On the Relationship between Reported Earnings and Earnings Concepts - A Study on the Relationship between Net Income and the Two Ideal Earnings Concepts; Permanent Earnings & Economic Earnings

Abstract: Permanent earnings and economic earnings are two conventional concepts often referred to as "properly measured" or "ideal" earnings. These concepts represent two opposing views on what income is and how it relates to value. Economic earnings relate to the change in (cum-dividend) value, whereas permanent earnings relate to the actual value and can thus be used as a valid starting point for valuation. Permanent earnings can be defined in two ways depending on the choice of capitalization rate: i) the risk-free rate or ii) the cost of equity. A recent study on US data conducted by Grambovas, Garcia, Ohlson and Walker (2014) found that net income, measured on a long-term average, tends to approximate permanent or economic earning more or less depending on the accounting in place. This paper replicates the aforementioned study to examine whether similar results can be obtained on Swedish data, and also investigates if the relationship between net income and the earnings concepts has changed over time. The purpose is to gain a better understanding of what the bottom line in the income statement represents and how it relates to value. The question is examined quantitatively by analyzing the difference between net income and the two earnings concepts respectively. In line with the results on US data, the results in this study indicate that net income overall is closer to permanent earnings than to economic earnings. In addition, the short-term risk-free rate seems to be the appropriate choice on a long-term average, while the cost of equity seems to be more appropriate for the later time period studied (2000-2013). In contrast to the study on US data, no significant differences between the two investigated industries were found on Swedish data. The differences over time are therefore considered to be a consequence of the volatile inflation rate rather than the accounting in place.