Earnings: Concepts vs. Reported

Journal of Law Finance and Accounting, Forthcoming

57 Pages Posted: 13 Sep 2016 Last revised: 13 Mar 2017

See all articles by Christos A. Grambovas

Christos A. Grambovas

Hellenic Open University

Juan M. García Lara

Universidad Carlos III de Madrid - Department of Business Administration

James A. Ohlson

Hong Kong Polytechnic University - School of Accounting and Finance

Martin Walker

University of Manchester - Manchester Business School

Multiple version iconThere are 2 versions of this paper

Date Written: February 13, 2017

Abstract

The paper examines three benchmark earnings concepts: (i) permanent earnings with the cost-of-equity determining the capitalization, (ii) permanent earnings with the risk-free rate determining the capitalization, and (iii) economic earnings (Hicks’s concept). The concepts can be measured empirically using stock prices. The study explains how the three concepts differ in terms of reflecting risk and growth. Critically, (i) and (ii) highlight two cases along a continuum. Case (i) renders growth irrelevant so that risk alone, as reflected by the cost-of-equity, determines the E/P yield ratio. By contrast, for (ii) the risk-free rate determines the E/P ratio because growth cancels out risk. The case is referred to as full cancelling out, FCO for short. The empirical part of the paper compares the earnings concepts to reported earnings using US data, for the period 1976 to 2015. These evaluations split firms into two categories, industrial and financial. Main findings show that for industrial firms, as an overall average, reported earnings relate closer to (ii) - that is, FCO - than to (i). Though the result is robust across methods, for distinct sub-periods (i) provides the better benchmark. As to reported earnings of financial firms, we hypothesize and find that reported earnings relate closer to (i) than (ii). This conclusion should be expected insofar financial firms rely on approximate fair value accounting, in which case earnings come close to economic earnings, (iii), and such earnings imply an average of (ii).

Keywords: Permanent earnings, Economic Earnings, Firm valuation, Earnings yields

JEL Classification: M41, G32

Suggested Citation

Grambovas, Christos A. and García Lara, Juan Manuel and Ohlson, James A. and Walker, Martin, Earnings: Concepts vs. Reported (February 13, 2017). Journal of Law Finance and Accounting, Forthcoming. Available at SSRN: https://ssrn.com/abstract=2838398

Christos A. Grambovas (Contact Author)

Hellenic Open University ( email )

Aristotelous 18
Patra, 26334
Greece

Juan Manuel García Lara

Universidad Carlos III de Madrid - Department of Business Administration ( email )

Calle Madrid 126
Getafe, Madrid, Madrid 28903
Spain

James A. Ohlson

Hong Kong Polytechnic University - School of Accounting and Finance ( email )

M715, Li Ka Shing Tower
Hung Hom, Kowloon
China

Martin Walker

University of Manchester - Manchester Business School ( email )

Booth Street West
Manchester, M15 6PB
United Kingdom

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