industrial Files
ii. security price and the factor to adjust for stock splits and dividends are available on the Center
for Research and Security Prices (CRSP) Monthly Returns File for the last day of the third trading
month after the firm's fiscal year end; and
iii. total assets and stockholders' equity are both greater than zero.

The selection process yields 119,389 firm-year observations for NYSE, AMEX and NASDAQ firms. 11 To
control for the effects of extreme values, we remove observations that are (1) in the top and bottom one-
half percent of either earnings-to-price or book value-to-market value, (2) in the one-half percent of firms
with the most extreme values of one-time items as a percent of income, a2 and (3) identified as outliers
in the regressions. 13 To maintain comparability across tables and figures, all tests in the paper are based
on the same final sample of 115,154 firm-year observations.