A study of the relationship between the qualitative characteristics of accounting earnings and stock return
The main purpose of this thesis is to test whether the quality of earnings improves the usefulness of accounting information in the decision making process. This is particularly important because the Financial Accounting Standard Board (FASB) considers the usefulness of accounting information as the primary objective of financial statements (FASB, 1978). To achieve this purpse, the thesis examines two interrelated subjects. The first subject of the study "The qualitative characteristics of accounting earnings and stock return" (Chaoter 3) assesses the impact of earnings quality on stock returns as a representative for the usefulness of earnings information. The research also attempts to extend the concept of earnings quality and its constructs based on the primary qualitative characteristics of accounting information from the FASB's viewpoint. Therefore, the study defines earnings quality as the extent to which reported earnings capture both dimensions of the qualitative characteristics of accounting information, relevance and reliability. Eight earnings quality attributes are characterized as either 'relevance-based' or 'reliability-based' to capture earnings information quality. Moreover, associations between earnings quality attricutes and stock returns are considered to test whether earnings quality information is reflected in the investors' decision-making process. The result indicates that all earnings quality attributes but one are associated with the returns of stock in the predicted way; the exception is conservatism. This finding suggests that the earnings quality attributes make accounting information useful for decision making, which is consostent with the FASB's assertion. In addition, comparisons of incremental explanatory power show that relevance-based earnings quality attributes explain more of the stock returns variation than do reliability-based earnings quality attributes. The second subject of the thesis, 'The effect of earnings quality on the value-relevance of accounting information' (Chapter 4), aims to link earnings quality constructs with the equity valuation model by assessing their effect on the relative desirability between the value-relevance of earnings and book value of equity. In this respect, the study investigated whether earnings quality constructs, systematized in the first topic of this study, are reflected in the equity valuation prcoess. This is an important issue, as the incorporation of earnings quality attributes into equity valuation models may provide more realistic estimates of the firm's value. The study conducts factor analysis on eight earnings quality attributes to construct an index of each earnings quality dimension for each firm-year. The results indicate that in portfolios of firms with high quality earnings (HH), the value-relevance of earnings and book value are respectively higher and lower than in portfolios of firms with low quality earnings (LL). Moreover, the study finds that the ability of earnings and book value jointly to explain stock price is significatnly higher in firms with high quality earnings information compared to firms with low quality earnings information. This finding confirms that earnings quality constructs provide relevant information in the valuation process.