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Residual income, non-earnings information, and information content

Author

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  • Ruey S. Tsay

    (Graduate School of Business, University of Chicago, Chicago, Illinois, USA)

  • Yi-Mien Lin

    (Department of Accounting, National Chung Hsing University, Taichung, Taiwan)

  • Hsiao-Wen Wang

    (Department of Accounting, National Changhua University of Education, Changhua City, Taiwan)

Abstract

We extend Ohlson's (1995) model and examine the relationship between returns and residual income that incorporate analysts' earnings forecasts and other non-earnings information variables in the balance sheet, namely default probability and agency cost of a debt covenant contract. We further divide the sample based on bankruptcy (agency) costs, earnings components and growth opportunities of a firm to explore how these factors affect the returns-residual income link. We find that the relative predictive ability for contemporaneous stock price by considering other earnings and non-earnings information is better than that of models without non-earnings information. If the bankruptcy (agency) cost of a firm is higher, its information role in the firm's equity valuation becomes more important and the accuracy of price prediction is therefore higher. As for non-earnings information, if bankruptcy (agency) cost is lower, the information role becomes more relevant, and the earnings response coefficient is hence higher. Moreover, the decomposition of unexpected residual income into permanent and transitory components induces more information than that of the unexpected residual income alone. The permanent component has a larger impact than the transitory component in explaining abnormal returns. The market and industry properties and growth opportunity also have incremental explanatory power in valuation. Copyright © 2008 John Wiley & Sons, Ltd.

Suggested Citation

  • Ruey S. Tsay & Yi-Mien Lin & Hsiao-Wen Wang, 2009. "Residual income, non-earnings information, and information content," Journal of Forecasting, John Wiley & Sons, Ltd., vol. 28(6), pages 487-511.
  • Handle: RePEc:jof:jforec:v:28:y:2009:i:6:p:487-511 DOI: 10.1002/for.1104
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    References listed on IDEAS

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    Cited by:

    1. Cheng, Che-Hui & Wu, Po-Chin, 2013. "Nonlinear earnings persistence," International Review of Economics & Finance, Elsevier, vol. 25(C), pages 156-168.

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