Some value relevance research studies are motivated by standard setting and seek to draw some standard setting inferences from these studies. Their studies are based on theories of accounting, standard setting and valuation.
Question: Are these theories that underlie value relevance studies descriptive of standards setting and valuation? If they are not, then the associations between accounting numbers and equity valuations are just mere associations and have limited standard setting inferences.
The authors then seek to introduce value relevance studies
Literature contains papers that investigate the empirical relations between stock market values and particular accounting numbers - Purpose: assess or providing a basis for the use or proposed use of those numbers in an accounting standard. - It will therefore only be useful if the underlying theories are descriptive and can explain and predict accounting, standard setting and valuation.
*If standard setters do not think that a high association between accounting numbers and stock values a desirable attribute, then the value-relevance inference for standard setting will not be very useful either. (So What? is Standard Setting's objectives?)
There are many other studies that addresses reasons various parties to standard setting such as managers prefer certain accounting method alternatives. This other aspect is critical to standard setting since they identify factors that influence accounting standards especially contracting but not incorporated into value-relevance studies.
The authors then introduce the different types of studies
i) Relative association studies: association between stock market values and alternative bottom-line measures e.g. association with stock market values of GAAP earnings measure and alternative proposed standards ii) Incremental association studies: investigate whether a certain accounting number is helpful in explaining value or returns (long window) iii) Marginal information content studies: does a particular accounting number add information available to investors (event studies - short window market reaction) The authors only focus on (i) and (ii) given most papers are association studies
They then drill down - do the papers purport to have standard setting inferences? Those that do have explicit statements or whose language implies so.
They then identify the theories underlying the literature. The 2 different theories of accounting and standard setting to draw inferences are: 1) Direct valuation - accounting earnings intended to be highly associated or to measure changes in equity market value; BV intended to either measure or be highly associated with equity market value --> Standard setting should therefore be interested in relative stock price associations of alternative accounting earnings or book value of equity measures. 2) Inputs to equity valuation - accounting's role is to provide info as inputs to valuation models. Focus on incremental association studies.
THE ROOT OF THE PROBLEM: MOST VALUE RELEVANCE AUTHORS ASSUME (A-S-S-U-M-E: makes an ASS out of U and ME) that accounting's dominant role is equity valuation, whichever accounting theory or standard setting theory they choose. ACCOUNTING MUST PROVIDE EITHER MEASURES ASSOCIATED WITH VALUE OR SUCH MEASURES (DIRECT) OR PROVIDE RELEVANT INPUTS TO EQUITY VALUATION MODELS (INPUTS).
Authors found assumptions that the best income measure is the one that is most highly associated with stock market value changes. but contracting is also important but there is no explanation as to why there should be any reference to stock price reaction.
- And therefore, this impedes the literature's formulation of a descriptive theory useful for standard setters.
Then they try to find if these underlying theories do well against FASB's explanations for standard setting. Very simply, FASB's SFAC No.1 directly contradicts direct valuation and states that inputs...