ISSN 1450-2275 Issue 97 February, 2018
© FRDN Incorporated
http://www.europeanjournalofeconomicsfinanceandadministrativesciences.com
The Impact of Fair Value Measurements on the Valuation Relevance of Traditional Accounting Metrics of
Earnings and Book Value
Mostafa A. Elshamy
Corresponding Author, Accounting Department College of Business Administration, Kuwait University
E-mail: elshamy@cba.edu.kw Metwally A. Kayed
Accounting Department, College of Business Administration Kuwait University
Aly M. Hewaidy
Accounting Department, College of Business Administration Kuwait University
Abstract
The main objective of this study is to investigate the impact of the new IFRSs development on the value-relevance of earnings and book values in equity valuation.
During the last two decades several International Financial Reporting Standards (IFRS) have been issued that might be described as a significant movement from the use of historical cost accounting to fair value accounting. This shift provides an opportunity to examine its effect on the value relevance of the accounting numbers and more specifically on the relative value relevance of earnings and book values. We examine the overtime change in these values over 22 years since the adoption of Kuwait to the IFRS in 1992 up to 2013. We partition the sample period into two distinct time periods. The first period includes years from 1992 to 2001 (mostly a historical cost accounting basis period) while the second includes years from 2002 to 2013 (a semi fair value accounting basis period).
The Ohlson (1995) model and a technique developed by Theil (1971) are used to measure the overall value relevance of earnings and book value, the incremental explanatory power of earnings, and the incremental explanatory power of book values. The study reports four primary findings. First, earnings and book values jointly and individually have significant explanatory power for securities prices over the twenty two year period.
Second, the combined value-relevance of earnings and book values has not changed significantly over the period. Third, the incremental value-relevance of book value has increased over time while that of earnings has declined. Fourth, the combined explanatory power of earnings and book value has insignificantly decreased and that the incremental explanatory power of book values (earnings) has significantly increased (decreased) after the movement to the fair value accounting basis.
The study findings have important implications for research and standards setters and financial reporting regulators.
Keywords: Value Relevance; Equity Valuation; Fair value Accounting 1. Introduction
During the last two decades the International Accounting Standard Committee (IASC) and its successor, the International Accounting Standard Board (IASB) adopted several financial reporting standards (IFRSs) that made a considerable change in the issues of valuation and recognition for the main elements of the financial statements. To date, the fair value concept is applied in several international financial reporting standards, such as IAS 16 “Property, Plant and Equipment”; IAS 37
“Provisions, Contingent Liabilities and Contingent Assets”; IAS 38 “Impairment of Assets”; IAS 39
“Financial Instruments”; IAS 40 “Investment Properties”; IAS 41 “Agriculture”; IFRS 2 Share-based Payment”; IFRS 3 “Business Combinations”; IFRS 9 “Financial Instrument”; and IFRS 13 “Fair Value Measurement”.
This shift motivated this paper to examine the effects of the change in the measurement and valuation rules on the value relevance of the accounting numbers and more specifically on the combined and incremental explanatory values of earnings and book values.
We expect that the movement to the fair value model will increase the incremental explanatory power of book values and to decrease the incremental explanatory value of earnings. Our expectation is conceptually supported by its consistency with the asset-based valuation model, under which the value of the firm’s equity is estimated at the fair value of the net assets of the firm. The new movement require the marking up of several assets to their fair values which is expected to provide a measure of book value of the firm that approximates more its market value and consequently increases the explanatory power of book value in equity valuation.
In addition, the excessive use of fair value and the recognition of the change in fair values in the income statement increases the transitory components in earnings, which will result in a decrease in the explanatory value of earnings in equity valuation. Transitory components are proved to be either value-irrelevant or have a limited valuation impact (Ramakrishnan and Thomas, 1998).
The study is an extension of Elshamy and Kayed (2005) that examined the value relevance of earning and book value during the 1992 to 2001 period which can be considered generally as a historical cost accounting period. We extend the analysis by examining the value relevance of earnings and book value during the 2002 to 2013 period, which can be considered a semi fair value accounting era. We examine the effect of the change to the fair value model on the value- relevance of earning and book values numbers.
The Ohlson (1995) model and a technique developed by Theil (1971) are used to measure the value relevance of earnings and book value and to decompose the combined explanatory power of earnings and book values into three components: (1) the incremental explanatory power of earnings, (2) the incremental explanatory power of book values, and (3) the explanatory power common to both earnings and book values. We examine the over-time change in the value- relevance of earnings and book value, the change in the incremental explanatory power of earnings, and the change in the incremental explanatory power of book values. We also compare the estimates of these values over the two periods to see if the adoption of these fair values standards has changed the value relevance and the incremental value relevance of earnings and book values.
To control for the possible effect of negative earnings on our results, we partition our sample into two sub-samples based on firms’ profitability and compare the results obtained during the two periods.
The study reports four primary findings. First, earnings and book values jointly and individually have significant explanatory power for securities prices over the last twenty two years.
Second, the combined value-relevance of earnings and book values has not changed significantly over the twenty two year period. Third, the incremental value-relevance of book value has increased over time while that of earnings has declined. Fourth, the combined explanatory power of earnings and book
value has insignificantly decreased and the incremental explanatory power of book values (earnings) has significantly increased (decreased) after the movement to the fair value model.
The remainder of this paper is organized as follows: section two provides an overview of the related research, section three presents the research design, section four contains the empirical results, and section five summarizes our findings and concludes the paper.
2. Related Literature
A large body of research has been compiled worldwide regarding the impact of IFRS adoption on the quality of financial reporting (See ICAEW, 2015 for a list of papers that examined the effect of IFRS adoption in the EU). A more recent stream of research examined the impact of IFRS adoption on the quality of financial information by examining its effect on income smoothing and earning management in different countries (See for example Dayanandan et al. (2016), Liu et al. (2011), and Liu & O’Farrell (2011)) and documented that the adoption of IFRS reduced income smoothing and earnings management.
Since the current study examines the impact of IFRS movement toward fair value accounting on the valuation relevance of earnings and book values in equity valuation and does not directly examine the quality of financial reporting, we will concentrate on reviewing the studies that directly examined the value relevance and the change in value relevance of earnings and book value in equity valuation. Related literature can be classified into three categories. The first examined the value relevance of earnings and book value generated under the same accounting reporting system. The second compared the value relevance of earnings and book value generated using different accounting reporting systems. The third examined the impact of a single fair value accounting standard on the value relevance of earnings and book value.
Studies related to the first category include among others Collins et al. (1997), Francis and Shipper (1999), Lev and Zarowin (1999), Gornik-Tomaszewski and Jermakowicz (2001), and Elshamy and Kayed (2005).
Collins et al. (1997) investigated the change in the value-relevance of the earnings and book values during the period of 1953-1993 using US data. They found that earnings and book values are value-relevant in equity valuation and that the combined value-relevance of earnings and book values has increased slightly overtime. They also documented a decline (an increase) in the ability of earnings (book values) to explain stock prices over the period of study. They found that reason for reduced explanatory power of earnings was mainly due to an increase in the incidence of one-time items and the reported losses as well as a decrease in the size of firms in the sample.
Francis and Schipper (1999) examined the value-relevance of earnings and book values over the period from 1951 to 1993. Francis and Schipper found that the explanatory power of earnings levels and changes for returns has significantly decreased over time. In contrast, their test of the explanatory power of book values of assets and liabilities (alone and combined with earnings) for market equity values shows no decline in the value-relevance of explained variability of the balance sheet relation or the book value and earnings relation.
Lev and Zarowin (1999) examined the value relevance of financial information to investors as measured by the association between capital market values (stock prices and returns) and major financial accounting variables (earnings, cash flows and book value of equity) over the period 1977- 1996. Contrary to the conclusion of Collins et al. (1997) and Francis & Schipper (1999), Lev and Zarowin (1999) found a systematic decline in the association between capital market values and major financial accounting variables. Lev and Zarowin (1999) rationale for the inconsistency between their conclusion and that of Collins et al. (1997) is the difference in the examined periods.
Gornik-Tomaszewski and Jermakowicz (2001) investigated the value relevance of a new accounting system in Poland. They found that both current earnings and lagged book values are positively and significantly related to prices and the incremental information content of lagged book values is greater than that of current earnings.
Elshamy and Kayed (2005) investigated the value relevance of earnings and book value for all listed companies in Kuwait Stock Exchange during the 1992-2001 period. They reported that earnings and book values jointly and individually are positively and significantly related to stock prices and that the incremental information content of earnings is greater than that of book values.
The second category that compares the value relevance of earnings and book value among different countries and/or different accounting reporting systems includes among others, Harris et al.
(1994), Joos and Lang (1994), King and Langli (1998), Bao and Chow (1999), and El Shamy and Al- Qenae (2005).
Harris et al. (1994) compared the value relevance of accounting numbers for U.S. and German firms during the 1982 – 1991 period and found little difference in the overall value relevance and that the explanatory power of earnings in Germany is approximately equal to that in the US, but the explanatory power of book value is much lower for Germany.
Joos and Lang (1994) examined the association between stock prices and earning and book values using sample firms from France, Germany, and United Kingdom covering the period 1982- 1990. They found that the explanatory power of earnings and book values for stock prices varies from country to country.
King and Langli (1998) examined accounting numbers and stock prices in Germany, Norway, and the United Kingdom. They found that earnings and book values are significantly related to stock prices across all three countries; UK accounting numbers have the highest relation. They also found that incremental and relative explanatory power of book values and of earnings differ across countries.
Book values explain more than earnings in Germany and Norway, but less in UK.
Bao and Chow (1999) examined the relative value relevance in equity valuation of two sets of financial reports, one based on International Accounting Standards (IASs) and the other based on China’s accounting regulations (domestic GAAPs). The result of the study showed that earnings and book values prepared under IASs explain more of the variation of stock prices more than those prepared under domestic GAAPs. The results indicates also that the explanatory power of earnings and book values increased over time.
Elshamy and Al-Qenae (2005) examined the change in the value-relevance of earnings and book values in equity valuation over a twenty year period in Kuwait. They found that the IFRSs adoption by Kuwait in 1992 improved the combined value relevance of earnings and book value. They also found that the incremental explanatory power of earnings (book values) has increased (decreased) since the adoption of IAS’s in 1992.
The third category that examined the impact of a single fair value accounting standard on the value relevance includes Barth (1994), Nelson (1996), Venkatachalam (1996), Khurana and Kim (2003) Asthana and Chen (2007), Elshamy et al. (2014), and Al Husaini and Elshamy (2016). Barth (1994) investigates how disclosed fair value estimates of banks' investment securities, and securities gains and losses (based on those estimates) are reflected in share prices in comparison with historical costs. Barth reports that fair value estimates of investment securities provide significant explanatory power beyond that provided by historical costs. On the contrary, Nelson (1996) examined the value relevance of fair value data disclosed under SFAS 107 by banksfor the years 1992 and 1993. He provided evidence that fair value disclosures have no or limited incremental power relative to book value.
Venkatachalam (1996) found evidence that fair value estimates for derivatives disclosed under SFAS 119 help explain cross-sectional variation in bank share prices and the fair values have incremental explanatory power over and above the notional amounts of derivatives.
Khurana and Kim (2003) test for the relative information content of fair value and historical cost. They find that fair value disclosures are likely to be more informative than historical cost for large bank holding companies than small bank holding companies. They conclude that the results are consistent with the notion that fair value is more value relevant when fair value measures are available.
Asthana and Chen (2007) investigated the change in the value-relevance of earnings and book value information from 1970 to 2005 and reported that the value-relevance of earnings and book value increases over time, the increasing trend is less prominent for financial institutions than for firms in other industries, and although the increasing trend is less pronounced for financial institutions, the value relevance of accounting information improves after firms adopt SFAS 133 in 2001.
Elshamy et al. (2014) investigated the value relevance of unrealized gains and losses arising from investment in equity and debt securities recognized under IAS 39. They provided evidence that including these gains and losses in net income enhances the incremental explanatory power of earnings.
Al Husaini and Elshamy (2016) examined the value-relevance of unrealized gains and losses recognized under IAS 40 using all real estate Kuwaiti firms listed on Kuwait stock exchange for the 2011-2013 period. They documented that unrealized gains and losses has no incremental information content over net income before unrealized gains and losses and that the inclusion of unrealized gains and losses in income numbers decreases the explanatory power of the valuation model and decreases the incremental explanatory power of earnings relative to that of book value.
Our study differs from previous studies in two aspects, we first examine the change in the value relevance of earnings and book value over a long period of time during which various fair value IFRSs has been issued that made a major change in the principals of the recognition and measurement of the main elements of the financial statements. Second, we examine the differences in the combined value relevance and the incremental explanatory value of earnings and book value over two period, the first covers the 1992–2001 period, which can be described as mostly a historical cost period and the second covers the 2002 - 2013 period, which can be described as a semi fair value accounting era.
3. The Research Design 3.1 Sample Selection
The sample selected for the study includes all Kuwaiti firms listed on the KSE whose earnings, book values, and share prices are available during the 1992-2013 period. All Kuwaiti firms listed on the KSE are required to apply the international accounting standards and the international financial reporting standards issued by the IASC and its successor, the IASB with no modifications since 1992.
To control for the effect of the extreme values, we removed observations that were in the top and bottom one-half percent of either earnings-to-price or book value-to-market value. The selection process yields a final sample ranging from 65 to 166 firms per year for the study period, including a total of 1508 firm-year observations for the entire period.
3.2 Examining the Value Relevance of Earnings and Book Values in Equity Valuation
The study employs the Ohlson 1995 model to measure the combined value relevance of earnings and book value in equity valuation. The model uses the association between stock prices and earnings and book values as measured by the coefficient of determination (adjusted R2) as a primary metric to measure value relevance.
The model can be expressed as follows:
Pit = a0 + a1Eit + a2BVit + eit (1) Where, Pit is firm i’s stock price at the end of year t, Eit is reported earnings per share for firm i during period t, BVit is book value per share for firm i at the end of period t, and eit is other value- relevant information of firm i for period t orthogonal to earnings and book values.
To investigate whether there has been a change in the combined value-relevance of earnings and book values over time, we regress adjusted Rt 2
(E,BV) acquired from equation 1on a Time - trend variable as follows:
Adjusted Rt 2
(E,BV) = a + b (Timet) + et (2)
Where Time = 1…22, corresponding to the years 1999 - 2013.
3.3 Examining the Change in Incremental Explanatory Power of Earnings and Book Values over Time
To examine the change in the relative explanatory power of earnings and book values for prices of equity over the examined period, we first examine the change in the coefficient of determination for the following two equations:
Pit = b0 + b1Eit + eit (3) Pit = c0 + c1BVit + eit (4) Adjusted R2 from equations 3 and 4 measures the absolute impact of earnings and book value and are denoted as R2(E) and R2(BV), respectively and are examined for a possible change over time. Our tests regress R2(E) and R2(BV) on a Time - trend variable as follows:
Adjusted R2(E)t= a + b (Timet) + et (5) Adjusted R2(BV)t= a + b (Timet) + et (6) Where Time = 1…22, corresponding to the years 1992 - 2013.
Secondly, we decompose the combined explanatory power of earnings and book value as measured by the coefficient of determination of equation 1 (R2(E,BV)) into three components: the incremental explanatory power of earnings, the incremental explanatory power of book values, and the explanatory power common to both earnings and book values. The incremental explanatory power provided by earnings (Incr. E) equals the difference between R2(E,BV) and R2(BV), while the incremental explanatory power provided by book values (Incr. BV) equals the difference between R2(E,BV) and R2(E)., and the remaining R2(E,BV) - R2(BV) - R2(E), represents the explanatory power common to both earnings and book values, and is denoted as (Incr. COM).
To investigate whether the incremental explanatory power of earnings and book values for prices has changed over time, we regress Incr. E, Incr. BV and Incr. COM on a Time - trend variable as follows:
Incr.t= a + b (Timet) + et (7) Where Time = 1…22, corresponding to the years 1992 - 2013.
3.4 Examining the Differences in Value-Relevance before and after the Movement to the Fair Value Model
To compare the explanatory power of earnings and book values for stock prices before and after the shift to the fair value model, the total sample was partitioned into two sub-samples. The first sub- sample covers the year 1992 - 2001 period and includes 559 firm-year observations, ranging from 31 to 65 firms per year, while the second sub-sample covers the 2002 - 2013 period and includes 949 firm- year observations, ranging from 65 to 166 firms per year. We then examine the differences between the average estimates of the total value-relevance and the components of the incremental explanatory power of earnings and book values of the before movement period (1992 - 2001) and those of the after movement period (2001 - 2013).
Previous research documented that net losses are less informative about future firm’s future prospects and hence will have lower incremental value relevance than net income (Hayn, 1995; Collins et al., 1999; Gornik-Tomaszewski & Jermakowicz, 2001; Jan & Ou, 1995; and Elshamy & Kayed;
2005). To control for the possible effect of negative earnings on the results obtained, each of the two sub samples are partitioned based on the sign of net income into two sub samples: (1) profit firms - sub sample consisting of 516 and 1,184 observations, and (2) loss firms - sub sample consisting of 43 and 324 observations for the first and the second period prospectively.
The combined value relevance, the incremental explanatory value relevance of earnings, and the incremental explanatory value of book values for the two periods are compared for the positive and negative earnings sub-samples.
4. The Empirical Results 4.1 Descriptive Statistics
Table 1 presents descriptive statistics and correlations among earnings, book values and stock price for the two sub-samples. The results reveal that the coefficient of variation as a measure of variability for earnings (book values) increased (decreased) over time and that the correlation between book value (earnings) and market price increased (decreased) over years. These preliminary results implies that as the IASB moves towards the fair value model, earnings per share become more volatile and book value per share becomes more closer to market prices on the expense of earnings per share.
Table 1: Descriptive Statistics and Correlation among Variables for the Sample Panel A: Descriptive Statistics and Correlation for the Period (2002-2013)a
Descriptive Statistics
Variable b Mean σ Min. Max. CV
Price (P) 0.409 0.496 0.145 3.920 1.213
Earnings (E) 0.027 0.064 -0.213 0.976 2.370
Book values (BV) 0.244 0.194 0.013 1.765 0.795
Correlation between Dependent and Independent Variables
Variable c P E BV
Price (P) 1 0.688* 0.800*
Earnings (E) 0.688* 1 0.680*
Book Value (BV) 0.800* 0.680* 1
Panel B: Descriptive Statistics and Correlation for the After IAS’s Adoption Descriptive Statistics for the Period (1992-2001)
Variable b Mean σ Min. Max CV
Price (P) 0.339 0.287 0.03 2 0.846
Earnings (E) 0.024 0.033 -0.062 0.323 1.375
Book values (BV) 0.190 0.109 0.024 1.182 0.574
Correlation between Dependent and Independent Variables (1992-2001)
Variable c P E BV
Price (P) 1 0.851* 0.785*
Earnings (E) 0.851* 1 0.814*
Book Value (BV) 0.785* 0.814* 1
a All values are expressed in Kuwaiti Dinar (KD). One KD equals approximately $3.3. The descriptive statistics and the statistical analysis for the 1992-2001 are taken from Elshamy &Kayed (2005).
b P is the price per share of firm i at the end of year t, E is the earnings per share of firm i for year t and BV is the book value per share of firm i at year end t.
c *Significant at 0.01.
4.2 The Change in the Combined Value-Relevance of Earnings and Book Values
Table 2 presents estimates of regressions (1) and (2). The results of Panel A show strong association between stock prices and earnings plus book values (earnings and book values are significant at better than 1% level in every year).
The average adjusted R2 for the entire period indicates that earnings and book values jointly explain 75% of the cross-sectional variation in securities prices.
Table 2: The Association between Stock Prices and Earnings + Book Values Panel A: Equation (1): Pit = a0 + a1Eit + a2BVit + eit
Year Firms a0 a1 a2 Adj. R2
1992 31 -0.016
(-0.256)
0.345 (2.288)
0.518
(3.433) 0.585
1993 38 0.016
(0.334)
0.568 (4.743)
0.348
(2.904) 0.662
1994 37 -0.016
(-0.748)
0.739 (12.384)
0.312
(5.233) 0.920
1995 45 0.054
(1.492)
0.790 (8.689)
0.178
(1.962) 0.883
1996 53 0.997
(2.644)
0.331 (3.4)
0.615
(6.314) 0.787
1997 65 0.217
(4.737)
0.834 (7.564)
0.033
(1.304) 0.734
1998 70 0.047
(1.281)
0.538 (6.217)
0.404
(4.601) 0.770
1999 75 0.073
(0.198)
0.777 (6.617)
0.374
(4.288) 0.832
2000 75 0.035
(0.180)
0.495 (4.684)
0.443
(4.203) 0.827
2001 70 0.030
(0.650)
0.458 (3.111)
0.449
(3.053) 0.787
2002 65 0.001
(0.018)
0.481 (4.629)
0.466
(4.481 0.835
2003 65 0.089
(1.508)
0.209 (2.582)
0.732
(9.031) 0.791
2004 77 0.145
(2.056)
0.577 (7.467)
0.381
(4.924) 0.803
2005 99 0.075
(1.114)
0.064 (.782)
0.783
(9.613) 0.683
2006 130 0.047
(0.181)
0.088 (1.449)
0.705
(8.003) 0.574
2007 165 0.049
(1.003)
0.037 (0.556)
0.759
(11.484) 0.611
2008 143 0.002
(0.065
0.248 (4.466)
0.666
(11.990) 0.606
2009 148 0.003
(0.109)
0.203 (3.223)
0.670
(10.613) 0.663
2010 150 0.021
(1.039)
0.297 (6.258)
0.680
(14.336) 0.833
2011 147 0.005
(0.202)
0.172 (2.448)
0.718
(10.247) 0.738
2012 159 0.041
(2.668)
0.298 (6.304)
0.676 (14.271)
0.849
2013 166 0.015
(0.752)
0.423 (6.939)
0.493
(8.075) 0.732
Average 0.750
Panel B: Equation 2: Adj. Rt 2 = a + b (Timet) + et
Total Sample B Adj. R2
Adj. R2 -0.153
(0.694) 0.024
A regression of the annual adjusted R2s in panel A on a time variable indicates (Panel B) that there is a non-significant decrease in the overall value-relevance of earnings and book values for stock prices (the estimated Time coefficient is negative at -0.153, t = 0.694).
The results of table 2 generally indicate that earnings and book value jointly have significant explanatory power for securities prices over the last twenty two years and the combined value- relevance of earnings and book values decreased overtime.
4.3 The Change in Incremental Explanatory Power of Earnings and Book Values over Time Panel A of table 3 presents estimate of the coefficient of determinations (Adjusted R2) for equation 1, 3 and 4 for the years 1992 - 2013 and the three components of the explanatory power of earnings and book values: the incremental explanatory power of earnings, the incremental explanatory power of book values, and the incremental explanatory power common to both earnings and book values. The results shows strong association between stock prices and earnings and book values individually. The average adjusted R2 for the entire period indicates that earnings and book values individually explains about 61% and 66%, respectively, of the cross-sectional variation in securities prices.
Panel B presents the results of the regression of the annual adjusted R2s obtained from equations 3 and 4 that measure the absolute impact of earnings and book value on a Time variable.
These results indicate that there is a significant increase (decrease) in the value relevance of earnings (book value) over the time period.
Panel C presents a regression of each of the three annual incremental explanatory power components (Incr. E, Incr. BV and Incr. Com) on a Time variable, spanning the period from 1992 to 2013. It indicates that there is a significant decrease in the incremental explanatory power of earnings, a significant increase of the incremental explanatory power of book values, and an insignificant decrease in the incremental explanatory power common to both earnings and book values.
Table 3: Summery of the Estimates and Changes of the Components of the Incremental Explanatory Power of Earnings and Book Values
Panel A: The Components of the Incremental Explanatory Power of Earnings and Book Values Over the Period from 1992-2003
Year R2(E,BV) R2(E) R2(BV) Incr. E Incr. BV Incr.COM
1992 0.585 0.431 0.525 0.060 0.154 0.371
1993 0.662 0.593 0.461 0.201 0.069 0.392
1994 0.920 0.859 0.570 0.350 0.061 0.509
1995 0.883 0.876 0.681 0.202 0.007 0.674
1996 0.787 0.743 0.625 0.162 0.044 0.581
1997 0.734 0.738 0.496 0.238 -0.004 0.500
1998 0.770 0.700 0.642 0.128 0.070 0.572
1999 0.832 0.792 0.734 0.098 0.040 0.694
2000 0.827 0.787 0.777 0.050 0.040 0.737
2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013
0.787 0.835 0.791 0.803 0.683 0.574 0.611 0.606 0.663 0.833 0.738 0.849 0.732
0.761 0.785 0.524 0.741 0.383 0.253 0.298 0.208 0.405 0.603 0.550 0.655 0.627
0.760 0.781 0.772 0.658 0.684 0.571 0.613 0.553 0.641 0.790 0.729 0.812 0.655
0.027 0.054 0.019 0.145 -0.001 0.003 -0.002 0.053 0.022 0.043 0.009 0.037 0.077
0.026 0.050 0.267 0.062 0.300 0.321 0.313 0.398 0.258 0.230 0.188 0.194 0.105
0.734 0.731 0.505 0.596 0.384 0.250 0.300 0.155 0.383 0.560 0.541 0.618 0.550
Average 0.750 0.605 0.660 0.090 0.145 0.515
Panel B: Equation 5: Adj. R2(E)t
= a + b (Timet) + et Equation 6: Adj. R2(BV)t
= a + b (Timet) + et
B Adj. R2
R2(E) -0.441** 0.155
R2(BV) 0.445** 0.158
Panel C: Equation 7: Incr.t = a + b (Timet) + et
Incr. B Adj. R2
Incr. E -0.658* 0.405
Incr. BV 0.598* 0.326
Incr. COM -0.169 0.020
*Significant at 0.01.
**Significant at 0.05
The overall results of table 3 reveal that the incremental explanatory power of earnings is decreasing and the incremental explanatory power of book value is increasing over the past twenty two years.
4.4 Differences in the Value-Relevance before and after the Movement to the Fair Value Model To examine if the shift to the fair value model had an impact on the explanatory power of earnings and book values for stock prices, we compare the average estimates of the total value-relevance and the components of the incremental explanatory power of earnings and book values of the before movement period (1992 - 2001) to those of the after movement period (2001 - 2013).
Table 4 presents a comparison of the averages of the combined explanatory power of earnings and book values, the incremental explanatory power of earnings, and the incremental explanatory power of book values before and after the movement to the fair value model. It shows that the average combined explanatory power of earnings and book value insignificantly decreased from about 78%
during the before movement to about 73% during the after movement period. Table 4 also shows that the average incremental explanatory power of book values (earnings) has increased (decreased) significantly from about 5% (15%) in the first period to about 22% (4%) in the second period.
The overall results of table 4 suggest that the combined explanatory power of earnings and book value has decreased and that the incremental explanatory power of book values (earnings) has increased (decreased) after the movement to the fair value model.
4.5 Differences in Value-Relevance Based on the Sign of Earnings
To control for the possible effect of negative earnings on the result obtained from the analysis in the previous subsection, we repeat the regression analysis based on the sign of earnings.
Table 5 presents the results of the first period (1992 – 2001). Panel A reveals that the coefficient of both earnings and book values are significant at the 1% level.
Table 4: The Combined and the Incremental Explanatory Power of Earnings and Book Values before and after the movement to the fair value model
Time Period Adj.R2 Incr E Incr BV Incr COM
(1992-2001) 0.779 0.152 0.051 0.576
(2002-2013) 0.726 0.038 0.224 0.464
Test of significance ANOVA Results F
t P Value
0.176 1.236 0.231
7.327 3.588 0.002
7.362 4.723 0.001
1.041 1.691 0.100
Table 5: The Results of Regressions for Positive and Negative Earnings (1992-2001)
Panel A: Cross-sectional Regression of Prices on Earnings and Book Values The Models:
Pit = a0 + a1Eit + a2BVit + eit (1) Pit = b0 + b1Eit + eit (2) Pit = c0 + c1BVit + eit (3)
Sub samples a1 a2 Adj. R2(E,BV) b1 Adj.R2(E) c1 Adj.R2(BV)
Profit firms 0.690 (17.613)
0.212
(5.377) 0.758 0.865
(38.834) 0.745 0.790
(28.576) 0.613 Loss firms -0.025
(-0.182)
0.543
(3.968) 0.239 -0.042
(-0,265) 0.008 0.258
(4.024) 0.258 Panel B: The Incremental Explanatory Power of Earnings and Book Values
Incr. E = R2(E,BV) - R2(BV)
Incr. BV = R2(E,BV) - R2(E)
Incr. Com = R2(E,BV) - Incr. E - Incr. BV
Sub samples Incr. E Incr. BV Incr. Com
Profit firms 0.145 0.013 0.600
Loss firms -0.019 0.231 0.045
Earnings are particularly strongly associated with stock prices, as evidenced by coefficient of 0.690 (t-statistics of 17.613) and 0.865 (t-statistics of 38.834) in both multiple and simple regression models, respectively.
Panel B reveals that earnings for profit firms add more to the overall explanatory of the model than book values. The incremental explanatory power of earnings, Incr. E, is relatively high at 14.5%.
By contrast, the incremental explanatory value of book values, Incr. BV, is only 1.3%. The common explanatory power of earnings and book value, Incr. Com. is 60%.
On the other hand, the results for the loss firms show although insignificant, a negative sign of the relationship between earnings and prices. The coefficient of variations for the multiple and simple regressions are 0.239 and 0.008 which are much lower than those obtained for the profit firms.
Earnings for loss firms do not add any value to the overall explanatory of the model. Whereas, the incremental explanatory value relevance of book values is relatively high at 23% and the common explanatory value of earnings and book value, Incr. Com, is particularly low at 5%.
Table 6 presents the results for the second period (2002 - 2013). As for the profit firms, Panel A reveals that the coefficient of both earnings and book values are significant at the 1% level. Book values are particularly strongly associated with stock prices, as evidenced by coefficient of 0.587 (t- statistics of 24.915) and 0.788 (t-statistics of 43.989) in both multiple and simple regression models, respectively.
Panel B reveals that book values for profit firms add more to the overall explanatory of the model than earnings. The incremental explanatory power of book values, Incr. BV, is relatively high at 17.7%. By contrast, the incremental information explanatory power of earnings, Incr. E, is only 4.3%.
The common explanatory power common of earnings and book value, Incr. Com, is 44.3%.
The results for the loss firms show although a significant negative sign of relationship between earnings and prices. The coefficient of variations for the multiple and simple regressions are 0.239 and 0.008 which are much lower than those obtained for the profit firms. Book values add more to the explanatory power of the model than earnings. The incremental information content of book values, Incr. BV, is relatively high at 25.1%. By contrast, the incremental information content of earnings, Incr. E, is only 2.1%. The common explanatory power common of earnings and book value, Incr. Com, is 7.6%.
Table 6: The Results of Regressions for Positive and Negative Earnings (2002-2013)
Panel A: Cross-sectional Regression of Prices on Earnings and Book Values The Models:
Pit = a0 + a1Eit + a2BVit + eit (1) Pit = b0 + b1Eit + eit (2) Pit = c0 + c1BVit + eit (3)
Sub samples a1 a2 Adj. R2(E,BV) b1 Adj. R2(E) c1 Adj.R2(BV)
Profit firms 0.288 (12.228)
0.587
(24.915) 0.663 0.697
(33.464) 0.486 0.788
(43.989) 0.620 Loss firms -0.161
(-3.413)
0.526
(11.171) 0.348 -0.317
(-5,990) 0.097 0.573
(12.553) 0.327 Panel B: The Incremental Explanatory Power of Earnings and Book Values
Incr. E = R2(E,BV) - R2(BV)
Incr. BV = R2(E,BV) - R2(E)
Incr. Com = R2(E,BV) - Incr. E - Incr. BV
Sub samples Incr. E Incr. BV Incr. Com
Profit firms 0.043 0.177 0.443
Loss firms 0.021 0.251 0.076
The overall results of the profit firms in tables 5 and 6 supports our proposition that the new developments in IFRSs by the IASB increased the incremental value relevance of book values and decreased the incremental value relevance of earnings. The results we obtain for loss firms are consistent with those obtained in other studies
5. Summary and Conclusions
This study investigates the change in the value-relevance of earnings and book values in equity valuation over the 1992 - 2013 periods using Kuwaiti data. During the last two decades the International Accounting Standard Committee (IASC) and its successor, the International Accounting Standard Board (IASB) adopted several financial reporting standards (IFRSs) that made a considerable change in the issues of valuation and recognition for the main elements of the financial statements. To date, the fair value concept is applied in several international financial reporting standards.
These developments provide an opportunity to examine the effects of the change in the measurement and valuation rules on the value relevance of the accounting numbers and more specifically on the incremental explanatory values of earnings and book values. We examine the overtime change in these values over 22 years since the adoption of Kuwait to the IFRS in 1992 up to 2013. We then investigate whether there has been a change in the combined value relevance, the incremental value relevance of earnings, and the incremental value relevance of book value as a result of these new development. This has been achieved by testing if there is a significant difference between these values over two distinct time periods. The first period includes the years from 1992 to 2001 (mostly a historical cost basis period) while the second period includes years from 2002 to 2013 (a semi fair value basis period).
The Ohlson (1995) model and a technique developed by Theil (1971) are used to measure the combined value relevance of earnings and book values, the incremental explanatory power of earnings, and the incremental explanatory power of book values.
The study reports four primary findings. First, earnings and book values jointly and individually have significant explanatory power for securities prices over the last twenty two years.
Second, the combined value-relevance of earnings and book values has not changed significantly over
the twenty two year period. Third, the incremental value-relevance of book value has increased over time while that of earnings has declined. Fourth, the combined explanatory power of earnings and book value has insignificantly decreased and the incremental explanatory power of book values (earnings) has significantly increased (decreased) after the movement to the fair value model.
Although the current study uses data from only one emerging capital market, it contributes to current literature on the relative value relevance of earnings and book value by examining how these values are affected by the movement toward fair value accounting by standard setters using a well- developed methodology and the whole data available from KSE during a long-time period.
The study has important implications for standard setters and for future research to support the results obtained by current study using data from other developed and developing economies.
References
[1] Al Husaini, W. and Elshamy, M. (2016). Accounting for Property Investment: An Examination of the Value Relevance of Unrealized Gains and Losses Recognized under IAS 40.
International Journal of Accounting and Finance. Vol. 6, Issue 2, pp. 100-117.
[2] Asthana, S. and Chen, L. (2007). Differential Changes in the Value-relevance of Earnings and Book Values over Time: Financial Versus Other Industries. Working Paper. The University of Texas at San Antonio, College of Business, 0026ACC-501-2007.
[3] Bao, Ben-Hsien and L. Chow. (1999, Summer). The Usefulness of Earnings and Book Value for Equity Valuation in Emerging Capital Markets: Evidence From Listed Companies in the People’s Republic of China. Journal of International Financial Management and Accounting, Vol. 10, pp. 85-104.
[4] Barth, M. (1994). Fair Value Accounting: Evidence from Investment Securities and the Market Valuation of Banks. The Accounting Review, Vol. 69, No.1, pp.1 - 25.
[5] Collins, D., E. Maydew, and I. Weiss. (1997, December). Changes in the Value-Relevance of Earnings and Book Values over the Past Forty Years. Journal of Accounting and Economics, Vol. 24, pp. 39 - 67.
[6] Collins, D., M. Pincus and H. Xie. (1999, January). Equity Valuation and Negative Earnings:
The Role of Book Value of Equity. The Accounting Review, Vol. 74, No. 1, pp. 29 - 61.
[7] Dayanandan, A, Donker, H., Iavnof, M. and Karahan. G. (2016). IFRS and Accounting Quality:
Legal Origin, Regional, and Disclosure Impacts. International Journal of Accounting and Information Management, Vol. 24, No 3, pp. 296-316.
[8] Easton, P. (1985, Supplement). Accounting Earnings and Security Valuation: Empirical Evidence of the Fundamental Links. Journal of Accounting Research, Vol. 23, pp. 54 - 77.
[9] Elshamy, M. and Kayed, M. (2005). The Value- Relevance of Earnings and Book Values in Equity Valuation: An International Perspective - The Case of Kuwait. International Journal of Commerce and Management, Vol. 15, No.1, pp. 68-79.
[10] Elshamy, M. and Al- Qenae, R. (2005). The Change in the Value-Relevance of Earnings and Book Values in Equity Valuation Over the Past Twenty Years and the Impact of the Adoption of IASs: The Case of Kuwait, International Journal of Accounting, Auditing, and Performance Evaluation, Vol. 2 Nos. 1 / 2, pp. 153-167.
[11] El-Shamy, M. A., Al-Hajri, M., & Al-Bassam, S. (2014). The Value Relevance of Unrealized Gains and Losses Recognized Under IAS 39: Evidence from Kuwait. International Journal of Commerce and Management, Vol. 24, Issue4, pp. 355-366.
[12] Financial Accounting Standards Board (FASB), 1991. Disclosures about Fair Value of Financial Instruments. Statement of Financial Accounting Standards No. 107. Norwalk, CT, FASB.
[13] Financial Accounting Standards Board (FASB), 1993. Accounting for Certain Investments in Debt and Equity Securities. Statement of Financial Accounting Standards No. 115. Norwalk, CT, FASB.
[14] Financial Accounting Standards Board (FASB), 1994. Disclosure about Derivative Financial Instruments and Fair Value of Financial Instruments. Statement of Financial Accounting Standards No. 119. Norwalk, CT, FASB.
[15] Financial Accounting Standards Board (FASB), 1998. Accounting for Derivative Instruments and Hedging Activities. Statement of Financial Accounting Standards No. 133. Norwalk, CT, FASB.
[16] Francis, J. and Schipper, K. (1999). Have Financial Statements Lost Their Relevance? Journal of Accounting Research. Vol. 37, No. 2, pp. 319 - 352.
[17] Gornik-Tomaszewski, S. and E. Jermakowicz. (2001, Spring). Accounting-based Valuation of Polish Listed Companies. Journal of International Financial Management and Accounting, Vol. 12, pp. 50 - 74.
[18] Hayn, C. (1995). The Information Content of Losses. Journal of Accounting and Economics, Vol. 20, pp. 125 - 153.
[19] Harris, T., M. Lang, and H. Moller. (1994, Autumn). The Value Relevance of German Accounting Measures: An Empirical Analysis. Journal of Accounting Research, Vol. 32, pp.
187 - 209.
[20] International Accounting Standard Board (2003 revised), International Accounting Standard IAS 16: Property, Plant and Equipment. London, U.K: IASC.
[21] International Accounting Standard Board (2001 revised), International Accounting Standard IAS 37: Provisions, Contingent Liability and Contingent Assets. London, U.K: IASC.
[22] International Accounting Standard Board (2004), International Accounting Standard IAS 38:
Intangible Assets. London, U.K: IASC.
[23] International Accounting Standard Board (2005 revised), International Accounting Standard IAS 39: Financial Instruments: Recognition and Measurements. London, U.K: IASC.
[24] International Accounting Standard Board (2003 revised), International Accounting Standard IAS 40: Investment Property. London, U.K: IASC.
[25] International Accounting Standard Board (2008 revised), International Accounting Standard IAS 41: Agriculture. London, U.K: IASC.
[26] International Accounting Standard Board (2004), International Financial Reporting Standard IFRS 2: Share-based Payment. London, U.K: IASC.
[27] International Accounting Standard Board (2004), International Financial Reporting Standard IFRS 3: Business Combination. London, U.K: IASC.
[28] International Accounting Standard Board (2014), International Financial Reporting Standard IFRS 9: Financial Instruments. London, U.K: IASC.
[29] IFRS 9 “Financial Instrument
[30] International Accounting Standard Board (2011), International Financial Reporting Standard IFRS 13: Fair Value Measurement. London, U.K: IASC.
[31] Jan, C. and Ou, J. (1995). The Role of Negative Earnings in the Evaluation of Equity Stocks.
Working Paper. New York University. New York, NY and Santa Clara, CA.
[32] Joos, P. and M. Lang. (1994, Supplement). The Effects of Accounting Diversity: Evidence from the European Union. Journal of Accounting Research, Vol. 32, pp. 141-168.
[33] Khurana, I. K., Kim, M., (2003). Relative Value-Relevance of Historical Cost vs. Fair Value:
Evidence from Bank Holding Companies. Journal of Accounting and Public Policy Vol. 22, pp.
19−42.
[34] King, R. and J. Langli. (1998). Accounting Diversity and Fair Valuation. The International Journal of Accounting, Vol. 33, pp. 529 - 567.
[35] Lev, B. and P. Zarowin. (1999, Autumn). The Boundaries of Financial Reporting and How to Extend Them. Journal of Accounting Research, Vol. 37, pp. 353 - 385.
[36] Liu, C., J. Yao, N. N. Hu, and L. Liu. The Impact of IFRS on Accounting Quality in a Regulated Market: An Empirical Study of China. Journal of Accounting, Auditing & Finance.
Vol. 26, No. 4, pp. 659-676.
[37] Liu, C. and G. O’Farrell (2011). The Impact of IFRS on Earnings Management: Evidence from the People’s Republic of China. International Journal of Services and Standards. Vol. 7, No. 3, pp. 264-277.
[38] Nelson, K. (1996). Fair value accounting for commercial banks: An empirical analysis of SFAS 107. The Accounting Review, Vol. 71, pp.161–182.
[39] Ohlson, J. (1995) Earnings, Book Values and Dividends in Equity Valuation: Contemporary Accounting Research, Vol. 11, pp. 661 - 687.
[40] Ramakrishnan, R. and J. Thomas. (1998). Valuation of Permanent, Transitory and Price- Irrelevant Components of Reported Earnings. Journal of Accounting, Auditing & Finance. Vol.
13, Issue 3, pp. 301-336.
[41] The Institute of Chartered Accountants in England and Wales (2015). The Effect of Mandatory IFRS Adoption in the EU: A Review of Empirical Research. ICAEW, Chartered Accountants’
Hall Moorgate Place, London EC2R 6EA UK.
[42] Theil, H. (1971). Principles of Econometrics. Wiley, New York, NY.
[43] Venkatachalam, M. (1996). Value-relevance of banks' derivatives disclosures. Journal of Accounting and Economics, Vol. 22, pp. 327–355.
