The Usefulness of Accounting Information in Assessing Systematic Risk: A Re-Examination

ABSTRACT This study documents the potential statistical problems in using accounting risk measures in assessing a firm's systematic risk. It is found that all three problems: measurement error, omission of variables and multicollinearity exist in this area of research. To underscore the serious nature of the problems, two most important empirical studies in this area of research are replicated with new data: the Beaver, Kettler and Scholes' study and the Eskew's study. In both cases, the results are inconsistent with their findings. An alternative model, LISREL, is recommended for this area of research. INTRODUCTION The objectives of this paper are 1) to reiterate the common problems in the application of the conventional regression model in empirical accounting research and provide some evidence that these problems do exist in accounting data and 2) to underscore these problems, two of the oft-cited earlier studies of the usefulness of accounting information in assessing systematic risk are partially replicated based on a new data set to see whether their results may be cross-validated and if not, why. But, first, some justification is given here as to why research in this area is important. Portfolio theory tells us that systematic risk is the only risk for which investors, holding diversified portfolios, need to be concerned about (e.g., Sharpe 1964). Thus, rational risk averse investors will hold well diversified portfolios. Systematic risk is an important economic decision variable for most investors because it is well known that most people are risk averse. The accounting literature also stresses the importance of risk assessment. It is stated in ASOBAT (AAA 1966, 4 and 19) that one of the objectives of accounting is to provide information for "making decisions concerning the use of limited resources" and it continues, "accounting information is the chief means of reducing uncertainty under which external users act". AICPA's Trueblood Report (1973, 13) states that, "the basic objective of financial statements is to provide information useful for making economic decisions". Also, the FASB (1983, par. 34) states that the objective of financial reporting is "to provide information that is useful to present and potential investors and creditors and other users in making rational investment, credit, and similar decisions". Hence, investigation into the usefulness of accounting information is an important area of research and is consistent with the pronouncements and viewpoints expressed by the above groups concerned with financial reporting. Capital market based accounting research has been widely accepted for this purpose, as is evidenced by the voluminous publications in prestigious accounting and finance journals. In fact, the article by Ball and Brown (1968), which served to introduce the capital market-based methodology in the accounting literature, was recently named the recipient of the American Accounting Association's newly established 'Seminal Contribution to Accounting Literature Awards. ' This noteworthy designation underscores the important contribution that capital market-based research has provided to the body of knowledge in accounting. Since systematic risk is theoretically an important decision variable for investors, creditors and managers, the ability of accounting information to assess systematic risk is of particular importance. Since the publication of Ball and Brown (1969) numerous research studies in this area have been conducted and published (e.g., Ang et al. 1984; Beaver et al. 1970; Bildersee 1975; Ben-Zion and Shalit 1975; Bowman 1979; Breen and Lerner 1973; Brenener and Smidt 1978; Elgers 1980; Elgers and Murray 1982; Eskew 1979; Hill and Stone 1980; Lev 1974; Lev and Kunitzky 1974; Logue and Merville 1972; Mandelker and Rhee 1984; Melicher 1974; Melicher and Rush 1974; Rosenberg and Mckibben 1973; Thompson 1976; White 1972). The results have been mixed and inconsistent. …