The Association between BVE AND MVE

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2.0 Introduction

The background of study, problem statement, research objectives and questions are established and discussed in the previous chapter. The main objective of this chapter is to review relevant past studies related to the value relevance of reported financial information. Firstly past empirical studies on value relevance of book value of equity, earnings and between earnings and operating cash flow are reviewed thoroughly and continue with the discussion of conceptual foundation together with the proposed research models adopted from past studies. At the end of this chapter, some hypotheses are developed based on the past researches.

2.1 Review of the Prior Empirical Studies

2.1.1 Association between Book Value of Equity(BVE) and Market Value of Equity (MVE)

Many studies have been conducted on the relevance between the market value of equity and both earnings and book values which affect the usefulness of financial statement. These studies are conducted by Kadri et al. (2009); Shamy and Kayed (2005); Gallizo and Salvador (2006).  Gallizo and Salvador (2006) defined that one of the main areas of empirical research in accountancy is value relevance. Value relevance is the association between market value of equity and accounting numbers (Kothari, 2001; Barth et al., 2001). It tests the relationship between market value of equity and both earnings and book values.

Most of the studies (Shamy et al., 2005; Kadri et al., 2009; Jamaluddin, Mastuki, & Ahmad, 2009; Gallizo et al., 2006) utilized the Ohlson (1995) model (OM) to investigate the value-relevance of the book values of equity of the company. Shamy et al., (2005) assessed the value relevance between market values of equity and book values to investors based on the statistical association. These authors aim to investigate whether book values of firms are value relevant and whether a change in financial reporting standards would affect the value relevance of book values. Shamy et al. has selected 31 listed firms in the Kuwait Stock Exchange to test the value relevance between book value and stock price using OM. The result showed that there is a positive and significant association between book value and market price.

Kadri et al. (2009) studied whether the book value of the firms is value relevance and whether a better quality of financial statements is available to the investors if a strong model relationship is established. Equity valuation model as suggested by OM is used to investigate the effect on value relevance of book value after the change in accounting standards. They selected data from Thomson Data Stream of property sector firms which comprises 59 companies listed on Bursa Malaysia. The data was collected from year 2002 to 2007 whereby year 2002 to 2005 is the period with old accounting standards while year 2006 to 2007 is the period for new accounting standards. The studies concluded that book value and other financial numbers are value relevance during the old accounting standards. In contrast, only book value is value relevance after the introduction of the new accounting standards. However, there are some previous studies showing mix results such as Harris and Muller (1999) and Lin and Chen (2005) as cited by Kadri et al. (2009).

Gallizo et al. (2006) studied the relevance of accounting variables (book values) to explain the influence of the book values on the evolution in the market price. The authors obtained a sample of 2164 firms from the Worldscope database which consists of US listed firms on the NYSE from year 1992 to 2000. Kothari's (1992) change-based approach was used to establish the regression equations to relate the variation in price with the changes in book value. The result showed that book value has a significant association against the evolution of market price.

Another study had been conducted in Malaysia by Pirie and Smith (2008) from Australia. The authors stated that many of the early researches are focused mainly on earnings, but trend has changed to include equity book value as an additional accounting variable. Besides, with an increasing attention on value creation, most of the firms are using residual income measures as their indicators of financial performance. Thus, the purpose of this research is to examine the relationships between market value and accounting variables in equity markets around the world whereas the finding of an empirical study is conducted in Malaysia. Three models were explained by the authors which are dividend discount model, residual income model and OM. However, only OM is adopted as their theoretical frameworks are difficult to be applied since other models required an estimate for an indefinite period of time. Therefore, in order to run the model with large samples and with minimum selection bias, all firms regardless of industry sector, financial year-end or any other conditions are taken from the Disclosure Wordscope database which covers ten years period from 1987 to 1996. Thus, the full sample in the Malaysia market involved 1,792 firms and trimmed sample only involved 1,705 firms. As a result, Pirie and Smith (2008) found that the coefficient on book value is positive and highly significant indicates that book value is value relevance and have incremental explanatory power for market value in the Malaysian market.

2.1.2 Association between Earnings (E) and MP

Shamy et al. (2005) used a valuation model provided by Ohlson (1995) to measure the value relevance between earnings and market prices to assess the usefulness of financial information to investor. This study made a comparison on the total information in the market place by using the data of listed companies in the Kuwait Stock Exchange in which earnings and market prices are available for the study period 1992-2002. Therefore, the sample consisted of 31 to 75 firms per year and the result showing that the earning are positively and significantly related to market prices and it is consistent with other findings.

Besides, Kwon (2009a) had investigated the relative and incremental value relevance of earnings in security prices which used Myers, Ohlson (1995) and Feltham and Ohlson (1995) valuation model. There were 4,865 firm year observations in the period from 1994 to 2005 which obtained from the KIS-FAS (Korea Investors Service-Financial Analysis System) and KISRI (Korea Securities Research Institute) stock databases. However, the research excluded the financial banking business firms and impairment of capital firms and the result showed that the earnings play no significant roles in security price.

However, in another Kwon (2009b) research, the researcher investigated the value relevance of earnings in security prices from 1982 to 2001 in Korean stock market that consists of 7,928 firm-year observation which uses option-style model of equity. However, the study excludes the financial banking business firms and the result showed that the value relevance of accounting earnings differed between loss firms and profit firms.

According to Kanagaretnam et al. (2009) who did a study in Canada in year 2009 on fair value accounting of financial instruments, they proved that the change in the fair value of the available-for-sale investments component of other comprehensive income is more strongly associated with market price. This is because the required firms need to report certain financial instruments at fair value and recognized the changes in their values as holding gains or losses temporarily in other comprehensive income until disposition (available-for-sale investments) which would then recognized in net income.

2.1.3 Association between Operating Cash Flow (OCF) and E

Finger (1994) studied the value relevance of earnings and operating cash flow by testing earnings' ability to predict futures operating cash flow. The author tested the ability of earnings to predict future cash flow by using eight years data from 1935-87 for 50 firms. These 50 firms accounting data were collected from the Compustat Annual Industrial File from 1968-87 and supplemented with hand-gathered annual report information from 1935-67. Time-series method was used to test the predictive ability over the entire time period. The result was then compared with out-of-sample forecast errors to obtain additional evidence of earnings' ability to forecast future operating cash flow. Finger (1994) found that earnings are a significant predictor of operating cash flow for the majority of the firms. But, out-of-sample forecast showed that earnings rarely improve cash flow forecasts as the result indicated that earnings help predicting cash flow but did not support the FASB statement that earnings are a better predictor of cash flow (Finger, 1994).

Another study had been done by Kim and Kross (2005) to investigate the relationship between earnings and operating cash flow from year 1973 to 2000. The authors adopted time series regressions model to examine the ability of earnings to predict operating cash flow over the past 28 years. Therefore, total sample of 100,266 observations were drawn from the annual Compustat industrial, full coverage, research and prices, dividends, and earnings (PDE) files running from 1972 through 2001. They found that relationship between current earnings and future cash flows has generally been strengthening over time. Kim and Kross (2005) augmented this evidence with out-of-sample forecasts of operating cash flows and increasing accounting conservatism has been taking into considerations in this research.

Ahmed and Goodwin (2006) investigated the relationship between earnings and operating cash flow in order to study the value relevance of book value and earnings. According to the authors, high quality of financial statement means value relevance. The authors also use the same model used by Kadri et al. (2009). The research found that earnings during the old accounting standards may have better prediction of operating cash flow if compared to new accounting standards one. Reasons for this finding are: (1) investors see new accounting standards as it produces a weaker balance sheet and (2) new accounting standards produce a large decline in retained earnings, which implies reduced dividend paying capability.

Relationship between earnings and operating cash flow is examined by Kadri et al. (2009) under two different financial reporting standards in Malaysia. The stronger the relationship between earnings and operating cash flow increases the value relevance and enhances the quality of financial statement. This study examines the two variables via non-market valuation model over the implementation of different accounting standards. This model was used to investigate whether earnings are relevant in explaining operating cash flow. Their results indicated that earnings have significant relationship with operating cash flow but no significant change due to the change in the financial reporting standards.

2.1.4 Changes in Value Relevance due to Changes in Financial Reporting Standard

Many studies have been conducted by past researchers to examine the value relevance of accounting numbers after the adoption of International Financial Reporting Standards (IFRS) in all over the world. Among the researches are Harris and Muller (1999), Lin and Chen (2005), Bartov, Goldberg and Kim (2005) and Lau (2010). Their findings are inconsistent from each other because the researches were done in different country. The difference of context and background of each country such as economic system, political system, rules and regulation imposed and the social cultural of the citizens could lead to the inconsistency. The following studies are organised according to the findings.

Firstly, there are some previous studies found mix results such as Lin and Chen (2005) and Harris and Muller (1999). Lin and Chen (2005) investigated the incremental value relevance of the reconciliation of accounts from the Chinese Accounting Standards (CAS) to the International Accounting Standards (IAS) by those Chinese listed companies that had issued stock A and stock B. The analysis used multiple linear regressions and consists of 415 companies that published their financial statements from year 1995 to 2000 in China and the results showed that the accounting numbers under CAS were more relevant for stock A and IAS accounting numbers were more value relevant for stock B.

Harris and Muller (1999) also found mix results. The purpose of their study is to test the value relevance of US GAAP and IFRS. They reconciled and analysed annual reports of 31 companies that met the IFRS and US GAAP requirements during 1992 to 1996. Ohlson model and earnings model were used in their study. Harris and Muller (1999) found that different models provide different results. By using Ohlson model, they found that financial statements prepared under IFRS are more value relevance than US GAAP. Besides, they also found that IFRS accounting numbers are more highly associated with price per share compared to US GAAP accounting numbers. But, when earnings model was used, they found that US GAAP accounting numbers are more highly associated with returns than IFRS accounting numbers.

Secondly, we discovered that some studies found either local standards or IFRS to be more value relevant. In Malaysia, Lau (2010) studied the value relevance of accounting information and financial reporting among firms across the three reporting periods with different levels of the IFRS adoption. The researcher used Ohlson model to test the value relevance of financial reporting and a period of 15 years (1993-2007) was selected for the analysis. The 15-year period was divided into Pre-MASB (1193-1998), Post-MASB (1999-2005) and IFRS Convergence (2006-2007). Therefore, the studt consisted 5,517 firm-year observations from the 491 public firms that were available in DataStream Advance Database which listed in the Bursa Malaysia as of 2008 and the results concluded that the IFRS is value relevant for decision making among the investors.

Bartov et al. (2005) on the other hand studied comparative value relevance under German GAAP, US GAAP or IFRS. They examined the annual reports of 417 German companies that published fully consolidated financial statement from 1998 to 2000 which obtained from the financial and industrial active and issue files of the 2000 Global Vantage. When they used linear regression model, they found that financial statement prepared under US GAAP or IFRS provided better information than financial statement prepared under German GAAP. This means that US GAAP or IFRS is more value relevant than German GAAP. This is because German GAAP has less concern on investors' interests and thus less focus in future cash flow.

By referring to these finding, question raised whether adoption of FRS is more value relevant on accounting numbers compared to previous standard.

2.2 Conceptual Foundation

Over the years, numerous past researchers have adopted the well-established Ohlson model (OM) as their theoretical framework in accounting research to examine the value relevance of share price relatively to accounting variables that are currently available in financial statement. It presents a concrete and complete framework to conceptualize how the market value relates to amount of accounting data and other information recognized or disclosed in financial statement (Ohlson, 1995). Lo and Lys (2000) commented that majority of the past studies rely on OM obtained strong linkage (high R2) between value change and accounting information. This model is also used to examine on the firm failure prediction in China (Ying & Michael, 2010).

The 2 key independent variables are book value and earnings. This is supported by the findings of Collin et al. (1997) who claimed that the joint explanatory power of earning and book value is increasing slightly over the four decades although they experienced systematic change over time. Kadri et al. (2009) have further developed the OM and proven that BE and E of Malaysian property firms are value relevance. The model shown that E and BVE offer high explanatory power which implied the BV and E contain information relevance to investors.

MVEit = a + a1Eit + a2BVEit + eit

The second model, non-market valuation model (Finger, 1994; Ahmed and Goodwin, 2006; Kadri et al. 2009) has proven that the change of accounting standard will have impact on the relationship between operating cash flows (OCF) and earnings (E). Past empirical study showed that earnings offers better prediction of future operating cash flows than current operating cash flows (Dechow, Kothari, & Watts, 1998).

OCFit = a + a1Eit + eit

Thus, these 2 models serve as the foundation for this study. The current study intends to investigate the effect of adoption of FRS 139 on value relevance of book value and earnings of Malaysian using equity market valuation model which is found by Ohlson (1995). In addition, the non-market valuation model was used to compare the relationship between earnings and operating cash flow of firms' pre- and post adoption FRS 139 samples.

2.3 Proposed Research Models

Adapted from Finger (1994); Ohlson (1995); Ahmed et al. (2006); Kadri et al. (2009)

We first adopted the Equity Valuation Model adopted from Ohlson (1995); Kadri, et al. (2009) to examine the value relevance of market value relatively to both book value and earnings as shown in Table 2.1

Where, MVEit, is the market value of firm i equity at the end of the quarter t, Eit is the earnings of the firm i for the quarter t under pre-adoption FRS 139 or post-adoption FRS 139, BVEit is the book value of the firm i equity under pre-adoption FRS 139 or post-adoption FRS 139 and eit is the error.

In Model 1a, the only different is we added two dummy variables to represent the effects of adoption of FRS 139. Eit*PFRS (earnings times FRS 139) represents the interaction between earnings and FRS 139 while BVEit*PFRS (book value equity times FRS139) represents the interaction between book value earnings and FRS 139. Pre and post adoption of FRS (PFRS) is represented by nominal value of '0' for pre-FRS 139 adoption and '1' for post-FRS 139 adoption. If there is an increase in value relevance of earnings and book value after the adoption of FRS 139, the Eit*PFRS and BVEit*PFRS will have significant p-value.

We further investigate the effect of adoption FRS 139 on value relevance of earnings and book values by separate the Model 1a into Model 1b and Model 1c. Model 1b represents value relevance of earnings and book values of firm i for pre-adoption of FRS 139 while Model 1c represents the effect after the adoption of FRS 139. Model 1b and Model 1c are shown in Table 2.1. Where, MVEit, Eit, BVEit, and eit are defined in Model 1.

In this study, we also adopted non-market valuation model stated by Finger (1994); Ohlson (1995); Ahmed et al. (2006); Kadri et al. (2009) to examine earnings' ability to predict operating cash flow. This model is represented by operating cash flow (OCF) where earnings is said to be value relevance if it has a significant relationship with OCF. This model (Model 2) is shown in Table 2.2.

Where, OCFit is operating cash flow for the firm i at the end of the quarter t, while Eit and eit are defined in Model 1. In order to investigate whether there has any changes on the relationship between operating cash flow and earnings after the adoption of FRS 139, Model 2a is developed.

Here, we added dummy variables to represents the interaction between earnings and pre-adoption FRS 139 and post-adoption FRS 139. OCFit, Eit, Eit*PFRS and eit are defined previously in Model 1 and Model 2.

Then, we further investigate the effect of adoption of FRS 139 on earnings' ability to predict operating cash flow by using Model 2b and Model 2c where, OCFit, Eit, and eit are defined previously.

2.4 Hypothesis Development

In line with the study's objective to study the effect of adoption of FRS on value relevance of reported financial information, there are a few hypotheses were developed for this research based on Kadri (2009) and other previous studies.

H1: Implementation of FRS 139 has significant effect on value relevance of book value in Malaysian Public Listed Companies (non-financial).

H2: Implementation of FRS 139 has significant effect on value relevance of earnings in Malaysian Public Listed Companies (non-financial).

H3: Implementation of FRS 139 has significant effect on relationship between operating cash flow and earnings in Malaysian Public Listed Companies (non-financial).

2.5 Conclusion

From the above literature review, most researchers conclude that adoption of different accounting standards (local standards to IFRS) could affect the relationship between market value, book value, earning and cash flow while some others found mix results. Therefore, we come out with a proposed research models and research hypotheses attempting to test whether there is a significant change in value relevance between market value, book value and earning and between earning and cash flow. Next, the discussion proceed to methodology detailing the methods to test the hypotheses.

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