a note on interpreting "incremental information content"

A Note on Interpreting "Incremental Information Content"Author(s): Ross JenningsSource: The Accounting Review, Vol. 65, No. 4 (Oct., 1990), pp. 925-932Published by: American Accounting AssociationStable URL: http://www.jstor.org/stable/247658 .

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THE ACCOUNTING REVIEW Vol. 65, No. 4 October 1990 pp. 925-932

A Note on Interpreting

"Incremental Information Content"

Ross Jennings University of Texas at Austin

SYNOPSIS: This note examines the term "incremental information content," considers the most informative composition of income to include only components that are valued by investors, and determines the preferred level of disaggregation. The most common analysis in studies of incremental information content is to examine the coefficients from a regression of market-adjusted security returns for a 12-month period on the unexpected portion of two or more accounting income variables. A nonzero coefficient on one accounting variable is interpreted as evidence that the variable has information content that is "incremental" to the other variables in the equation. The accounting interpretation of this result in terms of the composition or disclosure of income depends on the other independent (conditioning) variables included in the estimated relation. Therefore, the interpretation of results beyond a statistical statement that one variable has information content incremental to another depends on the specification of the regression equation that is estimated.

Results presented in two previous studies (Rayburn 1986; Bowen et al. 1987) are reviewed and extended from the perspective of the composition and disclosure of income. Taken together, the tests based on data reported in those two studies provide consistent and strong evidence that both cash flow and accrual components add to the informativeness of income. However data from Bowen et al. provide only weak evidence that current accrual and cash flow components of income are valued differently by investors, and similar tests based on Rayburn's data fail to reject the hypothesis that cash flows and current accruals are valued equivalently by the market. These results indicate that more research is needed on this issue.

Key Words: Accrual, Cash flow, Incremental information.

The comments of Rowland Atiase, Vic Bernard, Dave Burgstahler, Lane Daley, Dick Dietrich, Robert Freeman, Bill Kinney, Jim Noel, John Robinson, Bob Thompson, Pete Wilson, and an anonymous referee on earlier drafts are gratefully acknowledged.

Submitted February 1988. Revisions received June 1988, April and October 1989, and April 1990.

Accepted April 1990.

925



926 The Accounting Review, October 1990

A GROWING number of studies have examined the incremental information content of one accounting income variable conditional on one or more other income variables. For example, several studies (Beaver et al. 1982; Beaver and Lands-

man 1983; Bernard and Ruland 1987; Bublitz et al. 1985) have examined the information content of current cost accounting income incremental to historical cost income, and others (Bowen et al. 1987; Lipe 1986; Rayburn 1986) have examined the information content of various components of historical cost income incremental to other income components.' However, these studies have not described the accounting research im- plications of their findings beyond the statistical evidence of a conditional association with security returns. This note suggests two important and distinct research issues that are implied by the term "incremental information content," and interprets and ex- tends the results of two previous studies in terms of these issues.

The first research issue is to determine the most informative composition of income. If the criterion for evaluating informativeness is association with returns, the most informative measure of income includes income components that are valued by investors. The second issue is to determine the preferred level of disaggregation to use in the disclosure of income, given a particular composition of income. If the criterion for evaluating the disclosure of income components is association with returns, knowledge of the components of income is preferred by investors only when the components are valued (associated with returns) differently from each other.2 For components that are valued by the market equivalently, disclosure of their sum is sufficient because investors are indifferent to which component contributed more or less to income. The pur- pose of this article is to review and extend the results of Rayburn (1986) and Bowen et al. (1987) from the perspective of the composition and disclosure of income.

Section I distinguishes between tests of incremental information content that provide evidence on the composition of income from those that provide evidence on the disclosure of income, using a simple example with two income components. Section II interprets the main results of Rayburn (1986) and Bowen et al. (1987) in terms of the composition and disclosure of income, and discusses the results of additional tests based on data reported in those studies. The final section contains concluding remarks.

I. The Composition and Disclosure of Income

An example of an incremental information content study compares the relative information content of unexpected net income (INC), cash flow from operations (CFO), and total accruals (TA), which are related in the following way:

INC = CFO + TA. (1)

Previous incremental information content studies (e.g., Rayburn 1986) regressed excess security returns (RET) on two of these three accounting variables, and tested for the in-

' All of these studies test the association between returns and income (components) over long return intervals. The discussion here will be limited to these so-called "association" studies. Related work by Wilson (1986) studies the ability of accounting to communicate information to the market by examining very short return intervals around an announcement date. "Event" studies of this type will not be discussed here.

2 Association with returns is obviously not the sole criterion that would be applied in a comprehensive analysis of the most informative composition of income or the preferred disclosure policy. However, this is the contribution that capital market research makes to such an analysis.



Jennings-Interpreting Information Content 927

cremental information content of each relative to the other. For example, consider the following regression:3

RET=61CFO+G2TA+c. (2)

The test 01 =0 (02=0) examines whether the inclusion of CFO (TA) adds to the informativeness of earnings; i.e., these are tests of the composition of income. Whether to conduct this test as one-sided or two-sided depends on the structure that is imposed. Under the assumption that more income is preferred by the market, these tests are are one-sided. This assumption is supported by substantial empirical evidence in, for example, Ball and Brown (1968) and Beaver et al. (1979). If this assumption were not held by investors, then aggregating accounting variables into "income" would have no meaning, since the variables (components) would represent independent signals with no common link or interpretation. If that were the case, disaggregated data would always be preferable to aggregated data because of fineness, and two-sided tests would always be appropriate because the researcher has no way of knowing how market par- ticipants will interpret any particular signal.

The third test, 01=62, examines whether the two components, CFO and TA, are associated with returns differently from each other, i.e., the test of the disclosure of income. If 6, and 62 are equal, the equation collapses to a regression of returns on INC. In this case, the components do not add to the explanatory power of INC alone. Again, whether to conduct this test as one-sided or two-sided depends on the structure that is imposed. In the absence of additional theoretical structure specifying which component is more valued under the alternative, this is a two-tailed test. In contrast, if it is assumed, for example, that investors value unexpected changes in cash flow more highly than unexpected changes in accruals, then tests of the null hypothesis that these components are valued equivalently are one-sided.

Alternatively, these accounting variables can be examined by regressing excess returns on either CFO and INC or TA and INC. However, of the six coefficients that result from the three alternative regression specifications, only three are unique. To see this, consider the following regression:

RET='y l CFO +Y 2INC + (3)

Because the independent variables in equations (2) and (3) are linear transformations of each other, the coefficients in the two equations are also linear transformations of each other.4 The relations among the coefficients from the two equations are:5

01 ='Y I +Y2=O; (T-1)

02 =Y2 = 0; (T-2)

1 -02= YI= . (T-3)

3 Intercepts have been suppressed. This has no effect on the issues that are being discussed. I It is a simple matter to demonstrate this. See, for example, Christie et al. (1984), where this is shown for a

different reason. 5 All of the independent variables in equations (2) and (3) are specified in returns studies as the unexpected

changes in those variables. The choice of scaling of these independent variables can complicate the analysis. For simplicity, this effect will be disregarded in the discussion that follows.




Thus, the three tests that were described previously in terms of equation (2) can also be conducted using coefficient estimates from equation (3).

Using the term "incremental information content" to describe both the tests of whether the coefficients in equation (2) are equal to zero as well as the tests of whether the coefficients in equation (3) are equal to zero, does not distinguish between their very different interpretations. Based on the estimation of equation (2), tests of the incremental information content of CFO relative to TA, and TA relative to CFO are equivalent to equations T-1 and T-2, respectively. Given an association with returns criteria for deter- mining the most informative composition of income, equation T-1 (T-2) tests whether including CFO (TA) in income adds to its informativeness. The null hypotheses underlying equations T-1 and T-2 are that investors place no value on unexpected changes in one component conditional on the other. Based on the estimation of equation (3), tests of the incremental information content of CFO relative to INC, and INC relative to CFO are equivalent to equations T-2 and T-3, respectively. Equation T-2 tests the contribution that TA makes to the informativeness of income, as previously discussed. Equation T-3 tests the null hypothesis that these two components are valued equivalently by investors. Rejection of the null indicates that investors will respond differently to unexpected earnings depending on whether it is due to unexpected cash flows or unexpected accruals and, therefore, would prefer that these components be disclosed separately.

Two points may be made about tests of incremental information content based on equations (2) and (3). First, notice the effect of changing the conditioning variable on the interpretation of the incremental information content of CFO. When TA is the conditioning variable (eq. [2]), CFO has incremental information content if it is an informative component of net income. When INC is the conditioning variable (eq. [3]), CFO has incremental information content if it is valued differently than TA, implying that investors prefer to observe CFO and TA disclosed separately. Second, although it is not obvious, the test of the incremental information content of INC in equation (3) is equivalent to equation T-2, which examines whether the inclusion of TA adds to the informativeness of net income. The intuition for this interpretation is apparent from the relation between these accounting variables in equation (1): if unexpected cash flow from operations is held constant, a one-dollar change in unexpected income is identical to a one-dollar change in total accruals.

II. Accruals and Cash Flows

This section discusses the principal results of two similar studies, Rayburn (1986) and Bowen et al. (1987), that contrast the information content of cash flows and accruals. In both cases, the principal results are interpreted in terms of the composition and disclosure of income issues discussed previously, and additional results (based on data reported in the original studies) are reported.

Rayburn's Study

The main results reported by Rayburn (1986) are based on decomposing unexpected income into unexpected measures of cash flow from operations, current accruals (CA),




depreciation expense (DEPR), and deferred tax expense (DTAX), which are related in the following way:6

INC=CFO+CA+DEPR+DTAX. (4)

Using this decomposition of unexpected income, Rayburn estimates the following regression:

RET=G1CFO+02CA+03DEPR+04DTAX+E. (5)

The informativeness of the components of income is determined by testing whether each of the coefficients in equation (5) is different from zero. Assuming all four components are informative, disclosure can be addressed using equation (5) by conducting tests of up to 11 different combinations of the four coefficient estimates. Each test will be whether a pair (or three, or all four) of the coefficients are equal. The choice among these tests is made on the basis of the hypotheses being addressed by the researcher.

Rayburn estimated equation (5) in cross-section and conducted tests of whether each of the coefficients is equal to zero. Her tests examine whether each of these components adds to the informativeness of income. She specified two alternative sets of expectations models, and the results of the two models are presented in tables 7 and 9 of her article. For both expectations models, Rayburn reports significant coefficients on CFO and CA, but mixed results for DEPR and DTAX.7

Rayburn did not conduct tests for the disclosure of income, however, sufficient data is reported in her paper to do so. Assuming all four components are informative, I conducted the six pairwise tests for equality of coefficients using the year-by-year coefficient estimates reported by Rayburn in tables 7 and 9 (1986, 128 and 130).8 The null hypothesis was not rejected for any of these six tests at the five percent level using a two-sided test. Thus, these tests provide no evidence that investors prefer these components to be disclosed separately. Using the data presented in Rayburn's table 9 (1986, 130), the largest t-statistics were for the comparison between depreciation expense and cash flow from operations (t - - 1.98) and depreciation expense and change in working capital (t = - 1.91). These values, which are significant at the ten percent level, provide weak evidence that investors value an unexpected one-dollar reduction in depreciation expense more than a dollar of income from either cash flow from operations or change in working capital. However, the same tests based on the data reported in Rayburn's table 7 (1986, 128) are insignificant and of the opposite sign. As a result, there appears to be little evidence in Rayburn's data that these components of reported income are valued differently by investors.

6 Rayburn defined changes in working capital as the change in current assets other than cash and short- term investments minus the change in current liabilities other than current maturities of long-term liabillities. She then defined cash flow from operations as net income before extraordinary items plus depreciation, deferred taxes, and change in working capital.

' Rayburn conducted two-sided tests, and this decision affected her conclusions with respect to deferred taxes. Rayburn concluded that the results for deferred taxes were mixed, i.e., one significant and the other not. However, if a one-sided test had been conducted, the conclusion would have been that deferred taxes is significant for both expectations models. Moreover, in the published version of the study, there is an error in table 9. The mean for the coefficient estimates for deferred taxes is not consistent with the values reported for each year. If the values reported for each year are correct, the t-value that should have been reported for deferred taxes in table 9 is - 2.36, so that deferred taxes would have been significant even with a two-sided test.

I used a statistical procedure identical to the one used by Rayburn in her hypothesis tests. The tests for each coefficient are based on the mean of the 20 cross-sectional estimates reported in Rayburn and the standard errors of those distributions.




Bowen, Burgstahler, and Daley's Study

The main results reported by Bowen et al. (1987) are based on the following system of accounting variables:

INC = CFO + CA + NCA, (6)

WCFO = CFO + CA, (7)

CFAI = CFO + INV, (8)

where NCA is unexpected noncurrent accruals, WCFO is unexpected working capital from operations, CFAI is unexpected cash flow after investment, and INV is unexpected net investment. Using these accounting variables, Bowen et al. estimate the following regression:

RET=fINC+02WCFO+ 33CFO+ 34CFAI+E. (9)

Bowen et al. conduct two joint tests based on estimates from equation (9), a l1=132=0

and 3= 34=0. They characterize 01=32=0 as a test of the "incremental information content of cash flows beyond accruals" (Bowen et al. 1987, 739). They reject the null hypothesis and conclude that the "results are consistent with the alternative hypothesis that unexpected cash flows ... provide information beyond that contained in unexpected accrual flows...." They characterize the second test, f3 = f4 =0, as a test of the "incremental information content of earnings and WCFO (working capital from operations) beyond cash flows." Again rejecting the null hypothesis, they conclude that "this result is consistent with the alternative hypothesis that accrual operating flows (earnings and WCFO) jointly possess information in addition to that contained in the cash flow variables . . ." (Bowen et al. 1987, 739).

The interpretation of these results in terms of the composition and disclosure of these components of income (CFO, CA, NCA, and INV) is not obvious from this specification. To make this interpretation and to make the results in Bowen et al. comparable with those in Rayburn, consider the following alternative specification of equation (9):

RET= yCFO+ Y2CA+'Y3NCA+ Y4INV+E. (10)

Because the independent variables in equations (9) and (10) are linear transformations, the coefficients from the estimation of the regressions are also linear transformations, and are related in the following way:

, =13 +32 +03 + 04,

72=-1 +12,

73=(1,

'Y4 = 44

Using the coefficients from equation (10), it is a straightforward exercise to conduct tests of whether each of the components contributes to the informativeness of net income and tests of whether the components are valued differently by investors.9

Using the year-by-year results reported by Bowen et al. in table 7 (1987, 744), I

'Note that INV is not a component of net income under generally accepted accounting principles.




conducted these composition of income and disclosure tests in terms of equation (10). 10

The composition of income tests are yi = 0 for i = 1 to 4. Each of these (one-sided) tests is significant at the five percent level, except for y4, the coefficient on net investment. This indicates that the three components of historical cost income, but only those components, are associated with returns.1I These results are consistent with those reported by Rayburn (1986).

For the disclosure tests, I disregarded net investment since it is not associated with returns, and conducted the three pairwise tests of equal coefficients for the remaining components.'2 None of these (two-sided) tests is rejected at the five percent level, but the coefficients on cash flow from operations and current accruals differ from each other at the ten percent level (t= 1.90). This is weak evidence that investors value a dollar of unexpected cash flow more than a dollar of unexpected current accrual, and implies that investors prefer that these two components of income be disclosed separately. These results are not consistent with the results of similar tests (reported previously) based on Rayburn's data. Those tests failed to reject the hypothesis that cash flows and current accruals are valued equivalently by the market (t= -0.18 (table 7, 128) and t = 0.07 (table 9, 130)). The evidence in these two studies on the preferred disclosure of income is conflicting and weak.

III. Conclusion

The analysis of the results of Rayburn (1986) and Bowen et al. (1987) included additional tests not conducted in the original studies, but based on data in the published articles. Taken together, the results provide consistent and strong evidence that both cash flow and accrual components add to the informativeness of income. However, there is only weak and inconsistent evidence that accrual components of income are valued differently from cash flow components by investors. More research is needed on this issue before strong inferences can be made.

'? I used a statistical procedure identical to the one used by Bowen et al. in their year-by-year tests. The tests for each coefficient are based on the mean of the ten cross-sectional estimates reported in table 7 of Bowen et al., and the standard errors of those distributions.

I Bowen et al. report the results for 73=0 and -,4=0 because they are equal to 0, and 0,, respectively. 12 Bowen et al. report the results for -y2 = -y,, which is equivalent to O2 = O from equation (9). Assuming that

y4 = O, they also report the results for ay, = -2, which, under that assumption, is equivalent to 33= 0 from equation (9). Bernard and Stober (1989), in their discussion of Bowen et al., have the same interpretation of this result, providing (as they do) that 4 is assumed to be zero.

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Bernard, V., and R. Ruland. 1987. The incremental information content of historical cost and current cost income numbers: Time-series analyses for 1962-1982. The Accounting Review 62 (October): 707-22.

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a note on interpreting "incremental information content"

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