On the Relationship between Earnings, Cash Flows and Returns: An Australian Postscript to Lev and Zarowin (1999)

In a recent US study, Lev and Zarowin (1999) documented a steady decline in the value relevance of financial statements over a twenty year period. They attribute this decline, in part, to the inadequate financial reporting of intangibles, and particularly US accounting requirements for the immediate expensing of these items. In contrast to US accounting standards, capitalization of R&D expenditure is permitted in Australia under Approved Australian Accounting Standard AASB 1011 “Accounting for Research and Development Costs.” As expected, the capitalization of intangibles was found to be significantly higher in the new economy sector, with an increasing trend towards capitalization over the past five years. The results are broadly consistent with the US study. However, while not unequivocal, the results also suggest that the earnings‐return relationship was steadier, and the cash flow‐return relationship stronger overall in the new economy sector, indicating some tentative support for proponents of capitalization.