Return Measures as a Link Between Financial Statements

Abstract

Synopsis The research problem I examine whether and how presenting a return measure (e.g., return on assets) on the face of the income statement influences non-professional investors’ judgments of a company as a potential investment. Motivation Accounting research suggests investors focus on bottom-line earnings to the exclusion of other financial information. To evaluate a firm’s economic performance, valuation models suggest investors should assess not only income, but also the resources employed by the firm to generate the income. Value is created when companies earn a sufficient return on resources employed in the business. Therefore, positive and/or growing accounting earnings do not necessarily indicate a firm is performing well. Return measures, such as return on assets, are ways to measure a company’s return on its economic resources. The test hypotheses H[Formula: see text]: Reporting a return measure on the face of the income statement affects nonprofessional investors’ perceptions of investment attractiveness, and it does so by priming investors to evaluate the return on resources that the company earns. H[Formula: see text]: Reporting a return measure on the face of the income statement affects nonprofessional investors’ perceptions of balance sheet relevance and acquisition of balance sheet information. Target population Standard setters, financial statement preparers, and accounting researchers. Adopted methodology In an experiment, participants viewed an abbreviated annual report of a hypothetical company and provided judgments about the firm as a potential investment. I manipulated whether a return measure was reported on the income statement. I also manipulated the level of return; while net income and earnings per share were the same in all conditions, I manipulated balance sheet amounts such that return on assets was relatively high or low. Analyses Analyses included analysis of variance (ANOVA), analysis of covariance (ANCOVA), and conditional process analysis. Dependent measures included participants’ judgments about the company as a potential investment, perceived efficiency and effectiveness of the company’s management, perceived relevance of balance sheet information, and recall of financial statement information. Findings Results supported my first prediction — reporting a return measure on the income statement affected non-professional investors’ perceptions of the company as a potential investment; further, these judgments were driven by perceptions of managerial efficiency and effectiveness in earning a return on the company’s resources. Results did not support my second prediction that reporting a return measure on the face of the income statement influences non-professional investors’ perception of balance sheet relevance or affects acquisition of balance sheet information.