The relevance of the value-relevance literature for financial accounting standard setting

“K forms, an approach predominantly employed in the literature (Carter and Soo 1999; Healy and Palepu 2001; Holthausen and Watts 2001).”

“Value-relevance studies aim to assess the extent to which accounting data reflect information that is “relevant” for firm value as represented by the stock price (Holthausen and Watts, 2001).”

“…amounts (of which realized gains and losses on securities are only one type) is useful for various purposes, such as contracting and stewardship assessment (Watts 1993; Holthausen and Watts 2001), capital regulation (Khan 2010), and portraying firms’ business strategies (Nissim and Penman 2008).”

“Also, Holthausen and Watts (2001) and Negakis (2005), after reviewing the relevant literature, concluded that earnings and book values do not affect in the same manner stock prices.”

“First, we contribute to the controversy surrounding the use of unverifiable fair values, that is, fair values that depend on management judgment when observable market prices are absent (Holthausen & Watts, 2001).”

“” Holthausen and Watts (2001) see value relevance as the empirical relation between stock market values (or changes in values) and particular accounting numbers for the purpose of assessing or providing a basis for assessing the numbers used or proposed use in accounting standard.”

“For instance, accrual models (Van Tendeloo and Vanstraelen, 2005), value relevance models (Barth et al., 2001; Nicholas and Wahlen, 2004) research focusing on specific elements in the annual report (Hirst et al., 2004; Mbobo and Ekpo, 2016) and methods operationalizing the qualitative…”

“Unreliability and value irrelevance of accounting numbers may therefore be an issue that is a direct consequence of the management's incentives to bias any measurement of asset values ( Holthausen and Watts, 2001”

“It can also efficiently monitor management behaviors, especially opportunistic behaviors such as overstating future cash flows/net assets and delaying the termination of projects with negative net present value (Holthausen & Watts, 2001; LaFond & Watts, 2008; Watts, 2003a, 2003b).”

“Holthausen and Watts (2001), in their critique of the value relevance literature, point out that what is relevant for one group of investors may not be relevant for another and warn against the ‘‘virtually exclusive reliance on stock market data.’’”

“Despite the technical limitations raised by Holthausen and Watts (2001), we believe that useful insights can be gained by other approaches, properly conducted.”

“Second, a sudden drop in the level of conservatism generates auditor pressure and higher audit fees (Basu 1997; Holthausen and Watts 2001; Nikolaev 2010; DeFond, Lim, and Zang 2012).”

“Furthermore, timely loss recognition under conservatism reduces firms’ liability exposure (Basu, 1997; Holthausen and Watts, 2001).”

“…authors conclude that their results could be interpreted as providing support for the proposal although they also 40 E. Barone et al. state that regulators are ultimately responsible for responding to the trade-offs associated with standard setting (Holthausen and Watts, 2001; Barth et al., 2011).”

“Opponents deem expansion of fair values a violation of the age-old principle of conservatism that requires reliable accounting measurements and thus decreases the usefulness of accounting for contracting (Holthausen and Watts, 2001; Kothari et al., 2010; Watts, 2003; Watts and Zimmerman, 1986).”

“Since creditors’ decisions and information needs differ from those of equity investors (Holthausen and Watts 2001, Hann et al. 2007), evidence that IFRS is relevant to equity markets does not imply relevance for creditors.”

“Various studies show that earnings conservatism is an important attribute of accounting information (see, e.g. Basu, 1997; Pope and Walker, 1999; Givoly and Hayn, 2000; Giner and Rees, 2001; Holthausen and Watts, 2001; Garcı́a-Lara and Mora, 2003, 2004; Raonic et al., 2004).”

“Holthausen and Watts (2001) provide evidence that conservatism existed prior to formal standard setting and regulation in the United States, which suggests that managers of U.S. firms have incentives to report conservatively even in the absence of mandated rules and regulations.”

“Persistence, has been defined as the autocorrelation of earnings reports, which I denote here by ρ ≡ cov(rt ,rt−1)√ var(rt) √ var(rt−1) (see Francis, LaFond, Olson and Schipper, 2004).”

“Some milestones of the topic can be observed (Amir & Lev, 1996; Barth et al., 2001, 2008; Collins et al., 1997; Holthausen & Watts, 2001; Kothari, 2001; Lev & Sougiannis, 1996).”

“…This is one key reason why the relevance of ‘value relevance’ studies for standard setting purposes is highly controversial (see Barth et al., 2001; Holthausen & Watts, 2001), despite the voluminous evidence documented in the literature (for IFRS-related studies see Harris & Muller, 1999; Song,…”

“While Holthausen and Watts (2001) suggest that equity investors are not the only users of accounting information and there are other uses of accounting information such as contracting, Barth et al. (2001a) argue that other uses of accounting do not diminish the importance of equity valuation and…”

“…also listen to calls and/or read transcripts of calls.8 Suppliers and strategic partners who interact and contract with the firm could seek information provided in calls to enhance their knowledge about the firm to facilitate contracting (e.g. Watts and Zimmerman 1986, Holthausen and Watts 2001).”

“Jiang et al. [2005] and Zhang [2006a] argue that IU, as defined above, provides a unifying framework for understanding a number of curious results in empirical asset-pricing.”

“Of course, we cannot make unambiguous policy suggestions based solely on VR, given that equity investors are not the only users of accounting information (Holthausen and Watts, 2001).”

“2 We focus on private loan market first because Houston and James (1996) estimate that public debt represents only 17% of the outstanding debt and Dichev and Skinner (2002) report that private debt makes up 80% of corporate debt for their sample of large Compustat firms.”

“Though high value relevance is interpreted as high EQ (HEQ), there are reservations raised by several authors over the utility of value relevance for judging EQ (Christensen et al., 2009; Drymiotes and Hemmer, 2013; Holthausen and Watts, 2001).”

“2001; Holthausen and Watts 2001; Dechow and Schrand 2004) and revenues (Jegadeesh and Livnat 2006) on stock returns, but have virtually ignored the effects of financial ratios on short-window returns.”

“Holthausen and Watts (2001) find that conservatism is associated with auditors’ legal liability regimes. Cahan and Zhang (2006) find that auditors demand more conservatism from former Arthur Anderson clients following that company’s break-up in order to reduce litigation risk.”

“However, the economic mechanisms behind these associations remain largely a black box because how this information is used in individual investors’ valuation models is unclear (Barth et al., 2001; Holthausen and Watts, 2001).”

“Holthausen and Watts (2001) suggest that value relevance studies use two different theories of accounting and standard setting to draw inferences: (i) “direct valuation” theory and (ii) “inputs-to equity-valuation” theory.”

“Barth et al. 2001 provide a defense of value relevance studies, while Holthausen and Watts 2001 argue that these results are irrelevant for standard setting due to the use of an invalid quality criterion, self-selection problems, concerns about the valuation models used, and a host of…”

“First, an ample literature suggest that litigation risk is an important determinant of conditional conservatism (see, e.g., Basu 1997; Ball et al. 2000; Holthausen and Watts 2001; 24.”

“An interesting discussion about this approach can be found in Holthausen and Watts (2001) and Barth, Beaver, and Landsman (2001). A second group of studies uses event-study research design to analyze the association between abnormal stock returns (or abnormal trading volumes) and (unexpected) goodwill impairments.”

“Journal of Accounting and Investment, 2020 | 22 Value-relevance studies determine whether an accounting number is useful for valuing the firm by investigating whether the accounting number is associated with stock prices (Holthausen & Watts, 2001).”

“Similarly, Kachelmeier et al. (2014) find that participants have less confidence in a financial statement account that is identified in the auditor’s report as being a critical audit matter.”

“These findings may help reconcile apparently contradictory reports in the literature that intangible assets are problematic for contracting purposes, yet they often remain in covenant definitions (cf. Holthausen and Watts, 2001; Kothari et al., 2010; Watts, 2003 and Frankel et al., 2008).”

“6 For insightful discussions of value relevance studies, we refer readers to Barth et al. (2001), Holthausen and Watts (2001), Landsman (2007), Hodder et al. (2014).”

“firms, O’Hanlon and Pope (1999) find evidence against it, while Lin (2006) finds the opposite.”

“Holthausen and Watts (2001) strongly advocated the use of research methods that do not rely on capital market data to assess the relative quality of financial disclosures, especially when research using capital markets data yields inconclusive results.”

“The importance of financial information in equity valuation is well established (e.g. Holthausen and Watts 2001).”

“Fourth, one of the differences between the value-relevance models and the FASB statement concerns the users and uses of financial reporting, which have been explained by Holthausen & Watts (2001).”

“For a more detailed discussion of the value relevance approach, see, for example, Barth et al. (2001) and Holthausen and Watts (2001).”

“…the book value of equity (or a variation of it, for example, tangible net worth) as a proxy for the liquidation value of the company, the effect of fair value adjustments may reduce its relevance in bond valuation and contracting (see Holthausen and Watts 2001; Watts 2003a, b; Kothari et al. 2010).”