The findings of value relevance studies have a particular importance for accounting standard setters since accounting standards form a major part of financial regulatory requirements.
Holthausen and Watts (2001)critically evaluated the standard setting inferences that can be drawn from value relevance research studies that are motivated by standard setting. The study concentrates on theories of accounting, standard setting and valuation that underlie those inferences. They cite a variety of reasons why the value relevance literature has had little impact on standard setting. The major reason is that the literature does not seek to develop a descriptive theory of accounting and standard setting. Without such a theory there can be little assurance that the inferences drawn in the literature are valid. The literature uses equity valuation tests only. Much of the literature is motivated by an assumption that accounting provides inputs to investors‟ valuations, but the empirical tests amount either to associations with equity value or in many cases to equity valuation per se.
Holthausen and Watts (2001) argue that even if the value-relevance literature‟s tests effectively informed us about accounting‟s role in providing inputs to equity investor valuation, those tests ignore the other roles of accounting and other forces that determine accounting standards and practice. To the extent that accounting standards and practice are shaped by other roles and forces that are not perfectly correlated with the valuation role, the value relevance literature misses the key attributes of accounting.
Finally, Holthausen and Watts discuss the weakness of current valuation models used in accounting research. In particular, most of the models estimated assume away the existence of economic rents, and growth and abandonment options. In addition, most of the estimated models are linear, when there is both ample theory and empirical evidence to support the notion that the relationship between the variables in the models and value are non-linear. Thus, the advanced valuation models explicitly considering rents, growth
and abandonment options and the resulting non-linear relations, can be identified as an area of future research.
Barth et al. (2001) offered the view of the relevance of value relevance research for financial accounting standard setting that contrasts with the view offered in Holthausen and Watts (2001). Barth et al.‟s (2001) comment is limited in scope to a discussion of the relevance of the value relevance literature for financial accounting standard setting, but does not comprehensively review the value relevance literature.
The key conclusion of Barth et al. (2001) is that the value relevance literature provides fruitful insights for standard setting in the following manner.
1. Value relevance research provides insights into questions of interest to standard setters and other non-academic constituents. Although there is no extant academic theory of accounting or standard setting, the FASB articulates its theory of accounting and standard setting in its concept statements.
2. A primary focus of the FASB and other standard setters is equity investment. Although financial statements have a variety of applications beyond equity investment, the possible contracting uses of financial statements in no way diminish the importance of value relevance research, which focuses on equity investment.
3. Empirical implementations of extant valuation models can be used to address questions of value relevance, despite the simplifying assumptions underlying the models.
4. Value relevance research can accommodate conservatism, and can be used to study the implications for the relation between accounting amounts and equity values.
5. Value relevance studies are designed to assess whether particular accounting amounts reflect information that is used by investors in valuing firms‟ equity.
6. Econometric techniques can be and are applied to mitigate the effects of common econometric issues arising in value relevance studies.
Barth et al. (2001) comment on Holthausen and Watts‟s criticism of the models used in value relevance research. Currently, a frequently employed model is that based on Ohlson (1995) and its subsequent refreshments. Ohlson‟s model represents firm value as a linear function of book value of equity and the present value of future abnormal earnings. The model assumes perfect capital markets for a finite number of periods. With additional assumptions of linear information dynamics, firm value can be re- expressed as a linear function of BV, net income, dividends and other information.
Ohlson‟s (1996) model and its extensions capture the economic rents (rents in excess of the cost of capital for a finite number of periods) by the persistent parameter on abnormal earnings as well as by other information. Although economic rents can be viewed within Ohlson‟s framework as being reflected in the presence of abnormal earnings, rents also can be reflected in the model by including the present value of the future cash flows attributable to those rents. In fact, economic rents are attributable to many intangible assets.
Ohlson‟s model yields a particular form of non-linearity in the valuation equation. However, Ohlson often makes modifications to estimating equation specifications to incorporate potential effects of non-linearities in the particular setting being examined. The presence of abnormal earnings enters into the model‟s non-linearity. That is, for given levels of equity book value and abnormal earnings, marginal differences in persistence are not associated with constant marginal differences in equity value. Studies that permit valuation coefficients to vary cross-sectionally or across components of equity book value and abnormal earnings are explicit attempts to control for non- linearity. This can be viewed as being implicitly based on the non-linearity in abnormal earnings in Ohlson‟s model.