In 1968 Raymond Ball and Phillip Brown published ‘An empirical evaluation of accounting income numbers’ in the Journal of Accounting research. After an initial lukewarm response from the academic community it rapidly became what the American Accounting Association now calls ‘the seed that made a difference’. The purpose of this essay is to introduce the study of Ball and Brown(motivations, research questions and findings) and identify its significant contributions in capital markets research.
According to the resources provided, Ball and Brown described the motivation for their study as a test of existing scholarly research that painted a dim picture of reported earnings. The early articles concluded that earnings could not be informative, and therefore major changes to accounting practice where necessary to correct the problem.
In their research, Ball and Brown sought to answer the simple fundamental research question: are accounting income numbers useful? Their position was summarised: “An empirical evaluation of accounting income numbers requires agreement as to what real-world outcome constitutes an appropriate test of usefulness. Because net income is a number of particular interest to investors, the outcome we use as a predictive criterion is the investment decision as it is reflected in security prices”(Ball and Brown 1968).
Ball and Brown found that when stocks had a positive income surprise, the abnormal stock price returns for the event window were also likely to be positive, and vice versa. They also found that a majority of the increase in the abnormal returns was before the announcement date, which implied that analysts have fairly accurate forecasts of whether firms will outperform or underperform.
Significance of their contributions
Although there does have some limitations in Ball and Brown’s study, it had a significant impact on later research. Ball and Brown (1968) provide compelling evidence that there is information content in accounting earnings announcements. In the meantime, they correlate the sign of the abnormal stock return in the month of an earnings announcement with the sign of the earnings change of a certain firm’s earnings in a previous year earnings. Starting with Ball and Brown (1968), many studies used such association with stock returns to compare alternative accounting performance measures, such as historical cost earnings, current cost earnings, residual earnings, operating cash flows, and so on. As Watts and Zimmerman point out, most accounting research since Ball and Brown (1968) has been positive, and the role of accounting theory is no longer normative.
Ball and Brown (1968) heralded the positive-economics-based empirical capital markets research in the late 1960s.Concurrent developments in economics and finance constituted the theoretical and methodological impetus to the early capital markets research in accounting.
In addition, their study initially provides reliable evidence that stock markets can influence annual reports. Then researchers began to do a lot in reflect of stock market. Furthermore, the method used is also applicable to a large number of accounting and financial issues, including dividend announcements, earnings announcements, mergers and acquisitions, and investment spending.
Ball and Brown (1969) expressed a view of information in markets that was revolutionary and contributed to a significant change in attitudes towards investing and financial markets. By testing the connection between earnings expectations and share price changes they were the genesis of a body of research that now underpins modern day investment processes.
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Ball, R., and Brown, P. (1968), “An empirical evaluation of accounting income numbers”, Journal of Accounting Research 6 (2), pp.159-178
Watts and Zimmerman (1979), “The Demand for and Supply of Accounting Theories: The Market for Excuses”, The Accounting Review, Vol. 54, No. 2, American Accounting Association. ———————–