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The Matching Principle: Insights into Earning’s Usefulness to Investors.$ Harm Sch¨tt u
Haas School of Business University of California at Berkeley

Abstract This paper argues that matching expenses to revenues increases earnings’ usefulness to investors by providing an accounting rate of return (ARR) closer to current economic profitability. To test this, I estimate a proxy for a firm’s internal rate of return (IRR) in order to approximate the distortion between ARR and IRR. Results show that the magnitude of the difference is reduced for firms with a higher degree of matched expenses. The median magnitude is 2.3% for the highest matching quintile, suggesting that matching expenses provides a reasonable proxy for economic profitability. Secondly, it is argued that reducing the gap between ARR and IRR leads to more timely information included in current earnings. This is evidenced by a higher return reaction to current earnings (ERC) and a lower return relation with future earnings (FERC) for firms with a smaller gap between ARR and IRR and higher degrees of matched expenses. Keywords: Matching Principle, internal rate of return, timeliness, earnings quality

This paper is still in an early stage and I would greatly appreciate any feedback you might have. I thank Patricia Dechow, Sunil Dutta, Alexander Nezlobin, Richard Sloan, Ed Johnson, Alastair Lawrence, Panos Patatoukas, Malachy English, Aydin Usal and Eric Allen for many helpful discussions.

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Working Paper

October 8, 2012

1. Introduction Economists and academics such as Peasnell (1996) or Danielson and Press (2003) have often advocated that a firm’s accounting must be informative about a firm’s current underlying economic profitability in order to be useful in measuring profitability, pricing shares or assessing managerial performance. However, while it is easy to see why a better measure of current economic performance leads to a more accurate assessment of managerial performance, the link between...