Value Relevance of Accounting and Financial Information - Literature review Example

Value Relevance (Name of the student) (Course Tittle) (Name of the professor) (Date) Introduction Since the study of Ball and Brown (1968) in which they explore and investigated the relationship between the accounting earnings and the stock returns, there are several studies which have expounded on their findings. Study by Ohlson (1995) expanded the initial study by adding the market earnings to measure value relevance which was a new idea and concept in the accounting information. Firms Value is normally derived from the expected market value of the company performance (Barth and Clinch 2001). Accounting information usually provides the necessary information for the market participants to form their opinions and expectation. The equity book value usually represents the company past performance and the company current earnings are usually indicative of the future performance by the organization and the measurements are commonly used by the investors in firm valuation (Barth and Clinch 2001). Brimble and Hodgson (2007) states that accounting information has the ability in influence and affecting the relevance it has in determining the firm’s actual value. The firms earning figures can be manipulates by the people who are preparing them to meet their own desired needs hence their reliability and usefulness are sometimes questionable by the investors and the users of such information. Generally Accepted accounting principles (GAAP) normally allows some degree of freedom in reporting more so in accrual concept of reporting the earnings, the managements have the chances of exploiting this freedom (Brimble and Hodgson 2007). The degree of exploitation increases when the managers have the incentives to manipulate the accrual concept of accounting set by GAAP as they always aspire to reach a specific earning target. The idea behind the accrual concept is that is allows the managers and the people who are preparing financial statements to adjust cash flows to better reflects the performance and position of the company, with this line, accrual concept is normally used to reflect or signal market performance of a firm (Brimble and Hodgson 2007). In situations where managers have opportunistically manage and control a companies earnings, the earning measures is not normally reliable and can not be used to indicate the company financial performance and such behavior have the ability of reducing the usefulness and relevance of accounting information. The problem to market participants is on how to identify situations when such accrual concept have been manipulated and does not reflect the actual firm’s financial positions (Ota 2010). An information can be termed as relevant when they influences the user decision and by helping the users of such information to form a predictive ideas based on the past information and confirm such information’s too (Barth and Clinch 2001). Information is said to be reliable when such information can be dependent upon and faithfully and truthfully represent it without bias and undue error, the transactions of the events that it actually purports to represent. The term value relevance has several definition, Barth et al (2008) defines value relevance as a research which examines the relationship between the accounting information amount and the equity market value. Francis and Schipper (2010) give four different ways and methods of explaining and interpreting the construct value relevance. First they define the value relevance as the influence which financial information is having on stock prices through indicating the intrinsic share value towards which share prices shift (Francis and Schipper 2010). Secondly, the financial information is value relevant if it contains the variables used in the accounting and valuation model and also assists in predicting those variables. The third interpretation defines value relevance as the ability of the accounting and financial statement information to capture and have information which can be used to determine the firm’s actual value. Lastly the value relevance can be interpreted as accounting information which can directly used by investors to predict share earning of the stock market and company value (Francis and Schipper 2010) Literature Review There are several studies which have examined the importance of earnings and book value on the stock prices. Portfolio managers and active stock investors always look into the company financial statements analysis in order to ascertain the actual firms’ value. The investors are interested in knowing the companies net worth so that they can evaluate the respective stock prices of those firms (Barth et al 2008). One of the major objectives of financial reporting according to International financial reporting standards is to provide equity investors with information which will enables them to accurately estimate the company net worth. The content information in accounting numbers in relation to ascertaining security prices and security returns is very crucial in accounting and finance (Barth et al 2008). The unexpected earnings of a firm are directly related to the abnormal stock returns. The core objective and purpose of the financial statement of any company is to give true and fair view of the firms operations and the financial positions (Pathiriwasam 2010). Pathiriwasam, (2010) further states that, in case there is no relationship between the companies’ value and the figures in the financial statements, then that particular financial statements can be said to having no value relevance. If the said financial statements have typically lost their value relevance, then no one will be actually get interested with them, therefore, we can say that the investigation of value relevance of the given accounting and financial information is just but a direct check of the reliability and validity of the accounting and financial reporting standards as reflected in the published company financial statements. This investigation will also further reveal the claims of agency theory which claims that not always do managers try to maximize the shareholders value (Thomsen and Pedersen 2000). The value relevance do empirically investigates whether the goals and objecting of accounting and financial information preparation are met or not. It also helps to know if accounting information is relevant to investors who are interested in knowing and estimating the company value. The empirical research in relation between capital markets and financial statements are generally called capital market based accounting research (CMBAR) (Thomsen and Pedersen 2000). The relationship between ownership concentration as one of the mechanism which influences the decisions by managers and the value relevance of accounting information is something which is worth investigating (Thomsen and Pedersen, 2000). Some of the researchers also argue that big companies financial statements are more relevant than the financial statements of small companies which in most cases contain scanty information. This study is therefore intended to examine relevant literature review of the value relevance of accounting information to investors. Most of the literature on value relevance in early days is coming from United States. Hayn (1995) as quoted by Thomsen and Pedersen, (2000) in his study examines the value relevance of United States Stock market earnings. The study was analyzing the returns on stock between the year 1962 and 1990, in his findings, he found that there are positive relationship between the earnings and the return on stock. The finding also reveals that the firms which are making high profits and their stock prices are highly correlated with their returns. Barth et al (2008) in their investigation also found that the explanatory power of earnings the actual book value variables are systematically varies across industries. Frankel and Lee (1998) investigated the relationships between the share prices and the accounting variables using data from over 20 different countries. They found that both the current book value in the financial statements, the current earnings from the companies and the earnings which have been forecasted can explicitly explains the share price variability. In there study Chandra and Ro (2008) found that the combined value relevance of earnings and revenues has been static and that the value relevance of earnings has reduced while at the same time the impact of price of revenues has not yet declined. The same findings were echoed by Jenkins et al (2009) who further found that the value relevance of earnings is normally higher during economic contraction more so when the estimated future earnings expectations is higher during expansion period. In his study of value relevance of stock earnings, the company book value and the Pathirawsm (2010). He sampled over 129 companies from over six industries and sectors. The study found that earnings book value, earnings and return on equity normally have positive value relevance on the company market value of its securities and stocks. The value earning relevance have been improved by increased in new technology more so on accounting based earnings and information on issues like earning per share and return on equity in different parts of the world and Sri Lanka in particular. Jenkins et al (2009) in there study found that there is a stronger price-earnings relation in the countries which have common backgrounds and the research findings was mostly attributed to the demand by investors of timely financial statements and accounting statements from the listed companies. The use of accrual accounting concept in reporting of company earnings has also been reported has having negative relationship with the value-relevance to the financial statements more so in the countries which have not adopted International financial reporting standards (IFRS) and also weak shareholders protection policy. Jenkins et al (2009) clearly showed that earnings are low in quality due to both economic and political interference on reporting and accounting information. Agency influences also have a negative influence of the accounting information outcome and the returns from shareholders equity. Price and return model Price and return model are two commonly used valuation models in valuation theory. In most cases, these models give inconsistence result despite them originating from one background. In the absence of well developed valuation theories, return models is considered superior to the price model, though the two models are complimentary to each other and there are also instances where price model dominates the return model (Barth and Clinch 2001). In economic terms the two models are equal but return model is quite less problematic to use compared to price model. There are several criticisms concerning the price model though this can not deny it a chance to exist and prevail (Barth and Clinch 2001) Information concerning value relevance gives different reactions in different sectors. Some studies using data from United States stock market using return and price model, they found that the market earnings and the book value are largely irrelevant in sectors of wireless communication (Thomsen and Pedersen 2000). There is incremental decline in the value earning relevance in communication sector while the book value increases in the industrial and service sector, there is generally weak relationship between these accounting variables and the company market value (Brimble and Hodgson 2007). In applying price model in the US companies and German industrial and service companies, book value relevance is more relevant in United Kingdom service and industrial sectors and also in Australian companies. The value relevance in the book value has also been noted to be more relevant in Korean industrial and service sector while irrelevancy in value relevance has been noted in the Indonesia sectors (Thomsen and Pedersen 2000). A study in seven Asian countries found that there is relationship between book value relevance and the company earnings. The agency theory gives the explanation of the relationship between managers and business owners. It is generally assumed and accepted that the owners of business wish and aim at maximizing profits and wealth at the same time business managers may have different interest al together in business which included high compensation; low effort levels preferences of expenses among other preferences (Brimble and Hodgson 2007). Ownership concentration is therefore one of the most important pre-requisites to influence on managers activities (Brimble and Hodgson 2007). Price to earning ratio and ownership concentration has a positive correlation. Ownership concentration also has positive correlation with the market –to- book value of most equity as well as the business actual return on asset. Ownership identities also have greater influence and are very important for the company strategy and performances. Firm size is another important factor which influences the value relevance of accounting information where it is widely believed that the value relevance of large companies is normally higher than the value relevance of small firms. The value relevancy of earnings and the book value was examined by Brimble and Hodgson (2007) in Australian Stock Exchange where they found low value relevance of earnings and book value combined. They further found that the explanatory power for small companies is normally higher compared to larger firms Financial and accounting statements normally have several applications in the field of management and decision making process (Ohlson 1995). Traditional financial theory states that the theoretical value of company equity (EV) is the present value of all future dividends and to the free fresh cash flows to equity (FCE). The model further states that the value of a given company equity is equal to the companies book value added to the discounted value of future residual income of the company (Ohlson 1995). The Company abnormal income can be defined as the difference between the accounting income and the required actual return on the book value of the equity and this figure is normally computed using the company market based cost of capital. The model is mostly employed by equity investors to estimate the company’s net worth. For accounting and financial information to be value relevant, the accounting figures must be to larger extend related to the company current value as recommended by Generally Accepted Accounting Principles (GAAP) (Jenkins et al 2009). In case there is no relationship between accounting information and the accounting figures of the company value, then the accounting information does not qualified to be termed as value relevance therefore financial reporting is not capable of fulfilling it’s primary objective as set by GAAP. The value relevance of the actual book value normally increases with increase to price model and decreases with decline to return model (Jenkins et al 2009) Bibliography Ball, R., and P. Brown (1968) An Empirical Evaluation of Accounting Numbers. Barth, M. E., and G. Clinch (2001). Scale Effects in Capital Markets-Based Accounting Research. Working paper, Stanford University Barth, M. E., W. H. Beaver, and W. R. Landsman. (2008). Relative Valuation Roles of Equity Book Value and Net Income as a Function of Financial Health. Journal of Accounting and Economics 25: Barth, M.E., Beaver, W.H., & Landsman, W.R. (1998). Relative valuation roles of equity book values and net income as a function of financial health. Journal of Accounting and Brimble, M., & Hodgson, A. (2007). On the intertemporal value relevance of conventional financial accounting in Australia. Accounting and Finance, 47(4) Chandra, U., & Ro, B. T. (2008). The role of revenue in firm valuation. Accounting Horizons, Economics, 25(1) European firms: The importance of owner identity. Strategic Management Journal, 21(6), Francis, J . & Schipper, K. (2010). Have financial statements lost their relevance? Journal of Accounting Research 37 Frankel, R., & Lee, C. M. C. (1998). Accounting diversity and international valuation. Working paper. University of Michigan and Cornell University Jenkins, D. S., Kane, G. D., & Velury, U. (2009). Earnings conservatism and value relevance across the business cycle. Journal of Business Finance & Accounting, 36(9). Journal of Accounting Research 6 Kothari SP. (2001) Capital markets research in accounting. J Account Econ. Ohlson, A.J. (1995). Earnings, book values and dividends in security valuation. Contemporary Accounting Research, Ota, K. (2010). The value relevance of management forecasts and their impact on analysts’ forecasts: Empirical evidence from Japan. Abacus, Pathirawasam, C. (2010). Value relevance of accounting information: evidence from Sri Lanka. International Journal of Research in Commerce & Management, 8(1), 13-20. Thomsen, S., & Pedersen, T. (2000). Ownership structure and value of the largest Read More