Uncertainty resolution and the theory of depreciation measurement

Article Abstract:

The impact of the depreciation policy of a firm on the relation between the resulting accounting figures and the market value of the firm's equity is examined. This study extends some attribute of classical depreciation theory to nonclassical settings. A depreciation policy generates two complementary accounting measures under uncertainty with the zero net present value investment condition. Specifically, market value matches a simple weighted average of book value and capitalized earnings. In addition, it is possible to express the valuation function as the book plus a linear adjustment for above normal earnings. Profitability, defined in terms of abnormal earnings, is relevant in valuation under uncertainty. This simple model is applied to settings where the core of the valuation function consists primarily of book value adjusted for abnormal earnings continued, but adjustments are made for other information affecting beliefs about future profitability.

Depreciation, Uncertainty

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The role of earnings levels in annual earnings-returns studies

Article Abstract:

The findings of Easton and Harris (1991) regarding the explanatory power of both earnings changes and levels when simultaneously included in a regression on abnormal returns are replicated and analyzed with respect to earnings levels. Given that annual earnings can be described by an IMA (1,1) process, the latter variable is relevant to the earnings-returns specification because earnings in previous periods have transitory components. The more pronounced these components are, the larger the increase in the earnings response coefficient or ERC and in the explanatory power of the model upon introduction of the level variable. These results suggest that the low predictive power and ERCs obtained from annual unexpected earnings-abnormal returns studies which assume that annual earnings follow a random walk are due to measurement errors in unexpected earnings.

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Changes versus levels in earnings as explanatory variables for returns: some theoretical considerations

Article Abstract:

The use of earnings levels and changes in earnings as alternative specifications in explaining contemporaneous returns is contrasted and examined from a theoretical perspective. Conventional approaches use the latter, deflated by beginning-of-period price, as the main determinant for returns. However, this extension of Ohlson (1991) uses earnings levels instead in order to introduce value-relevant information aside from earnings and dividends. A general model is then used to test which variable, either the level of or the change in earnings, better correlates with earnings returns. The results indicate that the change variable performs better when the slope coefficient is greater than .5. However, the levels variable is the best determinant for returns when the levels of returns and earnings are not easily predictable.

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