Financial Accounting: In an Economic Context

THE ECONOMIC CONSEQUENCES ASSOCIATED WITH INCOME MEASUREMENT AND DISCLOSURE

Income is the most common measure of a company's performance. It has been related to stock prices, suggesting that equity investors use income in their decisions to buy and sell equity securities. An article in the Journal of Accountancy stated that “[accounting] research … has provided some well-established conclusions. Perhaps the most conclusive finding is the importance of accounting income to investors.” Almost daily the Wall Street Journal reports how stock prices respond to corporate earnings reports.

Income has also been related to bond prices, which indicates that debt investors use income in their decisions to buy and sell corporate bonds. Credit-rating agencies, such as Standard & Poor's and Dun & Bradstreet, use income numbers to establish credit ratings. In response to “improved financial statements,” for example, Standard & Poor's raised the credit rating on bonds issued by two of China's top four banks (Bank of China and China Construction Bank) from BBB— to BB+ which, in turn, increased the market value of their outstanding debt. In addition, three of Dun & Bradstreet's fourteen key business ratios (return on sales, return on assets, and return on net worth) explicitly use a measure of income in the formula, and most of the numbers used in the remaining eleven ratios are indirectly affected by the dollar amount of reported income.

Due to the importance attached to income, periodic public ...