The Relevance Of Accounting Information For Valuation And Risk

The Relevance of Accounting Information for Valuation and Risk Submitted in Fulfilment of the Requirements of the Degree of Doctor of Philosophy, Griffith University February, 2003 PhD Thesis, Mr Mark Andrew Brimble, School of Accounting, Banking and Finance, Griffith University, Brisbane, Australia Submission Statement In compliance with the requirements relating to admission to examination and submission of theses, for the Degree of Doctor of Philosophy of Griffith University, I hereby certify that this work has not previously been submitted for a degree or diploma in any university To the best of my knowledge and belief, the thesis contains no material previously published or written by another person except where due reference is made in the thesis itself Mark Andrew Brimble II Acknowledgments Firstly, my most sincere thanks to my thesis supervisor, Professor Allan Hodgson, for his unwavering support and guidance Your passion for research is inspiring and your willingness to make time for me in your hectic schedule is greatly appreciated I also wish to thank the members of the School of Accounting, Banking and Finance for their support and friendship over the past three years Particular thanks to Peta for your support and sympathetic ear Also to Dr Eduardo Roca (my associate supervisor) for your support, advice and detailed comments on my work, particularly in the later stages Further thanks goes to Professor Marc De Ceuster for his comments and input, seminar participants at Griffith University, The Australian National University, The Queensland University of Technology, the 2001 AAANZ Conference, the 2001 AAAA Conference, the 24th Congress of the European Accounting Association, and the 2002 Australasian Banking and Finance Conference Special thanks is reserved for my parents Thank you both for your love, support and guidance over the years Without you I would not have gotten to where I am today Finally, to my darling wife Tanya You are my light and inspiration, always there when I need you with a smile and a hug Your ceaseless love and support have made this possible, enjoyable and worthwhile III Abstract A key theme in capital markets research examines the relationships between accounting information and firm value Two concerns relating to the value relevance of accounting information are: (1) concerns over the explanatory and predictive power of the evidence presented in the prior literature (Lev, 1989); and (2) the evidence of a deterioration in the association between accounting information and stock prices over the past four decades (Collins, Maydew and Weiss, 1997; Francis and Schipper, 1999; Lev and Zarowin, 1999) These concerns provide the key motivation for this thesis which examines: (1) the usefulness of the clean surplus accounting equation in valuation; (2) the role of accounting information in estimating and predicting systematic risk and; (3) the changing nature of the relationship between accounting information, stock prices and risk over time The empirical research provides evidence of the value-irrelevance of the clean surplus equation and that controlling for the functional form of the earnings-returns relationship is more important Evidence is also provided that accounting variables are highly associated with M-GARCH risk betas and also possess predictive ability relative to these risk measures Finally, the relationships between stock prices, risk models and accounting information are shown to have not deteriorated over time, contrary to prior evidence Rather, the functional form of the relationship has changed from linear to a non-linear arctan association Overall, accounting information continues to play the central role in the determination of stock prices and risk metrics IV Contents Chapter 1: Introduction 1.1 Introduction 1.2 Objectives of the Thesis 1.3 Importance of the Research 1.4 Outline of the Thesis Chapter 2: Literature Review: The Value Relevance of Accounting Variables 11 2.0 Introduction 11 2.1 Capital Markets Research in Accounting 13 2.1.1 The Early Research 13 2.1.2 Development of the Literature 17 2.1.3 Overall Usefulness of the Value Relevance Literature 17 2.2 The Value Relevance of Accounting Information 21 2.3 The Earnings Response Coefficient 22 2.3.1 Determinants of the ERC 23 2.3.2 The Early ERC Literature 24 2.3.3 Low Explanatory Power 25 2.4 Other Earnings Studies 2.4.1 The Value Relevance of the Components 28 30 of Earnings 2.4.2 The Firm Size Effect 34 2.4.3 The Stability of the Earnings-Returns Relation 36 V 2.5 The Value Relevance of Non-Earnings Data 37 2.6 The Clean Surplus Relation and Stock Valuation 41 2.6.1 Defining the Clean Surplus Relation 42 2.6.2 The Early Research 42 2.6.3 Recent Research 45 2.7 The Long-Term Changes in the Value Relevance of 51 Accounting Information 2.7.1 Reasons Proposed for the Declining Relevance 52 of Financial Statements 2.7.2 Initial Evidence 55 2.7.3 Recent Developments/Extensions 61 2.8 Summary 63 Chapter 3: Literature Review: The Risk Relevance of Accounting Variables 65 3.0 Introduction 65 3.1 The Relevance of Risk Research 65 3.2 Accounting Standards Related to Risk 67 3.3 Systematic Risk 71 3.4 The Risk Relevance of Accounting Information 77 3.4.1 Early Research 77 3.4.2 Research Extensions 81 3.4.3 The Australian Evidence 85 3.5 Summary 86 VI Chapter 4: Research Design Issues in Capital Markets Research 88 4.0 Introduction 88 4.1 Research Design Issues in Capital Markets Research 88 4.1.1 Earnings-Returns Regression Specifications 89 4.1.2 Market Efficiency 94 4.1.3 Valuation Models 96 4.1.4 Levels or Differences? 101 4.1.5 Non-Linearity – Earnings Levels and Permanence 102 4.2 Research Design Issues in Beta Risk Estimation 108 4.2.1 Length of the Time Interval 109 4.2.2 Length of the Return Holding Period 110 4.2.3 Adjustments for Thin Trading 110 4.2.4 Adjustments for Central Tendency 112 4.2.5 Portfolio Formation to Reduce Estimation Errors 115 4.2.6 Adjustments for Leverage 115 4.2.7 Time Variance of Beta 119 4.3 Summary 122 Chapter 5: Dirty Surplus Accounting, Functional Relationships, and the Valuation Role of Accounting 123 5.0 Introduction 123 5.1 Background Literature 127 5.2 Dirty Surplus Variables in Australia 131 5.2.1 Asset Revaluations 131 5.2.2 Foreign Currency Translations 132 VII 5.2.3 Prior Period Adjustments 133 5.2.4 Extraordinary Items 134 5.3 Data and Method 136 5.3.1 Database 136 5.3.2 Linear Models 142 5.3.3 Size and Leverage 144 5.3.4 Knowledge of the Operating Earnings Stream 146 5.3.5 The Impact of the Length of the Returns 148 Estimation Window 5.3.6 Loss Versus Profit Making Firms 5.4 Empirical Results 150 151 5.4.1 Linear Regression Results 151 5.4.2 Comparison with Previous US and UK Results 153 5.4.3 Non-Linear Regression Results 155 5.4.4 Size and Leverage Effects 159 5.4.5 The Impact of the Length of the Return Window 161 5.4.5 Profit Versus Loss Making Firms 164 5.5 Summary and Conclusions Chapter 6: The Association Between Accounting Risk Variables 166 170 and Risk 6.0 Introduction 170 6.1 Background Literature 173 6.2 Data and Variables Used 176 6.2.1 Beta Estimation 178 VIII 6.2.2 Accounting Risk Variables 6.3 Regression Models 179 190 6.3.1 Industry Regressions 192 6.3.2 Statistical Validation of the Regression Models 194 6.4 Results 6.4.1 The Association Between Accounting Risk Variables 195 196 and Beta 6.4.2 Industry Beta Results 6.5 Summary Chapter 7: The Predictive Ability of Accounting Risk Variables 206 208 211 7.0 Introduction 211 7.1 Prediction Models 212 7.1.1 Regression Models 213 7.1.2 Out of Sample Forecasting Models 214 7.13 Statistical Validation of the Results 217 7.2 Results 218 7.2.1 Regression Results 218 7.2.2 Forecasting Results 221 7.3 Summary Chapter 8: The Long-Term Value Relevance of Accounting 232 235 Information 8.0 Introduction 235 8.1 Data and Method 239 IX 8.1.1 Initial Regression Models 240 8.1.2 Extensions 246 8.2 Results 250 8.2.1 The Earnings Relation 251 8.2.2 The Balance Sheet Relation 253 8.2.3 The Ohlson Relation 254 8.2.4 Size Effects 256 8.2.5 Leverage Effects 259 8.2.6 The Effect of Transitory Items 261 8.2.7 The Risk Relevance of Accounting Information 266 8.3 Summary Chapter 9: Summary and Conclusion 270 273 9.0 Overview of the Thesis 273 9.1 The Value Relevance of Dirty Surplus Accounting Flows 274 9.2 The Risk Relevance of Accounting Information 275 9.3 Long Term Trends in the Value Relevance of Accounting 277 Information 9.4 Conclusions References 279 280 X Fama, E, 1965, “The Behavior of Stock Prices”, Journal of Business, 38, pp 34-105 Fama, E., 1990, “Stock Returns, Expected Returns, and Real Activity”, Journal of Finance, 45, 1089-1108 Fama, E., Fisher, L., Jensen, M and R Roll, 1969, “The Adjustment of Stock Prices to New Information”, International Economic Review, 10, pp 1-21 Fama, E and K French, 1992, "The Cross-Section of Expected Stock Returns" The Journal of Finance, 47 (2), pp 427-465 Fama, E and K French, 1993, 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Journal of Accounting and Economics, 29, pp 125-149 304 ... information and firm value Two concerns relating to the value relevance of accounting information are: (1) concerns over the explanatory and predictive power of the evidence presented in the prior literature... Lev and Zarowin, 1999) These concerns provide the key motivation for this thesis which examines: (1) the usefulness of the clean surplus accounting equation in valuation; (2) the role of accounting... Furthermore, risk research can potentially significantly contribute to the literature by assisting in (1) the development of more efficient ex post risk measures; (2) the determination of the actual