Tài liệu Accounting Practices and the Market Valuation of Accounting Numbers: Evidence from Indonesia, Korea, Malaysia, the Philippines, Taiwan, and Thailand doc

Kingy *Oregon State University, Corvallis, OR, USA and yUniversity of Oregon, Eugene, OR, USA Key Words: International accounting practices; Valuation; Asia; Clean surplus; Conservatism

Accounting Practices and the Market Valuation of

Accounting Numbers: Evidence from Indonesia, Korea, Malaysia, the Philippines, Taiwan, and Thailand

Roger C Graham* and Raymond D Kingy

*Oregon State University, Corvallis, OR, USA and yUniversity of Oregon, Eugene, OR, USA

Key Words: International accounting practices; Valuation; Asia; Clean surplus; Conservatism

Abstract: This study examines the relation between stock prices and accounting earnings and book values in six Asian countries: Indonesia, South Korea, Malaysia, the Philippines, Taiwan, and Thailand The analysis is based on a residual earnings model that expresses the value of the firm in terms of book value and residual income The model holds for any clean surplus accounting system However, for finite time horizons, biased accounting may affect model estimates The six countries examined in this study differ in faithfulness to clean surplus accounting as well as bias (conservatism) The study addresses two questions First, are there systematic differences across countries in the value relevance of accounting, and are these differences related to accounting differences? Second, are there systematic differences in the incremental and relative information content of book value per share (BVPS) and abnormal (residual) earnings per share (REPS) across the countries, and are such differences related to accounting differences? We find differences across the six countries in the explanatory power of BVPS and REPS for firm values Explanatory power for Taiwan and Malaysia is relatively low while that for Korea and the Philippines is relatively high These differences are generally consistent with differences in accounting practice; however, since Korean accounting practice is strongly influenced by tax law, we did not expect the high association for Korea Second, with respect to the incremental and relative explanatory power of BVPS and REPS, we find BVPS to have high explanatory power in the Philippines and Korea but little in Taiwan In all six countries REPS has less explanatory power than BVPS in most years Again, the evidence may be interpreted as suggesting accounting practice affects valuation (with Korea again as the exception) Finally, we provide evidence on the sensitivity of the timing of comparisons of stock prices and accounting values We find that comparing prices at year-end (even though annual accounting information has not been released at that time), in general, provides the highest correlation between market and accounting numbers.

Differences in accounting practices across countries are a major concern to investors,accounting standard setters, stock exchanges, and financial analysts The International

Direct all correspondence to: Raymond D King, Lundquist College of Business, University of Oregon, Eugene,

OR 97403, USA; E-mail: rking@oregon.uoregon.edu

Accounting

Accounting Standards Committee (IASC) and the International Organization of SecuritiesCommissions (IOSCO) have devoted considerable effort to standardization or harmoniza-tion of accounting practices across countries Investment professionals claim that account-ing differences may impede international capital flows (Choi and Levich, 1991) Thisstudy examines the relation between accounting numbers and firm market values in sixAsian countries with diverse accounting practices: Indonesia, Korea, Malaysia, thePhilippines, Taiwan, and Thailand We focus on the incremental and relative explanatorypower of book value and residual earnings Because accounting systems differ across thesix countries, we examine whether those differences are related to the valuation usefulness

of accounting measures Our objective is to provide evidence on the value relevance ofaccounting numbers from different accounting systems Such evidence should inform thecurrent debate over international accounting standards and practices

Our analysis follows a model developed by Preinreich (1938), Edwards and Bell (1961),and Peasnell (1982) and formalized by Ohlson (1991, 1995) and Feltham and Ohlson(1995) sometimes termed the Residual Earnings (Income) model The model formallystates a simple concept: firm value is a function of book value and future residual earnings

A key aspect of the model is that its valuation accuracy does not depend on a particular set

of ``good'' accounting procedures The only requirement on accounting procedures is cleansurplus accounting, that is, book value of equity changes only with income or loss and netcapital investments and withdrawals (dividends) by owners In addition, empiricalapplications of the model to finite horizons are potentially affected by bias in theaccounting system Therefore, comparisons across countries with different accountingpractices are one way to investigate the value relevance of different accounting practices.Across the six countries, accounting systems vary in their faithfulness to clean surplusaccounting and in the extent to which they exhibit bias (conservatism) Hence, it ispossible that accounting values from some of the countries may provide better estimates offirm value than accounting values from the other countries Therefore, the usefulness ofaccounting for firm valuation may differ across countries as well On the other hand, theaccounting standards developed in these countries may be partly based on InternationalAccounting Standards (IAS) or US GAAP This would tend to make accountingprocedures and their value relevance similar Saudagaran and Diga (1997) report that ofour six countries, only Korea has not adopted some or all of IAS

We investigate the value relevance of different accounting practices using anempirical model that regresses current book value and current residual earnings onmarket prices In contrast, the residual income model is based on expected residualearnings Considerable prior research, as discussed in the next section, examines thecontemporaneous relation between accounting and market values In this study, weexamine that relation for six Asian countries However, our interest is in the relationbetween accounting practices and the value relevance of accounting numbers Wefocus on differences in accounting procedures across the six countries that affect bookvalue and residual earnings.1 The accounting procedures selected: accounting forgoodwill, asset revaluations, leases, research and development (R&D) expenditures,and the equity method of accounting for affiliated companies each may be categorized

in terms of faithfulness to clean surplus and extent of conservatism

We address the implications of these accounting procedures for the value relevance ofaccounting information Philippine firms, for example, record goodwill and revalue assets,

but firms in Taiwan do neither This means that book values in the Philippines will reflectmarket values of assets more closely than in Taiwan Therefore, we expect the explanatorypower of book value will be greater for Philippine firms than for Taiwanese firms Asanother example, only Indonesian and Malaysian firms capitalize leases and R&Dexpenditures and use the equity method for affiliated companies These are lessconservative accounting practices than alternatives used in other counties.

We find accounting in Korea and Taiwan to be least faithful to clean surplusaccounting Korea does not capitalize goodwill and asset revaluations are amortized toequity according to tax law Taiwan does not capitalize goodwill nor allow assetrevaluations Korea is also the only country not to use the equity method for affiliatedcompanies Thus, the earnings of Korean firms do not include the earnings of affiliatedfirms Philippine firms, however, amortize both goodwill and asset revaluations to income.Recall that violations of clean surplus accounting occur when income does not reflectchanges in equity value Thus, violations of clean surplus bias empirical calculations ofresidual earnings Therefore, we expect the explanatory power of residual earnings will behighest for Philippine firms and least for Korean and Taiwan firms

Overall, our results show significant differences across countries in the value relevance

of accounting earnings and book values Explanatory power over all firm-years rangesfrom R2= 17 in Taiwan to R2= 68 for Korea The incremental explanatory power of bookvalue per share (BVPS) and residual earnings per share (REPS) is similarly diverse.Incremental explanatory power of BVPS over all firm-years ranges from 7.2 percent(Taiwan) to 65.3 percent (Philippines) For REPS, the incremental explanatory power overall firm-years ranges from 1.4 percent (Korea) to 13.2 percent (Thailand)

Generally, we find differences in accounting appear to be related to differences in valuerelevance We find that the explanatory power of book value is highest in the Philippinesand lowest in Taiwan This is consistent with our expectations based on the accountingdifferences in the two countries Indonesia and Malaysia have accounting systems that areless conservative than other countries However, we find the incremental explanatorypower of book value does not stand out as high in Indonesia or in Malaysia This result isonly partly consistent with our expectations We also expected that the relative explanatorypower of residual earnings would be high in the Philippines and low in Korea and Taiwan,and the results support this prediction Our comparisons across countries should be viewedwith caution because the number of years of data available ranges from only 2 years for thePhilippines to 10 years for Malaysia

The next section of the article briefly reviews related research and this is followed bythe section discussing accounting differences in the six Asian countries This is followed

by the description of the sample and development the study design The section presentingthe analysis of our data and reporting the results of our tests follows A final sectionsummarizes our findings

RELATED RESEARCH

Research concerned with the relation of accounting numbers and stock prices coversdecades In this brief review we summarize recent research with study designs and researchmethods similar to ours We see two principal strains: first, research focused on explaining

stock prices with accounting book value and earnings; and second, research examining theincremental explanatory power of book value and earnings in the presence of the other.Stock Prices Explained by Book Value and Earnings Per Share

Examining a large set of US firms, Bernard (1993) found that book values explain 55percent of the cross-sectional variation in market prices When current return on equity(ROE; ranks) was added to the regression, these two accounting measures explain about

64 percent of the variation in market prices Bernard (1994) finds that return on commonequity (ROE) is mean reverting over time so that firms with the highest (lowest) currentROEs tend to have lower (higher) ROEs in later years

King and Langli (1998) examine the explanatory power of BVPS and earnings pershare (EPS) for three European countries: Germany, Norway, and the UK They findsignificant differences in the valuation power of accounting book value and earningsacross the three countries, and they interpret some of the differences as consistent withdiversity in accounting practices They also find future earnings realizations as proxies forexpected earnings do not have incremental explanatory power beyond that of currentearnings and book value

Frankel and Lee (1999) look at the relation between accounting values, earningsforecasts and market prices across 20 countries (including Korea and Thailand) for 8 years,1987±1994 Sample sizes for Korea and Thailand are small with 3 to 8 observations peryear (33 total firm-years) for Korea and 1 to 40 observations per year (162 total firm-years)for Thailand They find that estimates of value based on the residual earnings model haveincremental explanatory power beyond book value and earnings in explaining marketvalue in all countries In addition, they find evidence of superior returns to tradingstrategies based on an estimate of value from a residual earnings model

Joos and Lang (1994) relate book value and earnings to stock prices for France,Germany, and the UK Their sample covers 1982 to 1990, and they focus on the effects ofimplementing the accounting related directives of the European Union They find theexplanatory power of book value and earnings together ranges from 20 to 38 percent forGermany, from 48 to 78 percent for France, and from 14 to 42 percent for the UK They donot examine incremental explanatory power Evidence on changes over time is ambiguous,probably because the time periods for the sample are relatively short

Harris et al (1994) examine the value relevance of accounting numbers for Germanfirms compared to that for a matched set of US firms for 1982±1991 They find littledifference in overall value relevance (R2) between German and US firms However,coefficients (multiples) on book value and on earnings for German firms are greater thanfor matched US firms Further, they find that consolidation increases the value relevance

of accounting numbers, and restatements of earnings to adjust for transitory elements inGerman accounting also increases explanatory power

Incremental Explanatory Power of Book Value and Earnings Per Share

Collins et al (1997) examine the incremental explanatory power of book value andearnings across a 41-year time period (1953±1993) for US firms They find a decline

in the ability of earnings to explain market prices over this period But the explanatorypower of book values increases such that total explanatory power is actually higher inmore recent periods Average adjusted R2 for a model regressing BVPS and EPS onstock price for the first 10 years (1953±1962) was 50 increasing to 69 for their mostrecent 10-year period (1984±1993) Collins et al (1997) investigated possible reasonsfor these changes They find the reduced explanatory power of earnings is explained

by an increase in the incidence of one-time items and reported losses as well as adecrease in the size of firms in the sample

King and Langli (1998) examine a 15-year period (1982±1996) for Germany, Norway,and the UK They find that for Germany the incremental explanatory power of book valueincreases significantly while that for EPS decreases There is no significant change in theircommon information For Norway, there is no significant change in the incrementalexplanatory power of book value or EPS over time While for the UK, the incrementalexplanatory power of book value increases and the incremental explanatory power of EPS

is unchanged over the time period

Harris et al (1994) also examine the separate explanatory power of book value and ofearnings using simple regressions with only one variable They do not report the teststatistics However, they say that while the explanatory power of EPS in Germany isapproximately equal to that in the US, the explanatory power of book value is much lower.This contrasts sharply to the King and Langli (1998) results for a longer time period TheHarris et al (1994) results are not, however, tests of incremental explanatory power sincethe simple regressions use only one variable

This study extends the evidence summarized above We examine the value relevance ofaccounting numbers for companies in Asian countries Prior financial reporting research inEnglish language journals has been limited

ACCOUNTING DIVERSITY ACROSS THE SIX COUNTRIES

The accounting systems in all six countries have developed relatively recently The sixaccounting systems differ on some dimensions but are similar on others Two dimensionsthat we examine are (1) the model on which the accounting systems are based and (2) thetype of standard setting body Table 1 shows these characteristics for the six countries IASwas the primary basis for accounting standards in Indonesia, Malaysia, and Thailand(although Thailand has also been influenced by US GAAP) US GAAP, on the other hand,was the primary basis in the Philippines and Taiwan (although Philippine GAAP issecondarily based on tax law) Korean accounting standards are unique in that they arebased on Korean tax law that, like tax law in all countries, emphasizes cash realization.Different accounting models may lead to differences in the value relevance of the resultingaccounting numbers We have no prior expectations concerning the relative valuerelevance of IAS versus US GAAP It is likely, however, that tax law is more susceptible

to political influence than other accounting bases To the extent that such politicalinfluence might serve to make accounting less informative, Korean accounting may beless value relevant because it is based on tax law

The standard setting bodies in four of the six countries are independent of thegovernment In Korea and Taiwan, however, standard setting is not independent Where

standard setting is influenced or controlled by government there is greater potential forpolitical influence in the standards setting process As where accounting follows tax law,this may lead to lower value relevance of accounting numbers.

We analyzed the accounting standards and practices for each country using a variety

of sources including Akathaporn (1995), Graham and Wang (1995), and publicationsfrom the AICPA (1989, 1990, 1992), CIFAR (1995), Deloitte Touche TohmatsuInternational (1995a,b, 1996a,b, 1997), Price Waterhouse (1995a,b, 1996a,b,c,d), andMathew Bender & Co.(1996) Under the residual earnings model the only crucialaccounting characteristics are unbiased accounting and clean surplus accounting.Conservative accounting practices are biased since value changes are reflectedasymmetrically, value declines are recognized more quickly than value increases.The clean surplus relation (CSR) allows book value of equity to change only withincome or loss and net capital investments and withdrawals (dividends) by owners.CSR is violated if changes in book value can by-pass income We focus our analysis

on the effects of accounting differences on book value and on residual (abnormal)earnings, the accounting arguments in the residual earnings model However, account-ing differences affect valuation only when they are violations of unbiased accounting

or clean surplus accounting

Differences Across Countries Affecting Book Value

Revaluing assets is a violation of CSR if the accompanying credit is taken directly toequity Yet asset revaluations bring book value nearer to market value Immediate write-off

of goodwill violates CSR and usually moves book values farther from market values Insummary, both recognizing goodwill (consistent with CSR) and revaluing assets (violatingCSR) bring book value nearer to market value Hence, developing predictions on theeffects of specific accounting treatments on value relevance is not always clear.Conservative accounting (bias) is expected to generally reduce the value relevance ofboth book value and earnings since the essence of conservatism is delay in reflectingcertain events in the accounting records

Recording goodwill is common practice in Indonesia and the Philippines, anduncommon but allowed in Malaysia and Thailand Korea and Taiwan do not allowgoodwill to be recorded Asset revaluations are common in all countries except Indonesiaand Taiwan where they are allowed but restricted in practice Table 2 presents a summary

of our analysis of these accounting practices

Table 1 Accounting Standards and Standard Setting in the Six Countries

Asset revaluation and goodwill are both recorded only in the Philippines, and neither isrecorded in Taiwan The other four countries allow one procedure or the other but notboth We expect the incremental explanatory power of book value to be high in thePhilippines and low in Taiwan relative to the other five countries However, the effect ofthese accounting practices on the incremental explanatory power of book value for theother countries is ambiguous.

The six countries also differ in other accounting practices, including capitalizing leases,capitalizing research development costs, and applying the equity method to affiliatedfirms Firms that capitalize and use the equity method are likely to have book values thatare closer to market values than firms that do not.2Table 3 presents a summary of ouranalysis of these accounting practices

Only Indonesia and Malaysia allow or require all three accounting procedures Theeffect of these accounting differences on incremental explanatory power is ambiguous forthe other countries However, we expect the explanatory power of book value in Indonesiaand Malaysia to be higher than in Thailand and Taiwan

Differences Across Countries Affecting Residual Earnings

As explained in the previous section, conservatism is expected to reduce the valuerelevance of both book value and residual earnings In addition, we can make somepredictions about the effects of clean surplus accounting for goodwill and asset revalua-tions on the value relevance of book value However, the effects of these accountingpractices on the value relevance of residual earnings are less clear

The Philippines is the most faithful to clean surplus accounting as both goodwilland asset revaluations are amortized to income over their useful lives The other

Table 2 Goodwill and Asset Revaluations on the Balance Sheet

Table 3 Other Asset Values on the Balance Sheet

countries (1) do not record goodwill (Korea and Taiwan), (2) do not record assetrevaluations (Indonesia and Taiwan), (3) immediately write-off goodwill to equity(Malaysia and Thailand), or (4) amortize asset revaluation increments to equity (Korea,Malaysia, and Thailand) Korea and Taiwan are least faithful to clean surplusaccounting Korea does not capitalize goodwill and asset revaluations are amortized

to equity according to schedules mandated by tax law Taiwan does not capitalizegoodwill nor allow asset revaluations Korea is also the only country that does not usethe equity method for affiliated companies; therefore the earnings of Korean firms donot include the earnings of affiliated firms We expect the relative explanatory power

of residual earnings to be high in the Philippines and low in Korea and Taiwan Theeffect on the explanatory power of residual earnings for the other countries isambiguous Table 4 presents a summary of the amortization practices

Summary of the Research Questions

Our examination of accounting practices reveals some systematic differences across thesix countries While the differences appear to be substantial, it is an empirical questionwhether they result in meaningful violations of the CSR or in significant accounting bias(conservatism), the important factors for the residual earnings model Accounting bias willlikely reduce the explanatory power of both book value and earnings Furthermore,violations of the CSR may either increase or decrease the explanatory power of book valuedepending on whether the violation moves book value toward or away from marketvalues Because countries differ on both dimensions, ex ante hypotheses on which effectwill dominate are problematic Even so, we expect that bias and CSR violations will affectthe value relevance of accounting numbers in systematic ways Particularly becausePhilippine firms record both goodwill and asset revaluations and Taiwan firms do neither,

we expect the value relevance of book value to be greatest in the Philippines and least inTaiwan Because both Indonesian and Malaysian firms capitalize leases and R&Dexpenditures and use the equity method we expect the value relevance of their bookvalues to exceed the value relevance of book value in Thailand and Taiwan BecausePhilippine firms amortize both goodwill and asset revaluations to income, we expect thevalue relevance of residual earnings to be high in the Philippines

In addition, we investigate changes in the value relevance of accounting numbers overtime Our sample contains 3,655 firm-years across six countries We have sufficient datafor only 2 years of yearly regressions for the Philippines but 10 years for Malaysia We

Table 4 Goodwill and Asset Revaluation Amortization

trace the total explanatory power of accounting earnings and book value and theincremental explanatory power of each earnings and book value in the presence of theother across time for each country.

SAMPLE AND STUDY DESIGN

Our sample covers publicly traded firms in Indonesia, Korea, Malaysia, the Philippines,Taiwan, and Thailand across the period from 1987 to 1996 The stock prices andaccounting data for this study are from the Worldscope Global Researcher The sampleselection criteria are:

1 Accounting data is from consolidated financial statements

2 Financial firms are excluded (insurance, banks, and other miscellaneous financialfirms) Accounting practices for these firms are so distinct that their valuationparameters are likely to be substantially different from those for industrial firms

3 Firms with negative book values are deleted These firms are likely to be infinancial distress and may be interesting in their own right However, the focus ofthis study is the across country differences in value relevance of accountingnumbers derived under different accounting practices Hence, restricting oursample to firms with positive book values will allow us to focus on firms wheredifferences are mostly likely to reflect accounting differences

4 Twelve firms with EPS greater than their BVPS are deleted since data on those firms

is likely to contain errors These firms constituted less than 1 percent of the sample

5 Twenty firm-years with excessive statistical influence in our regressions weredeleted The firm-years showed undue influence by the diagnostics and cutoff rulesdescribed in Belsley et al (1980)

These restrictions on the sample will have several effects First, the model will appear

to ``fit'' better than it would fit unrestricted data That is, the explanatory power of bookvalue and of residual earnings information in the sample is likely to be greater than for anunrestricted sample Second, the samples across the six countries will be more homo-geneous and the effects of different business cycles in the six countries will be reduced.This should allow a better focus on the effects of accounting differences Table 5 shows thecountries and number of firm-years

Table 5 Sample Countries and Firm-Years

Table 6 provides descriptive statistics for the sample Per share values are in nominalcurrency of the countries, so comparisons are difficult However, we can compare ROE(the ratio of EPS to average book value) across countries and the differences aresubstantial Median ROE ranges from 6 percent (over 8 years) in Korea to 14 percent

Table 6 Descriptive Statistics on Variables for Six Southeast Asian Countries

Price = Stock price at the end of year t BVPS = Book value of shareholders' equity at the end of year t EPS = Earnings per share

lending rate in year t taken from the International Financial Statistics Yearbook Price, book value, EPS, and REPS amounts are in

(over 5 and 2 years) in Indonesia and the Philippines For comparison, King and Langli(1998) find ROE over the 1980s and 1990s to be about 6 percent in Germany, 10 percent

in Norway, and 13 percent in the UK In the US, this measure has averaged around 13

Table 7 Correlation Statistics on Variables for Six Asian Countries ( p values in parentheses)

Price = Stock price at the end of year t EPS = Earnings per share for year t BVPS = Book value of shareholders' equity at

Financial Statistics Yearbook.

percent over the last 20 years Prior research has speculated that such differences acrosscountries may reflect differences in conservatism of accounting methods As noted above,for example, Taiwan does not record either goodwill asset revaluations (most conservative)while both are recognized in the Philippines (least conservative).

Table 7 reports the pair-wise correlation between stock price and accounting variablesfor all countries For all countries except Korea the rank (Spearman) correlations aregreater than the product±moment (Pearson) correlations However, the patterns andsignificance of the parametric (Spearman) and non-parametric (Pearson) correlations aresimilar Stock prices are strongly correlated with BVPS and with EPS for all countries Thepair-wise correlations between price and EPS are approximately the same as between priceand BVPS The correlation (Pearson) between BVPS and EPS is high in Thailand (.81),the Philippines (.78), and Korea (.74), and relatively low for Taiwan (.24) If EPS is used

as a proxy for residual earnings, the high correlation between BVPS and EPS (they arerelated by size) may make it difficult to partition value relevance between book value andearnings However, the pair-wise correlations between BVPS and REPS are far smaller,significant in some cases, insignificant in others, and sometimes negative This isanticipated since there is no reason to expect residual (unexpected) per share earnings

to be related to book value One important reason for using REPS in the empirical analysis

is to avoid the high correlation between BVPS and EPS

TESTS AND ANALYSIS

Our analysis is based on contemporaneous cross-sectional regressions of accounting bookvalues and residual earnings on stock prices (dependent variable) We analyze both therelative and the incremental explanatory power of book value and residual earnings using anapproach applied previously in accounting by Biddle et al (1995) and Collins et al (1997).Empirical specification of the residual earnings model requires estimates of book value,residual earnings, and the horizon for residual earnings For residual earnings estimated toterminate at time T, the model would be:

Priceitˆ a0‡ a1BVPSit‡ a2REit‡1‡ a3REit‡2‡ a4REit‡3‡ ‡ akREiT‡ eit …1†where Priceitis the price per share of firm i at the end of period t, BVPSitis the book valueper share of firm i at the end of period t, and REitis the residual earnings per share of firm ifor year t + k

The coefficient a1would have an expected value of 1.0 while the coefficients a2to a4

would have expected values of (1 + r)ÿ t Finally, the expected value of coefficient ak

would be (1/r)*(1 + r)ÿ T.3Residual earnings horizons will differ cross-sectionally; fore, parsimonious cross-sectional representations of Equation (1) will have only a fewterms For example Frankel and Lee (1999) use T = 2 because analysts' forecasts used topredict future residual earnings were only available for 2 years

there-Our first tests are concerned with the incremental explanatory power of book value andresidual earnings As in Collins et al (1997) we compare the results of three regressionequations to address the question of relative and incremental explanatory power Equation(2) below provides the most parsimonious empirical specification of the residual earnings

model on a per share basis (the horizon is only one period) Current period residualearnings is the proxy for future expected residual earnings Residual earnings are estimated

by subtracting an estimate of normal (expected) earnings from reported earnings Expectedearnings is the product of the estimated rate of return (r) and book value Like Frankel andLee (1999), we derive the estimated rate of return from interest rates in the InternationalFinancial Statistics Yearbook published by the International Monetary Fund (1997).Frankel and Lee (1999), however, are able to calculate a risk-adjusted return by adding

a risk premium to long-term government bond rates Government bond rates are notavailable for four of the countries; therefore, we use commercial lending rates Concep-tually, this rate is the sum of a riskless rate and the average commercial lending riskpremium In the residual earnings model, book value and firm value are taken at time twhile future abnormal earnings are for periods after time t In our empirical analysisresidual earnings (REt) are for the period ending at time t Hence, as in Bernard (1994) andCollins et al (1997), current earnings is a proxy for expected future earnings

where Priceitis the stock price per share of firm i at the end of year t, BVPSitis the bookvalue of shareholders' equity of firm i at the end of year t, REPSitis the residual earnings pershare, which is equal to EPSitÿ r*(BVPSt ÿ 1)4(proxy for expected REPS in period t + 1),EPSitis the earnings per share of firm i for year t, and r is the country's average commerciallending rate in year t taken from the International Financial Statistics Yearbook

Book values and earnings are, of course, unobservable until some weeks after the end ofthe fiscal year This raises the question of the timing of the market value measure to beassociated with the accounting variables As discussed by Barth et al (1996), choice ofcontemporaneous versus lagged market values is a trade-off The advantage to using alagged market price is that it may reasonably reflect the accounting results since sufficienttime has passed for these results to be public information However, lagged market valueswill include effects of information and events occurring after the end of the fiscal year.Collins et al (1997), examining associations between market and accounting numbers for

US firms, take prices 3 months after the end of the fiscal period In cross-country studies,however, this is problematic since the time lag between fiscal year-ends and report dates canvary widely For this reason, our tests examine the relation between accounting numbers(book value and residual EPS for a fiscal year) and stock prices at the end of the fiscal year.Later, we analyze the sensitivity of our results using stock prices lagged 0 to 6 monthsfollowing the end of the fiscal year

Equation (2) expresses price as a function of book value and residual earnings.Examining the relative and incremental explanatory power of book value and of residualearnings requires two additional equations expressing price as a function of book valuealone, Equation (3), and residual earnings alone, Equation (4).5