Value Relevance of Inflation-adjusted Equity and Income

This paper investigates the role incremental information content of inflation-adjusted data plays in explaining the market value of equity and stock returns on the Istanbul Stock Exchange (ISE). We show the effect of inflation accounting application on basic financial ratios, and we test the value relevance of inflation-adjusted and historical cost-based book value and earnings. The findings show that inflation adjustment affects financial ratios significantly, which may create different risk assessments for the selected firms. Furthermore, the results indicate that both inflation-adjusted and historical cost-based earnings and book values are significantly value relevant. The two sets of data are not to be used as substitutes, but, rather, they are complementary. For this reason, inflation-adjusted data should be required as supplementary data to the historical cost information rather than in place of historical cost data.     

The Role of Earnings and Book Values in Pricing Stocks: Evidence from Turkey

In this study, we examine factors associated with equity valuation in a newly emerging market, Turkey. In the United States and other developed countries, research indicates that both earnings and book value are important predictors of equity valuation. In Turkey, earnings appears to have information content but earnings, by itself, appears to be declining in importance over time. Book value adjusted for inflation has a stronger association with equity values. In the inflationary and risky environment of Turkey, where future value of earnings is quite uncertain, investors may be paying less attention to earnings and more attention to book values. With respect to the role of book value there are competing explanations. While some researchers conclude that it is only important because it is a control for scale differences, (Barth & Kallapur 1996) others conclude that it is relevant as a proxy for normal earnings (Ohlson, 1995). Still others conclude that it is only relevant in the valuation of loss making and generally unsuccessful firms (Berger, Ofek & Swary 1996; urgstahler & Dichev, 1997). The additional contribution of this study is to show that book value is also important as a value proxy for firms operating in environments where there is rampant inflation. Our study also indicates that, overall, earnings and inflation-adjusted book values combined virtually explain almost 75% of the variation in equity prices in Turkey.     

Value relevance of international accounting standards harmonization: Evidence from A- and B-share markets in China

Applying both the price-levels model and the lagged-price-deflated returns model, we investigated the incremental value relevance of the reconciliation of accounts from the Chinese Accounting Standards (CAS) to the International Accounting Standards (IAS) by those Chinese listed companies that have simultaneously issued A-shares and B-shares. In addition, we examined the usefulness of accounting numbers (earnings and book values) and their value relevance to the A- and B-share markets in China. The study finds that earnings and book values of owners’ equity determined under CAS are more relevant accounting information for the purpose of determining the prices of A- and B-shares. The CAS-based earnings changes were reflected in stock returns in the B-share market, while the CAS-based earnings were closely associated with stock returns in the A-share market. However, the study found that the reconciliation of earnings and book values from CAS to IAS basis is partially value-relevant, mainly to stock prices in the B-share market, while the earnings reconciliation is generally not value-added to stock returns in either the A- or the B-share market. The study results suggest that accounting numbers based on domestic accounting standards, in contrast to IAS, are more value-relevant in the Chinese stock market at present.     

The Impact of Recession on the Value‐relevance of Accounting Information

The Global Financial Crisis of 2007–2008, and the subsequent global economic downturn, has heightened the need for research on whether the value‐relevance of accounting information is impacted by periods of macroeconomic decline. In this study, we examine whether the occurrence of a recession impacts the value‐relevance of two key accounting constructs: book value of equity and earnings. Consistent with our priors, we find that controlling for recession significantly increases the value‐relevance of both the book value of equity and earnings. Our findings indicate the importance of controlling for recession in value‐relevance studies. Sample periods that include recession events, and that do not incorporate such conditioning, may be mis‐specified, with results difficult, if not impossible, to interpret.     

Developing countries converging with developed-country accounting standards: Evidence from South Africa and Mexico

I examine the usefulness (relevance and timeliness) of earnings announcements in two emerging markets, the Johannesburg Stock Exchange (JSE) and the Bolsa Mexicana de Valores Stock Exchange (BMV). A weighted least-squares regression is used to test the association of book values of earnings and equity with firm market value. I find that, on JSE and BMV, earnings and/or book value of equity are value relevant in explaining stock prices. I also find that this association is greater in 2000 as compared to 1998 on the BMV. Regarding timeliness, I find that earnings announcements are accompanied by unusually different returns on JSE, but not on BMV. Market infrastructure, specifically insider-trading rules, may explain BMV results. I suggest that accounting and market infrastructure interact and that such interaction is valuable input to the Financial Accounting Standards Board (FASB) and International Accounting Standards Board (IASB) in their deliberations regarding one set of accounting regulations for all countries.     

Value versus growth: Australian evidence

The value‐growth effect is one of the most pervasive patterns in stock prices. In this study, the ability of four proxies for value‐growth, book‐to‐market, sales‐to‐price, earnings‐to‐price and cash‐flow‐to‐price to explain equity returns is analysed. The findings show that in aggregate, book‐to‐market best explains cross‐sectional variation in Australian equity returns, which in isolation suggests that it is the superior proxy for value‐growth. The analysis is taken further and the value‐growth effect is examined separately in positive and negative earnings firms. After segregating firms, it is found that in the negative earnings sample, book‐to‐market is the best value‐growth proxy and in the positive earnings sample, cash‐flow‐to‐price has the highest level of significance and is thus the superior value‐growth proxy. The economic significance of this result is telling, as the firms that report positive earnings are much larger than those that report negative earnings.     

The Value-relevance of Earnings and Book Value, Ownership Structure, and Business Group Affiliation: Evidence From Korean Business Groups

Abstract:  We investigate the quality of two primary accounting summary measures, i.e., earnings and book value, provided by firms belonging to Korean business groups (chaebols). We find that the value-relevance of earnings and book value is significantly smaller for firms affiliated with business groups. We also find that cross-equity ownership (a proxy for the agency problem between controlling and minority shareholders) negatively affects value-relevance, while foreign equity ownership (a proxy for the monitoring effect) positively affects value-relevance. This evidence is consistent with the view that the poor quality of earnings and book value provided by chaebol-affiliated firms is due to the inherently poor governance structure of chaebols.     

Domestic Accounting Standards, International Accounting Standards, and the Predictability of Earnings

We investigate (1) whether the variation in accounting standards across national boundaries relative to International Accounting Standards (IAS) has an impact on the ability of financial analysts to forecast non-U.S. firms' earnings accurately, and (2) whether analyst forecast accuracy changes after firms adopt IAS. IAS are a set of financial reporting policies that typically require increased disclosure and restrict management's choices of measurement methods relative to the accounting standards of our sample firms' countries of domicile. We develop indexes of differences in countries' accounting disclosure and measurement policies relative to IAS, and document that greater differences in accounting standards relative to IAS are significantly and positively associated with the absolute value of analyst earnings forecast errors. Further, we show that analyst forecast accuracy improves after firms adopt IAS. More specifically, after controlling for changes in the market value of equity, changes in analyst following, and changes in the number of news reports, we find that the convergence in firms' accounting policies brought about by adopting IAS is positively associated with the reduction in analyst forecast errors.     

HOW TO FIX ACCOUNTING—MEASURE AND REPORT ECONOMIC PROFIT

Bending accounting rules has become so ingrained in our corporate culture that even ethical business leaders succumb to the temptation to “manage” their earnings in order to meet analysts' demands for smoothly rising results. The author of this article argues that such behavior reflects not a general decline in ethical standards so much as executives' growing sense that accounting itself has become “unhinged from value.” For example, clearly valuable expenditures on R&D, customer acquisition, and employee training are generally expensed immediately against earnings. And reported corporate income is often further reduced by provisions for losses that most companies never expect to incur, by “book” taxes they never expect to pay, and by depreciation charges on assets that are actually increasing in value. At the same time, the opportunity costs associated with employee stock options and the corporate use of equity capital are not reflected in the accountant's measure of profit. To improve the quality of corporate governance and revitalize the public's faith in reported earnings, the author proposes a complete overhaul of GAAP accounting to measure and report economic profit, or EVA. Stated in brief, the author's concept of economic profit begins with an older, but now seldom used, definition of accounting income known as “residual income,” and then proposes a series of additional adjustments to GAAP accounting that are designed to produce a reliable measure of a company's annual, sustainable cash‐generating capacity. Besides expensing the cost of equity capital as well as stock options, the author recommends bringing off‐balance‐sheet items such as pension assets and liabilities back onto the balance sheet, eliminating reserve accounting, capitalizing R&D and other expenditures on intangible assets, and recording economic rather than accounting depreciation. Such changes, by replacing the accountants' current flawed definition of earnings with a comprehensive new statement of value added, could restore investor confidence in financial statements. Even more important, managers would be less likely to pursue their now common practice of boosting earnings by making value‐reducing operating and investment decisions and more likely to use financial reporting not to mislead the market but as an opportunity to communicate relevant, forward‐looking information.     

Valuing Loss Firms: What Can Be Learned From Analysts' Forecasts?

Prior research documents an anomalous negative price–earnings relation when a simple earnings capitalization model is estimated for loss‐making firms. Collins et al. (1999 ) suggest that the model is misspecified due to the omission of book value of equity. However, results from previous studies are confusing. We try to enrich prior literature by focusing on analysts' forecasts. In particular, we assess the role of earnings and book value in valuing loss firms using several measures based on the information provided by analysts. We hypothesize that the role of accounting figures depends on whether the loss firm is supported or not by investors. According to this argument, we construct several measures of investor support based on analysts' forecasts, and then test the value relevance of accounting information depending on the degree of support. Our results confirm the usefulness of the notion of ‘investor support’. For those loss firms that are expected to liquidate, we find that the inclusion of book value of equity in the model removes the negative sign on the earnings coefficient. However, for those loss firms that are expected to reverse current losses, we find that the coefficient on earnings remains negative despite the inclusion of book value.     

An International Analysis of Historical and Forecast Earnings in Accounting-Based Valuation Models

Abstract:  In this paper we examine whether the valuation properties of historical accounting amounts, namely earnings and equity book value, differ from those of forecasted earnings for firms in 17 developed countries classified into six accounting regimes. We compare the performance of a historical model and a residual-income forecast model for explaining security prices. The historical model uses the book value of equities and actual historical earnings and the forecast model uses the book value of equities and analysts' forecasts of earnings in the residual income for estimating the intrinsic value of the firm. The results suggest that book values, historical earnings or forecasted earnings are value relevant in most regimes and countries examined. The forecast model offers significantly greater explanatory power for security prices than the historical model in the Anglo-Saxon and North American countries, Japan, Germany, and three Nordic countries. The explanatory power of the historical model is similar to that of the forecast model in the Latin countries, two Nordic countries, and Switzerland. We find that the forecast model performs similarly to the historical model where financial analysts' forecasts are noisy and analysts are less active. Further results indicate that the forecasted earnings are more value-relevant than the historical earnings in countries with stronger investor protection laws, less conservative GAAP, greater income conservatism, and more transparent accounting systems.     

Searching for value relevance of book value and earnings: a case of premium versus discount firms

We examine the premium/discount firm characteristic that fundamentally affects the value relevance of two key accounting line items, earnings and book values. We argue that from the perspective of both the residual income and option-style valuation models, the relative valuation roles of earnings and book values differ fundamentally between firms that trade at a premium vis-à-vis discount to book value. We find that book values play a significantly more important role in equity valuation than earnings when firms trade at a discount. We also find that other known influential conditions, such as the sign of earnings (Collins et al. in Acc Rev 74(1):29–61, 1999) or the relative levels of earnings and book value (Burgstahler and Dichev in Acc Rev 72(2):187–215, 1997), become inconsequential when the premium/discount condition of the firm is controlled for. The discovered relationships between the relative valuation roles of book values and earnings and the discount/premium characteristics of the firm are robust to the effect of time, information environment and the industry of the firm.     

Detecting news in aggregate accounting earnings: implications for stock market valuation

How much news is there in aggregate accounting earnings? I provide evidence that earnings changes at the stock market level are correlated with new information about not only expected future cash flows but also discount rates. A comprehensive investigation of the link to discount rates reveals that aggregate earnings changes are tied to news about all components of the expected future stock market return, i.e., the real riskless rate, expected inflation, and the expected equity risk premium. Over the sample period studied, cash flow news and discount rate news in aggregate earnings changes covary positively and have offsetting impacts on stock market prices. As a result, stock market prices appear to be insensitive to aggregate earnings changes. The findings highlight the importance of separating cash flow news from discount rate news when evaluating the information content of accounting earnings at the stock market level. Overall, my study sheds new light on the informativeness and relevance of accounting earnings for valuation at the stock market level.     

Terminal Value,Accounting Numbers,and Inflation

In a 2008 article published in this journal, Michael Bradley and Gregg Jarrell argue that the well‐known Gordon‐Shapiro (henceforth “GS”) model for calculating terminal values does not properly account for the effects of inflation. Bradley and Jarrell suggest modifying the growth factor in the standard GS model by adding an additional term to the nominal growth rate that reflects the positive effect of inflation on the value of existing assets. In this article, the authors support the original Gordon‐Shapiro method for calculating terminal values by showing what they believe to be an oversight of the Bradley‐Jarrell critique. According to the authors, the disagreement stems from the use of fundamentally different assumptions about the effect of inflation on the capital investment required to sustain a business. Although Bradley‐Jarrell agree with the authors that intrinsic value is the discounted value of future free cash flows, their assumptions about capital investment effectively lead them to conclusions similar to those practitioners who attempt to value companies on the basis of discounted future accounting earnings. Despite much common practice, the GS model was meant to be applied to free cash flows, not accounting earnings. And for companies with substantial capital investment, the differences between accounting earnings that involve accruals and free cash flows can be very large.     

Equity valuation in practice: The influence of net financial expenses

This study investigates the relevance of net financial expenses with respect to equity valuation in an IFRS accounting regime. According to the residual earnings valuation model, income related to balance sheet items that are recorded at fair value is not applicable for valuation purposes. There are no residual earnings associated with these items because the balance sheet provides ‘perfect’ value estimates for the items in question. In accordance with the contention that under IFRS, aggregate net financial liabilities are recorded at a book value that is close to fair value, this study demonstrates that net financial expenses are not associated with the market prices of stocks. The investigation discusses the empirical findings in light of the enduring controversies regarding the use of fair value accounting.     

Earnings Quality and Market Values of Indonesian Listed Firms

We find that earnings quality (EQ) is reliably negatively correlated with the market values of equity of firms listed on the Jakarta Stock Exchange (IDX). The financial reporting process produces earnings viewed as increasingly ‘incomplete’ for valuation purposes by the capital market despite moves towards high‐quality financial reporting standards (IFRS) during the sample period 1995–2015. Time‐series analyses reveal that EQ decreases rather than increases through time. The role of earnings in valuation is replaced by other attributes, most notably net dividends. Firms that pay out dividends are valued significantly higher, and firms that issue equity are valued lower. These results are robust regardless of other accounting, market and governance controls. Large and closely held firms are valued higher than smaller firms, consistent with some aspects of the political cost hypothesis. Shares with higher idiosyncratic risk are valued higher, consistent with option value, as are shares where the volume of shares traded is more volatile. Collectively, the results indicate that the mere adoption of high‐quality accounting standards (IFRS) and other nominal changes in capital market regulations do not automatically increase the quality of the financial reporting process.     

Differences in the valuation of earnings and book value: Regulation effects or industry effects?

This paper uses a valuation framework on a sample of firms from four European countries (France, Germany, Netherlands, and United Kingdom) to examine how income, accruals, and book value of equity are perceived by the respective capital markets. Our model includes adjustments for industry effects and taking into account the linear information dynamics of the accounting variables posited in the Ohlson model. Consistent with previous researchers, we find that both earnings and book value of equity have valuation implications and that there is significant dispersion in the country-specific and industry-specific valuation multiples. However, when using accounting variables to forecast market values we find that industry-specific valuation multiples reduce forecasting error more than country-specific ones.     

Using Forecasts of Earnings to Simultaneously Estimate Growth and the Rate of Return on Equity Investment

We develop a method for simultaneously estimating the cost of equity capital and the growth in residual earnings that are implied by current stock prices, current book value of equity, and short-term forecasts of accounting earnings. We demonstrate the use of our method by calculating the expected equity risk premium. Our estimate is higher than estimates in extant studies that are based on the same earnings forecast data. The main difference between our study and these papers is that while they provide arguments supporting an assumed rate of growth beyond the forecast horizon, we estimate this rate.     

The impact of regulatory reform on the value-relevance of accounting information: Evidence from the 1993 regulatory reforms in New Zealand

This paper examines the impact of the 1993 financial reporting regulatory reforms in New Zealand on the value-relevance of accounting information. The study achieves this by regressing stock data of companies on book values and earnings for the pre- and post-regulatory periods. The Financial Reporting Act of 1993 was enacted in New Zealand as part of a wider package of company law reform. The 1987 share market collapse led to a Ministerial Committee of Inquiry that criticised the quality of financial reporting and the high level of non-compliance with accounting standards. The Committee recommended establishing an Accounting Standards Review Board to give the accounting standards a force of law. Whether this development increases the value-relevance of accounting information is an empirical question. The results, however, fail to find any significant increase in the total value-relevance of accounting information in the post-regulation period. There is, however, a corresponding increase in the incremental explanatory power of equity book values in the post-regulation period. This study also extends extant research on the effect of regulation on the value-relevance of accounting information by incorporating firm-specific factors to isolate the effect of regulation.