6 Collins and Kothari - 1989 JAE Paper

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An Analysis of Intertemporal and

Cross-Sectional Determinants of
Earnings Response Coefficients
Article in Journal of Accounting and Economics · February 1989

DOI: 10.1016/0165-4101(89)90004-9 · Source: RePEc
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Journal of Accounting and Economics 11 (1989) 143-181. North-Holland
AN ANALYSIS OF INTERTEMPORAL AND CROSS-SECTIONAL

DETERMINANTS OF EARNINGS RESPONSE COEFFICIENTS*
Daniel W. COLLINS
University of low, Iowa Ci+, IA 52242, USA
Duke lJniversi{v, Durhum, NC 37706, USA
S.P. KOTHARI
University of Rochester, Rochester, NY 1462 7, USA
Received November 1987. final version received February 1989
Stock price change associated with a given unexpected earnings change (the earnings response
coefficient) exhibits cross-sectional and temporal variation. We predict and document evidence
that the earnings response coefficient is a function of riskless interest rates and the riskiness,
growth and/or persistence of earnings. The earnings response coefficient also varies cross-section-
ally with the holding period return interval. Collectively, our results explain the previously
reported differential earnings response coefficient with respect to size. Moreover, by including the
factors noted above, the empirical specification of the earnings/returns relation is significantly improved.
1. Introduction
Considerable research has focused on the relation between security returns

and unexpected earnings to assess the information content of the latter.
Typically, inferences regarding the information content of earnings are based
on the significance of the slope coefficient (b) and explanatory power (R*) of
the following linear model estimated cross-sectionally and/or over time:
CAR,, = a + bUXi, + ejt,
where CAR if is some measure of risk-adjusted return for security i cumulated

over period I, UX;, is a measure of unexpected earnings (appropriately scaled),
*This paper has benefited from workshop discussions at the University of Chicago, Iowa,
Michigan, Minnesota, MIT, Ohio State, Rochester, the Stanford Summer Camp, and the Interna-
tional-Symposium on Forecasting at Boston. We acknowledge R. Ball, V. Bernard, L. Brown, S.
Choi. P. Easton. J. Fellineham. G. Foster. T. Harris, P. Healv R. Kormendi, R. Leftwich, S. Linn.
T. Linsmeier. B. Lipe. RrLundholm, J. Ohlson, B. Ricks, M. Weisbach, P. Wilson, R. Young, J.
Zimmerman, M. Zmijewski, and especially R. Watts and S. Penman (the referee) for their
comments on earlier versions of the paper. We are particularly grateful to Johannes Ledolter and Mike Rozeff for
extended discussions.
01654101/89/$3.5001989, Elsevier Science Publishers B.V. (North-Holland)

144 D. W. Collins and S. P. Kothari, Variation in earnings response coefficients
and ei, is a random disturbance term assumed to be distributed N(0, u,‘). The slope
coefficient, b, is called the earnings response coefficient (ERC).l
Generally, the returns/earnings relation is investigated using either an ‘events’ study
or an ‘association’ study method. The event studies infer whether the earnings
announcement, per se, causes investors to revise their cash flow expectations as
revealed by security price changes measured over a short time period (typically, 2-3
days) around the earnings announcement. Exam-ples include Foster (1977), Hagerman,
Zmijewski, and Shah (1984), and Wilson (1986, 1987). In essence, the focus is on
whether earnings announce-ments convey information about future cash flows.
In an association study, returns over relatively long periods (fiscal quarters or years)
are regressed on unexpected earnings or other performance measures such as cash
flows [Raybum (1986)] or replacement cost earnings [Beaver, Griffin, and Landsman
(1982)] estimated over a forecast horizon that corre-sponds roughly with the fiscal
period of interest. Association studies recognize that market agents learn about
earnings and valuation-relevant events from many nonaccounting information sources
throughout the period. Thus, these studies investigate whether accounting earnings
measurements are consistent with the underlying events and information set reflected
in stock prices. Typically, causality is not inferred. Rather, the focus is on whether the
earnings determination process captures in a meaningful and timely fashion the
valuation relevant events.
Regardless of the perspective used, the bulk of the extant empirical litera-ture
assumes the returns/earnings relation is homogeneous across firms. The slope b in eq.
(1) is treated as a cross-sectional and temporal constant. Recent studies relax this
assumption to improve eq. (1)‘s specification and explanatory power [see, e.g., Beaver,
Lambert, and Morse (1980) Ohlson (1983), Miller and Rock (1985) Kormendi and
Lipe (1987), and Easton and Zmijewski (1989)]. By combining alternative valuation
models with different earnings process assumptions these studies provide important
insights into factors that explain variation in ERCs.
This study provides further insights into factors contributing to differential ERCs in
an annual association study context. In contrast to the previous work, we examine
temporal as well as cross-sectional determinants of ERCs. The temporal variation in
ERCs is hypothesized to be negatively related to the risk-free interest rate. We expect
cross-sectional variation in ERCs to be positively related to earnings persistence and
negatively related to firm’s systematic risk. In addition, we hypothesize that ERCs are
positively related to growth opportunities that are not likely to be fully captured by
persistence
‘In using the term ‘response’ we do not imply causality. The term is used in a generic sense to
measure the degree of comovement between security returns and shocks to an earnings series
without necessarily implying that the latter cause the former. The distinction is made clearer below.
D. W. Collins and S. P. Kothari, Variation in earnings response coefficients 145
estimated using time series models. Our empirical results are consistent with all these
predictions.
We also demonstrate empirically that the earnings/returns relation varies with firm
size, where size is a proxy for information environment differences.* Differences in
information environment affect the extent to which price changes anticipate earnings
changes [Collins, Kothari, and Rayburn (1987) and Freeman (1987)]. Once differences
in the information environment are controlled by varying the return holding period,
there is little difference in the extent to which price changes covary with earnings
changes across firm size. This explains the differential magnitude of ERCs as a
function of firm size documented in Burgstahler (1981), Freeman (1987), and Collins
et al. (1987).
Our analysis also suggests that association studies that use a holding period
corresponding to a firm’s fiscal period (or between earnings announcement dates)
understate the earnings/returns association. Holding periods that begin at an earlier
point in time and span a longer time horizon enhance the
earnings/returns association relative to the conventional twelve-month hold-ing
periods, particularly for larger firms.
In section 2 we identify the determinants of ERCs using a simple dividend
capitalization model where accounting earnings are assumed to be related to future
dividends. In section 3 we discuss how noise in accounting earnings measurement and
variation in the information environment affect the estima-tion of ERCs. We also
propose ways to deal with these problems empirically.
Section 4 identifies the sample used in our empirical analysis. Section 5 demonstrates
differences in the strength of earnings/returns relation for large versus small firms as
one varies the return holding period. Section 6 is broken into two parts: first, variation
in the earnings/returns relation over time and its association with long-term risk-free
interest rates are documented; second, cross-sectional variation in the earnings/returns
relation and its association with risk, earnings persistence and/or growth are
documented. Section 7 summarizes our findings and discusses some of the implications
of our results for past and future research.
2. Equity valuation and determinants of earnings response coefficients

This section outlines an equity valuation model in which price is the discounted
present value of future expected dividends. By specifying a positive relation between
current earnings and future expected dividends, we relate the current period’s earnings
shock to unexpected stock returns via the ERC. We
‘Information environment is defined broadly to include all sources of information relevant to

assessing firm value. It includes government reports on macroeconomic conditions, industry
reports and trade association publications, firm-specific news in the financial press and reports
issued by analysts and brokerage houses in addition to accounting reports, and vertical and
intra-industry information transfers via sales and industry reports.
then discuss the cross-sectional and temporal determinants of the ERCs which
provide the basis for our empirical investigation. Finally, we compare the
determinants of the ERCs identified in this study with those in the related literature.
2.1. Equity valuation and the earnings response coefJicient
The price of security i at time t may be written as
P,, = ft E,(%+k) Tfil{l/i1 + E(fL+,)l>~

k=l
where
E,( Di,+k) = expectation at time t of dividends to be received at the end of period t + k, and
E( R i1+7) = expected rate of return on the security from the end of t + T - 1 to the end of t + 7.
In writing eq. (2), the future expected rates of returns are assumed known and
the only uncertainty about future prices is due to reassessments through time
of expected future dividends. These assumptions, together with the other
assumptions underlying the Sharpe-Lintner Capital Asset Pricing Model
(CAPM), are sufficient for the multiperiod CAPM to hold [Fama (1977)].
To derive the ERC, we assume accounting earnings are related to future
dividends and, hence, unexpected earnings cause investors to revise their
expectations of future dividends leading to security price changes. Future expected dividends are
assumed to be related to current earnings according to
k=1,2 ,..., oo,

E,(&+k) = hir+kXr, A,r+k ’ 0, (3)
where X,, is firm i’s reported accounting earnings for period t. While the
assumption in eq. (3) is ad hoc, it is useful in generating empirical predictions
tested later in the paper. Moreover, the dividends/earnings relation in eq. (3)
underlies, at least implicitly, the empirical analysis in numerous previous studies, including Ball
and Brown (1968), Freeman (1987), Kormendi and Lipe (1987), and Easton and Zmijewski
(1989). The precise values of the hittks will depend on the particular time series process that
earnings follow as a function
of the firm’s investment and dividend policies. The next section demonstrates
how alternative earnings process assumptions affect the Xitiks and the ERCs.
Substituting eq. (3) into (2):
D. W. Collins and S. P. Koihari, Variation in earnings response coeJicients 141
The unexpected return associated with unexpected earnings is derived using eq. (4) as
R;z- Et-i(R,,) = [P;,- E,-i(Pi,) + Di,- E~-~(D,,)I/PL~-~

or
uR,,= Z
‘it+kf~{L’[1+E(&+,)I>U&/f’t(5)-~>
[x*, + 1
k=l 7=1
where UX,, = X,, - E,-,( X,,) is the unexpected earnings in period t. Eq. (5)
relates unexpected earnings to unexpected returns and the coefficient on
unexpected earnings scaled by price is the ERC (the bracketed term).
2.2. Determinants of the earnings response coe@cient
Eq. (5) reveals that, ceteris paribus, the ERC is inversely related to the expected rate of return
on a security. Because we assume complete knowledge
of future expected rates of returns consistent with the multiperiod CAPM, we
can substitute the Sharpe-Lintner CAPM relation in each period:
E(h) = R/t + [E(R,,,)- R/t]6,. (6)

Using the CAPM eq. (6) and further assuming that pi, is either constant
through time or highly positively autocorrelated through time, we conclude
that the ERC is a decreasing function of a security’s systematic risk. In
valuation terms, the higher the systematic risk the smaller the present value of a given increase in
expected future dividends caused by unexpected earnings.
The ERC is affected positively by the hit+k s which relate current earnings
to future dividends. If the earnings time series has a high persistence (i.e., current period’s
earnings shocks tend to persist in the future and affect future
earnings expectations), then dividend expectations will be revised more than if earnings shocks
have low persistence. Thus, the higher the earnings persistence the higher the hrr+k~.
The effect of persistence on ERC can be shown more formally in the context of a specific
earnings process. Earnings persistence is typically measured by
estimating an ARIMA time series earnings process [e.g., Kormendi and Lipe
(1987)]. If earnings follow an IMA(l, 1) process, earnings expectations for all future periods will
be revised by (1 - fl)a,, where a, = X, - E,_,( X,) and 0 is
the moving average process parameter. Thus, revisions in earnings expecta-
tions are an increasing function of (1 - e), the persistence of an IMA(l, 1) process. Because
dividends are assumed a positive fraction of earnings, greater
persistence will lead to larger revisions in dividend expectations and the ERC
will be larger. Implications of persistence under alternative earnings process
148 D. W. Collins and S. P. Kothari, Variation in earnings response coeflcients
Table 1
Persistence factors under different ARIMA earnings processes
Persistence factor Sum of the present value of A E, ( X, + k )s

k periods in future” over all k time periods, discounted at
Earnings process AE,(X,+,) =+ku, interest rate of rb
ARIMA(O.l,
[random walk]
0) 1 or
ARIMA(O,O, 1) -@.a, k=l
1- O
[Miller and Rock 0 k>l
(19W1
ARIMA(O.1, 1) (1-B)u, forall k
L- 1
[Beaver, Lambert, r a,
and Morse (1980)]
ARIMA(1,O.O)
++1
[Easton and
Zmijewski (1989)]
ARIMA(2,l.O) (1+ r)/r

-1 a,
[ Kormendi and 4, = (1 + +,)a, k=1
1 - &/(l + r) -$5/Q + r>* I
Lipe (1987)]
‘u, = X, - E,_ i( X,) is the shock in period t’s earnings, Earnings follow an ARIMA time series
prYess.
Following Kormendi and Lipe (1987) and Flavin (1981), the present value of the revisions in
earnings expectations caused by (I, over an infinite horizon for an ARIMA( p, d, q) process is a
function of the AR( c$) and MA( 8) paramenters as follows:
One plus the bracketed term in the last column gives the theoretical earnings response coefficient
for that particular earnings specification.
assumptions used in previous studies are presented in table 1. Assuming

constant discount rates and an isomorphic relation between future earnings
expectations and future dividend expectations, one plus the right column in
table 1 presents the theoretical ERC for each of the alternative earnings processes. The
theoretical ERC is the price change induced by a one-dollar shock to current earnings and is
equal to one plus the present value of the revisions in expected future earnings caused by this
shock. Therefore, the ERC
D. W. Collins and S.P. Kothari, Variation in earnings response coejficients 149
is expressed in terms of the autoregressive [AR(+)] and moving average [MA( 0)]
parameters of the alternative ARIMA earnings specifications accord-ing to the formula
adapted from Kormendi and Lipe (1987) and Flavin (1981).
Many valuation models express firm value as the sum of the present value of
dividend stream from investments yielding a ‘normal’ rate of return and growth in
future dividends stemming from the existence of investment oppor-tunities that are
expected to yield an above ‘normal’ rate of return [see, e.g., Fama and Miller (1972, ch.
2)]. The ‘normal’ rate of return is the rate of return commensurate with the riskiness of
investments in a competitive industry. Growth because of investing in projects that
yield above normal rates of return in generally referred to as ‘economic growth’.
Ceteris paribus, the future earnings and dividend streams will be larger in the presence
of growth opportunities than absent such opportunities. Hence, if the current earning
surprise is informative of the growth opportunities, the hil+k~ are expected to be a
positive function of growth opportunities.
In the context of classic valuation models [e.g., Miller and Modigliani (1961)]
current earnings may not necessarily reveal growth opportunities because in these
models only future investments are assumed to earn above normal rates of returns.
Realistically, however, current earnings are a result of investments in both growth and
no-growth projects. Accordingly, growth opportunities include investments in new as
well as existing projects where the profit rate (m) differs from the normal rate of return
(r). Current earnings are likely to signal useful information about the changing spread
between 7r and r for the current investments as well as for future investments.
Moreover, current earnings and current dividends may jointly signal managements’
private information about growth opportunities on future investments. For example,
Easton (1985) finds a negative relation between current dividends and future dividends
after controlling for the current earnings effect. This is consistent with lower current
dividend payout signalling higher future divi-dends because of earnings invested in
projects where 7~> r.
A key question that remains is whether time series persistence estimates fully and
accurately capture economic growth opportunities. We believe this is problematic for at
least two reasons. First, time series analysis cannot distin-guish between correlation in
successive earnings numbers brought about by mere expansion (i.e., earnings
reinvestment through time or increases in external financing) versus economic growth.
The latter has shareholder wealth implications while the former does not. Second, and
perhaps more important, ARIMA models typically assume parameter stability.
Therefore, any trend term that picks up earnings expansion and/or growth is constrained
to be a constant. This is a limiting assumption, particularly when estimates are based on
annual data for a 20-30-year time frame [see Kormendi and Lipe (1987)]. Given a
competitive environment and dynamic macroeconomic conditions, economic growth
opportunities are likely to be short-lived. Accordingly, fixed
150 D. W. Collins und S.P. Kothnri, Variation in earnings response coefficients
parameter ARIMA estimates derived from lengthy time series represent some
sort of a weighted average of changing growth opportunities over time. Because we expect the
persistence estimates from time series models to be
deficient in accurately reflecting current growth opportunities, we include a
proxy for the latter as an additional determinant of ERCs.
In addition to the three cross-sectional determinants of the ERC, we
hypothesize interest rates as a temporal determinant of the ERC. To derive a temporal relation
between interest rates and the ERC, we assume that the
expected rates of returns in the future periods vary over time. That is, E(Rit+7) can vary over t.
We further assume that the current risk-free interest
rate is highly positively autocorrelated with the future risk-free interest rates. Because the risk-
free interest rates are a component of E(R,,+,), the higher the current risk-free interest rate the
higher the expected rate of return on the
security in the future periods. Therefore, we predict a negative relation between interest rates
and the ERC through time.3
In hypothesizing the negative temporal association between interest rates and the ERC, we
deviate from the assumption underlying the discounted cash flow model and the multiperiod
CAPM that all the future E( R,,,,) are known at time t and, thus, cannot vary with t. However,
relaxing this assumption
generates an interesting empirical prediction and is consistent with the evi-dence that both
nominal and real interest rates change through time [see, e.g.,
Ibbotson and Sinquefield (1985)]. If the ERC is derived using continuous time
valuation models like Merton (1973) or by allowing uncertainty in future
commodity prices and the future investment opportunity sets [Long (1974)], the effect of interest
rate variation through time on the ERC will enter into the model more directly. These extensions
are beyond the scope of this paper, but are fruitful avenues for future research.
To summarize, we identify four factors contributing to cross-sectional and temporal

differences in the ERC. The ERC is positively related to earnings
persistence and economic growth opportunities. The ERC is negatively related to the securities’
future expected discount rates. The discount rate is made up of (i) the risk-free interest rate, R,,
and the market risk premium, and (ii) the firms’ CAPM beta risk. Because R, and the market risk
premium are the same
for all firms, they obviously are not a source of cross-sectional variation in ERCs. The ERCs are
negatively related to the interest rate levels through time and the CAPM beta risk in the cross-
section.
3 We use a partial equilibrium analysis to examine the interest rate effect on the ERG. Interest
rate changes affect, among other things, the saving/investment decisions of individuals and
corporations which, in turn, affect the firms’ future cash flows. Incorporating these effects on cash flows and their
present values to derive a relation between interest rates and the ERCs requires a
complete equilibrium analysis that is beyond the scope of this paper. We essentially ignore the
saving/investment and associated cash flow implications of interest rate changes in making our predictions.
D. W. Collins und S. P. Kothari, Vuriation in eurnings response coefficients 151
Previous studies identify persistence and systematic risk as the determinants of ERCs. The
Garman and Ohlson (1980) and Ohlson (1983) earnings capital-ization models suggest that
ERCs are positively related to the extent to which
current period’s unexpected earnings lead to revisions in future periods’
dividends and earnings (i.e., earnings persistence) and inversely related to the
systematic risk of earnings. Miller and Rock (1985) derive the effect of earnings persistence and
systematic risk using a two-period model.
Kormendi and Lipe (1987) and Easton and Zmijewski (1989) derive ERC
determinants using a discounted cash flow valuation model. The primary
difference between their analysis and ours is that they derive the ERC by
assuming a specific time series earnings process, namely, an autoregressive earnings process.
Both these studies provide evidence that persistence has a positive effect on ERCs and Easton and
Zmijewski (1989) report a modest negative relation between beta risk and ERCs. However,
neither study explic-
itly considers the effect of growth on the ERCs. Effectively, the impact of
growth opportunities on ERCs is assumed to be fully captured by their earnings persistence
measures. Our previous discussion and subsequent empir-ical analysis reveal that persistence
estimates are unlikely to capture economic growth fully.
3. Estimation problems and methodological considerations
3.1. Error in measuring unexpected earnings and returns
The covariance between unexpected returns (UR ir) and unexpected earnings (UR,,) can be
summarized as follows:
c+> (-> (+I c-1

cov(W,Jx,,) =f( P ersistence, risk, growth, interest rates ).
temporal
cross-&tional
variation variation
Empirically, at least two other factors affect the estimated COV(UR,~,UX,~)

and, hence, the estimated ERC: (a) noise in reported accounting earnings as
an indicator of future expected dividends and (b) the firm’s ‘information environment’.
The above two factors lead to error in measuring UX,,. Empirical proxies for
UX,, contain error because: (i) Accounting earnings measure firms’ future dividend paying
ability with error. The market uses other variables in addition
to accounting earnings in forecasting future expected dividends and in this
sense unexpected accounting earnings is a noisy predictor of revisions in
future expected dividends. (ii) The market’s earnings expectation at a given
point in time differs from a simple time series earnings expectation proxy. The
presence of competing (and more timely) sources of information in addition to
reported earnings renders the time series earnings expectation a noisy measure of UXi,
[see, e.g., Collins et al. (1987) and Freeman (1987)].
Measurement error in a UXi, proxy attenuates the ERC and makes it difficult to
detect the influences of the ERC’s determinants. The bias in an estimated ERC can be
substantial. Indeed, evidence in Beaver et al. (1980) suggests that ERCs estimated at
the individual security level using a time series earnings expectation proxy for UX,,
understate the ‘true’ or theoretical ERCs by as much as 70-80%, on average.
If we could obtain a better measure of the market’s earnings expectation at time r -

1, the measurement error problem in a proxy for UXi, would be reduced. However,
empirically this is difficult. While analysts’ forecasts are better than time series proxies
[Brown et al. (1987a, b)], they are not available in a machine-readable form over the
time period examined in this study and they are generally available only for the larger,
more widely held firms. An alternative approach to reduce the measurement error
problem is to set t - 1 (i.e., the beginning of the holding period) at a point such that the
time series proxy (in our case, a random walk specification) approximates the market’s
earnings expectation. We adopt the latter approach by varying the return window.
Varying the return window ensures that a particular UX,, proxy matches up closely
with the true (but unobservable) market earnings expectation and provides a
specification check on previous work relating earnings changes to security returns.
This allows us to u e the same earnings expectation model across all firms (which is
typically done in empirical work) and find the point in calendar time when that
particular proxy best approximates the market’s earnings expectation for a particular
firm. This ensures that the estimated response coefficient fully captures the market’s
valuation of unexpected earn-ings. Varying the return window also allows us to assess
how this affects the
earnings/returns association as measured by adjusted R* across firm size.4 In addition
to error in UX,, proxy, cross-sectional differences in the infor-
mation environment contribute to nonrandom variation in the earnings/ returns relation.
If firm size is a proxy for information environment differ-ences, then different size
firms will exhibit different ERCs on measuring UXjrs over a fixed holding period for
all firms [see, e.g., Collins et al. (1987)]. In this sense returns measured over fixed
holding periods contain ‘error’. Holding the earnings expectation model and the return
cumulation period constant across all firms can result in a spurious association between
firm size and ERCs in an
41f returns are the dependent variable and we vary the length of the holding period from one
model to another, then the adjusted R’s are no longer comparable since the total sum of squares will differ from one
model to another.
D. W. Collins and S.P. Kothari, Variation in earnings response coeficients 153
annual association study. This spurious correlation occurs because of differ-ences in the
lead-lag structure in the earnings/returns relation caused by the information
environment differences for large versus small firms. Moreover, if the lead-lag relation
between returns and earnings changes is ignored and time series proxies for UX,, are
used, then association studies will severely understate ERCs.
3.2. Reverse regression and the return response coejicient

We use multiple regressions to test whether various factors identified earlier are
related to the ERCs. To address the measurement error problem, we employ reverse
regression [see Maddala (1977) Learner (1978), Klepper and Learner (1984), and
Beaver, Lambert, and Ryan (1987)]. Specifically, we regress earnings changes on
returns and a series of terms representing interac-tions between returns and risk, growth
and/or persistence, and interest rates. We adopt this approach over various grouping
procedures in direct regression for several reasons.5
First, using a UX;, proxy as the dependent variable reduces the attenuation bias that
exists when ERCs are estimated at the individual security level using eq. (1). Second,
having returns on the RHS allows us to conveniently test for differences across firm
size in the lead-lag relation by incorporating both
contemporaneous and earlier period’s returns as explanatory variables. Fi-nally, with
returns on the RHS, we can vary the length of the return holding period for different
firms (i.e., combine varying portions of contemporaneous and leading returns into one
metric). As noted earlier, by varying the length of the return window we control for
cross-sectional differences in information environment because the return period is
expanded until the market’s expecta-tion of current period’s earnings is approximated
by the prior year’s earnings (i.e., earnings change is now unexpected).6
One consequence of using reverse regression is that we estimate the return response
coefficient (RRC) rather than the ERC. The reciprocal of RRC is an estimate of the
ERC in the simple regression context. This interpretation is
‘See Beaver et al. (1980) for a discussion of alternative grouping procedures in direct regression
to mitigate measurement error in I/X,, proxies. Beaver, Lambert, and Ryan (1987) discuss reasons
for preferring reverse regression over these grouping procedures.
6This approach assumes implicitly that the market is able to forecast accurately the prior year’s earnings number
well in advance of its actual release. Thus, using the prior year’s earnings as a
basis for predicting the current year’s earnings (even though the former has not yet been released) only assumes that
the market makes an unbiased assessment of what the number will actually be.
To the extent this assumption does not hold, it weakens the earnings/returns association when
return cumulation begins in an earlier period. Evidence in Beaver et al. (1980), Collins et al. (1987), and Freeman
(1987) suggests that the market anticipates earnings changes from t - 1 to t well before earnings for t - 1 are reported.
154 D. W. Collins and S.P. Kothari, Variation in earnings response coefficients
based largely on the evidence in Beaver, Lambert, and Ryan (1987). In section 2 we posited that
the ERC is related to four factors: earnings persistence (+),
growth (+), risk (-), and interest rates (-). In reverse regressions, these
functional relations are inverted. That means the RRC increases in risk and interest rates and
decreases in earnings persistence and growth. These predic-tions are expected to hold when
earnings changes are scaled by price which is the scaling variable according to the analysis in
section 2 and in Christie (1987). However, if earnings changes are scaled by previous year’s
earnings as in Beaver et al. (1980) and many other earnings association studies, then RRC
is likely to exhibit lesser association with the four determinants for reasons discussed in section
3.3.3.
The inverse of the estimated RRC is the upper bound for ERC. Therefore, attempts to infer
the earnings process or to place other economic interpreta-tions on the inverse of the estimated
RRC must be approached with caution.
Accordingly, we interpret the RRCs conservatively and use significance tests
only to judge whether its determinants have the predicted signs.
3.3. I. Empirical measures of returns
The analysis in section 2 suggests that the appropriate return metric is

R,, - E,_,( Ri,). We use R,, (return inclusive of dividends) throughout as a
first approximation for three reasons:
(1) E,_ t( R,,) is an ex ante measure of expected return, but ex ante measures of riskless rates
and risk premia are not readily available. Most studies use
an ex post measure of E,_ i( R,,) conditional on the realized market return for period t
which introduces error into the return metric.
(2) Relative to the temporal and cross-sectional variability in R,,, the variabil-ity in E,_,( Rjt)
is small. Hence, the use of R,, - E,_i( Rjt) essentially amounts to using Ri,.
(3) Beaver et al. (1980) and Beaver, Lambert, and Ryan (1987) report that the
earnings/returns relation is essentially the same whether one uses R,, inclusive or exclusive
of dividends or market model prediction errors.
3.3.2. Proxy for unexpected earnings
While the model in section 2 is in terms of a generic unexpected earnings measure (UX), our
empirical analysis uses annual earnings change (scaled by price or previous year’s earnings) as a
proxy for UX. There are at lease three reasons for this choice.
(1) Many annual earnings/returns association studies use a random walk model as a proxy for
the market’s earnings expectation as of the beginning
of the year. Thus, annual earnings change is the appropriate proxy for
unexpected earnings.
(2) Unexpected earnings using more sophisticated ARIMA models require a

relatively long data history (20-30 years) to estimate parameter values. This would restrict
our sample severely and reduce the range of size and
risk profiles which are determinants of the ERCs. We do, however, use an
IMA(l, 1) model to estimate earnings persistence for a subset of our sample firms with the
requisite data and these results are reported below.
(3) The two empirical procedures described above (i.e., reverse regression and
expanding the return holding period) reduce the potential measurement error that results
from using annual earnings changes as a proxy for VX,,.
_??._‘.3. Scaling factor for earnings changes
Although the specification of ERC in section 2 suggests the appropriate scale variable for AX
is Pt_l, we also report results when AX, is scaled by
X ,_I.7 This is to demonstrate the sensitivity of our findings with respect to a
popular alternative scale variable and to enhance the comparability of our results with previous
studies that have used A X,/X,_ 1 variable to investigate
the earnings/returns relation [e.g., Beaver et al. (1980) Burgstahler (1981)
Beaver, Lambert, and Ryan (1987) and Collins et al. (1987)J.”
Another reason for using A X,/X,_, variable is to test the implication
following from the assumption in Ohlson (1983) and Beaver et al. (1980) that
the earnings capitalization rate (p) is a temporal constant.If this assumption
is true, then the slope in the earnings/returns relation is smaller by a factor of
l/p when AX, is scaled by X,_ 1 versus Pt_l, where p is the temporal constant
earnings multiple that incorporates interest rates, risk, growth, and earnings
persistence. That is, ERC when AX, scaled by X,_ 1 = (ERC when A X, scaled
by P,_l)/p. Thus, with constant capitalization rates, scaling by X,_ 1 elimi-
nates (or reduces substantially) both cross-sectional and temporal dispersion
in ERCs. Thus, factors such as risk, persistence, growth, or interest rate should
possess little explanatory power in the earnings/returns relation.
We hasten to note that these predictions are conditional on the descriptive
validity of the assumptions underlying the Beaver et al. (1980) or Ohlson
(1983) models. These results may not obtain empirically for at least three reasons:
(1) p is likely to vary with changes in risk-free interest rates or risk premia.
Casualobservation suggests that P/E ratios are relatively high (low) during low (high)
interest rate periods. Therefore, in a relation between
‘Because annual earnings change is used as proxy for UX, we use AX instead of UX in the
remainder of the paper.
“Some argue that price is not an appropriate deflator and conclude, at least implicitly. that some
other deflator like previous year’s earnings is a more appropriate deflator [see. e.g., Lustgarten (1982)].
156 D. W. Collins and S.P. Kothari, Variaiion in earnings response coefficients
nominal returns and earnings changes, ERCs are likely to vary over time even
when scaling by X,_ i.
(2) While price is expressed as a multiple of expected or current earnings, the
prices/earnings relation is unlikely to be deterministic. A more realistic
prices/earnings relation would be
where qit is a random disturbance. Thus, when scaling by Xt_i, it is not obvious
that the effect is simply to render the ERC smaller by a factor of l/p as shown
earlier.
(3)Measurement error in the earnings variable is another factor affecting the

magnitude of the ERCs through time. This is particularly true when reported
earnings for t - 1 are negative. (We, like others, delete such observations from our
empirical analysis.)
In summary, we make clear-cut predictions about the sign of the relation between
ERCs and risk, persistence, growth, and interest rates when AX, is scaled by
Pt_l.However, when scaling by X,_ 1 the only clear prediction is that the relation
between these factors and ERC will be zero if the assumption of constant temporal
capitalization rate on earnings holds. If this assumption does not hold, then the
predicted relations between these factors and ERCs noted in section 2 will be
attenuated or may even change sign.
4. Sample selection and descriptive statistics
4.1. Sample selection
We initially identify a sample of firms from the Compustat Industrial

Annual and the Compustat Research Annual tapes with a December 31 fiscal
year-end and a minimum of three years of earnings data for each year t from
1968 to 1982 (a total of 15 years).’ The December 31 fiscal year-end criterion
is imposed to facilitate data analysis and enhance comparisons with previous
studies that have imposed this restriction [e.g., Beaver et al. (1980) and
Kormendi and Lipe (1987)]. From the Compustat sample, only firms listed on
the NYSE are included for further analysis. We limit the sample to NYSE
firms because we use monthly return data to estimate systematic risk and also
use monthly returns to obtain buy-and-hold returns over varying holding
‘Identifying firms from the Compustat Research Annual tape reduces the severity of the
survivorship bias inherent in sampling only from the Compustat Industrial Annual tape. Also,
data for firms delisted because of mergers, acquisitions, and takeovers are available on the research tape for the years
prior to their mergers, etc. We increase the sample size by approxi-mately 20% by using the research tape.
periods. The CRSP monthly returns tape contains only NYSE-listed firms. We use
monthly return data to estimate systematic risk because beta estimates using daily
returns data are biased and inconsistent [Scholes and Williams (1977)]. The subset of
NYSE firms for which monthly return data are available on the CRSP tapes for eight
consecutive years ending in year t + 1 is included in the final sample. Monthly returns
for the five years up to the end of year t - 2 are used in estimating the firms’ systematic
risk (market model betas) and returns over varying lengths of time for the next three
years (i.e., years t - 1 to t + 1) are used in the regression analysis. These criteria yield a
sample of 9776 firm-year observations. The number of observations in each year varies
from 519 in 1968 to 730 in 1978.
4.2. Descriptive statistics

Descriptive statistics for the sample are presented in table 2. Since the sample
selection criteria result in only firms with NYSE listing, the sample firms are above
average in their equity market values relative to all publicly traded stocks. The mean
firm size is $860.4 million. However, a large standard deviation ($2644.2 million) of
the sample distribution of market values and the minimum and maximum market
values of equity of the sample firms suggest there is considerable variation in firm size
within our sample. This is important because one of our objectives is to assess whether
ERCs are a function of firm size and to demonstrate that this variation is sensitive to
the definition of the return holding period.
Each security’s systematic risk is estimated by regressing monthly returns over sixty
months on the CRSP equally weighted market return index. The sample mean beta is
0.92 which suggests that the sample is slightly less risky than the average security
listed on the NYSE. This is expected because the sample selection criteria are biased
towards including larger NYSE firms and previous evidence suggests that firm size and
beta are inversely related [see, for example, Banz (1981)].
Summary statistics for the percentage change in earnings variable (%AX,) are based
on 9045 firm-year observations because we exclude observations with a negative
denominator or observations with I%AX,l > 2008.” The reduction in sample size is due
largely to firms reporting losses (negative denominator) and thus represents an
asymmetric loss in the sample. This is a problem that is common to all the research
studies using the %AX, variable. On average, firms in our sample report an annual
increase of 7.85% in their earnings over the years 1978 to 1982. The second earnings
variable, change in earnings deflated by price (A Xt/P1_r), is free from the negative
denominator
“The decision to exclude observations with ISA X,( > 200% may seem arbitrary, but it is
consistent with previous research in this area.
158 D. W. Collins and S.P. Kothari, Variation in earnings resporwe coeJ%ents
Table 2
Summary statistics for market value of equity, risk, and change in earnings: Sample of 9776
firm-years from 1968-82.=
Standard
Variable N Mean Median deviation Minimum Maximum
Market 9776 860.4 245.3 2644.1 1.86 47,888

value of
equityb
Risk 9776 0.92 0.87 0.40 - 0.37d 3.01
(beta)’
Percentage 9045 7.85% 8.63% 43.22% - 200.0% 198.0%
change in
earnings’
Change in 9718 0.82% 0.77% 10.94% - 97.85% 99.76%
earnings
scaled by
price’
“Initially any firm listed on the Compustat Industrial Annual or the Compustat Annual Research tape with a
December 31 fiscal year-end and a minimum of three years of earnings data during 1968-82 is included in the
sample. From this sample, the subset for which monthly return
data are available for eight consecutive years ending in 1969-83 is included in the sample analyzed in this study.
bMarket value of equity is defined as the beginning of the year share price times the number of
shares outstanding; in millions of dollars.
‘Market model beta estimated by regressing monthly returns over five years on the NYSE equally weighted index.
dMarket model betas of three securities are negative.

“Percentage change in earnings, WAX,, is change in earnings per share from year t - 1 to r divided by the earnings
per share for year t - 1, all adjusted for stock splits and dividends. A total
of 731 observations with negative denominators or \%A X,1 z 200% are excluded.
‘Change in earnings scaled by price, A X,/P,_ Lr is change in earnings per share from year t - 1
to t divided by share price at the beginning of year t. A total of 58 observations with
IAX,/P,_,l> 100% are excluded.
problem. Therefore, it has a larger sample of 9718 firm-year observations.

Observations with (AX,/P,_,I > 100% are excluded which causes a small
reduction in sample size from 9776 to 9718 observations.” The sample mean
and standard deviation for the distribution of AX/P,_, are 0.816% and 10.94%.
5. Firm size, information environment, and holding period returns
As noted earlier, a contemporaneous regression of annual returns on earn-

ings changes understates the ERC and the degree of understatement varies
“Once again, the decision to exclude observations with /A X,/P,_ ,( > 100% is arbitrary, but, as
can be seen from table 2, these observations are more than nine standard deviations away from
the mean. Inclusion of these observations in the sample would likely have an undue influence on the estimated
regression coefficients.
with firm size. If firm size is correlated with risk, growth, and persistence (which seems likely),
then failing to control for differences in the lead-lag
structure of returns and earnings will confound tests for differences in the
earnings/returns relation due to the factors identified earlier.
To demonstrate the relation between firm size and the lead-lag structure, we regress earnings
changes (scaled by Pt_lor X,_,) on security returns from
the contemporaneous and lagged fiscal year according to the following model:
where, consistent with previous research, R;,is measured from April of year t to March of year
t + 1 and R itI-is measured in an analogous fashion.
Results in the first two rows of table 3, using all stocks in the sample, reveal that coefficients
on both current and lagged year’s returns are of comparable
magnitude and highly significant. l2 Thus a nontrivial portion of the events
contributing to accounting earnings changks in the current period are captured in security
returns from an earlier period.
To ascertain whether the degree to which lagged returns explain earnings changes varies
with firm size, we partition our sample into three equal-sized
groups by ranking firms each year according to the beginning of year equity market vales.
Results of estimating eq. (8) for the small, medium, and large firm groups are reported in the
lower portion of table 3. Lagged year’s returns
possess significant explanatory power for all three size groups. However, the
magnitude and significance of f1 in relation to f2 suggest that R,+,is more
important in explaining earnings changes for large versus small firms, which is
consistent with Collins et al. (1987) and Freemen (1987).
While the above analysis suggests that the earnings/returns association is enhanced by
including returns from an earlier time frame, the results do not identify exactly how far back one
should go. This is difficult to specify a priori
and will vary as a function of the timing of valuation relevant economic
events, the nature of a firm’s information environment, and how quickly
economic events are captured in the accounting earnings numbers. Basically, then, it becomes
an empirical issue.
To shed some light on this issue, we regress earnings changes on returns
where the return measurement is started at varying points in time and
extended over varying time frames. We always use buy-and-hold returns.
Specifically, we vary the start of the return cumulation process from January of fiscal year t - 1
to June of fiscal year t and allow the length of the holding
‘*The t-statistic may be overstated because cross-dependencies are ignored. However, even after
downward adjustments the p-value is likely to be less than 0.01.
160 D. W. Collins and S.P. Kothari, Variation in earnings response coejicients
Table 3
Pooled time series cross-sectional regression of earnings changes on contemporaneous and lagged
security returns: 1968-82.a
I ,. ,.
Dependent
variable Firm sizeb NC ( t-s&)d (r-skgd ( t-s:2at)d Adj. R2
AT/p,-, All 9718 0.001 0.038 0.058 3.56%

(3.04) (10.56) (16.82)
%AX, All 9045 0.034 0.256 0.310 6.90
(7.18) (16.78) (21.47)
AX/p,-, Small 3215 0.005 0.031 0.083 3.68

(1.87) (3.86) (10.79)
AX/p,-, Medium 3251 - 0.002 0.045 0.043 4.61
(- 1.09) (9.43) (9.34)
AX/p,-, Large 3252 0.000 0.044 0.033 5.72

(0.33) (11.69) (9.31)
%AX, Small 2725 0.032 0.213 0.384 6.76
(2.92) (6.90) (12.93)
‘%AX, Medium 3126 0.024 0.255 0.293 7.28
(3.14) (10.54) (12.70)
%AX, Large 3194 0.045 0.311 0.231 7.97
(7.37) (13.94) (10.99)
“Sample selection criteria are given in footnote a to table 2.

A X,/P,_, is change in EPS from year t - 1 to t divided by share price at the end of year t - 1.
A total of 58 observations with IA X,/P,_ II > 100% are excluded.
%A X, is change in EPS from year t - 1 to t divided by the EPS for year t - 1. A total of 731
observations with negative denominators or Is&AX,1 z 200% are excluded.
R ,,- L is raw return from April of year t - 1 to March of year t and R,, is raw return from April of year r to March of year r + 1.
bAll the sample firms are ranked every year on the beginning-of-the-year market values of equity and assigned to
the small, medium, and large firm portfolios in equal numbers.
‘N is number of firm-yearobservationsin each regressions.N is not equal in each regressions
because of asymmetricreduction in sample due to negative denominators or outliers.
dt-statistic of 1.96 implies a p-value of 0.05 and t-statistic of 2.58 implies a p-value of 0.01 using two-tailed tests.
period to range from 12 to 18 months.13 For example, when returns are

measured over 14 months, the first 16month period is from January of year t - 1 through
February of year t and the 18th 1Cmonth period begins in June of year t and extends through
July of year t + 1.
Since size is hypothesized to affect the lead-lag structure between returns and earnings
changes we estimate regressions separately for small, medium, and large firm groups. The
entire analysis is performed using both earnings
t3We also used periods longer than 18 months, but the earnings/returns association is
maximized using returns measured over periods shorter than 18 months. We, therefore, do not report these results.
change variables, i.e.., AXJP,_, and %AX,, as the dependent variable. Since the
dependent variable is the same across all models, adjusted R2 is the criterion used for
identifying the starting point and length of cumulation period that maximizes the
earnings/returns association.‘4 Obviously our re-sults are sample- and period-specific
and only indicate the sensitivity of the earnings association tests to the length of the
holding period return. Hopefully, these results will guide future research in specifying
return holding periods in association study contexts.
Adjusted R2s from the regressions of SAX, on returns measured over alternative
periods for the large and small firm portfolios are plotted in figs. 1 and 2.15 Fig. 1
reveals that the length and starting month of the return measurement have a dramatic
effect. For example, the typically selected 12-month April to March return period
results in an adjusted R2 of 2.41% which suggests a weak association between large
firms’ price and earnings changes. However, when the 12-month period begins in
January the explana-tory power jumps to 6.49%. The maximum adjusted R2 of 10.94%
is attained when a 15-month period starting in August of year t - 1 is used. Thus, the
explanatory power for large firms increases substantially by increasing the length of the
holding period from 12 to 15 months and by measuring returns from August of year t -
1 instead of April of year t. The same return measurement period maximizes the
model’s explanatory power for medium size firms and overall the results are quite
similar to those in fig. 1.
Turning to fig. 2, for small firms, adjusted R2 is maximized once again using a 15-
month period but beginning in November of year t - 1. This is consistent with the
regression results for large and small firms reported in table 3 and the evidence in
Freeman (1987) and Collins et al. (1987). The maximum adjusted R2 for small firms is
9.34%.
Comparing figs. 1 and 2 demonstrates clearly the systematic differences between
large and small firms in the extent to which alternative holding
periods dominate the conventional April-March or January-December peri-ods. There
are many fewer holding periods that dominate a January-Decem-ber holding period for
small firms as compared to large firms. The association between earnings and price
changes is maximized for holding periods (of fixed
14Conclusions based on adjusted R’s are not affected by our choice of reverse regression. This
follows because in case of simple regression adjusted R* is unchanged when the independent and
dependent variables are interchanged [see Maddala (1977, pp. 77-79)]. Our discussion of the
sensitivity of the degree of association to length and cumulation period of returns ignores
magnitudes of slope coefficients from all the regressions. The magnitude of the slope coefficient is
maximized when adjusted R* is maximized since R* is an increasing function of the estimated slope when it is
positive.
“To improve the visual clarity of the graphs, figs. 1 and 2 do not plot adjusted R’s when returns are measured over
17 and 18 months. The results for A X,/P,_ I are virtually identical to those reported here.
D. W. Cohs und S. P. Kothari, Variation in eurrtings response coeficients
15 Month Holding Period

Aug, t-l - Ott, t
Jan, t - Dee, t
0 I I I I I I -J
0 1 6 12 16
at- 1 1 t --__
Beginning month for the return holding period
12 - month return holding period 4 15 - month return holding period
16 - month return holding period

13 - month return holding period -El-
Fig. 1. Large-firm sample results: Association of various holding period returns with earnings
changes in period t. Month 1 is January of fiscal year t - 1 and month 18 is June of fiscal year f.
15 Month Holding Period

Nov, t-1 - Jan. t+l
r Jan, I - Dee, I
t - Mar. I+1
0 1 6 12 16
c------- I- 1 t --__
Beginning month for the return holding period
+I- 12 - month return holding period + 15 - month return holding period
+ 13 - month return holding period

il-
f 14 _ month return holding period
Fig. 2. Small-firm sample results: Association of various holding period returns with earnings changes
in period t. Month 1 is January of fiscal year t - 1 and month 18 is June of fiscal year t.
length) that begin at an earlier point in time for large firms compared to small firms.16
To summarize, a conventional 1Zmonth return period understates the

earnings/returns association, particularly for larger firms. The association is maximized
when returns are measured over 15 months starting from August of year t - 1 for large
and medium firms and November of year t - 1 for small firms. All further analysis is
performed using returns measured over the 15-month intervals appropriate for each
size grouping. In the remainder of the analysis the AX,/P,_, variable is defined as AX,
scaled by price at the beginning of the appropriate 15-month return interval for each
firm. This ensures that the scale variable is consistent with the model in section 2.
6. Determinants of earnings response coefficients: Empirical evidence
6.1. Interest rates and temporal differences in response coeflcients
Based on the model in section 2, the rate at which earnings are capitalized into
prices is inversely related to the risk-free interest rate. From an empirical standpoint the
capitalization rate would be a function of current as well as expected future interest
rates or the term structure of interest rates. We use yields on long-term U.S.
Government bonds reported in Ibbotson and Sinquefield (1985) as a proxy for the risk-
free interest rate and assume that the term structure is flat.” While this may not be
descriptively valid, it simplifies the analysis and biases against finding a temporal
relation between interest rates and the RRCs.18
The correlation between long-term U.S. Government bond yields and the RRCs
from annual regressions of earnings changes on returns measures the
t6A potential limitation of extending the return interval to include lagged periods returns is that
part of the price change in f - 1 is likely to capture shocks or changes in accounting earnings for that period. If there is
positive serial correlation in successive earnings changes this may create a
correlated omitted variables problem and overstate the coefficient on the lagged period’s return.
This potential problem can be addressed by including lagged earnings changes as an additional
explanatory variable. Nayar and Rozeff (1988) explore this issue using an earnings/returns
specification and sample virtually identical to ours. They find only modest negative partial
correlations between successive earnings changes and the coefficient on lagged returns remains positive and highly
significant with lagged earnings changes included as an additional explanatory variable.
“We also used one-year T-bill rates with slightly weaker but similar results as reported here.
These results are available from the authors upon request.
“Even if we were to identify the term structure of interest rates, it is not obvious how to use
that information in relating the response coefficient to interest rates. It seems that some kind of a
weighted average interest rate is called for where the weights are proportional to the expected
levels of interest rates and inversely proportional to their timing. We do not know the extent of
improvement in the relation between interest rates and RRCs that would result from such an exercise and leave it for
future research.
Table 4
Product moment and rank order correlations between long-term Government bond yields and
annual return response coetlicients estimated by re essing annual earnings changes on
Fr
security retums.a.
Correlation between interest rates

and return response coeffrcientse
Earnings change Product moment Rank order
variable’ Return periodd (p-value) (p-value)
A x,/P,-, January-December 0.68 0.84

(0.005) (0.001)
s&Ax, January-December 0.50 0.55
(0.060) (0.035)
AX/P,-, 15 months 0.73 0.85

(0.002) (0.001)
%AX, 15 months 0.55 0.50
(0.034) (0.056)
“Long-term Government bond yields used as proxies for risk-free interest rates are taken from
Ibbotson and Sinquefield (1985).
bAnnual return response coefficients (n,s) are estimated from the following annual reverse
regressions: %A X,, or A X,,/P,,_ 1= %, + yl, R,, + E,,. The sample selection criteria employed to obtain data for
these regressions are given in footnote a to table 2.
‘A X,/P,_ 1 is change in EPS from year t - 1 to t divided by share price at the beginning of the
relevant return period (i.e., 12- or 15-month period). A total of 58 observations with /A X,/P,_ 1I> 100% are
excluded.
‘%AX, is change in EPS from year t - 1 to t divided by the EPS for year f - 1. A total of 731
observations with negative denominators or IBA X,1 > 200% are excluded.
Return period refers to the independent variable in the annual regressions. R,, is raw return on security i over the
relevant return period.
dReturn period January-December is 12 months starting from January of fiscal year t for each security. The 15-
month return period starts in November of fiscal year t - 1 for the small firms and starts in August of fiscal year t - 1
for the medium and large firms,
‘All correlations are based on 15 annual observations for the period 1968 to 1982.
sensitivity of the earnings/returns relation to interest rate fluctuations. Since we

estimate reverse regressions, correlations are expected to be positive. Also, as noted
earlier the correlation is expected to be weaker when the dependent variable is SAX,.
Product moment and rank order correlations between the RRCs and inter-est rates
(i.e., bond yields) are summarized in table 4. Because interest rates are as of the
beginning of the year, RRCs are estimated using returns measured over 12 months
beginning in January. However, to be consistent with the evidence that covariation
between earnings and price changes is maximized using returns measured over
15month periods, we also report correlations based on RRCs estimated using 15-month
returns. Using 15month returns and A X,/P,_ 1, product moment (rank order)
correlation between the response coefficient and interest rates is 0.73 (0.85) which has
a p-value of 0.002 (0.001). This evidence is consistent with the hypothesized relation
between interest
rates and RRCs. The p-values are small despite only 15 annual observations
(1968-82) used to estimate correlations. Correlations using response coeffi-cients based on
1Zmonth returns are comparable to those based on 15-month returns.
As expected, the correlations when %AX, is the dependent variable in the

earnings/returns relation are smaller compared to those using A X,/P,_,. Using 15-month returns
and SAX,, product moment (rank order) correlation between the response coefficient and interest
rates is 0.55 (0.50) which has a p-value of 0.034 (0.056). These results are consistent with interest
rate fluctua-tions having less influence on response coefficients estimated with the previous
year’s earnings as the scale factor on AX,. However, the correlations are still
consistently positive and statistically significant. Thus, the sensitivity to inter-est rates is reduced
but not eliminated by using earnings as the scale factor. A likely reason for the association is that
the response coefficient for year t also reflects the effect of any interest rate change during the
year on the returns on all securities.
6.2. Risk and growth expectations as determinants of the return

response coeficient
This section analyzes the factors explaining cross-sectional differences in the

earnings/returns relation. First, we test the effects of risk and growth (and/or
persistence) using the entire sample of firms identified earlier. To estimate firm-specific
persistence using time series analysis requires a lengthy earnings
history. Since this requirement reduces our sample by about one-half, we
report the effects of persistence on the earnings/returns relation in the
following section using only the subsample that meets the necessary data requirements.
We use common stock betas estimated from monthly returns as a proxy for the riskiness of
earnings. The market value to book value of equity relative to the median market value to book
value ratio of all the sample firms in each
year is used as a proxy for the firms’ economic growth opportunities. The difference between
the market value and book value of equity when measured
relative to the market average roughly represents the value of investment
opportunities facing the firm [Smith and Watts (1986)]. The market to book value ratio depends
upon the extent to which the firm’s return on its existing
assets and expected future investments exceeds its required rate of return on
equity. Since future earnings are affected by the growth opportunities, the higher the market to
book value of equity ratio, the higher the expected earnings growth. We use the market to book
value of equity ratio as of the
beginning of each year t as a proxy for expected growth. This proxy for growth, however, is also
likely to be affected by earnings persistence. That is, high market to book value of equity ratio is
likely to be associated with high
D. W. Collins and S. P. Kothan. Variation m earnings response coeficients 167
persistence as well. Therefore, on the basis of our regression results we cannot

conclude unambiguously that ERC is affected by growth. Rather, a relation
between market to book ratio of equity and ERC will suggest that growth
and/or persistence affect ERC.
To assess the effect of risk and growth on the RRC, the following model is estimated in year t
from 1968 to 1982:
A X,,/P,,- 1 or %AX,, = yo,+ Ed,, + Y~$W * R,, + Y&~ * R,,+ c.
(9)
where
R,, = return measured over the appropriate U-month period for the small, medium, and large
firms,
MB,, = market to book value of equity ratio, calculated at the beginning of year t,19
84, = market model systematic risk.20
The coefficient on R,,, yl, is expected to be positive. When AX, is scaled by

P r_l, y2 is hypothesized to be negative because, in the reverse regression, the RRC is decreasing
in growth. The effect of risk on the RRC is expected to be
positive. When scaling by X,_, we make no predictions on the signs of the latter two coefficients
for the reasons noted in section 3.3.3.
The results of estimating eq. (9) are reported in table 5. The top number
across from each independent variable is the sample mean of the parameter
estimates from the 15 yearly cross-sectional regresssions, and the t-statistic is
calculated from the standard error of the sampling distribution of parameter
estimates. Since statistical inferences are based on standard errors from the
“When book value of equity was negative (4 firm-year observations). MB,, was set equal to
zero. This is done because negative MB,, values do not have an economic interpretation in the context of the regression
model being estimated. To avoid undue influence of very large values of
MB,, on the regression coefficient estimates, MB,, > 5 values are set equal to 5 (less than 5%
firm-year observations). All the results are insensitive to truncating extreme values at MB,, = 3, 4, or 6.
*‘We also estimated eq. (9) and all other models in the remainder of the paper by nominally
classifying firms into high and low growth or risk portfolios. That is, we did not use the market to
book ratios or beta as a continuous variable. In the regressions, the independent variables were dummies for risk or
growth times R,,. The dummies were assinged a value of 1 for high growth
firms or high risk firms, and 0 for low growth or low risk firms. The high/low classification was
redetermined in each year. Similarly, when interest rate and persistence were included among the
independent variables, high interest rate years or high persistence firms were assigned a value of 1
and 0 otherwise. The primary motivation for using dummy variables instead of continuous
variables was that these variables are likely to be measured with error. All the results using
dummy variable times returns instead of the continuous variable times returns are virtually
indistinguishable from those reported in this paper. All these results are available to interested readers.
Table 5
Effect of risk and growth expectations on the response coefficient from an earnings/price relation:
Annual regression analysis from 1968-82.a
AX,,/P,,-, or %A&, = YO, + x,R,, + YW+% * 4, + n,B,, * R,, + E,,
Expected sign when Time series mean (t-statistic)

dependent variable is of estimated coefficientsb
Independent variable AX/p,-, BAX, AX/p,-, %AE,
Intercept - 0.001 0.023

(0.21) (0.62)
Return (R,,) + + 0.080** 0.661**
(4.92) (11.09)
Growth (MB,, * R,,) - ? -0.021** -0.57**
( - 4.31) ( - 4.69)
Risk (R,, * R,,) + ? 0.028* - 0.067
(2.67) (- 1.70)
‘Sample selection criteria are given in footnote a to table 2.

AX,/P,_, is change in EPS from year t - 1 to t divided by share price at the beginning of the
U-month return period. A total of 58 observations with [A X,/P,_ II > 100% are excluded.
observations with negative denominators or [%A X,1 > 200% are excluded.
R,, is raw return on security i over the relevant return window. R,, is measured over a 15-month period beginning
in November of year r - 1 for the small firms and over a 15-month period beginning in August of year t - 1 for the
medium and large firms.
MB,, is the market to book value of equity ratio calculated at the beginning of each year t. /3,, is the market
mode1 systematic risk estimate obtained by regressing 60 monthly returns
ending in year t - 2 on the CRSP equally weighted return index.
bSignificance at OL= 5% is indicated by one asterisk (*) and at Q = 1% by two asterisks (**). One tailed t-tests are
performed when sign of the coefficient is predicted. Otherwise, two-tailed tests are performed.
time series sampling distribution of the regression coefficients, they are free from the
cross-sectional dependence problem described in Bernard (1987).
Results using the A X,/P,_, variable are uniformly consistent with our hypotheses.
The ur coefficient on return is positive and significant. v2 on the
growth/return interaction is equal to -0.021 and reliably negative as pre-dicted.
Similarly, the response coefficient increases in risk as seen from the coefficient
estimate of 0.028 which is significant at 1% level. The evidence suggests risk and
growth (and/or persistence) significantly impact the RRC when earnings change is
scaled by price.
The coefficient estimates on the return and growth variables from the regression
using %AX, as the dependent variable have the same sign as when AX, is scaled by
P,_l. The coefficient for which a prediction can be made, j$ is positive and highly
significant. The coefficient on the growth/return interac-tion (j$) too is significant and
negative. Thus, when X,_, is the scale variable, the RRC is significantly influenced by
growth (and/or persistence). The risk/return interaction (7s) is not significantly
different from zero. This result
is consistent with the effect of risk on cross-sectional dispersion in the

earnings/returns relation being attenuated when scaling by X,-r.
To provide additional evidence on variation in the return response coeffi-cient, we
estimate the following pooled cross-sectional regression:
+YA * R;, + rJ, * R,, + &,t,
where Db8 to D,, are dummy variables taking on a value of 1 for data from year t and 0
otherwise and I, is the long-term risk-free interest rate in year t. All other variables are
as defined earlier. We do not include R,, as an independent variable because, when
annual dummies are included, Ri, and I * Ri, are almost perfectly correlated. Note that I
is a cross-sectional con-stant in any given year which means I * R,, is a scalar multiple
of Ri, in any given year. Use of annual dummy variables reduces cross-correlation
because the dummies control the effects of economy-wide changes in earnings in each
year.21
Results in table 6 reveal that for the AX,/P,_, variable, all the estimated coefficients
have their predicted signs and are statistically significant. The coefficient on the
interest/return interaction term is highly significant regard-less of the scale variable.
This indicates that the capitalization rate on earnings and the sensitivity of price
changes to earnings changes is not an intertemporal constant as was assumed in Beaver
et al. (1980) and Ohlson (1983).22 When AX, is scaled by X,_, all coefficients have
the same sign as when scaling by PI_ 1. The coefficients on growth (and/or
persistence) and interest rate interac-tion variables are significant, but the risk
coefficient is insignificantly different
from zero. The adjusted R2 is 12.73% using the AX/P,_, variable and 17.98% using the
%A X, variable. By comparison, when we estimate the regression with an intercept and
R, as the only explanatory variable where R, is measured over the conventional window
of April, to March,+, for all firms, the adjusted
R2 is 2.47% using AX/P,_, and 4.01% when using %AX,. Clearly, there is a substantial
improvement in the explanatory power of the model that incorpo-rates year dummies
and risk, growth (and/or persistence), and interest rate terms to account for variation in
the response coefficients.
*tGeneralized least squares would control for the remaining cross-correlation and heteroskedas-
ticity problems, but with only 15 annual observations the variance-covariance matrix cannot be
estimated for a sample of several hundred firms in each year.
**Because of the high collinearity between the return and the interest/return interaction
variables we cannot unambiguously attribute the significance of the interest rate variable to the
RRC’s sensitivity to interest rate variation through time. However, results in table 6 and table 4
put together provide compelling evidence that the RRC is related positively to interest rates through time.
Table 6
Effect of risk, growth expectations, and interest rates on the response coefficient from an
earnings/returns relation: Pooled regression analysis using data from 1968-82.*
AX,,/p,,~,or%AX,,=y,+u,,D,,+ ‘.’ +Y~~D~~+Y~MB,,*R,,+Y~P,,*R,~+Y~~*R,~+~~
Expected sign when Estimated coetlicient ( r-statistic)b

dependent variable is
Dependent variable
Independent variable %AX,
Intercept - 0.059** -0.272**

(- 15.58) (- 16.62)
D 6X 0.054** 0.273**
(9.50) (11.30)
D69 0.062** 0.276**

(11.03) (11.52)
D 70 0.060** 0.250**
(10.82) (10.49)
D71 0.062** 0.280**
(11.27) (11.77)
D 72 0.076** 0.451**
(14.00) (19.43)
D 73
0.083** 0.504**
(15.28) (21.90)
D 74
0.090** 0.467*’
(16.31) (19.88)
45
0.030** 0.180**
(5.75) (7.97)
D 76
0.066** 0.331**
D 77 (12.61) (14.86)
0.067** 0.356**
D 7R (12.89) (16.11)
0.080** 0.413**
D 79 (15.40) (18.54)
0.069** 0.338**
D 80 (13.26) (15.38)
0.027** 0.119**
43, (5.10) (5.39)
0.050** 0.230**
Growth (MB,, * R,,) (9.56) (10.35)
Risk _ ? - 0.024** - 0.042**
(P,, * K,,)
(- 11.70) (-4.75)
+ ? 0.018** PO.013
Interest (I, * R,,) (3.36) ( - 0.53)
+ ? 0.012** 0.062**
Adjusted R* (15.36) (17.78)
N
12.73% 17.98%
9718 9045
For table footnotes see next page.

D. W. Collins and S.P. Kothari, Variation in earnings response coefficients 171
Table 6 (continued)

A X,/P,_, is change in EPS from year t - 1 to f divided by share price at the beginning of the
15-month return period. A total of 58 observations with /A X,/P,_ II > 100% are excluded.
%A X, is change in EPS from year t - 1 to t divided by the EPS for year I - 1. A total of 731
observations with negative denominators or ISA X,1 > 200% are excluded.
R,, is raw return on security i over the relevant return window. R,, is measured over a
15.month period beginning in November of year r - 1 for the small firms and over a 15-month
period beginning in August of year [ - 1 for the medium and large firms.
MB,, is the market to book value of equity ratio calculated at the beginning of each year 1.
/I$, is the market model systematic risk estimate obtained by regressing 60 monthly returns ending in year t - 2 on the
CRSP equally weighted return index.
I, is the long-term Government bond yield in year t.
DhX through D,, are annual intercept dummies which are set = 1 for observations from respective years 68
through 81 and area set = 0 otherwise.
hSignificance at a = 5% is indicated by one asterisk (*) and at a = 1% by two asterisks (**). One tailed r-tests are
performed when sign of the coefficient is predicted. Otherwise two-tailed t-tests are performed.
To summarize, variation in the earnings/returns relation is explained by differences in risk,

growth (and/or persistence), and interest rate factors when earnings changes are scaled by Pt_l.
The relation between earnings changes and returns appears to be less sensitive to risk differences
when the scale factor is last year’s earnings.
Analysis in section 5 revealed that differences in the earnings/returns

relation are related to firm size which is hypothesized to reflect differences in
information environment. We show below that for both definitions of the
earnings change variable firm size is nor incrementally useful in explaining variation in the RRC
once we adjust the holding period return to account for
differences in the information environment and growth and risk factors are included in the
model.
In table 7 we report results of estimating the following model in each year t from 1968 to
1982:
AX,,/f’,-1 or %A-%,= ~0 + YS,, + ~ztMB,t * R,, + Y3rPir*R,,
+ y,,Size,, * R,, + qf,
where Size;, = 1 for the medium and large firms and 0 for the small firms where firms are
reclassified every year. all other variables are as defined earlier.
For both specifications of the earnings change variable, v4 is not significantly different from
zero. The size coefficient is - 0.008 (t-statistic = - 0.78) when P1_ 1 is the scale variable and it is
0.022 (t-statistic = 0.44) when X,_, is the deflator. Once again, when AX, is scaled by Pt_l all of
the other coefficients
172 D. W. Collins and S.P. Kothari, Variarion in earnings response coefficients
Table 1
Effect of risk, growth expectations, and firm size on the response coefficients from an earnings/
returns relation: Annual regression analysis from 1968-82.a
AX,,/P,,~,~~%AX,,=~O,+Y,,R,,+~~,MB,,*R,,+Y,,B,,*R,,+~,,S~~~,,*R,,+F,,
Expected sign when Estimated coefficient (r-statistic)’

Dependent variable
Independent variable AX/p,-, %AX, A X,/P,- L %AX,
Intercept - 0.001 0.023

( - 0.17) (0.64)
Return (R,,) + + 0.089’* 0.651**
(4.69) (10.98)
Growth (MB,, * R,,) _ ? - 0.021** ~ 0.060* *
(-4.59) (- 5.10)
Risk (I$, * R,,) + ? 0.025* - 0.059

(2.26) (-1.54)
Size (Size,, * R,,) ? ? - 0.008 0.022
( - 0.78) (0.44)

A X,/P,_, is change in EPS from year 1 - 1 to I divided by share price at the beginning of the
15-month return period. A total of 58 observations with \AX,/P,_,I > 100% are excluded.
%A X, is change in EPS from year t - 1 to 1 divided by the EPS for year t - 1. A total of 731
observations with negative denominators or I%A X,( z 200% are excluded.
15-month period beginning in November of year t - 1 for the small firms and over a 15-month period beginning in
August of year I - 1 for the medium and large firms.
MB,, is the market to book value of equity ratio calculated at the beginning of each year t. p,, is the market model
systematic risk estimate obtained by regressing 60 monthly returns
ending in year I - 2 on the CRSP equally weighted return index.
Size,, = 1 for the medium and large firms and 0 for the small firms.
‘Significance at a = 5% is indicated by one asterisk (*) and at a = 1% by two asterisks (**). One tailed r-tests are
performed when sign of the coefficient is predicted. Otherwise two-tailed r-tests are performed.
have the predicted sign and are statistically significant. Scaling by X,_,
attenuates the influence of risk on the RRC. Growth (and/or persistence)
continues to be significantly associated with the RRC when X,_, is the scale
variable. Overall, the results are consistent with there being no theoretical
justification for incremental explanatory power of the firm size variable on
including risk and growth (and/or persistence) variables to explain cross-sec-tional variation in
the relation between earnings and returns.
6.3. Persistence and response coeficients
In demonstrating a relation between persistence and ERC, the error in

estimating earnings persistence and the error in the proxy for unexpected
D. W. Collins and S.P. Kothari, Variation in eumings response coefficients 173
earnings variable (VX) pose a nontrivial problem. The problem arises because the error
in estimating earnings persistence using an ARIMA model at the individual firm level
can be large. Moreover, this error is likely to be related to the error in the proxy for
UX. If ERC is estimated using eq. (1) it varies inversely with the measurement error in
the lJXi, proxy and a spurious correlation between estimated persistence and estimated
ERC could result simply because estimation errors in the two variables are correlated.
We analyze the relation between persistence and response coefficients dif-ferently

from previous research and in a way that reduces the correlated measurement error
problem noted above. We first estimate IMA(l, 1) persis-tence factors of those firms
with a complete earnings history on the Compustat tape. This data restriction cuts our
original sample approximately in half. We then test the interaction of the estimated
persistence variable with returns (8, * R,,) along with other interaction terms in the
cross-sectional regression equation described earlier in eq. (10) and table 6.23 Since we
estimate RRCs rather than ERCs, the coefficient on persistence is predicted to be
negative. Moreover, the dependent variable is the scaled annual earnings change rather
than the ERCs. Since the dependent variable in our analysis is not conditional on the
individually estimated IMA(1,l) models, potential spurious correlation because of
measurement error is reduced.
The limitation of estimating persistence using reported earnings, as noted earlier, is

that the estimate is confounded by earnings growth. Thus, the persistence estimates also
reflect economic growth and this adversely affects our ability to separately document
the growth and persistence effects.24 Be-cause both persistence and growth proxies are
included in the regressions, coefficients on each reflect each variable’s incremental
effect on the RRC. If both proxies are measuring the same underlying construct, then
incremental association of each variable with the RRC implies that neither proxy fully
captures the underlying construct. Unfortunately, this cannot be verified empirically.
The results of adding the earnings persistence variable to the model for the reduced
subsample of firms are reported in table 8. When the dependent variable is A X,/P,_ 1
the coefficient on persistence is significantly negative as predicted (-0.051 with a t-
statistic of -4.91). For this specification, all the other factors that are hypothesized to
affect the earnings/returns relation (i.e., growth, risk, and interest rates) have the
predicted sign and are statistically
23Because estimated @s could be positive or negative, we use (1 - 0) instead of -0 as the

multiplier in the persistence/return interaction variable. This ensures that the multiplier is always positive and the
higher the (1 - 0) value the higher the persistence. (1 - 0) is the persistence factor for an IMA(1, 1) process as seen,
for example, in Beaver et al. (1980) or table 1.
24Altematively, as we have noted earlier, the results in the earlier tables could be reflecting the
effect of persistence and growth on the RRC rather than the effect of growth alone.
Table 8
Effect of risk. growth, persistence, and interest rates on the response coefficient from an
earnings/returns relation: Pooled regression analysis using data from 1968-82.a
A X,,/P,, 1or %JX,, = y. + Y~RL~,~+ + yxl4 + x MB,, * R,, + YzP,,* R,,
+ ~3 4 * R,, + x,4 * R,, •t ‘r
Expected sign when Estimated coefficient (t-statistic)

Dependent variable
Independent variable AT/p,-, %AX, AT/p,-, %AX,
Intercept - 0.065** - 0.327**

(- 13.17) (- 15.86)
D68 0.062** 0.333**

(8.98) (11.73)
D69 0.074** 0.372**

(10.71) (13.17)
D 70 0.064** 0.286**
(9.26) (10.09)
D71
0.059** 0.263*’
(8.56) (9.17)
D 72 0.077’: 0.491**
(11.21) (17.21)
D,, 0.093** 0.579**

(13.49) (20.43)
D 74 0.116** 0.630**
(16.28) (21.48)
D75 0.012 0.132**

(1.75) (4.70)
D 76 0.073** 0.371**
(10.67) (13.06)
D 77 0.072** 0.396*”
(10.58) (14.05)
D 7* 0.086** 0.459**
(12.51) (16.23)
D 79 0.079** 0.441**
(11.61) (15.64)
D80 0.030** 0.153**

(4.34) (5.49)
DUl
0.062** 0.333**
(9.10) (11.86)
Growth (MB,, * R,,) ? - 0.024** - 0.066**

(-8.23) (- 5.46)
Risk (P,, * R,,) + ? 0.049** 0.17u**
(5.85) (4.85)
Interest (I, * R,,) ? 0.01s** 0.059**

(12.95) (10.19)
Persistence (0, * R,,) ? - 0.051** 0.062

( - 4.91) (1.36)
Adjusted R2 19.43% 27.33%
N 4841 4587
For table footnotes see next page

Table 8 (continued)
“Initially any firm listed on the Compustat Industrial Annualor the Compustat Annual
Research tape with a December 31 fiscal year-end and complete earnings data during 1968-82 is included in the
sample. From this sample, the subset for which monthly return data are available
for eight consecutive years ending in 196943 is included in the sample analyzed in this study.
A X,/P,_ 1 is change in EPS from year t - 1 to t divided by share price at the beginning of the
15-month return period. A total of 58 observations with Id X,/P,_, 1z 100% are excluded.
%A X, is change in EPS from year r - 1 to t divided by the EPS for year t - 1. A total of 731
observations with negative denominators or l%AX,1 > 200% are excluded.
R,, is raw return on security i over the relevant return window. R,, is measured over a 15-month period beginning
in November of year I - 1 for the small firms and over a 15-month
period beginning in August of year t - 1 for the medium and large firms.
MB,, is the market to book value of equity ratio calculated at the beginning of each year t.
/I,, is the market model systematic risk estimate obtained by regressing 60 monthly returns ending in year t - 2 on the
CRSP equally weighted return index.
I, is the long-term Government bond yield in year r.
Dbx through OR1 are annual intercept dummies which are set = 1 for observations from respective years 68
through 81 and are set = 0 otherwise.
8, is the persistence coefficient measured as (1 - 0) from an IMA(l.l) process.
‘Significance at a = 5% is indicated by one asterisk (*) and at a = 1% by two asterisks (**).
One-tailed r-tests are performed when sign of the coefficient is predicted. Otherwise two-tailed r-tests are performed.
significant. When the dependent variable is %AX, the coefficient on persis-

tence has a positive sign, but is statistically insignificant. Again, this can be explained, in part, by
the scaling factor, X,-r, which itself is a function of the
same parameters that determine the persistence measures. Finally, the ex-
planatory power of the model applied to the reduced sample is considerably higher than for the
full sample with an adjusted R2 of 19.43%, when AX,/P,_,
is the dependent variable and 27.33% for %AX,. The corresponding adjusted R2s for the full
sample from table 6 are 12.73% and 17.98%.
The significance levels of the various estimated coefficients reported in table 8 could be
overstated because the OLS standard errors ignore cross-correlation among data. We, therefore,
estimate a model similar to eq. (9) in each year
from 1968 to 1982. The only difference is that we now include a
persistence/return interaction variable as well. These results are reported in table 9. Statistical
inferences are drawn from the sample mean and standard
error of the coefficient estimates from the 15 yearly cross-sectional regressions. Results using
the A X,/P,_ 1 variable are uniformly consistent with the hypoth-esized relation between the
RRC and risk, growth, and/or persistence factors.
The coefficient on the persistence variable is -0.069 (t-statistic = -2.95)
which is negative at a 5% significance level. When %AX, is the dependent variable, the
coefficients on risk and persistence are not reliably different from zero, but the coefficient on
growth is negatively related to the RRC at 5%
significance level. Overall, the results indicate that risk, growth, and/or
persistence are significant determinants of the RRCs when earnings changes
Table 9
Effect of risk, growth expectations and persistence on the response coefficients from an
earnings/returns relation: Annual regression analysis from 1968-82.a
* X,/P,,-I or Ax,, = for + YINR,, + Y,,MB,, * 8, + nd,, * R,, + ~a,@,*4, + E,I
Expected sign when Estimated coefficient (~tatistic)~

Dependent variable
Independent variable * x,/P, - , %AX, *X,/p,-, %AX,
Intercept - 0.003 0.23

(-0.36) (0.47)
Return (R,,) + + 0.153** 0.695**

(4.55) (4.08)
Growth (/‘JB,, * R,,) _ ? - 0.017** - 0.053*

(-4.14) (-2.31)
Risk (P,, * R,,) + ? 0.051* 0.081
(2.01) (0.84)
Persistence (6, * R,,) _ ? -0.069** - 0.039
( - 2.95) (-0.38)
_____
A X,/P,- 1 is change in EPS from year t - 1 to t divided by share price at the beginning of the
15-month return period. A total of 58 observations with )A X,/P,_ II > 100% are excluded.
observations with negative denominators or l%A X,1 > 200% are excluded.
15-month period beginning in November of year t - 1 for the small firms and over a 15-month period beginning in
August of year I - 1 for the medium and large firms.
MB,, is the market to book value of equity ratio calculated at the beginning of each year 1. @,, is the market
model systematic risk estimate obtained by regressing 60 monthly returns
ending in year t - 2 on the CRSP equally weighted return index.
0, is the persistence coefficient measured as (1 - 8) from an IMA(1, 1) process.
bSigniticance at a = 5% is indicated by one asterisk (*) and at o = 1% by two asterisks (**),
One-tailed r-tests are performed when sign of the coefficient is predicted. Otherwise two-tailed r-tests are
performed.
are scaled by price. However, these factors have less influence on RRCs when earnings
changes are scaled by last year’s earnings.
Table 10 summarizes how the explanatory power of the earnings/returns relation is
enhanced by varying the return interval and by incorporating terms that capture the
effects of risk, growth, and/or persistence and interest rates on the RRC. The first two
columns report adjusted R*s from models esti-mated with the full sample, while the
last two columns present similar results for the subsample with complete data
throughout our sample period. Compar-ing the first two rows of table 10 we see that
the explanatory power of a model where earnings changes are regressed on returns
more than doubles when we
Table 10
Effect of varying the return interval and additional independent variables on the explanatory power of the
regression of earnings changes on returns: Regressions using data from 1968-82.”
Adjusted R2 from earnings returns regression using

Firms with data for
Full sample’ all 15 years
Return interval and
independent Dependent variable Dependent variable
Row variables A x,/P,-, %Ax, AX/L, %AX,
_
(1) 12-month April to
2.47%’ 4.01% 2.11% 2.96%
March returns
(2) 15-month retumsd 6.32 9.87 8.37 13.04
(3a) 15-month returns with

proxies for risk,
growth, and
interest rates 8.14 10.09 11.29 13.22
(3b) 15-month returns with

proxies for risk,
growth, persistence,
and interest rates - 11.63 13.71
(4a) 15-month returns with

annual dummies and
proxies for risk,
growth, and
interest rates 12.73 17.98 19.05 27.31
(4b) 15-month returns with

annual dummies and
proxies for risk,
growth, persistence,
and interest rates 19.43 27.33
“Sample selection criteria for the full sample are given in footnote a to table 2 and for the sa?ple consisting of firms
with complete data for 15 years are given in footnote a to table 8.
When full sample is used, there is no proxy for persistence included as an independent variable.
‘Table values are adjusted R’s from regressing either A X,/P,_ 1 or % X, on the set of variables indicated in the
left-hand column,
dThe 15-month returns that are associated with the earnings change in period I are measured
from August,_ 1 to November, for large and medium firms and November,_, to February,+ 1 for small firms.
use a 15month return holding period beginning in August of t - 1 for

large/medium size firms and November of r - 1 for small firms. Adding terms
that proxy for varying levels of risk, growth and/or persistence, and interest
rates (row 3 versus row 2) increases the explanatory power by an additional
10-30’S%. Finally, adding annual dummies to capture the year-to-year differ-
ences in average earnings changes contributes an additional 50-708 to the adjusted R2 of the
pooled model (row 4 versus row 3).
178 D. W. Collins and S.P. Kothari, Variation in earnings response coeJicients
Comparing the first and last row of table 10 shows the dramatic improve-
ment achieved by varying the return interval and allowing nonconstant inter-
cept and slope terms in the earnings/returns relation. For the full sample the adjusted R2 increases
by 415% when the dependent variable is A X,/P,_, and by 348% when the dependent variable is
%AX,. The comparable improvements for the reduced sample of firms with complete earnings
data throughout the 15 years of our study were 821% and 823%. Despite these dramatic
improvements
in overall explanatory power it is obvious that a substantial amount of
variation (roughly, 70-80s) in accounting earnings changes is unrelated to security returns. This
suggests there is ample room for further refinement in
the earnings/returns relation and/or that accounting earnings contain a large
noise component that is irrelevant to valuing the firm.
7. Summary and implications for future research
This paper extends the empirical literature on the differences in the relation
between earnings and security returns. Using a simple discounted dividends
valuation model we hypothesize that the earnings response coefficient varies
negatively with the risk-free interest rate and systematic risk; and it varies positively with
growth prospects and earnings persistence. This analysis pre-
dicts cross-sectional and temporal variation in the amount of price change associated with
earnings changes.
Our empirical analyses suggest methodological refinements that have impli-
cations for past and future association study research. We examine the
implications of differences in the information environment which are charac-
teristic of the security market. Specifically, we show that conventional associa-
tion study methods that measure returns over the fiscal 1Zmonth period, or
from April, to March,_ r, seriously understate the degree of association be-
tween price changes and earnings changes in an annual association study
context. The price/earnings association improves dramatically on starting the
measurement period earlier than the contemporaneous fiscal period. Varying
the return measurement period for different size firms controls for the infor-
mation environment differences among the large and small firms and also
explains the previous finding that the degree of price change to earnings change varies with
firm size.
Empirical evidence is consistent with the predictions that the ERC increases
in growth and/or persistence and decreases in interest rates and risk. Because
the proxies used for growth and persistence could potentially reflect the effect
of both variables, we cannot conclude unambiguously that growth and persis-
tence affect ERC individually. To reduce the errors-in-variables problem, we
use reverse regression to document the effect of differences in persistence
and/or growth, risk, and interest rates on the response coefficient.
7.1. Implications for future research

Evidence in this paper has several implications for interpreting the findings in previous
research and for future research. First, in both association study
and events study contexts, ignoring the sources of cross-sectional and temporal variation in ERC
can result in statistically less precise parameter estimates and
downward biased test statistics on the response coefficients [see Maddala
(1977, ch. 17)]. In addition, the explanatory power of the model would be reduced.
Second, in certain contexts researchers include various nonearnings mea-

sures to proxy for such constructs as the amount of predisclosure information,
political costs, or contracting costs. Popular variables include firm size and debt to equity ratios.
As noted by Christie (1987) and Easton and Zmijewski
(1989) these other explanatory variables may have significant coefficients
simply because they are correlated with the cross-sectional variation in ERC. A priori, there is
strong reason to suspect this is true for size and debt to
equity ratios. 25 The finding that the earnings/returns relation varies over time
as a function of the risk-free interest rate suggests that temporal pooling of
observations must be approached with caution unless interest rates are in-cluded in the model.
Finally, to the extent the number and quality of competing information

sources differ cross-sectionally, a researcher’s ability to document and inter-
pret differences in ERCs is clouded when the information environment differ-
ences are left uncontrolled. Return measurement over periods beginning earlier than the fiscal
year is proposed as one approach to control for the
information environment differences.
7.2. Future extensions
Our analysis suggests a number of extensions. First, the evidence that

differences in the earnings/returns relation are related to interest rate differ-ences over time
suggests the present analysis can be extended to include
variables that predict such changes. Possible explanatory variables include inflation, money
supply, federal budget deficits, and trade deficits. In addition,
financial policy and investment opportunity set variables could be examined in
greater detail as possible determinants of both cross-sectional and temporal differences in the
ERCs.
25Easton and ZmiJewski (1989) find a positive relation between firm size and earnings persis-
tence. Moreover, both theoretically and empirically, debt/equity ratios and betas are positively
associated. This implies a negative relation between leverage and ERC. Therefore, research designs that restrict the
ERC to be constant and include either size or leverage in the regression equation
are likely to find significant coefficients on these variables because they proxy for sources of
cross-sectional variation in the ERCs.
Another extension of our analysis of ERCs and interest rates would be to analyze
differences in the market risk premia through time and their impact on
the earnings/returns relation. Possible proxies for ex ante risk premia are suggested in
Merton (1980) Keim and Stambaugh (1986), and French, Schwert, and Stambaugh
(1987) among others. Hopefully, extensions along these lines will enhance
specification of the earnings/returns relation and yield more powerful tests of the
information content of accounting numbers.
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An Analysis of Intertemporal and

Article in Journal of Accounting and Economics · February 1989

The user has requested enhancement of the downloaded file.

AN ANALYSIS OF INTERTEMPORAL AND CROSS-SECTIONAL

Received November 1987. final version received February 1989

Considerable research has focused on the relation between security returns

CAR,, = a + bUXi, + ejt,

where CAR if is some measure of risk-adjusted return for security i cumulated

01654101/89/$3.5001989, Elsevier Science Publishers B.V. (North-Holland)

2. Equity valuation and determinants of earnings response coefficients

‘Information environment is defined broadly to include all sources of information relevant to

2.1. Equity valuation and the earnings response coefJicient

The price of security i at time t may be written as

P,, = ft E,(%+k) Tfil{l/i1 + E(fL+,)l>~

k=1,2 ,..., oo,

R;z- Et-i(R,,) = [P;,- E,-i(Pi,) + Di,- E~-~(D,,)I/PL~-~

2.2. Determinants of the earnings response coe@cient

E(h) = R/t + [E(R,,,)- R/t]6,. (6)

Persistence factor Sum of the present value of A E, ( X, + k )s

ARIMA(2,l.O) (1+ r)/r

assumptions used in previous studies are presented in table 1. Assuming

To summarize, we identify four factors contributing to cross-sectional and temporal

3. Estimation problems and methodological considerations

3.1. Error in measuring unexpected earnings and returns

c+> (-> (+I c-1

Empirically, at least two other factors affect the estimated COV(UR,~,UX,~)

If we could obtain a better measure of the market’s earnings expectation at time r -

3.2. Reverse regression and the return response coejicient

3.3. I. Empirical measures of returns

The analysis in section 2 suggests that the appropriate return metric is

3.3.2. Proxy for unexpected earnings

(2) Unexpected earnings using more sophisticated ARIMA models require a

_??._‘.3. Scaling factor for earnings changes

(3)Measurement error in the earnings variable is another factor affecting the

4. Sample selection and descriptive statistics

4.1. Sample selection

We initially identify a sample of firms from the Compustat Industrial

4.2. Descriptive statistics

Market 9776 860.4 245.3 2644.1 1.86 47,888

dMarket model betas of three securities are negative.

problem. Therefore, it has a larger sample of 9718 firm-year observations.

5. Firm size, information environment, and holding period returns

As noted earlier, a contemporaneous regression of annual returns on earn-

AT/p,-, All 9718 0.001 0.038 0.058 3.56%

AX/p,-, Small 3215 0.005 0.031 0.083 3.68

AX/p,-, Large 3252 0.000 0.044 0.033 5.72

“Sample selection criteria are given in footnote a to table 2.

period to range from 12 to 18 months.13 For example, when returns are

15 Month Holding Period

Beginning month for the return holding period

12 - month return holding period 4 15 - month return holding period

16 - month return holding period

14 - month return holding period

15 Month Holding Period

Beginning month for the return holding period

+I- 12 - month return holding period + 15 - month return holding period

+ 13 - month return holding period

f 14 _ month return holding period

To summarize, a conventional 1Zmonth return period understates the

6. Determinants of earnings response coefficients: Empirical evidence

6.1. Interest rates and temporal differences in response coeflcients

Correlation between interest rates

Intercept - 0.059 -0.272

D69 0.062 0.276

Intercept - 0.065 - 0.327

D68 0.062 0.333

D69 0.074 0.372

D,, 0.093 0.579

D80 0.030 0.153

Growth (MB,, * R,,) ? - 0.024 - 0.066

Interest (I, * R,,) ? 0.01s 0.059

Return (R,,) + + 0.153 0.695