Accounting Recognition and the Relevance of Earnings as an Explanatory Variable for Returns

The recognition of economic events in accounting earnings tends to lag that of the market. An informed market recognizes the effects of economic events when they occur, but earnings recognition must await compliance with formal accounting recognition criteria. The application of these criteria involves such basic concepts as reliability, objectivity, conservatism, and verifiability, and affects earnings in two ways: (1) current earnings will include recognition of certain prior periods' economic events, and (2) current earnings does not recognize all of the current period's economic events until future periods (see also Easton et al. 1992). Economic events for which accounting recognition tends to lag market recognition include purchase and sale commitments, contingencies, post-employment employee obligations, investments in human capital, and variations in the market values of assets and liabilities. The purpose of this article is to investigate accounting recognition as a major determinant of earnings' explanatory power for returns. Our hypotheses are threefold. First, if accounting recognition lags that of the market, then its effect is predictably greater in shorter reporting periods. The shorter the reporting period, the lower the percentage of economic events recognized in both earnings and returns. For example, if all economic events that are immediately recognized in returns are recognized in earnings one quarter hence, then the current quarterly earnings' explanatory power would be zero, whereas annual earnings would reflect the recognition of three-fourths of all the economic events recognized in returns. Second, if the criteria for accounting recognition yield a multiperiod lag in earnings recognition of economic phenomena, then future periods' earnings possess explanatory power for current returns. A corollary hypothesis predicts that the incremental explanatory power of future periods' earnings varies inversely with the length of the reporting period. Third, if the influence of accounting recognition criteria for earnings measurement differs by companies' economic circumstances, then cross-sectional differences in these circumstances are predictably linked with earnings' explanatory power for returns. Economic circumstances that affect earnings recognition include companies' operating cycles, riskiness of cash flows, and the reliability, objectivity, availability, and verifiability of accounting and market data. We document evidence consistent