The value relevance of accounting information in the Netherlands

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

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Table of contents

Abstract
Samenvatting
1. Introduction

p. 5

2. Financial statements

p. 7

3. Value relevance

p. 17

4. Related literature

p. 19

5. Research method

p. 30

5.1 Methodology

p. 30

5.2 Sample selection

p. 34

6. Empirical results

p. 35

7. Summary and Conclusions

p. 40

References

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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.

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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.

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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 (GornikTomaszewski 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.
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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.

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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).

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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).

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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.

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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
reporting is often affected by management’s estimates and judgments. It is easier for
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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.

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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.

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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 moreuseful 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.

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).

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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).

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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.
Materiality

Information is material if its omission or misstatement could influence the decisions
that users make on the basis of an entity’s financial information (FASB, 2008).
Information with material omissions or misstatements is incomplete, biased, or not
free from error.

Cost
Financial reporting imposes costs, like collecting and processing the information,
costs of verifying it, and costs of disseminating it. The benefits of financial reporting
should justify the related costs.

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

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

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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

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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.

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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 threemonth lag in the price (beyond the fiscal year-end) defined as:
Pit = β 0 + β1 Eit + ε it

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:
Pit = γ 0 + γ 1 BVit + ε it

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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:
Pit = x0 + x1 Eit + x2 BVit + ε it

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 19531993. To further test this, Collins et al. (1997) regress the R² measures on a time
trend variable in the following model:

R 2 t = φ 0 + φ1TIMEt + ε t

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

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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 onetime 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
of earnings;
(3) refers to the hedge portfolio formed on the basis of the percentage change in
cash flows;
(4) refers to the hedge portfolio formed on the basis of the fundamental values taken
from Lev and Thiagarajan (1993). They examine the ten financial signals in the
reduced model which may be useful in security valuation used in Lev and
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.

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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:

R j ,t = ρ 0,t + ρ1,t ΔEARN j ,t + ρ 2,t EARN j ,t + ν j ,t

Where R j ,t is the cumulative market-adjusted return on security j over the 15-month
period ending 3 months following fiscal year t; ΔEARN j ,t is the firms j’s earnings
before extraordinary items in year t minus its earnings in year t-1, deflated by the

market value of equity at the beginning of fiscal year t; EARN j ,t firms j’s earnings
before extraordinary items in year t, deflated by the market value of equity at the
beginning of fiscal year 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:

MV j ,t = π 0,t + π 1,t ASSETS j ,t + π 2,t LIABS j ,t + ξ j ,t

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where MV j ,t is the per share market value of equity securities of firm j at the end of
fiscal year t; ASSETS j ,t is the per share book values of firm j’s total assets at the end
of fiscal year t; and LIABS j ,t is the per share book value of firm j’s total liabilities at
the end of fiscal year t.

The third relation investigated the ability of book values and earnings to explain
market equity values (book value & earnings relation) defined as:

MV j ,t = δ 0,t + δ 1,t BV j ,t + δ 2,t EARN j ,t + ξ j ,t

where BV j ,t is the per share book value of equity for firm j at the end of fiscal year t.

The estimated coefficients of the relation between market and accounting measures
are all significant at the .001 level for the earnings relation, balance sheet relation,
and the book value & earnings relation. The over time patterns of the explained
variability measures show a distinct decrease in the adjusted R² from the earnings
relation, a distinct increase in the adjusted R² from the balance sheet relation, and a

less obvious upward trend in the adjusted R² from the book value and earnings
relation.
Additional regressions of the R² on a time trend variable are also used in this study.
The authors found that, consistent with Collins et al. (1997), earnings declined in
value relevance over the sample period, while both the balance sheet and combined
earnings and book values over time approaches slightly increased.

Lev and Zarowin (1999) also investigated the declining relevance of accounting
information over time, specifically they examined the changes over time in the
informativeness of earnings, cash flows, and book values. They investigated changes
in the value relevance of accounting information over the 20-year period 1977-1996,
using US data.

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Lev and Zarowin (1999) used three models. Their first analysis examined the
usefulness of reporting earnings, using a cross-sectional regression to estimate the
association between annual stock returns and the level and change of earnings. This
is defined as:

Rit = α 0 + α 1 Eit + α 2 ΔEit + ε it

where Rit is the firm i’s stock return for fiscal year t, Eit is the reported earnings
before extraordinary items of firm i in fiscal year t, and ΔEit is the annual change in
earnings: ΔEit = Eit - Eit −1 , proxying for the surprise element in reported earnings.

Their second model splits earnings into cash flow and accrual components and is
defined as:

Rit = α 0 + α 1CFit + α 2 ΔCFit + α 1 ACCit + α 2 ΔACCit + ε it
where Rit is the firm i’s stock return for fiscal year t, CFit and ΔCFit are the cash flow
from operations and the yearly change in cash flows from operations, respectively,
and ACCit and ΔACCit are the annual reported accruals and the change in annual
accruals, where accruals equal the difference between reported earnings and cash
flows from operations.

The third model is an Ohlson model similar to the third model used in Collins et al.
(1997) study which examined the combined impact of earnings and book value in a
regression model defined as

Pit = α 0 + α 1 Eit + α 2 BVit + ε it
where Pit is the share price of firm i at end of fiscal year t, Eit is the earnings per
share of firm i during year t, and BVit is the book value per share of firm I at the end
of year t.

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For model 1, the association between stock returns and earnings, as measured by
R², had been declining for the sample period: for the first ten years R²s of 6-12%, and
for the last ten years of the sample R²s of 4-8%. This decrease is statistically
significant, which is measured with a regression of the annual R²s on a time trend
variable similar to those employed in Collins et al. (1997).
Another perspective on the usefulness of reporting earnings is provided by the
earnings response coefficient (ERC), defined as the sum of the slope coefficients of
the level and change of earnings ( α1 + α 2 in regression 1). This measure reflects the
average change in the stock price associated with a dollar change in earnings. A low
slope coefficient means that the earnings are not informative, and a high slope
coefficient means that earnings are largely informative (a large stock change is

associated with reported earnings).
The estimated ERC’s have been decreasing over the sample period, from a range of
0.75-0.90 in the first ten years to 0.60-0.80 in the last ten years. This decrease is also
statistically significant, which is measured with a regression of the annual R²s on a
time trend variable. This evidence of the ERC’s complements the inferences based
on the declining R²s.

The results of model 2 indicated that the value relevance of cash flows declined over
the sample period. The association between stock returns and cash flows, as
measured by R², had been declining for the sample period: for the first ten years R²s
of 5-12%, and for the last ten years of the sample R²s of 3.5-7%. This decrease is
statistically significant, which is measured with a regression of the annual R²s on a
time trend variable.
Similarly to the ERC in model 1, the combined slope coefficients of the level and
change of cash flows ( α1 + α 2 in regression 2), also tend to decrease over time.

The results of model 3 are similar to the first two models. The association between
stock prices and book values + earnings declined over the sample period: in the late
70’s R²s of 0.90, to 0.8 and higher in the 1980s, to 0.50-0.60 in the 1990s. A
regression of the yearly R²s on a time trend variable also shows a negative
coefficient and is statistically significant.

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