The Role Of Investment Opportunities In The Value-relevance Of Accounting Earnings

Relevance is one of the requirements of quality of accounting information. As important accounting information, accounting earnings should be relevant. If the investors use the accounting earnings to evaluate the investment value of a company, which causes the corresponding fluctuations in stock prices, then the accounting earnings are value-relevant. Consistent empirical studies at home and abroad have shown that accounting earnings are value-relevant. However, what factors affect the value-relevance of earnings is still inconclusive. This paper will examine whether investment opportunities affect the value-relevance of accounting earnings, that is, whether investment opportunities affect the preference of investors for the accounting earnings.We examine how the value-relevance of accounting earnings varies with investment opportunities. On the one hand, it is necessary for the theoretical development. Empirical studies abroad have shown that investment opportunities affects the value-relevance of earnings, while domestic academic community is still lack of research in this area at present. To a certain extent, our study can enrich the related research in China. On the other hand, this paper also has an important guiding significance on the practice. We can learn the preference of investors for the use of accounting information when the growth opportunities of companies are different. It will be helpful for standard-setters to improve the guidelines to provide investors with more useful information. Also, it can help regulators formulate laws and regulations to regulate capital markets. In addition, our analysis can provide some reference to investors for their investment decisions.Our sample includes all unregulated firms that only issue A shares and have sufficient data on Shanghai stock market for at least three consecutive years between 2006 and 2008. The analysis is motivated by the growth information hypothesis and the noisy measure hypothesis, both of which are about how and why the value-relevance of earnings varies with investment opportunities. We consider non-monotonic relations between the value-relevance of earnings and investment opportunities. We further divide earnings into two components—cash flows from operations (CFO) and accruals, whose measurements are totally different, then examine how the value-relevance of CFO and accruals varies with investment opportunities. Investment opportunities measure combines five commonly used investment opportunities metrics—the ratio of the market-to-book-value of equity, the ratio of the market-to-book-value of assets, geometric mean annual growth rate of market value of assets, the ratio of the book-to-market-value of the fixed assets and E/P.The results show that earnings, CFO and accruals are value-relevant, which means that the investors use these information to price the stock. The value-relevance of earnings, CFO and accruals declines as investment opportunities increase. That is, investment opportunities have negative impact on the value-relevance of these accounting information. It indicates that the higher the investment opportunities are, the less accounting earnings, CFO and accruals are used by investors when they evaluate the value of a company. That may be due to deficiencies in the accounting measurement standards. On the one hand, CFO not only represent cash flows from operating activities, but also include that from investing activities. For example, accounting standards require that advertising expenditures, which incurred for the establishment of brand image, be classified as CFO. On the other hand, accruals can be manipulated arbitrarily. Therefore, earnings are not economic earnings. If exploiting investment opportunities entails investments in such projects that probably include accounting errors, then measurement errors in earnings will increase directly with investment opportunities and the credibility of earnings declines.