The value relevance of accounting information in the Netherlands

According to the FASB framework 2008, “the objective of financial statements is to provide financial information about the reporting entity that is useful to present and potential equity

Master’s Thesis

The value relevance of accounting information in the Netherlands

Ruud Klijn Student number 0237558 MSc in Accountancy

UvA

Final draft June 2008

First Supervisor:

Dr Georgios Georgakopoulos

Second Supervisor:

Dr Igor Goncharov

Abstract

This thesis investigates the value relevance of earnings and book values over time for firms in the Netherlands over the time period 1998-2007 The existing accounting literature argues that there is a decline in value relevance of accounting information due to the wholesale changes in the economy and the inability of accounting

standards to reflect these changes in the financial statements This thesis focuses on the Dutch market, because there is little research on the value relevance of

accounting information in the Netherlands

The results show that the value relevance of earnings and book value of equity, individually or together, does not decline over the sample period More specifically, this provides evidence that the value relevance of accounting information is not

significantly changing over the period 1998-2007

Samenvatting

Deze scriptie onderzoekt de waarderelevantie van inkomsten en boekwaarden over een tijdsperiode van 1998-2007 voor bedrijven in Nederland De bestaande literatuur debatteert dat er een daling in relevantie van financiële informatie is, doordat er grote veranderingen in de economie zijn en door het onvermogen van

boekhoudingsnormen om zich aan te passen op deze veranderingen in de financiële rapporten Deze scriptie focust zich op de Nederlandse markt, omdat er weinig

onderzoek is gedaan naar de waarderelevantie van financiële informatie in

Nederland

De resultaten laten zien dat de waarderelevantie van inkomsten en boekwaarden van eigen vermogen, individueel of samen, niet gedaald is in Nederland over de periode 1998-2007 Specifieker, dit verstrekt bewijsmateriaal dat de waarderelevantie van financiële informatie niet significant is gedaald over de periode 1998-2007

Introduction

This paper investigates changes in the value relevance of earnings and book values

of the past 10 years for companies in the Netherlands My research is motivated by other research on the value-relevance of earnings and book values and related claims from the professional community, like Collins et al (1997), and Francis and Schipper (1999) There appears to be a widespread impression that historical cost financial statements have lost their value-relevance because of wholesale changes in the economy In particular, many (Elliot and Jacobson, 1999; Jenkins, 1994; and Rimerman, 1990) claim that the shift form an industrialized economy to a high-tech, service-oriented economy has rendered traditional financial statements less relevant for assessing shareholder value (Collins et al., 1997)

The Ohlson (1995) valuation model provides the basis for investigating the value relevance of earnings and book values over time This model expresses price as a linear function of both earnings and book value of equity According to the accounting literature, book value is important in the valuation models for three reasons (Gornik-Tomaszewski and Jermakowicz, 2001) The first reason is that book values proxies for expected future normal earnings Second, for financially distressed firms, book value is perceived as a proxy for a firm’s liquidation value (Berger et al., 1996; Barth

et al., 1996; Burgstahler and Dichev, 1997; Collins et al., 1999) The third and last reason is that book value can be perceived simply a control for scale differences in a cross-sectional valuation equation (Barth and Kallapur, 1996)

I estimate yearly regressions for the period 1998-2007 and the adjusted R² is used as the primary metric to measure value relevance The total explanatory power of

earnings and book values is then decomposed into three components; (1) the

incremental explanatory power of earnings, (2) the incremental explanatory power of book value, and (3) the explanatory power common to both earnings and book value

I use this decomposition to investigate whether the value relevance of accounting information has changed over time To test this, the obtained R² statistics will be regressed on a time-trend variable

The findings are consistent with the results of Amir and Lev (1996), that the value relevance of accounting information has not declined for Dutch firms over the period 1998-2007 The results here show that the incremental power of earnings and the incremental explanatory power of book values is not significantly changing over time

It also illustrates that the combined explanatory power of earnings and book values is not significantly changing

The remainder of the thesis is as follows Section 2 describes the topic financial statements and section 3 will explain the definition of value relevance Section 4 outlines previous research on the value relevance of accounting information over time Section 5 explains the models used and the data selection Section 6 presents the results and section 7 presents the conclusions, limitations and future research

Financial statements

This section will describe the topic financial statements It explains why users need financial information and what the objectives are of financial statements To explain these objectives I will describe the qualitative characteristics of the FASB and IASB framework in 2008 (FASB, 2008) These characteristics are explained to make

information useful to users and to meet the objectives of financial statements

Financial statements are summaries of monetary data about an enterprise The most common financial statements include an income statement that describes the

operating performance during a time period, a balance sheet that states the firm’s assets and how they are financed, a cash flow statement that summarizes the cash flows of the firm, and a statement of changes in equity that outlines the sources of changes in equity during the period between two consecutive balance sheets (Palepu and Healy, 2007)

According to the FASB framework (2008), “the objective of financial statements is to provide financial information about the reporting entity that is useful to present and potential equity investors, lenders, and other creditors in making decisions in their capacity as capital providers Information that is decision useful to capital providers may also be useful to other users of financial reporting who are not capital providers” The information provided by financial reporting focuses on the needs of all capital providers, the people with a claim to the entity’s resources, not just the needs of a particular group

Management is accountable for the custody and safekeeping of the entity’s economic resources and for their efficient and profitable use They are also responsible, to the extent possible, for protecting the entity’s economic resources from unfavorable effects such as price, technological and social changes Another responsibility is that the entity complies with the laws and regulations Management’s performance in discharging its responsibilities, often referred to as stewardship responsibilities, particularly is important to existing equity investors when making decisions in their capacity as owners about whether to replace or reappoint management, how to compensate management, and how to vote on shareholder proposals about

management’s policies and other matters (FASB, 2008)

An entity obtains economic resources from capital providers in exchange for claims to those resources Because of those claims, capital providers have the need of

financial information about the economic resources of an entity Accordingly, financial reporting should provide information about the economic resources, and the claims to those resources Capital providers include equity investors, lenders, and other

creditors, who have common information needs (FASB, 2008)

1) Equity investors: equity investors include holders of equity securities, holders of partnership interests, and other equity owners Equity investors are directly interested

in the amount, timing, and uncertainty of an entity’s future cash flows, because they generally invest economic resources in an entity with the expectation to receive more cash than they provided and increases in the share prices or other ownership

interests Equity investors often have the right to vote on management actions

and therefore are interested in how well the directors and management of the

entity have discharged their responsibility to make efficient and profitable use

of the assets entrusted to them (FASB, 2008)

2) Lenders: lenders provide financial capital to an entity by lending it economic

resources They expect to receive a return in the form of interest, repayments of borrowings, and prices increases of debt instruments Lenders are also interested in the amount, timing, and uncertainty of an entity’s future cash flows and may have the right to influence or approve some management actions

3) Other creditors: other groups that provide resources as a consequence of their relationship with an entity are, for example, employees that provide human capital in exchange for a salary or other compensation Another example are suppliers that may extend credit to facilitate a sale A third example is a customer that may prepay for goods or services to be provided by the entity To the extent that employees, suppliers, customers, or other groups make decisions relating to providing capital to the entity in the form of credit, they are capital providers

Financial statement information is very important for users because they have no direct access to accounting records, they must depend on the information contained

in the reports Financial statements are the primary means of communicating

important accounting information to users It serve as the vehicle through which owners keep track of their firms’ financial situation (Palepu and Healy, 2007)

Users are interested in financial information because it provides useful information for making decisions They make decisions like whether and how to allocate their

resources to an entity, and how to protect or enhance their investments When they make those decisions, they are interested if the entity is able to generate net cash flows and if management is able to protect and enhance these investments

Like I stated before, financial reporting should provide information about the

economic resources of the entity and the claims to those resources Financial

reporting also should provide information about the effects of transactions and

circumstances that change an entity’s economic resources and the claims to those

resources (FASB, 2008) That information is useful for users to assess an entity’s

ability to generate net cash inflows and the ability of management to protect their

investments

I will now explain why this information is useful for users Information about an

entity’s economic resources and the claims to them, its financial position, can provide

a user of the entity’s financial reports with a good deal of insight into the amount, timing, and uncertainty of its future cash flows (FASB, 2008) With that information it

is easier to identify the financial strengths and weaknesses of the entity and to

assess its liquidity and solvency It also indicates the cash flow potentials of

economic resources and the cash needed to satisfy most claims of creditors Users also can compare their expectations with actual results to asses the effectiveness with which management has discharges it responsibilities to capital providers of the entity

Information about effects of transactions and other events and circumstances that change an entity’s economic resources and the claims to them helps a capital

provider of the entity’s financial reports to assess the amount, timing, and uncertainty

of its future cash flows (FASB, 2008) Such information is also used to asses the effectiveness with which management has discharges it responsibilities to capital providers of the entity

Financial performance provides information about the return it has produced on its economic resources To generate a positive net cash flow and to provide a return to the capital providers, an entity must produce a positive return on its economic

resources Past financial performance information is also helpful to users in

predicting the entity’s future return on its resources

Accrual accounting depicts the financial effects of transactions and other events and circumstances that have cash or other consequences for an entity’s resources and the claims to them in the periods in which those transactions, events, or

circumstances occur (FASB, 2008) A lot of operations that affect its economic

resources and the claims to them during a period, often do not coincide with the cash receipts and payments of the period Information about these economic resources and claims to them generally provides a better understanding for assessing past performance and future prospect This provides information whether the entity has increased its available economic resources through its operations It also may

indicate the extent to which events, such as changes in interest rates, have increased

or decreased the entity’s economic resources and the claims to those resources Important economic resources would be excluded from financial statements without accrual accounting

Cash flow information during a period also helps users to assess the entity’s ability to generate future net cash flows Information about an entity’s cash flows during a period indicates how it obtains and spends cash, including information about its borrowing and repayment of borrowing, cash dividends or other distributions to equity owners, and other factors that may affect the entity’s liquidity or solvency (FASB, 2008)

Financial statements also provides information about changes in economic resources that do not results from its financial performance, for example financing transactions between the entity and its owners This information is useful for users to see changes

in economic resources that are not a result of financial performance These changes helps users to assess which changes in economic resources are attributable to management’s ability to protect and enhance the economic resources, and therefore form expectations about the future performance

Other information that is useful for capital providers are the management’s

explanations This information is needed to understand the information provided Management’s explanations of the information in financial reports enhance the ability

of users to assess the entity’s performance and form expectations about the entity (FASB, 2008) Management knows more about the entity than external users and by identifying and explaining particular transactions and other circumstances that

affected the entity, the usefulness of financial information is increased Financial

capital providers to evaluate the financial information when they know the

management’s underlying assumptions or models used

However, there are some limitations of financial statement information that users should consider Financial statement information is just one source of information needed Other information, like general economic conditions, political event, and company outlooks, is also important Another limitation is that financial information is based on estimates, judgments, and models The framework establishes the concept that underlie those estimates, judgments, and models These concepts are the goal toward the preparers of financial statements, but it is unlikely to fully achieve this goals because of the technical infeasibility and cost

According to the FASB framework (2008), “the objective of financial statements is to provide financial information about the reporting entity that is useful to present and potential equity investors, lenders, and other creditors in making decisions in their capacity as capital providers Information that is decision useful to capital providers may also be useful to other users of financial reporting who are not capital providers” The degree to which that financial information is useful will depend on its qualitative characteristics Fundamental qualitative characteristics distinguish useful financial reporting information from information that is not useful or is misleading They can be distinguished as fundamental or enhancing characteristics, depending on how they affect the usefulness of information Each qualitative characteristic contributes to the usefulness of financial reporting information

Economic phenomena are economic resources, claims to those resources, and the transactions and other events and circumstances that change them Financial

reporting information depicts economic phenomena in words and numbers in

financial reports To be useful, financial information must possess two fundamental qualitative characteristics; (1) relevance and (2) faithful representation (IASB, 2008)

Relevance

Information is relevant if it is capable of making a difference in the decisions made by users in their capacity as users Financial information can make a difference when it has predictive value, confirmatory value, or both This information is not dependent

on whether it has actually made a difference in the past or will definitely make a difference in the future

Information about an economic phenomenon has predictive value if it has value for

capital providers as an input to make predictions about the future Accounting

information, in itself, need not be predictable to have predictive value

Information about an economic phenomenon has confirmatory value if it confirms

or corrects previous or present expectations based on previous evaluations If the information confirms past expectations, it increases the likelihood that the outcomes will be as expected If the information corrects the expectations, it also corrects the range of possible outcomes (FASB, 2008)

Faithful Representation

Information must be a faithful representation of the economic phenomena that it purports to represent, to be useful in financial reporting Faithful representation is attained when the depiction of an economic phenomenon is complete, neutral, and free from material error Financial information that faithfully represents an economic phenomenon depicts the economic substance of the underlying transaction, event, or circumstance, which is not always the same as its legal form

A depiction of an economic phenomenon need to be complete It is complete if it includes all the information that is necessary for faithful representation of the

economic phenomena that it purports to represent Omissions can cause financial information to be false or misleading, and therefore not helpful to the users of

financial statements

Neutrality is the absence of bias intended to attain a predetermined result or to

induce a particular behavior Neutral information is free from bias so that it faithfully represents the economic phenomena that it purports to represent Accounting

information must be decision-neutral It is not neutral if it intentionally leads to the making of a decision in order to achieve a predetermined result or outcome

However, to say that financial reporting information should be neutral does not mean that it should be without purpose or that it should not influence behavior

Because accounting information are generally measured under conditions of

uncertainty, faithful representation does not mean that there is total freedom from error in the depiction of an economic phenomenon An estimate must be based on appropriate inputs and must reflect the best available information to be faithfully representative

A depiction that is an unfaithful representation of a relevant phenomenon is not decision useful, just as a depiction that is a faithful representation of an irrelevant phenomenon Thus, either irrelevance or unfaithful representation results in

information that is not decision useful Together, relevance and faithful representation make financial reporting information decision useful (FASB, 2008)

Enhancing Qualitative Characteristics

Besides the fundamental qualitative characteristics of relevance and faithful

representation, there are enhancing qualitative characteristics that are

complementary to the fundamental qualitative characteristics They distinguish useful information from information that is less useful The enhancing qualitative characteristics are comparability, verifiability, timeliness, and understandability These characteristics makes the decision usefulness of accounting information that is relevant and faithfully represented better

more-Comparability

Comparability is the quality of information that enables users to identify similarities in

and differences between two sets of economic phenomena Consistency refers to the use of the same accounting policies and procedures, either from period-to-period within an entity or in a single period across entities Consistency helps in achieving comparability

When users make decisions they have to choose between alternatives Thus,

information that can be compared with similar information about other entities and with similar information about the same entity for some other period is more useful Comparability is a quality of the relationship between two or more items of

information Information that are alike must look alike, and different information must look different

To maximize the fundamental qualitative characteristics, some degree of

comparability should be attained That is, a faithful representation of a relevant

economic phenomenon should naturally possess some degree of comparability to a faithful representation of a similar relevant economic phenomenon by another entity (FASB, 2008)

Verifiability

Verifiability is a quality of information that helps assure users that information

faithfully represents the economic phenomena that it purports to represent

Verifiability implies that different knowledgeable and independent observers could reach general consensus, although not necessarily complete agreement, that either:

a The information represents the economic phenomena that it purports to

represent without material error or bias; or

b An appropriate recognition or measurement method has been applied without material error or bias

Verification may be direct or indirect With direct verification, an amount or other representation itself is verified, such as by counting cash or observing marketable securities and their quoted prices With indirect verification, the amount or other representation is verified by checking the inputs and recalculating the outputs using the same accounting convention or methodology (FASB, 2008)

Timeliness

Timeliness means having information available to decision makers before it loses

its capacity to influence decisions Users that have relevant information available very soon can enhance its capacity to influence decisions, stale information does not bear

on users’ decisions and is therefore not relevant (FASB, 2008)

Understandability

Understandability is the quality of information that enables users to comprehend its

meaning Understandability is enhanced when information is classified,

characterized, and presented clearly and concisely

Entities have to present the information clearly and concisely to help capital providers

to comprehend it, but the understandability depends largely on the users of the

financial report Users must be able to read a financial report and to have a

reasonable knowledge of business and economic activities However, when the underlying economic phenomena are very complex, fewer users may understand the financial information Information that is too complex for users to understand but that

is relevant and faithfully represented should not be excluded from the financial

reports (FASB, 2008)

Enhancing qualitative characteristics improve the usefulness of financial information, but, individually or with each other, cannot make information useful for decisions if the financial information is unfaithfully represented or irrelevant However, these enhancing qualitative characteristics should be maximized to extent possible

An enhancing qualitative characteristic may be sacrificed to maximize another

qualitative characteristic For example, if it is better to temporary reduce the

comparability to improve the relevance in the longer term

Providing useful financial information is limited by two pervasive constraints

on financial reporting; (1) materiality, and (2) cost

In summary, financial statement information provide users with an explanation of how their money has been invested, the performance of those investments, and how current performance fits within the firm’s overall philosophy and strategy Accounting information provides a record of past transactions, and also reflect management estimates and forecasts of the future Accounting information is a useful way of communicating with users, because management is likely to make more accurate forecasts of the future than those capital providers

A depiction that is an unfaithful representation of a relevant phenomenon is not decision useful, just as a depiction that is a faithful representation of an irrelevant phenomenon Irrelevance or unfaithful representation results in information that is not useful for making decisions Irrelevance means that the economic phenomenon is not connected to the decisions to be made, and unfaithful representation is that the

depiction is not connected to the phenomenon Together, relevance and faithful representation make financial reporting information decision useful

Value relevance

A variable is defined as value relevant if it exhibits the predicted association with a measure of market equity value (Holthausen and Watts, 2001) Francis and Schipper (1999) identified four approaches to study the value relevance of accounting

information: (1) the fundamental analysis view of value relevance, (2) the prediction view of value relevance, (3) the information view of value relevance, and (4) the measurement view of value relevance

(1) The fundamental analysis view of value relevance

Fundamental analysis involves determining a firm’s intrinsic value without reference

to the price at which the firm’s equity trades on the stock market (Bauman, 1996) Under this approach, financial statement information leads stock prices by capturing intrinsic share values toward which stock prices drift (Francis and Schipper, 1999) Because under this approach it is not assumed that the market reflects all the

available information at all times, it allows for an inefficient stock market Value relevance would be measured as the returns generated from implementing

accounting-based trading rules

(2) The prediction view of value relevance

The second view of value relevance focuses on the relevant variables used in

valuation and how to predict them Financial information is relevant if it contains variables used in a valuation model or assists in predicting those variables (Francis and Schipper, 1999) Information is relevant when it can be used to predict future earnings, future dividends, future cash flows, or future book values

The third and fourth views of value relevance are based on the statistical association between accounting information and prices or returns

(3) The information view of value relevance

Under this interpretation, accounting is value relevant if accounting information is used by investors when setting prices The interpretation assumes that the stock market is efficient It uses statistical association measures as an indicator to see whether investors really use the new information and causes to revise their

expectations Studies under this approach have the purpose to study the market reaction to accounting disclosure over short time periods (Beaver, 1997)

(4) The measurement view of value relevance

The measurement view of value relevance is a statistical association between

accounting information and market values or returns, particularly over a long window, which mean that the accounting information is correlated with information used by investors Value relevance is measured by the ability of financial statement

information to capture or summarize information, regardless of source, that affects share values (Francis and Schipper, 1999) Accounting information do not have to be the earliest source of information

Related literature

A variable is defined as value relevant if it exhibits the predicted association with a measure of market equity value (Holthausen and Watts, 2001) The literature about the relation between capital markets and financial statements had grown rapidly in the past three decades (Kothari, 2001) A part of this research is the change of accounting information in value relevance over time The motivation for these studies are concerns in the professional literature that financial statements have lost their value-relevance because of wholesale changes in the economy There is a shift from

an industrialized economy to a high-tech and service-oriented economy

Collins et al (1997) investigated changes in the value-relevance of earnings and book values over the 41-year period 1953-1993 using US data

They estimated yearly cross-sectional regressions for the sample period and used R²

as the primary metric to measure the value-relevance using three different models They decomposed the combined explanatory power of earnings and book values 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 They used this decomposition to investigate whether the value-relevance of accounting information has changed over time The first model examined the value relevance of earnings in a price levels regression with a three-month lag in the price (beyond the fiscal year-end) defined as:

it it

P =β0+β1 +ε

where for company i and fiscal year t, P is the price of a share three months after the

fiscal year-end, E is the earnings per share during the year

The second model examined the value relevance of book value in a price levels regression with a three-month lag in the price (beyond the fiscal year-end) defined as:

it it

P =γ0+γ1 +ε

where for company i and fiscal year t, P is the price of a share three months after the

fiscal year-end, and BV is the year-end book value per share

The third model examined the combined impact of earnings and book value in an Ohlson (1995) style regression model defined as:

it it it

it x x E x BV

P = 0+ 1 + 2 +ε

where for company i and fiscal year t, P is the price of a share three months after the

fiscal year-end, E is the earnings per share during the year, and BV is the year-end book value per share

This common component takes into account that, to some extent, earnings and book values act as substitutes for each other in explaining prices, while they also function

as components by providing explanatory power incremental to one another

The results from these models showed that the incremental explanatory power of earnings had declined over the sample period It also illustrated an increase in the incremental explanatory power of book values over time, and a slight increase in the combined explanatory power of earnings and book values over the period 1953-

1993 To further test this, Collins et al (1997) regress the R² measures on a time trend variable in the following model:

t t

R2 =φ0 +φ1 +ε

The results of this model confirmed that the incremental explanatory power of

earnings had declined, that the incremental explanatory power of book values

increased, and that there was a slight increase in the combined explanatory power of earnings and book values over time

Because they found a temporal shift in value-relevance from earnings to book values, they investigated possible explanations for this shift They examined the level of intangible intensity, the occurrence of one-time items, negative earnings, and firm

size They concluded that much of the shift in value-relevance from earnings to book values appears to be the result of the increasing frequency and magnitude of one-time items, the increased frequency of negative earnings, and changes in average firm size and intangible intensity across time

Another study that investigated changes in the value-relevance of financial

statements is the study of Francis and Schipper (1999) They used two methods to measure the value-relevance:

(1) the total return that could be earned from foreknowledge of financial statement information

(2) the explanatory power of accounting information

Both these measures are applied to samples over the period 1952-1994 using US data

The first method focuses on the market-adjusted returns which could be earned based on foreknowledge of accounting information This method calculated fifteen month market-adjusted returns to five hedge portfolios defined as:

(1) refers to the hedge portfolio formed on the basis of the sign of the change in earnings;

(2) refers to the hedge portfolio formed on the basis of both the sign and magnitude

Thiagarajan (1993) These financial signals are (1) earnings (2) inventory, (3)

accounts receivable, (4) capital expenditures, (5) gross margin, (6) sales and

administrative expenses, (7) effective tax, (8) labour cost, (9) earnings quality (use of FIFO vs FIFO), and (10) audit status; and

(5) refers to the hedge portfolio formed on predictions based on the returns-book value and earnings regression

They found that there were significant declines in the returns of three accounting hedge portfolios over the sample period The hedge portfolios which did not find a decline in returns are portfolios (3), and (4) The conclusion of Francis and Schipper (1999) from this is that there has been a statistically significant decline over time for some financial statement metrics, and for other metrics not

The second method is based on the on the explanatory power of accounting

information for measures of market value; the ability of earnings to explain annual market-adjusted returns; and the ability of earnings and book values of assets and liabilities to explain market values of equity This method examines three

contemporaneous relations between market value measures and accounting

information

The first relation examined the ability of earnings to explain market-adjusted returns (earnings relation) They regressed market-adjusted security returns on the change in earnings and the level of earnings They used the following regression for each year

in their sample period:

t t t

t t

The second relation investigated the ability of assets and liabilities to explain market equity values (balance sheet relation) This relation is based on a firm’s equity at time

t being equal to its assets at t minus its liabilities at time t:

t t t

t t

t

MV, =π0, +π1, , +π2, , +ξ ,