ACC 6050 Module 1 Written Assignment: Critiquing a Landmark Accounting Study Example

Do Earnings Matter to Prices? A Critique of Ball and Brown and What It Taught Accounting Research

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Master of Science in Accounting, Thomas Edison State University

ACC-6050: Fundamentals of Accounting II

Mentor Name

Month Day, Year

Do Earnings Matter to Prices? A Critique of Ball and Brown and What It Taught Accounting Research

Introduction

For most of the twentieth century, accounting theory was argued deductively: scholars reasoned from premises about income or capital to recommended methods. By the 1960s, critics wanted evidence. Wolk et al. (2017) describe the shift toward empirical research, in which hypotheses about accounting are tested against data, as one of the most important developments in the discipline.

Four Research Approaches

Each approach answers different questions. Capital markets research asks whether accounting numbers carry information investors use; behavioral research asks how specific people interpret them.

The Study: Ball and Brown (1968)

Ray Ball and Philip Brown asked a simple question that earlier theorists had debated without evidence: do reported annual earnings convey information that investors use? Critics of historical cost accounting had argued that accounting income was a meaningless mix of measurement methods. If so, share prices should not respond to it.

Ball and Brown studied 261 New York Stock Exchange firms from 1957 to 1965. For each firm-year, they classified earnings as good news or bad news by comparing actual earnings with a simple expectation based on the previous year. They then measured each firm's abnormal stock returns, the part of its return not explained by market-wide movements, for each month from twelve months before to six months after the earnings announcement (Ball & Brown, 1968).

Findings

Firms with good news showed positive abnormal returns and firms with bad news negative ones, so the sign of the earnings surprise predicted the direction of price changes. Most of the price adjustment, however, occurred before the annual report was released, as information reached the market through interim reports and other sources. Annual earnings therefore carried information, but the annual report was not a timely source of it.

Limitations

The study's design has several limits. Its earnings expectation model was crude, so some firms classified as surprises may not have surprised investors. It measured only the sign of the surprise, not its size. It relied on the assumption that markets are efficient, absorbing information quickly and without bias, a hypothesis Fama (1970) had just formalized and that later research would qualify. And it could show association, not causation: earnings and prices might both respond to underlying economic events, with earnings simply recording what the market already knew. Finally, the finding that most adjustment preceded the report raised a question the study could not answer: what value does the annual report itself add?

Later studies refined the design with analysts' forecasts as the expectation model and with daily rather than monthly returns, which sharpened the measured response.

Influence

Despite these limits, Ball and Brown transformed accounting research. Their event study method became the standard tool for testing whether accounting information affects prices, and the question of information content shifted debates from what income should be to how information is used. Regulators and standard setters began citing capital markets evidence when evaluating disclosures. Later work examined the magnitude of surprises, the speed of adjustment and anomalies such as post-earnings-announcement drift, in which prices continue to move after announcements, a pattern that challenges full efficiency.

The study also launched decades of work on the earnings response coefficient, which asks not only whether prices move with earnings news but by how much, and why the response is weaker for firms with less persistent or noisier earnings. That literature tied the usefulness of accounting numbers to their quality, a question Ball and Brown could raise but not answer.

Conclusion

Ball and Brown gave empirical support to the usefulness of accounting earnings and launched capital markets research, while their design limits and their finding about timeliness set the agenda for decades of later work. The study shows what empirical research can contribute to theory: not a final answer, but evidence that sharpens the question.

References

Ball, R., & Brown, P. (1968). An empirical evaluation of accounting income numbers. Journal of Accounting Research, 6(2), 159-178. https://doi.org/10.2307/2490232

Fama, E. F. (1970). Efficient capital markets: A review of theory and empirical work. The Journal of Finance, 25(2), 383-417. https://doi.org/10.2307/2325486

Wolk, H. I., Dodd, J. L., & Rozycki, J. J. (2017). Accounting theory: Conceptual issues in a political and economic environment (9th ed.). Sage Publications.