This article provides confirmatory evidence of the value-relevance of book values of oil and gas properties. Harris and Ohlson (1987) find that the book values correlate significantly with the inferred market values of oil and gas properties. Reserve recognition accounting requires the simultaneous publication of alternative measures that are often assumed to be more relevant values of the oil and gas properties. The question that logically follows is whether the significance of the book values results from their value-relevance, or whether investors are "functionally fixated" on these accounting values.
To address this question, we evaluate zero-investment trading rules based on portfolios constructed from values of the imputed market value (per equivalent barrel of proved reserves). If the security market is informationally efficient, this trading rule should not yield systematic positive returns and the Harris Ohlson (1987) results then clearly suggest that the book values are value-relevant. We find that the trading rule based on cross-sectional variation in the inferred market values yields significant positive returns that cannot be explained by portfolio risks. This suggests a market inefficiency that could occur because the market "incorrectly" uses book values (per equivalent barrel) to determine market values. That is, functional fixation on book values may be the cause of the successful initial trading strategy. To reject a hypothesis of functional fixation and, thus, the value-irrelevance of book value, it is necessary to try and exploit the book-value-induced cross-sectional variation in the inferred market values. To do this we construct an additional trading rule that controls for the book-value component of the inferred market value.
This second trading rule provides even larger returns than the first, and so argues against a simple form of functional fixation. To finally conclude against functional fixation on book values, we consider trading rules that control for other information, in particular the present value of future cash flows. Although these trading rules also yield significant returns, they do not improve on the results from the trading rule that controls for book values.
Harris, Trevor, and James A. Ohlson. "Accounting Disclosures and the Market's Valuation of Oil and Gas Properties: Evaluation of Market Efficiency and Functional Fixation." The Accounting Review 65, no. 4 (October 1990): 764-780.
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