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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 1968 research was the genesis of a now deep body of research on how investors utilise accounting information and the
influence of accounting information on stock price returns. Our Australian equity investment philosophy is grounded by this research
and much of the empirical and academic research that followed.
The Ball and Brown research transformed the study of accounting by showing what for us today seems obvious: there is a
relationship between stock price fluctuations and the information contained in accounting reports. At the time of this groundbreaking
paper while researchers had hypothesised on whether there was a connection between what a company said its earnings per share
would be, any changes to this forecast and its share price 12 months later, no one had empirically tested this.
It is difficult to comprehend how groundbreaking this research was at the time as it is now widely accepted that accounting
information forms the bedrock of many investment processes.
However, in the mid 1960s the dominant accounting literature was a priori in nature with little in the way of empirical testing.
The accounting literature at the time had two central conclusions:
1. Financial statement information prepared under existing reporting rules is meaningless to investors; and
2. Radical changes in the nature of financial statement information are required.
By 1968 the above conclusions had been around for decades. There was general agreement at the time on the first conclusion that
financial statements prepared under the given accounting rules were meaningless because they involved the aggregation of data
calculated under heterogeneous rules. Consequently, the research and debate predominately revolved around the second
conclusion that the rules governing financial statements needed to be changed.
Strange as it may seem to investors today, the accounting literature then had not deemed it fruitful to investigate how financial
statement information affected or was related to share prices.
2
Ball and Brown proposed a number of reasons for this in their 2012 retrospective . One likely reason was data availability; another
was that the share market was not seen as a suitable area of accounting research. A third reason was that the accounting literature
was focused on its own accounting measurement models.
3
Even amongst this widespread mentality, a significant study had still emerged on the behaviour of share prices. Fama (1965a ,
4
1965b ) made the conceptual breakthrough of framing stock prices as a function of information flows. These days that is taken for
granted, however, in the mid-1960s this concept was an important advance in financial thinking.
In their research Ball and Brown sought to answer the simple fundamental research question; are accounting numbers useful? Their
position was summarised in Ball and Brown (1968) p 160:
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
They considered both the relevance and the timeliness of income announcements to equity markets because, as Ball and Brown
saw it, .usefulness could be impaired by deficiencies in either.
Ball and Brown took an information perspective in their research by measuring the difference between expected change in income
and actual change in income and how this difference affected stock prices. What they were measuring was the unexpected
component or forecast error in earnings announcements (1968, 162) using a simple random walk model and a model that
controlled for market effects. This is now termed as earnings surprise.
Ball, R., and Brown, P., An empirical evaluation of accounting income numbers, Journal of Accounting Research 6 (2), 1968, pp.159-178
Ball, R., and Brown, P., Ball and Brown (1968):A Retrospective, American Accounting Association, 2012
3
Fama, E.F., The behaviour of stock-market prices, The Journal of Business 38 (1): 1965a, pp. 34-105
4
Fama, E.F.,. Random walks in stock market prices, Financial Analysts Journal 21 (5): 1965b, pp. 55-59
2
5
6
Ball, R., and Brown, P., Ball and Brown (1968):A Retrospective, American Accounting Association, 2012
Kuhn, T.S., The structure of scientific revolutions, Illinois: University of Chicago Press, 1969
Harry Moore
Peter Heine
Peter Weldon
Dan Bristow
Liz White
Rose Lor-Kershaw
Hugh ONeill
Helen Squadrito
Bachar Beaini
Hazuki Nojiri-Kenny
Edward Tighe
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