Does Inflation Affect Earnings Relevance? A Century-Long Analysis

Financial reports present assets, liabilities, and earnings on a nominal basis (unadjusted for inflation). Using a novel dataset of nearly a century of financial reports, this paper examines whether and how inflation affects the relation between accounting earnings and stock market value, i.e., earnings relevance. On the one hand, inflation may decrease earnings relevance as historical cost accounting relies on historical transaction prices that become less relevant when inflation changes the price level. On the other hand, inflation may increase earnings relevance by increasing firms’ discount rates and thereby shifting agents’ focus towards nearer-term payoffs. Consistent with the latter hypothesis, we document a strong positive relation between earnings relevance and inflation. Cross-sectional tests indicate that this relation is stronger for firms that are more sensitive to discount rate changes. We find that inflation is of first-order importance relative to determinants of earnings relevance explored in prior literature.