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EXPLORING THE RELATIONSHIP BETWEEN MARKET VALUES AND ACCOUNTING NUMBERS OF FIRMS

LISTED IN AN EMERGING MARKET

Eko Suwardi

California State University Fresno (M.S. Accounting) 1994 Gadjah Mada University (Sarjana / BA. Accounting) 1987

Principal Supervisor: Professor Roger Willett Associate Supervisor: Dr Malik Mirza

A dissertation submitted for the degree of Doctor of Philosophy within the School of Accountancy Faculty of Business

Queensland University of Technology

February 2004

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Keywords: Capital market research, Value relevance, Fundamentals, Time series analysis, Cointegration, Error Correction Models, Indonesian financial market and Emerging markets.

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Abstract

Studies of the relationship between market values and accounting numbers have long

been a part of an established theme in capital markets research (CMR). These studies

have taken various forms, most being conducted on a cross sectional basis, tied

closely with the assumptions of equilibrium behaviour and efficient markets.

Explanatory variables for market value have been dominated by firm-specific

variables without incorporating macroeconomic variables. Recently, however, some

studies have employed macroeconomic variables and dynamic specification in

assessing the relationship between market values and accounting numbers (e.g. Bilson

et al. 2001, Nissim and Penman, 2003, and Willett, 2003).

The objective of this thesis is to investigate the nature of the relationship between

share prices and accounting numbers on the Jakarta Stock Exchange for the period

1992-2002, using dynamic modelling principles in addition to the more usual cross

sectional analysis. The approach to regression modelling (general-to-specific strategy)

incorporated in this thesis relies less heavily than most CMR on prior economic

theories of equilibrium behaviour. Apart from these novel aspects of approach and

method, the study also provides valuable information about the emerging financial

markets of Indonesia.

The results of this thesis show that cointegration and the accompanying equilibrium

correction relationship between market and book values for firms listed on the Jakarta

Stock Exchange (JSX) can often be identified using accounting and macroeconomic

regressors. The models are typically more informative, plausible and consistent than

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cross sectional models and are useful in interpreting the context in which the market to

book relationship exists in Indonesia. A possibly surprising result is that in Indonesia,

compared to similar models estimated using US data, the book value of net assets

seems to have a stronger relationship with market value. This may be a function of the

relative importance of financial statements as a source of information on the JSX.

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Table of contents CHAPTER 1 INTRODUCTION ......................................................................................................1

1.1 PURPOSE OF THE STUDY..........................................................................................................1 1.2 PRIOR RESEARCH ....................................................................................................................2 1.3 INDONESIAN CAPITAL MARKET AND ACCOUNTING..................................................................5 1.4 RESEARCH QUESTION .............................................................................................................7 1.5 SIGNIFICANCE OF THE STUDY..................................................................................................7 1.6 RELATION TO PREVIOUS RESEARCH ........................................................................................8 1.7 THE MAIN FINDINGS OF THIS THESIS........................................................................................9 1.8 PLAN OF THIS THESIS ............................................................................................................10 1.9 SUMMARY ............................................................................................................................12

CHAPTER 2 LITERATURE REVIEW ........................................................................................13 2.1 INTRODUCTION .....................................................................................................................13 2.2 FUNDAMENTAL ANALYSIS ....................................................................................................13

2.2.1 Cross sectional studies of fundamentals in mature financial market economies ............14 2.2.2 Cross sectional studies of fundamentals in emerging financial market economies.........25 2.2.3 Time series studies of fundamentals in mature financial markets ...................................31 2.2.4 Time series studies in emerging markets.........................................................................38

2.3 STOCK MARKET REACTION STUDIES......................................................................................41 2.3.1 Stock market reaction studies in mature financial market economies.............................41 2.3.2 Stock market reaction studies in emerging market economies ........................................47

2.4 ISSUES RAISED BY CMR .......................................................................................................48 2.5 RESEARCH INTO THE INSTITUTIONS AND FINANCIAL SYSTEM OF EMERGING MARKETS .........51

2.5.1 Institutional Foundations ................................................................................................52 2.5.2 Corporate Governance....................................................................................................57 2.5.3 Corporate Financial Reporting in the EFM environment...............................................58

2.6 SUMMARY ............................................................................................................................60 CHAPTER 3 THE JAKARTA STOCK EXCHANGE AND ITS INSTITUTIONAL ENVIRONMENT..................................................................................................................................61

3.1 THE JAKARTA STOCK EXCHANGE.........................................................................................61 3.1.1 The History of the Jakarta Stock Exchange ....................................................................61 3.1.2 Recent Development of the Jakarta Stock Exchange.......................................................62 3.1.3 Market Structure .............................................................................................................64 3.1.4 The JSX Trading System..................................................................................................64 3.1.5 Capital Market Supporting Institutions and Professionals .............................................66

3.2 COMPANY LAW AND CORPORATE SECTOR.............................................................................67 3.2.1 Company Law..................................................................................................................67 3.2.2 Public Companies ...........................................................................................................67 3.2.3 Shareholder rights...........................................................................................................68 3.2.4 Corporate sector .............................................................................................................69

3.3 MACROECONOMIC ENVIRONMENT........................................................................................70 3.3.1 Foreign Exchange Rate...................................................................................................71 3.3.2 Interest Rate ....................................................................................................................71 3.3.3 Money Supply and Domestic Credit ................................................................................72 3.3.4 Inflation...........................................................................................................................72 3.3.5 Gross Domestic Product .................................................................................................73

3.4 STUDIES OF MACROECONOMIC INDICATORS AND SHARE PRICE ...........................................73 3.5 SUMMARY ............................................................................................................................75

CHAPTER 4 THEORETICAL FRAMEWORK..........................................................................76 4.1 INTRODUCTION .....................................................................................................................76 4.2 ISSUES ARISING FROM THE LITERATURE REVIEW...................................................................77

4.2.1 Variable identification.....................................................................................................77 4.2.2 The functional form suggested from prior studies...........................................................80 4.2.3 Dynamic Specification.....................................................................................................81 4.2.4 Nature of the theory underlying CMR.............................................................................83 4.2.5 Replication ......................................................................................................................85 4.2.6 Context ............................................................................................................................86

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4.3 FRAMEWORK ........................................................................................................................87 4.3.1 Relationship of framework to issues raised by prior research ........................................87 4.3.2 General-to-specific approach..........................................................................................90 4.3.3 Basic model formulation .................................................................................................93

4.4 SUMMARY ............................................................................................................................95 CHAPTER 5 RESEARCH METHOD...........................................................................................96

5.1 INTRODUCTION .....................................................................................................................96 5.2 SAMPLE OF FIRMS AND VARIABLE DEFINITIONS ....................................................................96

5.2.1 Sources of data and selection criteria .............................................................................96 5.2.2 Variable definitions .........................................................................................................98

5.3 REPLICATION PROCESS .......................................................................................................102 5.4 MODEL CONSTRUCTION ......................................................................................................103

5.4.1 Exploratory data analysis .............................................................................................104 5.4.2 Benchmarking of model results .....................................................................................106 5.4.3 General-to specific modelling: Incorporating macro-economic data...........................108

5.5 ANALYSIS OF RESULTS IN CONTEXT....................................................................................109 5.6 SUMMARY AND CONCLUDING REMARKS ON METHOD .........................................................110

CHAPTER 6 RESULTS................................................................................................................111 6.1 INTRODUCTION ...................................................................................................................111 6.2 REPLICATION ......................................................................................................................111

6.2.1 Graham and King (2000) ..............................................................................................112 6.2.2 Chen et al. (2001)..........................................................................................................121 6.2.3 Results ...........................................................................................................................123

6.3 TIME SERIES ANALYSIS .......................................................................................................127 6.3.1 Descriptive statistics .....................................................................................................127 6.3.2 Basic assessment of dynamic characteristics of quarterly book data ...........................131 6.3.3 Equilibrium correction modelling .................................................................................134

6.4 BENCHMARKING THE GK AND CHEN ET AL. MODELS AGAINST AN ECM MODEL...............140 6.4.1 ECM model....................................................................................................................141 6.4.2 GK model ......................................................................................................................146 6.4.3 Chen et al. Model ..........................................................................................................148

6.5 GENERAL-TO-SPECIFIC MODELLING....................................................................................151 6.6 EXTENSIONS: ALTERNATIVE FUNCTIONAL FORMS FOR ECMS ............................................159

6.6.1 Single firm .....................................................................................................................159 6.6.2 Aggregated time series (59 firms) .................................................................................160

6.7 SUMMARY OF RESULTS .......................................................................................................161 CHAPTER 7 DISCUSSION AND ANALYSIS...........................................................................163

7.1 INTRODUCTION ...................................................................................................................163 7.2 IMPLICATIONS OF RESULTS FOR ISSUES RAISED IN PRIOR RESEARCH ...................................164 7.3 FIRM LEVEL ANALYSIS........................................................................................................169

7.3.1 PT. Unilever Indonesia .................................................................................................169 7.3.2 PT. Hero Supermarket...................................................................................................177

7.4 THE INDONESIAN ECONOMY...............................................................................................181 7.4.1 Efficiency of the JSX and the impact of changes in accounting standards....................183 7.4.2 The Indonesian economy 1991-2002.............................................................................185

7.5 SUMMARY ..........................................................................................................................187 CHAPTER 8 CONCLUSIONS.....................................................................................................189

8.1 INTRODUCTION ...................................................................................................................189 8.2 SUMMARY OF THE THESIS ...................................................................................................190 8.3 CONTRIBUTION OF THE THESIS............................................................................................192 8.4 LIMITATIONS AND FUTURE RESEARCH ................................................................................193

REFERENCES....................................................................................................................................195 APPENDIX A ......................................................................................................................................206 APPENDIX B ......................................................................................................................................218 APPENDIX C ......................................................................................................................................229

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Index of Tables TABLE 3-1 MOST ACTIVE STOCKS BY MARKET CAPITALISATION (SOURCE: CHWSDCE, 2002). .............63 TABLE 4-1 FRAMEWORK OF RESEARCH DESIGN .......................................................................................88 TABLE 5-1 NUMBER OF FIRMS IN SAMPLE ................................................................................................98 TABLE 6-1 MEANS, STANDARD DEVIATIONS AND CORRELATION MATRIX FOR GK PRICE MODEL ..........113 TABLE 6-2: REGRESSIONS OF SHARE PRICE ON BOOK VALUE OF NET ASSETS AND RESIDUAL EARNINGS BY

YEAR AND FOR THE POOLED SAMPLE............................................................................................117 TABLE 6-3 INCREMENTAL AND RELATIVE EXPLANATORY POWER OF BOOK VALUE AND RESIDUAL

EARNINGS BY YEAR (ALL R2S ARE ADJ. R2) ................................................................................118 TABLE 6-4 MEANS, STANDARD DEVIATIONS AND CORRELATION MATRIX FOR THE CHEN ET AL. MODEL

.....................................................................................................................................................122 TABLE 6-5 REGRESSIONS OF SHARE RETURNS ON EARNINGS/PRICE AND CHANGE IN EARNINGS/PRICE BY

YEAR AND FOR THE POOLED SAMPLE ............................................................................................124 TABLE 6-6 MEANS, STANDARD DEVIATIONS AND CORRELATIONS MATRIX OF THE DATA FOR THE

INVESTIGATIVE TIME SERIES ANALYSIS ........................................................................................129 TABLE 6-7 ADF TESTS ON INDIVIDUAL FIRM PRICE AND BOOK VALUE DATA.........................................133 TABLE 6-8 THE COINTEGRATION TESTS ON INDIVIDUAL FIRMS ..............................................................135 TABLE 6-9 SUMMARY EQUILIBRIUM CORRECTION TERM STATISTICS FOR............................................137 TABLE 6-10 ECM COEFFICIENT ESTIMATES AND SUMMARY INFERENTIAL STATISTICS FOR ROLLING

CROSS SECTION AND POOLED SAMPLES.........................................................................................143 TABLE 6-11 GK MODEL COEFFICIENT ESTIMATES AND SUMMARY INFERENTIAL STATISTICS FOR ROLLING

CROSS SECTION AND POOLED SAMPLES.........................................................................................146 TABLE 6-12 CHEN ET AL. MODEL COEFFICIENT ESTIMATES AND SUMMARY INFERENTIAL STATISTICS FOR

ROLLING CROSS SECTION AND POOLED SAMPLES..........................................................................149 TABLE 6-13 ECM ESTIMATED ON POOLED DATA SET INCLUDING MACRO-ECONOMIC VARIABLES ........154 TABLE 6-14 COMPARISON OF ECTS IN MODELS INCLUDING AND EXCLUDING MACRO-ECONOMIC

VARIABLES ...................................................................................................................................155 TABLE 7-1 LISTING HISTORY OF PT. UNILEVER INDONESIA ..................................................................174 TABLE 7-2 COEFFICIENT ESTIMATES AND SIGNIFICANCE LEVELS – ECM FOR PT. UNILEVER................175 TABLE 7-3 LISTING HISTORY OF PT. HERO SUPERMARKET ...................................................................178 TABLE 7-4 COEFFICIENT ESTIMATES AND SIGNIFICANCE LEVELS – ECM FOR PT. HERO .......................179 TABLE 7-5 DISEQUILIBRIUM CORRECTION AND LONG RUN BVPS COEFFICIENTS FOR POOLED CROSS

SECTION DATA..............................................................................................................................184

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Index of Figures FIGURE 6.1 TIME SERIES OF AVERAGE SHARE PRICE AND BOOK VALUE: POOLED CROSS SECTION SAMPLE

1993-2001....................................................................................................................................114 FIGURE 6.2 TIME SERIES OF INCOME POOLED CROSS SECTION SAMPLE 1993-2001.................................115 FIGURE 6.3 HISTOGRAM, SCATTER PLOT, AN PARTIAL REGRESSION PLOT............................................121 FIGURE 6.4 HISTOGRAM, SCATTER PLOT AND PARTIAL REGRESSION PLOT.............................................126 FIGURE 6.5 DESCRIPTIVE STATISTICS OF TIME SERIES SAMPLE DATA .....................................................130 FIGURE 6.6 PERFORMANCE GRAPHICS FOR ECM MODEL OF UNVR.....................................................138 FIGURE 6.7 RECURSIVE GRAPHICS FOR THE ECT IN THE ECM FOR UNVR ..........................................138 FIGURE 6.8 PERFORMANCE GRAPHICS FOR ECM BASED ON BOOK VALUES USING .................................139 FIGURE 6.9 SCATTER PLOT OF CHANGE IN PRICE AGAINST LAGGED PRICE IN ECM MODEL – POOLED DATA

.....................................................................................................................................................142 FIGURE 6.10 GRAPHICAL ANALYSIS OF RESIDUALS IN ECM ON POOLED DATA .....................................145 FIGURE 6.11 GRAPHICAL ANALYSIS OF RESIDUALS IN GK MODEL ON POOLED DATA.............................148 FIGURE 6.12 GRAPHICAL ANALYSIS OF RESIDUALS IN CHEN ET AL. MODEL ON POOLED DATA ..............150 FIGURE 6.13 DESCRIPTIVE TIME SERIES BEHAVIOUR FOR MACRO-ECONOMIC VARIABLES .....................153 FIGURE 6.14 PERFORMANCE GRAPHICS FOR ECM BASED ON BOOK VALUES AND MACRO-ECONOMIC

USING AGGREGATE TIME SERIES SAMPLE......................................................................................155 FIGURE 6.15 PERFORMANCE GRAPHICS FOR ECM ON THE AGGREGATED TIME SERIES FOR THE SAMPLE OF

59 FIRMS.......................................................................................................................................157 FIGURE 6.16 FORECASTS USING ECM DERIVED BY PCGETS AND BASED SOLELY UPON MACRO-ECONOMIC

VARIABLES ...................................................................................................................................158 FIGURE 6.17 AN ECM COMPUTED FOR UNIC BASED UPON USING ONLY LOGS OF BOOK VALUES ..........160 FIGURE 7.1 : PT UNILEVER INDONESIA - COMPARISON OF TIME SERIES DATA FOR PRICE ......................171 FIGURE 7.2 PT UNILEVER INDONESIA: COMPARISON OF ECMS ............................................................173 FIGURE 7.3 PRICE AND BVPS PT HERO SUPERMARKET......................................................................178 FIGURE 7.4 PERFORMANCE GRAPHICS FOR LOGARITHMIC ECM CONTAINING MACRO-ECONOMIC

VARIABLES – PT HERO SUPERMARKET. .......................................................................................180 FIGURE 7.5 MAJOR EVENTS OVER SAMPLE PERIOD................................................................................182 FIGURE 7.6 EXPLANATORY POWER (R2) OF OHLSON, CHEN ET AL. MODELS AND ECM .........................183 FIGURE 7.7 ACTUAL AND PREDICTED BEHAVIOUR OF CHANGE IN PRICE BASED UPON ECM ..................186

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ACKNOWLEDGEMENTS

I would like to extend my gratitude to Professor Roger Willett, my principal

supervisor, who has excellently directed and supported me during my study in the

Ph.D. program and especially in the writing up of this thesis. My gratitude is also

forwarded to Dr. Malik Mirza, for his long standing support and encouragement.

My thanks to Prof. Dr. Zaki Baridwan, Dr. Suwardjono and Dr. Supriyadi from the

Faculty of Economics in Gadjah Mada University for their support and QUE Project

for the scholarship.

I would like to thank Professor Peter Little, Associate Professor Chris Ryan,

Associate Professor Peter Best, Dr. Majella Percy, Mr. Steve Marsden, Dr. John

Sweeting, Mr. Don Abel, Dr. Conor O’Leary, Associate Professor Jenny Goodwin and

Dr. Janet Mack, your encouragement and kindness made me feel at home during my

time at QUT.

My deep appreciation is also extended to my fellow Ph.D students Muhammat S.

Hasan, Steve Su, Victoria Clout, Teruyo Omura and Chun Wei Huang for their

genuine friendship and support. The same appreciation is also forwarded to Mas

Taufiq, and Mas Icha from the Jakarta Stock Exchange, Mas Untung and Dik

Mangkun for their assistance during the data collection step.

Gina, Trina and Rhonda, Kylie and Thu thank you very much for your help during my

studies here at the school of Accountancy.

Lastly I would like to thank my parents and family Bapak Darmowasito, Simbok

Satirah, Bapak Piran, Ibu Siti Aminah, my parents in law (Alm) Bapak R. Rio

Prodjosaputro, and Ibu Asminah Prodjosapoetro, all my sisters and brothers. My

deepest thanks to my family, Ning, Annisa, and Qori for their patience, love and

support. Alhamdulillahirabbil’alamiin.

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Chapter 1 Introduction

1.1 Purpose of the study The objective of this study is to investigate the nature of the relationship between

functions of accounting numbers and functions of stock prices on the Jakarta Stock

Exchange (JSX). An important variant of this type of research has become known in

the literature as relating to the ‘value relevance of accounting numbers’. Financial

statements are widely used by stakeholders to assess the economic value of firms on

the assumption that accounting numbers have a certain relationship with equity market

values. However, the nature of the relationship between accounting data and market

values of the firms for this purpose, particularly in emerging markets, has yet to be

determined with any degree of certitude.

Emerging market studies are gaining importance in accounting and finance studies for

a number of reasons (Bruner et al. 2002). First, there is no generally accepted model

for share price valuation in emerging markets. Second, emerging markets are

different from developed markets in a number of respects: for instance, transparency,

liquidity, level of corruption, volatility, governance, taxes and transaction costs. Third,

the flow of capital into, and the growth of investor numbers in, emerging markets have

been very substantial.

Indonesia, as one of the emerging markets in South East Asia has some characteristics

that make its capital market an interesting case for investigation. It is one of the largest

recipients of foreign investment in the region. However, it was also one of the worst

affected by the recent financial crises, due to massive, but relatively temporary, capital

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outflows. Furthermore, corporate governance in Indonesia has yet to be implemented

properly (La Porta et al.1998). The Indonesian economy generally seems to be volatile

with respect to its relationship with the global economy and its internal political

situation. An econometric analysis of the general nature of the relationship between

share prices and accounting numbers under these circumstances is relatively an

uncharted territory and is the subject of this thesis.

1.2 Prior research

Recent academic studies have documented evidence into the power of financial

statements to explain movements in share prices. In the US, Collins et al. (1997), and

Francis and Schipper (1999) using cross-sectional regression modelling techniques

concluded that the overall explanatory power of accounting numbers had not declined

over the periods of their studies. Although the explanatory power of earnings appeared

to have declined, that of book value appeared to have correspondingly increased. In

contrast, Chang (1998) and Brown et al. (1999) concluded that the explanatory power

of earnings, book value and the combination of both had declined over the period

through to the mid-nineties. To date, the great majority of empirical research into the

value relevance of accounting numbers has been carried out in mature capital market

environments, such as the United States (US). In an emerging financial market (EFM)

such as in Indonesia, research dealing with the relationship between accounting data

and market values has been limited, although this situations is now rapidly changing

in the wake of the recent crises in EFMs (Baydoun and Willett, 2000).

Graham and King (2000) investigated the relationship between book values and share

prices in a comparative study involving Indonesia, Korea, Malaysia, the Philippines,

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Taiwan and Thailand and accross varying time periods. Using a modified Ohlson

model (1995), they assessed the relationship between accounting numbers and market

value in the six countries, claiming to find a number of positive and significant

relationships. They concluded that the differences in the explanatory power of

accounting numbers across the six countries were consistent with differences in their

accounting practices.

These brief references to prior research will be returned to in the main body of the

thesis but they illustrate the focus of much current work on a number of issues. These

are: (i) the ‘value relevance’ theme; (ii) the belief that cross sectional econometric

linear regression analysis can identify the supposed relationship between book and

market values; (iii) the narrow focus on the impact of accounting variables and (iv) the

fact that much the same techniques and theoretical frameworks can be applied to ask

the same questions in an emerging financial market as have been asked in mature

markets.

This thesis extends previous research in several ways to assess these issues. First, the

value relevance theme will be amended to rely less on unproven assumptions

embedded in prior theories. The modern value relevance literature originates in

Ohlson (1995) and Penman (1992). This is essentially an application of neo-classical

economic theory supplemented by a general assumption about the efficiency of capital

markets. In its strongest manifestation this includes the belief that financial markets

reflect ‘true’ value and that accounting numbers can be assessed by their ability to

predict, or at least explains such values. Such a thesis requires a strong commitment to

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certain beliefs about the structure of markets and the rational behaviour of investors,

none of which have ever been tested in a rigorous scientific manner (Lee, 2001).

In this research, as a first point of departure from prior studies, a less theoretical

approach to the econometric testing of models will be taken but greater care will be

exercised in developing models of relationships between book and market values at

different levels of analysis. The expected outcome from this approach will be an

improved description and understanding of the relationship between book and market

values, unrestricted by interpretations dependent upon debatable assumptions

borrowed from economic theory.

Second, the econometric methods used to test the models specifying the relationships

between book and market values will combine time series and cross sectional analysis.

An over emphasis on cross sectional techniques places too much reliance on being

able to identify equilibrium relationships between the variables analysed, (see Kim et

al. 2002). The econometric procedures used in specification and diagnostic testing

will follow the design recommended by Hendry (2002). This is quite novel in an

accounting context.

Third, the research methods will incorporate broader macroeconomic variables to give

an improved understanding of the overall relationship between book values and share

prices in Indonesian financial markets. The econometric techniques described above

will be used to inform the assessment of this relationship, rather than test a central,

single research hypothesis concerning the relationship. The literature on EFMs

suggests that the conventional assumptions of capital markets research (CMR) such as

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the Capital Asset Pricing Model (CAPM), efficient markets and portfolio theory, even

if applicable to the analysis of mature financial markets, are inappropriate to achieving

an understanding of the workings of EFMs. In this case, context becomes especially

important. Consequently, a combined quantitative and qualitative analysis of the

broader macro-economy and institutional settings of Indonesian financial markets

becomes important to appreciating the nature of the relationship of market to book

values.

1.3 Indonesian capital market and accounting The Indonesian capital market is considered an emerging market by the International

Monetary Fund (IMF 2000) and other multilateral funding agencies (ADB 2000) and

is classified as such by private rating and data collecting services such as Standard and

Poors (2001). The Indonesian stock market began official operations in 1956.

However, it did not operate continuously and the market ceased trading due to

political turmoil in the 1960s. It was not until the early 1990s that the number of

companies listed in the Indonesian capital market (Jakarta and Surabaya Stock

Exchanges) rose above one hundred. Since then, this number has increased, albeit

with some volatility during the crisis of 1997-1998. In June 2001 there were 361

stock issuing firms on the JSX (Bapepam 2001).

In line with this financial market development, in 1973 the first Indonesian

Accounting Principles, Prisip Akuntansi Indonesia (PAI), were published by the

Indonesian Institute of Accountants (IIA) based on Paul Grady’s Inventory of GAAP

for Business Enterprises (Saudagaran and Diga 2000). In 1984, the PAI were slightly

revised to incorporate some Indonesian business concepts. Several US accounting

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standards were also incorporated in the PAI prior to 1991. In 1994, the IIA issued a

series of Indonesian Financial Accounting Standards (IFAS) and made these standards

mandatory for all publicly listed companies in the Indonesian market. Compared to

previous standards, the IFAS are more comprehensive and adopted in modified form

the International Accounting Standards (IAS). At the end of 2000, the IIA had issued

59 Statements of Financial Accounting Standards (IIA 2001).

Like nearly all EFMs, the Indonesian capital market lags more mature markets in its

level of information disclosures. It is also weaker in this respect compared to some

other emerging markets such as those of Malaysia and the Philippines (Craig and Diga

1998). The Indonesian capital market al.so lacks the enforcement of accounting

standards compared to such countries (Sudagaran and Diga 1997), has lower standards

of corporate governance (Gul and Qui 2002), suffers from weaknesses in the

application of laws (La Porta et al., 1998) and restricts competition (Beim and

Calomiris 2001).

The recent Asian financial crisis has heightened awareness of the need for Indonesia

to attract foreign capital from a variety of sources. The Indonesian capital market and

large Indonesian companies, under some pressure from foreign investors and the IMF,

are struggling to improve their transparency (Fischer 2000; Viswanath and Kaufman

1999). There is, therefore, some interest in the impact of recent improvements in the

transparency and the quality of disclosure in the financial statements of Indonesian

companies on the nature of the relationship between accounting numbers and market

values. This interest will be served by one of the expected outcomes of this study,

which is the provision of a better understanding of the relationship between

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accounting book values and earnings, and share prices in the Jakarta Stock Exchange

(JSX).

1.4 Research Question As discussed later in Chapter 2, it is often assumed that accounting numbers are used

in decision making as a ‘proxy’ for market value. To date however, the nature of the

relationship between accounting numbers and market values still remains unclear.

With regard to the specific research described above, some studies have documented

that the explanatory power of accounting information has increased (e.g. Collin et al.,

1997; Francis and Schipper 1998), while others have concluded that the opposite is the

case (Chang 1988; Lev and Zarowin 1999; Brown et al.,1999).

This study aims to explore this issue through an examination of the evidence from the

Indonesian capital market regarding the nature of the relationship between book

values and share prices. The focus of this study may therefore be expressed as asking

the research question: What is the nature of the relationship between accounting

numbers and share price information on the Jakarta Stock Exchange (JSX)? This is a

general question and is exploratory in nature.

1.5 Significance of the study The significance of this study is embodied in the three issues it addresses, referred to

above. 1) The study takes a less theory-laden approach to the examination of the

research question than is normally taken, but at the same time places greater emphasis

on the logical consistency of the different levels of models of the relationships

between share price and accounting variables; 2) It lays more emphasis on empirically

driven econometric techniques that utilise both time series and cross sectional linear

8

models; and 3) it adopts an eclectic approach to the use of research method,

combining econometric analysis with ‘qualitative’ approaches to answer the research

question. This provides a comprehensive analysis of the research question and also

one that is more useful in informing policy decisions. Specifically it is expected to

provide an extension to CMR literature on emerging financial markets and useful

information for the Indonesian Accounting Standard Board, regarding the setting of

accounting standards.

1.6 Relation to previous research While the research will take a novel approach to the analysis of the relationship

between book and market values in the several ways described above, it will relate the

analysis to prior research by initially testing the Indonesian data to discover to what

extent earlier results can be replicated. Thus, any conclusions concerning the value

relevance of accounting numbers will be benchmarked against the earlier studies of

Graham and King (2000) and Chen et al., (2001). The study of several Asian countries

by Graham and King (2000) which included data relating to the Indonesian capital

market, found that book value and residual income appeared to have a significant

relationship with share prices.

This was also the conclusion reached by Chen et al., (2001) in the case of China. A

number of conclusions drawn from these and other similar studies are reassessed using

the Indonesian data collected in this thesis. These are not central issues to the research

questions but they will serve to validate the data set or highlight differences with

previous research that require further explanation. The contribution to prior research

9

will be in the form of a significant extension of the scope and level of the assessment

of the research question as presented in the next section.

1.7 The main findings of this thesis Cross sectional analyses on the data set of this thesis confirm results from previous

studies both in price and returns models, in the sense that share prices appear to be

significantly associated with contemporaneous book values and earnings in a similar

manner to that described in earlier studies. The econometric modelling demonstrates,

however, that explicit dynamic specification significantly improves the estimation,

inference and specification characteristics of the models. In particular cointegration

analysis and equilibrium correction modelling is profitable. Asset book values appear

from this analysis to have a stronger and more robust relationship with market value

than is the case with share prices in some mature markets (e.g. the US).

This surprising result may be due to accounting information being a relatively more

important source of information for the share markets, compared to mature financial

market economies. Also the Indonesian markets appear to be as efficient in the way

they incorporate book data into value as share markets in developed economies such

as the US. A further interesting finding is that macroeconomic variables appear to

increase in importance as regressors as data sets become more highly aggregated

across firms. These findings are a significant contribution to knowledge and have

important implications for future research. The next section summarises how the

thesis reports these matters.

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1.8 Plan of this thesis The remainder of this thesis is organised as follows. Chapter 2 presents the literature

review focusing on fundamental analysis, market reaction studies and research into the

institutions and financial systems of emerging markets. Section 2.2 covers

fundamental analysis, including cross sectional studies in both mature and emerging

markets. This section also presents time series studies of fundamentals in both mature

and emerging markets. Section 2.3 discusses some findings from stock market

reaction studies that have some relevance to the approach taken in the thesis. Section

2.4 summarises the issues raised by CMR and Section 2.5 presents research into the

institutions and financial systems of emerging markets.

Chapter 3 provides background information concerning the Jakarta Stock Exchange in

section 3.1. This contains a detailed discussion about the JSX including its history,

recent developments, its market structure, the trading system and capital market

support institutions. Section 3.2 provides details concerning company law and the

corporate sector in Indonesia. Section 3.3 provides contextual background with details

about macroeconomic variables, the foreign exchange rate, interest rate, the money

supply, domestic credit, inflation and GDP.

Chapter 4 discusses the theoretical framework for the research methodology reported

in the following chapters. This chapter consists of two mains sections: issues arising

from the literature review in section 4.2 and the framework itself in section 4.3.

Section 4.2 discusses issues arising from the literature review including matters

relating to the variables to be modelled, model functional form, the nature of dynamic

11

specification, the nature of the theory underlying CMR, and the importance of

replication and context. Section 4.3 deals with the relationship of the framework to

the issues raised by prior research, general-to-specific approach modelling and the

basic model formulation.

Chapter 5 presents the research method used in the study. After a short introduction,

Section 5.2 presents the sample of firms and the variable definitions. Section 5.3

discusses the replication process. Section 5.4 presents the model construction

strategy used to address the research question, including the exploratory data analysis

phase, benchmarking of the model results, general-to-specific modelling and the

incorporation of macroeconomic data.

Chapter 6 presents the results of the thesis. This chapter has seven sections. Section

6.1 introduces the chapter while section 6.2 reports the replication process on the

thesis data, using the models of Graham and King (2000) and Chen et al. (2001), here

after GK and Chen et al.. In Section 6.3, the time series analysis of quarterly book

data is reported and the nature of the resulting equilibrium correction models (ECMs)

described. Section 6.4 reports the results of benchmarking the GK and Chen et al.

models against an ECM formulation of the market-to book relationship. The

incorporation of macroeconomic variables in a general-to-specific modelling context

is reported in section 6.5. Section 6.6 reports extensions to alternative functional

forms of the ECMs, both on firm-specific and on aggregated time series data.

Chapter 7 analyses and interprets the results of the thesis reported in Chapter six.

After the introduction in Section 7.1, the implications of the results reported in

12

Chapter 6 for issues raised in prior research are considered in section 7.2. The next

two sections, 7.3 and 7.4 presents additional analyses at the firm level and macro level

respectively. A firm level analysis is conducted on two Indonesian firms, PT. Unilever

Indonesia and PT. Hero. The contextual economic analysis, in section 7.4, reflects on

the efficiency of the JSX and the impact of changes in accounting standards and on

the development of the Indonesian economy in the period 1992-2002. Section 7.5

concludes the chapter.

Chapter 8 closes the thesis by summarising its findings, its contributions and

limitations. The various implications of this research are noted and suggestions made

for future research.

1.9 Summary The preceding sections have outlined the aims, significance and expected contribution

of the thesis research. Section 1.8 presented the plan of the thesis. In the next chapter a

detailed review of relevant prior research is given.

13

Chapter 2 Literature Review

2.1 Introduction

The current approach to capital market research (CMR) in the accounting literature

began with Ball and Brown (1968). That study was one of the first to attempt to

systematically explore the empirical relationship between market and book values by

the use of rigorous statistical techniques. Since then CMR has developed

significantly, including research into the earning response coefficient, fundamental

analysis and market efficiency (Kothari 2001). The literature most relevant to this

thesis is that which relates to (i) fundamental analysis, (ii) stock market reaction

studies and (iii) research into institutional and financial systems underlying the

economies of emerging markets. Categories (i) and (ii) involve studies in accounting

and financial economics while category (iii) is based upon the economic institutions

and policy analysis literature. The following subsections detail findings pertaining to

these three areas of research.

2.2 Fundamental analysis

Many studies have been conducted in developed economies such as the US

investigating the relationship between accounting numbers and market values by

regressing accounting numbers (book values of assets and earnings) on market

variables (stock prices and returns). In addition, there is a growing body of similar

research using data from developing economies with ‘emerging’ financial markets.

This research is discussed here under the heading of ‘fundamental analysis’ leaving

14

regression involving abnormal returns and unexpected earnings to be dealt with under

the heading ‘stock market reaction studies’ in section 2.3. The findings of research

into fundamentals are reported in this section for both mature and emerging financial

markets. Most studies have been cross-sectional in approach. However, there has

been a growing number of studies recently that have adopted a time series approach to

analysing the relationship of market and book values. The different approaches and

contexts form the basis of the fourfold classification of the research used in this

section: cross sectional versus time series approaches and mature versus emerging

markets. The extent to which the findings of CMR studies may be useful in

understanding the development of emerging financial markets and certain special

factors that have to be taken into account in analysing the latter is discussed in section

2.5.

2.2.1 Cross sectional studies of fundamentals in mature financial market economies

Following Ball and Brown (1968) early CMR embraced a stock market reaction

perspective focusing on either the relationship between abnormal earnings and

changes in accounting earnings. This literature is reviewed in section 2.3 below. In a

wide ranging critique of the stock market reaction literature in the late 1980s, Lev

(1989) noted that apparently weak results derived from econometric models of the

abnormal returns-changes in earnings relationship could be due to a number of

factors, including accounting measurement-bias, misstatements by management and

the lack of sound valuation theory. Pursuing in particular the latter concern, in the

early nineties Penman (1992) and others (e.g. Brennan 1991 and Ohlson 1990) urged

researchers to return to fundamentals to investigate the relationship between the value

15

of securities and accounting information. Until recently, most research has

approached this issue using cross sectional regression methods.

Penman (1992) drew attention to an apparent conundrum in relation to commonly

assumed basic stock market valuation models in CMR. This pertained to the use of

discounted dividend and cash flow models that have a long tradition in stock

valuation by accountants. The former bases the stock price on expected future

dividends while the latter determines security prices based upon future cash flows.

Both models are closely related in concept and application. Penman argued that the

logic behind the use of dividends in the discounted dividend model was unclear in

view of Modigliani and Miller’s (1961) dividend irrelevancy proposition. The use of

cash flows rather than earnings was similarly problematic in that cash flows are

relevant to the distribution of wealth rather than creation of wealth, the latter in

Penman’s view being more closely connected to share valuation. He went on to

contend that CMR had been misdirected during the previous 25 years. CMR in this

view had investigated the relationship between share prices and accounting numbers

on the assumption that market is efficient. Furthermore the information content of

accounting numbers had been evaluated based upon the apparent reaction of the share

market to the release of accounting information, not on the ability of accounting

numbers to reflect the value of the firm.

Endeavouring to progress matters, Penman (1992) showed how accounting

information might provide a way of avoiding the dividend and cash flow conundrum.

Three features of accounting information were argued to be useful in share valuation:

net book value and earnings as a measure of the change in net book value, earnings as

16

calculations independent of dividends, and future dividends as a function of net book

value. To understand the value of securities, it was argued it would be more sensible

to use information about future earnings or book values, not future dividends and cash

flows.

Penman proposed that accounting net income and balance sheet net book values

together with other relevant information should be used to predict future earnings.

Following Ryan (1986) and Ohlson (1986), Penman suggested that price-earning ratio

(P/E) might be a good indicator of future changes in earnings. Penman argued that

the share price should be based on either a multiple of current accounting earnings or

an estimate of the present value of future earnings or a multiple of current book value

with either premium or discount. Penman’s theory implied that the valuation of share

prices should be based upon a combination of some function of earnings and book

values. In turn this implied that a key issue in the valuation model would be the

relative weights of the earnings and book value components of the models (Penman

1997).

Ohlson (1990 and 1995) had already begun to pursue a fundamental agenda, similar to

that of Penman, developing, in more detail, a securities valuation model based on neo-

classical economic theory. In developing his model, Ohlson assumed certain key

elements. First, he assumed the market value of firms equals the present value of

future dividends. Second, accounting data was assumed to follow a ‘clean surplus

relation’ (CSR1) that enables the traditional dividend discount model to be

transformed into a fundamental valuation model based upon accounting book values

and earnings . Third, the behaviour of abnormal earnings was assumed to follow a

1 Accounting data is defined to be clean surplus when the change between opening and closing retained income equals income less dividends in the intervening period.

17

stationary first order autoregressive time-series model. Specifically, Ohlson’s model

implied that share price equals current book value per share plus the present value of

expected future abnormal earnings.

Another theoretical paper suggesting that CMR should relate stock prices to

fundamental accounting variables was by Brennan (1991). The paper pointed out

some problems in valuation studies. For instance the regression coefficients were not

stable possibly due to misspecification of the model used across the year. Brennan

argued that regression in per share measure creates problems because all the variables

are deflated by the number of outstanding shares except the constant. Earnings served

as an independent variable in explaining changes in stock prices but did not contain

information representing potential future earnings, thereby omitting an important

variable. In short, the lack of a sound theoretical background for valuation studies was

held to be a serious weakness in the literature relating stock prices to accounting

earnings.

Following Penman, Ohlson and Brenan’s papers, many studies have investigated the

role of fundamental variables in explaining the relationship of stock prices and returns

with the book values of assets and earnings. These have implemented the

fundamental paradigm in CMR within various settings and objectives. Some have

concentrated on the role of book value, some on both book value and earnings and

others have investigated the role of other variables in equity valuation. These studies

are dealt with in turn below.

18

2.2.1.1 Studies of the role of book value in equity valuation

One of Penman’s (1992) models provided a book value rationale for the value of

equity. This sub-section discusses other studies which addressed the role of book

value in equity valuation.

In a study addressing the extent of conservatism in accounting standards, Burgstahler

(1998) estimated the slope of the coefficient on book value in a cross sectional

regression of price on book value for a sample of U.S. firms. It was observed that if

this coefficient is greater than one, the market value of the firm is higher than book

value and thus the relevant accounting standards may be interpreted as being

‘conservative’. While the conservatism of accounting standards is only of secondary

interest here, Burgstahler claimed that book value has an important role in equity

valuation because it serves as an indicator of future earnings.

Subramanyam and Venkatachalam (1998) suggested that book value might be

expected to have an indirect role in the valuation of shares because book value serves

as a stock variable and represents aggregate past and current earnings. Using data

taken from the Compusat file for the period of 1967-96, they analysed and concluded

that book values play a more important role than earnings in equity valuation when

earnings are small or negative.

Collins et al. (1999) further investigated the role of book value in equity valuation

when earnings are negative. Here three alternative hypotheses regarding the role of

book value in valuation were proposed: first, as a control for scale differences,

second, as a proxy for future normal earnings in the case of loss-making firms and

19

third, as a proxy for abandonment value in the case of firms most likely to cease

operations. Based upon analysis on loss firms data taken from the Compusat file for

the period of 1974-1993, it was claimed that the results confirmed both the second

and third hypotheses.

2.2.1.2 Studies of the role of earnings in equity valuation

Easton and Harris (1991) investigated whether the level of earnings deflated by stock

price at the beginning of the stock return period appeared to be relevant for evaluating

earning-return associations in models containing an earnings change variable. They

employed three models: two univariate regressions separately assessing earnings

levels and earnings changes variables and a multiple regression containing both

variables. The results from the univariate analysis revealed that earnings levels and

earnings changes were both associated with returns. The results from the multiple

analysis indicated that earnings levels were significantly associated with returns in all

years, whilst earnings changes were associated with returns only in half of the years in

the sample period.

Teets (1992) compared the slope of coefficient and explanatory power of earnings of

regulated and unregulated firms. It was expected that the coefficient and R2 of

regulated firms would be smaller than those of unregulated firms because restrictions

imposed on regulated firms led to management being unable to adjust policy to meet a

changing environment. Using a paired sample consisting of 64 regulated electric

utilities and 64 unregulated firms for the period 1975-80, Teet’s expectations were

confirmed. The average of the slope of coefficient on earnings of regulated firms was

20

0.5, while that of unregulated firms was 1.11. Likewise, the R2 of the corresponding

models were 0.15 and 0.28 respectively.

Liu and Thomas (2001) attempted to assess why it appeared that conventional returns

and earnings regressions tended to have low explanatory power. Motivated by a

search for misspecifications in conventional returns-earnings regression models, an

independent variable representing a discount rate that reflects future earnings was

added. This additional variable increased the explanatory power of their model.

Shroff (1995) investigated the determinants of the returns-earnings relation based

upon a sample of all industrial firms listed on the New York Stock Exchange (NYSE)

and American Exchange (AMEX) and appearing on the 1989 Compusat file. The

study proposed two growth variables, P/E and ROE, as possible significant

independent variables in the relation between earnings and returns. The results of this

study produced an average slope coefficient for earnings in the presence of high

values for P/E and ROE of 6.17 (t=8.99). In comparison the slope coefficient in the

presence of low P/E and ROE values was only .415 (t=1.82). Shroff (2002) also

examined the relationship between aggregate earnings and stock returns over a long

period of time and found that the longer the returns period the greater the coefficient

and explanatory power of earnings. The study noted the observed higher R2 over

long intervals due to the positive covariance between current earnings and accounting

lag.

21

2.2.1.3 Studies of the role of book values and earnings in equity valuation

Penman (1992), Ohlson (1995) and Feltham and Ohlson (1995) argued that both book

value and earnings are fundamental determinants of firm values. The following

studies have discussed the joint role of book value and earnings in equity valuation.

Barth et al. (1995) examined the role of book value and net income in equity

valuation with respect to a firm’s financial health. Using data taken from 1994

Compusat files for the period 1974-93 their study showed that the explanatory power

of earnings was positively associated with firm financial health. Conversely, the

explanatory power of book value was negatively associated with firm’s financial

health. These results were consistent with the results of Collins (1999) and

Subramanyam and Ventakachalam (1998) studies suggesting that book value serves

as a proxy for abandonment value.

Burgstahler and Dichev (1997) investigated the role of book value and earnings as

complementary fundamental determinants of market values in imperfect markets.

They contended that it is not a matter of simply adding book value and earnings to

obtain the market value. Rather, there is a convex relationship between these

accounting components. They argued that, in a price-book value and earning

regression, the coefficient on earnings increases, and the coefficient on book value

decreases, as the ratio of earnings to book value increases. Conversely, the coefficient

on earnings decreases, and the coefficient on book value increases, as the ratio of

earnings to book value falls. Their analysis was consistent with book values becoming

a more important indicator of market value for firms with low earnings or losses.

22

Another study investigating the role of fundamental elements in market valuations

was conducted by Tan (2001) employing a sample of distressed firms. Distressed

firms were classified into bankrupt and merger firms. Based upon the two distinct

samples, the association between book values and earnings and market values was

investigated. The results indicated that whilst for merger candidates both book value

and net income were significantly associated with market value, in the case of

bankrupt firms, only book value of equity was significantly associated with market

value. Again this result was also consistent with previous study results regarding the

importance of book value as an indicator of distressed firm value.

Collins et al. (1997) investigated the relationship between earnings, book values and

stock prices over time using a yearly cross sectional regression analysis for the period

1953 to 1993. They decomposed the combined explanatory power of earnings and

book values into three parts: the incremental explanatory power of earnings, the

incremental explanatory power of book values and the explanatory power common to

both earnings and book values. Their study documented three primary findings. First,

the combined explanatory power of earnings and book values appeared not to have

declined over the past forty years. Second, the explanatory power of earnings had

declined, but at the same time the explanatory power of book values had increased.

Third, the shift in value-relevance from earnings to book values seemed to be

associated with changes in the average firm size and levels of intangibles, the

increasing significance of one-time items and the increased frequency of negative

earnings.

23

Francis and Schipper (1999), in a value relevance study over the period 1952- 1994,

interpreted their results as providing mixed evidence on whether financial reports

have lost relevance. Their results indicated that the explanatory power of earnings

levels and changes in returns has significantly decreased over time. Conversely, their

test of explanatory power of book values provided no evidence of a decline.

Chang (1998) investigated changes in the relationship between accounting numbers

and stock price for the period from 1953 to 1996 and the factors associated with those

changes. He used three alternative value relevance measures: portfolio measures,

variation measures and valuation lag measures and followed a framework based upon

accounting valuation principles. Price was taken to be a function of both book value

and earnings. For the portfolio measures, it was found that the combined value

relevance of earnings and book values had declined, whereas returns from an

earnings-based portfolio had remained constant. Chang study’s second metric based

upon a variance measure also indicated that value relevance had declined over the

period. With respect to the third measure, the study found that the valuation lag had

changed over time. The study then investigated factors associated with the change in

value relevance of accounting numbers (book value and earnings) and found that

intangible intensity, growth of sale, cost of capital and non-recurring items were all

inversely associated.

2.2.1.4 Studies of the role of other fundamental variables in equity valuation

The inclusion of fundamental variables such as inventory, account receivables and

gross margin in regressions may enhance the explanatory power of earnings as an

24

indicator of market value. Lev and Thiagarajan (1993) included such fundamental

variables in their analysis and found that they appeared to provide improved

information relating to earning persistence. During the period of the 1980s, the

inclusion of such fundamental variables in the returns earnings regression added the

explanatory power of earnings about 70%. Another finding was that incorporating

contextual macroeconomic variables appeared to enhance the relationship between

stock returns and fundamental variables.

Abbarbanel and Bushee (1997) examined the relationship between fundamental

signals (such as account receivables, gross margins and selling expenses) and

contemporaneous stock returns of firms listed on the NYSE and AMEX for the period

1974-1988. A cross-sectional linear regression was used to investigate the relationship

between the variables. It was concluded that fundamental signals provided

information about future returns that were associated with future earnings, and that

the variables examined appeared to have some explanatory power. It was also

concluded that the analyst’s forecast revisions failed to impound all the information

about future earnings contained in the fundamental signals.

Whisenant (1998) investigated the role of specific fundamental variables such as

intangible capital (IC), accumulated depreciation (PPE), net pension liability (NPL),

net OPEB assets (NOPEBL), net operating leases (NOL), and loss contingencies (LC)

in the relationship between market value and book value. Whisenant divided book

value into book value of assets and book value of liabilities. These two components

of book value were then adjusted using data concerning the other variables. Using a

US, sample for the period 1992-1993, the results suggested that adjusted book values

25

seemed to have a more significant association with market value than did unadjusted

book values. This finding was consistent with the conjecture that the fundamental

variables are useful for investors as supplementary information beyond book value in

determining the value of firms.

The study of fundamentals has re-emerged as an important theme in CMR in the

1990s. There is now a large amount of published research in this area. The main

findings and the relevant details of this research are summarised in Table 2.1. The

table includes the research reviewed above and that reviewed in sub-section 2.2.2

below. This subsection and Table 2.1 contain references to research carried out in the

context of developed economies with mature financial markets. In the next sub-

section, fundamental-type CMR research in emerging markets is reviewed.

2.2.2 Cross sectional studies of fundamentals in emerging financial market economies

Compared to studies carried out in mature financial market economies, work on

fundamentals in EFMs has to date been much more limited. This section discusses

studies carried out in emerging market settings.

A study by Graham and King (2000) investigated the explanatory power of

accounting numbers derived from six Asian countries: Indonesia, Korea, Malaysia,

the Philippines, Taiwan and Thailand. These countries followed different accounting

practices in a number of respects and this fact was used to develop differing

expectations with respect to the relevance of accounting information in the valuation

of firm equity. Philippine firms, for example, report goodwill and asset revaluations,

26

whereas Taiwan firms do neither. Accordingly, it was expected that the explanatory

power of book value in regressions of market on book as measured by R2 would be

higher in the Philippines than in Taiwan. For similar reasons, the explanatory power

of book value in Indonesian and Malaysian firms is expected to be higher than that of

Thai firms because Indonesian and Malaysian firms were required, at the time of the

study, to capitalise leases and Research and Development (R & D) expenditure,

whereas this was not the case in Thailand. The explanatory power of accounting

numbers was expected to be the lowest in Korea due to the pervasive influence of tax

law on accounting practice.

A cross sectional model was used to regress current book value and current residual

earnings on market price or share price on book value of equity. Current residual

earnings were used as a surrogate for expected residual earnings in a slight departure

from the original residual income model of Ohlson (1995). The study followed

Collins et al. (1997) decomposing the total R2 of the price to earnings and book value

regressions into the incremental R2 attributable to earnings, the incremental R2

attributable to the book values and the R2 attributable to both explanatory variables.

The Graham and King (2000) study noted the following points. First, the explanatory

power of accounting book value and earnings appeared to differ systematically across

the six countries. Second, the coefficients on both book value and earnings in the six

countries were not greatly different from those measured in mature markets. Third,

the authors’ prediction that Philippine firms’ accounting numbers would have a higher

explanatory power than those of Taiwanese firms seemed to be substantiated. Fourth,

contrary to initial expectations, the explanatory power of accounting numbers of

27

Korean firms appeared to be high, whereas, the explanatory power of book value in

the Indonesian and Malaysian samples were to be found less than the expected. Fifth,

Thai firm data provided a high explanatory power in both book value and earnings,

with R2 (explanatory power) ranging from 13.9% to 79.8% for book value and 21.6%

to 37.3% for earnings. The averages of explanatory power for book value and

earnings were 42.5% and 30.3% respectively, higher than that for the Indonesian,

Malaysian and Taiwanese firms.

Graham et al. (2000) investigated the explanatory power of accounting information in

Thailand around the 1997 decline in the value of the Baht. The study addressed two

questions: First, what was the nature of the relationship between Thai accounting

information and stock price? Second, what was the affect of the economic crisis on

the relationship between financial accounting information and market price?

Following Ohlson (1995), this study used a basic regression model that expressed

firm value as a function of earnings and book value. It reported that the explanatory

power of accounting earnings was stable, whilst the explanatory power of book values

increased during the crisis period.

Chen et al. (2001) investigated the relationship between accounting information and

stock prices using the financial data of firms listed on the Chinese stock exchange for

the period from 1991 to 1998. The methodology used here was based upon price and

return models. The price model reported that both net income and book value seemed

to be positively and significantly related to market price during the study period,

although earnings appeared to be unrelated to stock price in the period 1991-1994.

The explanatory power of both book value and earnings for all firm years was 25%.

28

The returns model suggested that accounting earnings and earnings changes were

significantly associated with stock returns and that the variation of the association

could be explained by several factors, namely, positive and negative earnings, firm

size, earning persistence, and the liquidity of stock. Firms with positive earnings

showed a significant association between accounting numbers and market returns,

whereas firms with negative earnings showed no significant association. Small firms

in the Chinese stock exchange seemed to have more significant coefficient on

earnings and greater explanatory power than was evidenced by large firms. For

publicly held firms (i.e. firms owned by many shareholders without concentrated

ownership), accounting numbers seem to be more significantly associated with stock

returns and to have greater explanatory power (adjusted R2). Domestic Chinese share

prices did not appear to be sensitive to persistence variables in regression models in a

manner similar to patterns exhibited in CMR in mature financial markets. The Chen

et al. study also assessed the ‘value relevance’ of accounting information for domestic

stock (A-share) issuing firms and foreign stock (AB-share) issuing firms, concluding

that the accounting information of A-share stock issuing firms seemed to show more

value relevance. Evidence from the price model supported the results of the returns

model.

Jermakowicz and Tomaszewski (1998) examined the association between stock

returns and earnings of Polish firms listed on the Warsaw Stock Exchange (WSE).

Based upon a 52 firms sample for the period of 1995-97, as in the Easton and Harris

(1991) study, annual stock returns were regressed on both earnings and changes in

earnings and both. The results indicated that earnings on the WSE appeared to have

‘information content’, however the R2 were modest. Earnings level, earnings changes

29

and both variables together explained only 8%, 5% and 7% respectively of the

variation in annual returns.

Barniv (1999) examined the value relevance of earnings of listed firms on the Tel

Aviv Stock Exchange during the hyperinflationary period 1985-1988. The sample

consisted of 107 firms disclosing both historical cost earnings and inflation adjusted

earnings. Linear regression analyses was employed to estimate the association

between earnings, earnings changes and stock returns. The results indicated that,

during the period of study, historical earnings were not significantly associated with

stock returns, but, inflation adjusted earnings were associated. The results suggested

that in a hyperinflationary environment, conventional earnings are distorted and

therefore ignored by investors.

Akdeniz et al. (2000) investigated the cross sectional relationship between stock

returns and the explanatory variables: size, market beta, book value and earnings

using Istambul Stock Exchange data for the period 1992-1998. It was concluded that

earnings failed to explain the variation of stock returns. In this instance, firm size and

book value seemed to dominate other variables in explaining the variation of stock

returns.

Using Ohlson’s model (1995) and data from the Sao Paulo Stock Exchange (SPSE)

for the period of 1996-1999, Lopes (2002a) found that book value had greater

explanatory power than earnings. Lopes argued that the earnings information was less

useful because of the very concentrated nature of firm ownership in Brazil. The study

thus identified ownership concentration as a possible factor influencing the quality of

30

earnings. Lopes also contended that Brazilian accounting book values and earnings

had low explanatory power for the Brazilian sample. Contrary to the findings of the

Collins et al. study (1997), the accounting numbers of high-tech firms seemed to

possess higher explanatory power than the accounting numbers of firms generally on

the SPSE. Following Ball et al. (2001) and Ball and Shivakumar (2001) Lopes argued

that the quality of accounting information is a function of the demand for financial

information and not of specific accounting standards. The higher explanatory power

of accounting numbers of high technology firms was said to be due to better corporate

governance in that industry. The fact that Brazilian Generally Accepted Accounting

Principle (GAAP) allows firms to capitalise intangible assets and amortise costs over

long periods of time was also suggested as being an explanation for the higher

explanatory power of accounting numbers in high-tech firms.

Lopes (2002b) investigated the valuation properties of accounting numbers in Brazil

under three different capitalization models: earnings, book value and residual income.

Based upon the data taken from the SPSE for the period 1995-1999, this study

reported that the residual income model dominated both earnings and book value

capitalisation models in terms of its explanatory power.

Dan (2002) investigated the value relevance of accounting numbers of firms listed on

the Shanghai Stock Exchange. Using a paired sample of Chinese GAAP firms and

IAS firms for the period of 1994-99, the study concluded that accounting numbers

based upon both types of accounting standards are value relevant. However, the

Chinese GAAP firms were held to have more value relevance than those of IAS firms.

31

Furthermore, the study also found that the value relevance of book value and earnings

had declined over the period 1994-1999.

Jung and Kwon (2002) examined the relationship between the ownership structure

and earning informativeness for firms listed on the Korean Stock Exchange (KSE) for

the period 1993-98. More specifically, they investigated whether owner-manager

behaviour appeared to follow the convergence of interest hypothesis or the

management entrenchment hypothesis. The result suggested that the greater the

ownership holding, the more informative are earnings. This supported the

convergence of interest hypothesis. Other results indicated that earnings

informativeness increased with the holdings of institutions but decreased with the

chaebol-affiliated firms.

Accounting studies on emerging markets have generally used similar models to that

used in mature markets to assess the fundamental nature of the relationship between

accounting numbers and share prices. The results generally confirm evidence from the

studies of developed market economies in the sense that fundamental elements such

as book value and earnings are able to partially explain the value of firms. In the

Indonesian setting, however, there has as yet been no specific study that attempts to

assess the nature of the relationship between accounting numbers and share prices.

2.2.3 Time series studies of fundamentals in mature financial markets

As in the cross sectional studies reviewed above, time series studies have been

mostly conducted in mature markets, with only a relatively small number of studies

32

have been conducted in emerging markets. The literature in financial economics is an

important source for this kind of work.

Time series analysis in accounting research was, until quite recently, mostly applied

to investigate the dynamic behaviour of particular accounting numbers, eg earnings,

sales and various expense categories. Time series studies often focused on earnings

forecasts because of their perceived importance in valuations and the fact that these

were not usually as readily available as they have since become. Also, as Kothari

(2001) notes, for theoretical reasons (i.e. the discounted dividend model), earnings

forecasts have also been considered a significant explanatory variable in

understanding the dynamic behaviour of stock returns.

Many time series studies have used quarterly data for a number of reasons: seasonal

patterns may be of interest; quarterly data is more timely than annual data as a proxy

for market expectation; and quarterly data availability has improved due to changing

reporting standards – which is itself sometimes an issue attracting research. The main

weakness of quarterly data is that it is unaudited.

An example of initial time series studies investigating the properties of earnings

which supported the hypothesis earnings time series followed a random walk. Other

studies, however, found that the time series of earnings was mean reversionary (Brook

and Buckmaster 1976). This and other research into such matters are discussed in

Brown (1993) and Kothari (2001).

33

A frequently encountered characteristic of time series studies is the relatively small

number of firms used in the research. In Watts et al. (1977) for example 23 firms

formed the sample investigated. This is not necessarily a significant limitation to the

findings since the most important aspect of such studies is usually the length of the

time series. Quarterly data is often required to establish a sufficiently long time series,

to obtain reliable estimation and inference in models. However it has characteristics,

not shared by annual data, that restricts its use in making inferences about the

properties of annual data. Foster (1977), for instance, investigated the dynamics of

quarterly accounting data over the period of 1963-1974 finding that each quarterly

series had both seasonal and adjacent quarter to quarter components.

Book values of net assets, earnings, and dividends are the variables most often used in

time series analysis of the relationship between market values and accounting

numbers. Ratios of these variables are sometimes used to avoid problems of scale and

also for theoretical reasons. Kothari and Shanken (1995) for example, investigated

whether dividend yield and the book-to-market ratio (B/M) explained the variation of

stock returns over the period 1926-91. Using time series analysis, they found that B/M

was more significantly correlated to stock return for full sample period, whilst

dividend yield relation was stronger for the sub period 1926-1941. Choice of

regressors such as these originates in the finance literature (e.g. Fama and French,

1992).

As has been shown above, most studies in CMR attempting to determine whether

book value is a good proxy for equity market value have addressed the

contemporaneous, cross sectional, relationship between those variables. As such, the

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studies do not reveal the dynamics of the relationship between book value and equity

market value over time. Understanding this dynamic is important, however, in

determining the stability or consistency of the relationship between book value and

market value.

In a study much closer to the present research in intent and motivation, Qi et al.

(2000) investigated the Ohlson model (1995) through cointegration testing. Using a

sample of 95 firms with time series data from 1958 to 1994, they reported that book

value and market value were not stationary for most of the firms in the sample and

went on to conduct cointegration tests on book value, residual income and market

value. Their results indicated that both variables, book value and residual income,

were not cointegrated with market value for 80 percent of sample firms. Their

findings suggested that direct estimation using the Ohlson model on the time series

data might result in apparently significant results and high R2 but would in fact be

spurious and misleading. Their results also confirmed that the cointegrated firm

sample produced less biased forecasts than that of non-cointegrated sample.

In a more general investigation of the dynamic relationship between the book value of

equity and the market value of equity, Bartholdy et al. (2000) used Johansen’s

systems estimation approach to cointegrationa to model the relationship betw