In the early to mid 1960s, the finance world had a very low opinion of accounting, particularly in terms of financial statement information. The generally accepted wisdom was that such accounting was of no value in the assessment of a business’s worth, and was therefore completely unrelated to such investment matters as stock prices. It’s an attitude that seems absurd today.
The respect in which accounting is currently held is partly due to the work done by two young Australians at the University of Chicago. One was Philip Brown. The other was Ray Ball, who arrived at the university’s hallowed halls a few years after Brown.
“When I arrived the place just crackled with ideas,” Ball, who was four-and-a-half years younger than Brown, says.
“You would walk into the faculty lounge and say something and someone would immediately get up and start writing on the blackboards, trying to dissect the idea, pull it apart and play with it.
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The idea that Ball and Brown challenged was the one around the value of accounting. The lowly opinion of the profession came from the fact that, at the time, there were so many different methods accountants could choose to produce various financial results. It led to the belief that number crunchers were simply employed to hoodwink investors or creditors.
This was a serious issue at the time. An academic paper written by another Australian accounting heavyweight, R.J. Chambers, concluded that from a single set of organisational transactions, the various accounting methods available meant it was possible to report 30 million different profit figures. Another problem was historical-cost accounting, which did not take inflation into account and therefore, on balance sheets, did not compare like with like.
Ball and Brown believed that accounting would never have played such a central role in business and finance for so many centuries if it truly lacked value and meaning.
They decided to run a study, which, put very simply, would find out whether and how share prices had reacted to information captured in financial statements in the past. The pair did so by crunching big data, and the data really was big. The computer (the only one at the University of Chicago) filled two rooms!
“It took up an enormous space, but the size of its memory was one two-millionth the size of my iPhone’s memory,” smiles Ball, who is now the Sidney Davidson Distinguished Service Professor of Accounting at the University of Chicago Booth School of Business.
“When one person was running a job on it, nobody else in the university could do any computing. The file of historical stock returns was on magnetic tape that took three minutes for the computer to read from one end to the other.”
The results of their study empirically demonstrated for the very first time that accounting figures were of immense value to investors. Accounting reports, such as annual reports, profit reports and profit warnings, correlated directly with shifts in stock prices.
Also, the now famous “Figure 1” graph in their published paper – “Ball and Brown (1968): An Empirical Evaluation of Accounting Income Numbers” – clearly illustrated the fact that the market anticipated profit reports, building value into a stock (or taking it away) in the lead-up to a report, as well as responding with a rise or fall in value after a report’s release.
The article was originally rejected by The Accounting Review, partly because it was all but impossible to find a referee with the knowledge to handle the submission, but also because editors felt it had “little to do with accounting”.
However, in 1968, when Nicholas Dopuch (also remembered as a transformational figure in accounting research) was appointed as editor of The Journal of Accounting Research, the study finally earned its place in history.
The result
In the pre-internet era, news didn’t spread quickly. Ball and Brown returned to Australia and got on with their lives. Academics mostly reacted to their paper with indifference. The typical financial academic, Brown says, went on believing financial statement information meant nothing. Still, in the absence of the two young Australians, their research study took on a life of its own.
As more academics cited “Ball and Brown (1968)” in their own work, people began to take notice. Eventually, those in the academic and financial realms recognised the work as a true classic.
“Overall, ‘Ball and Brown (1968)’ expressed a view of information in markets that was new to the accounting literature, and contributed to a sea change in attitudes toward financial markets, disclosure, and financial reporting,” the pair wrote in a 2014 paper called “
Ball and Brown (1968): A Retrospective”, published in The Accounting Review.
“Viewed more generally, the research demonstrated that accounting is a viable area for market-based and information-economics reasoning, at a time when these areas were just being developed. It helped elevate the status of accounting research among colleagues in adjacent areas and in universities generally. We are fortunate and proud to have authored
it.”
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