A Survey of Research Relating Accounting Numbers to Systematic Equity Risk, with Implications for Risk Disclosure Policy and Future Research.

Abstract In this paper, I survey research in accounting and finance that relates accounting numbers to market measures of systematic equity risk. In my view, this research provides two main findings for accounting policy makers. First, earnings variability has historically been the accounting variable most strongly related to systematic equity risk. Second, systematic equity risk is positively associated with sources of operating risk (price and quantity variability), operating leverage and financial leverage. Moreover, firms with greater operating risk tend to choose a lower level of financial leverage to yield an acceptable level of systematic equity risk. I discuss the implications of this research for risk disclosure policy, indicating ways that the accounting system can evolve to provide better information about earnings variability, sources of operating risk, operating leverage and financial leverage. Specifically, I argue that earnings variability would be better indicated by more extensive fair value accounting and by well-considered disaggregation of balance sheet accounts and major accrual estimates. I argue that the elimination of absorption costing in favor of direct costing and better segment reporting would improve the information provided about sources of operating risk and operating leverage. I also indicate various possibilities for future research useful to accounting standard setters. Such research will be of particular interest in the near future, since the organizers of the 1997 AAA/FASB Financial Reporting Issues Conference currently intend to focus that conference on risk disclosures.