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    HLSEVIER Journal of Accounting and Economics 30 (2001) 401-420, ‘wwwelseviercomMocatelecontase Accounting standards and value relevance of financial statements: An international analysis ~ Mingyi Hung* Level Sco of Accomtng and Maral Shoo of Baines, iver of Sear Califor, ios Angles, C4 080-441 USA ‘Accepted 19 Apxil 2001, Abstract Using 17,743 firm-year observations of industrial companies in 21 countries from 1991 t0 1997, this paper finds that the ase AF acerial acconnting (versus cash accounting) negatively affects the value relevance of financial statements in countries with weak shareholder protection. This negative elfect, however. docs not exist in countris with strong sharsholdor protection. These findings are consistent with the belief that shareholder protection improves the effectiveness of accrual accounting, and suggest the importance of considering shareholder protection when formulating sccounting policies related to accruals. © 2001 Elsevier Science B.V. All rights reserved, JEL elasieaton: G13; MAL ‘Keywords: nfernational anes! reporting; Accounting standards; Accrual accounting Tam grateful w Jennifer Babevck, who not only provided indexes of global accounting standards but also shared many important insights that substantially contributed to the paper. thank Paul Asquith, Pan! Healy, SP. Kothari and (Peter Wilk far their eneruragement an tuidanee. T also thank Charles Chen (the refered), Mark DeFond, Mery Ellen Carter, KR, Subramanyam, Robert Trezevant, Rebecca Tsui, Wim Van der Stede, Erie Wolf, Jerry Zimmerman (the editor), and workshop participants at Bank of Japan, Boston College, Emory Tsisersity, Massachieette Ineitute of Tovhnaloey. Taine Vsiveriy, Tlniversty of Reich Columbis, University of Southem Califorsis, Waseda Univerity, and the 2000 American Accounting Association Annual Meeting. Tok 41213 140 727%; fans 1 213 747 2818, E-mail address: mingsin@ usc edu (M. Hung) (0165-4101/01/5-sce front matter «© 2001 Elsevier Science BV. All rights reserve. PESO 169-4101 (01 }000L +8 m2 M, Hang { Journal of Accounting and Economies 30 (2001) 401-420 1. Introduction ‘This paper investigates the relation between accrual accounting and the value relevance of accounting measures in countries with different levels of shareholder protection. ‘This isene is important heeanse acral accomnting Which transforms cash lows into earnings, iy a hey Feature oP any accounting system. The study finds that stronger shareholder protection, tutional factor characterizing a country’s corporate governance environment (Lt Port et al, 2000), improves the effectiveness of the accrual system. This finding suggests the importance of considering shareholder protection when formukat- ing accounting policies related to accruals Accrual accounting provides better matching of revenues and expenses than cash accounting and theretore makes accounting intormation more value relevant. However, accrual accounting also presents more opportunities for managers to manipulate accruals tor personal gain and hence may cause accounting information to be less value relevant, Consequently, an aecounting system mandating more accrual accounting (hereatter. referred to as ‘a higher use of accrual accounting’) has offsetting effects on the value relevanee of accounting information. JT argue that managers are more likely to behave opportunistically in an environment with weak shareholder protection (La Porta et al, 1997). Since a higher use of accrual accounting provides managers with more opportunities to manage earnings and poor shareholder protection exacerbates this managerial propensity, I predict that a higher use of accrual accounting negatively affects the value relevance of accounting information in markets with weak shareholder protection. In addition, since strong shareholder protection deters managers from manipulating accruals, 1 predict that strong shareholder protection will attenuate this negative impact. ising 17.743 firm-year observations of industrial companies in 21 counties font 1991 to 1997, T text the impact of auciual accounting on the value relevance of accounting numbers for countries with different levels, of shareholder protection. I measure a country’s use of accrual accounting by the frequency of accrual-related accounting standards and evaluate the level of shareholder protection by antidirector rights and legal system (La Porta et al, 1996; Ball et al., 2000a,b). Following prior studies, 1 define the value relevance of financial statements as the ability of aecounting data to summarize mntormation impounded in market prices (Chang, 1998; Francis and Schipper, 1999). As in Chang (1998), I focus on two summary accounting Performance measures from financial statements earnings and return on equity (ROB) "This study does not dress operating cash lows because the use of acrual accounting only alfets earnings, not cash ows. M, Hang { Journal of Accounting and Economies 30 (2001) 401-420 403 Controlling for tax and financial reporting conformity, the study has three primary findings. First, a higher use of accrual accounting negatively affects the value relevance of accounting measures for countries with weak shareholder protection. Second, strong shareholder protect ing’s negative effect on the valne relevance af earnings Finally, secrnal accounting does nut negatively affect earnings’ value relevance for countries strong shareholder protection. My interpretation of the results depends on dhe assumption that prive formation is ronghly the same across countries. However, price formation likely varies weross countries and is likely correlated with shareholder protection. A plausible scenario is that countries with strong shareholder Protection are likely to have more private information production and mandated disclosures. which ceteris paribus decrease earnings’ value relevance by causing prices to lead earnings more. In this scenario, countries with strong shareholder protection would display a relatively lower association between carnings and stock returns because prices would lead earnings to a greater extent. Therefore, high shareholder protection would appear to reduce the value relevance of carnings. However, this scenario works against finding support for my hypotheses.” My findings contribute to the literature on earnings’ properties in two way’. t, since a country has a fairly constant accrual system, previous in-country studics generally compared the value rolevanee of earnings with that of cash flows (e.g., Ball and Brown, 1968; Bowen et al., 1987; Dechow, 1994, Cheng ct al, 1996). My study complements these in-country studies by comparing the value relevance of earnings across different countries’ accrual systems. Second, prior cross-country studies have mainly examined the relation between country-specific factors and the value relevance of accounting numbers (Alford et al., 1993; Ali and Hwang. 7000: Rall et al, 70009, h)* This stndy adds to these eross-conntry stuicy by adldiesving the impact of sharchoklcr protection on the relation between the use of accrual accounting and the value relevance of accounting information. ‘The paper is structured as follows. Section 2 develops the research hypotheses. Section 3 presents the research methodology. Section 4 describes the sample selection and variable definitions. Section 5 shows the empirical results, Section 6 summarizes the findings and concludes the study. 1 attenuates accrual account Fi 2s posible that there are also other unspeifed seonaios, where sharsholder protection affects sot just comings but also price formation via nowaccouutiagrlused iafoimation, tat could provide alternative explanations for the results. 5 although La Porta etal (1996, 1997, 2000 discuss the elation between accounting standards and insitulional factors across countnes, thelr proxy for aecounling standards 1s Uke disclosure level based on annual reports rather than the atibute of the accountng standards 408 M, Hang { Journal of Accounting and Economies 30 (2001) 401-420 2. Hypothesis development Accrual accounting systems are expected to generate more valne relevant accounting performance measures (i<., earnings and ROE) than cash flows hhecanse accrual systems are hetter at matching revennies and expences (Rall and Brown, 1968, Dechow, 1994, and Cheng et al., 1996). Thus, acct wal accounting performance measures help investors helter assess firm values and operating performance han operating casts lows. However, accrual systems also allow managers to opportunistially manipulate accruals, Because managers make estimates for the accrual syste and are often evaluated and rewarded based on accounting performance measures, managers might manipulate accruals for personal gain (Healy, 1983; DeAngelo, 1988: MeNichols and Wilson, 1988) and thus cause accounting measures to be less value relevant. Consequently. movement toward @ higher use of accrual accounting has offsetting effects on the value relevance of accounting measures. For example, ‘consider accounting for pensions. U.S. standards require that pension costs be recognized (ic., acerued) in the balance sheet and charged to carnings when the costs are incurred. Recognizing pension costs when incurred, rather than when paid, better matches revenues and expenses and thus generates more valuc relevant performance measures for U.S. companies. However. a U.S. manager ‘might bias the estimate of a company’s pension expense downward (upward) to prevent a negative earnings surprise (take a hath) and thus reduce the value ‘elevance of earnings to investors, As a result, the net impact of adopting accrual pension accounting on the value relevance of accounting performance measures is unclear. However. strong shareholder protection in the marketplace should attenuate management opportunism (Jensen and Meckling, 1976; Holmstrom, 1979). Alternatively, weak shareholder protection in the marketplace will exacerbate the opportunism. Theicfore, T argue that manguciy ate muie likely to manipulate accruals in weak shareholder protection environments than in strong shareholder protection environments. For example, the U.S. has many mechanisms for oppressed shareholders to make legal claims against directors, but Germany has few such mechanisms (La Porta et al., 1996). While US. managers who materially mistepresent earnings generally face shareholders’ class action suits and securities regulators” investigations, German managers rarely face such consequences. Due to the higher cost of opportunistic behavior, U.S. managers, relative to German managers, are less likely to exhibit stich behavior. ‘The preceding discussion leads to two hypotheses. First, since a higher use of accrual accounting provides more opportunities for earnings management and inadequate sharcholder protection exacerbates this manage- rial propensity, I predict that the use of accrual accounting will negatively M, Hang { Journal of Accounting and Economies 30 (2001) 401-420 405 affect the value relevance of earnings in countries with weak shareholder protection, ‘The use of accrual accounting neg. ees ( ly seduces the value earnings and ROF) in Hypothesis rolovance of accounting performance me: ‘counties with weak shareholder protection, Second, since shareholder protection deters acomnals, 1 presliet that strong shareholder protect upuct of accrual ucvounting on value relevance. nagers from nanipuking ill reduce the negative Hypothests 2, Strong shareholder provection reduces the negative impact of accrual accounting on the value relevance of accounting performance 3. Research di This section discusses the method for measuring the use of accrual accounting, evaluating sharcholder protection, calculating the value relevance fof accounting performance measures, and assessing the link hetween tax reporting aud financial aevounti 3.1, Use of accrual accounting ‘The use of accrual accounting represents the extent that the accounting system deviates from a cash method of accounting. To measure the use of accrual accounting, I create an accrual index from the data in the 1993 International Accounting Summaries by Coopers and Lybrand (Coopers & Lybrand, 1993)." L assume the accounting standards in 199.5 are representative of my sample period, 1991-1997. One concern is that several countries in my sample began modifying their national accounting standards to conform to International Accounting Standards (IAS) during the period analyzed. However, Joos and Lang (1994) suggest that harmonizing national accounting standards to achieve greater conformity is a slow process T compute the actual index by equally weighting 11 acctual-vetated seounting standards for each country. Among the accounting standards surmmanized in Coopers and Lybrand (1993), I select 11 standards that ave directly related to the timing differences hetween cash reveipt/dishursement and revenucjexpense recognition, For example, one accruaFrelated accounting standard is accounting for research and development (R&D). All else equal, « Thank Jenifer Babcock for graciously providing the accrual indexes forthe same count 46 M, Hang { Journal of Accounting and Economies 30 (2001) 401-420 country that requires R&D expenditures to be capitalized and amortized, such as Finland, will have a higher accrual index than a country that requites R&D expenditures to be immediately expensed, such as the U.S. The accrual index excludes accounting treatment of measurement issues, such as asset revaluation and inflation adjustment, hecause such treatment does not involve direct cash receipt (disbursemeut.® ‘An accounting standard is assigned a weight of one if it applies accrual wcthods.® For example, in the U.S, accounting for other post-retirement benefits is assigned weight of one since it requires the henefits to he acerued, but in Japan, it is assigned a zero because it does nol requite this. Panel A of Table | further explains the assignment of weights. Table ? lists the resulting aaccruall indexes for the sample countries. Table 2 shows that the U.S, requires the most accrual accounting. 0.86. and Switzerland the least, 0.32. Table 2 also compares the accrual indexes among the Mueller et al. (1994) accounting clusters. These clusters are based on the overall similarity of ‘countries’ accounting practices. Mueller et al. classify countries into four clusters: BritishAmerican, Continental, South American, and Mixed Econo- my. The sample countrics fall into cither the Dri Continental clusters. Table 2 shows that the accrual indexes are similar for ‘countries in the same accounting cluster, which is expeeted since the accrual indexes are based on accounting standards. For example, Australia. Canada the U.K., and the U.S. all belong to the British-American cluster and have accrual indexes around 0.8. The average accrual index is 0.75 for countries in the Dritish-American cluster and 0.57 for those in the Continental cluster, with the difference significant at p-value less than 0.01 American or the 3.2. Proxies for shareholder protection: Antidirector rights indexes and legal systems T use two altcinative prosicy for the level of shaicholder protection in a country, antidirector rights and legal systems, based on La Porta et al, (1996) and Ball et al. (2000a), because there is no single agreed- upon measure for shareholder protection.” The first proxy for share- hholder protection is antidirector tights, Since shareholders exercise Tiare the impart af ase revaluation om vale relevance ef earningt hae generated grat intrest among rescurchers (Easton otal, 199% Darth and Clinch, 1998), T rerun the teats after including accounting standards on the revaluation of property, plant, and equipment, and on the revaluation of intangibles in the ceraal index, The results are simile. Luse an oqual weighting method because dive i av well-defined theuy for other weighting methods. I note thatthe importance of an accountng standard vanes across countries But See 0 reason that the equal weighting wil bias the resis. 1 also combine antiitector rights and legal systems to form & single proxy for shareholder protection, The results ate qualitatively the same. M, Hang { Journal of Accounting and Economies 30 (2001) 401-420 or Table | Procedures for cukulaling accrual and tax book conformity indenes* The acrual index ensures the use of ucrual accounting and the tx-book conformity index measures the link between reporting and financial accounting Accounting standards Panel A: Accrual index Gouwil/s ic capitalize? Equity method sit requited? Depresition lo additional accelerated depreciation alowel?™ Purchased intangibles it capitalized? Developed intangibles i capitalized? R&D expenditurels it capitalized? Intrect capitalization Te it capitalized? Finance ses i capitalized? Percentage of completion it allowed? Pension/Are future pension costs accruc? Other post retirement honoitgAte ney accrued? Pa R: Taxsbonk conformity index Average consensus estimate of the talation hoteen tay and financial ‘porting Do deferred taxes exist? es legal Form dominate substance? Is additional sccclrated Aeprociauon allowed? Do amortization petiods depend con tax laws? Dee lass capitalization depend on tax law? Rating Weisht Les 0-Yes (= —3 Yeas) yt O-May expense Les ON vi No 0 Vee yt |-Requited 0.5-Permitted O-Not permitted [-Permited 0 5-Limted U-Not permitod |-Permitted 0/5-Limited 0-Not permite [Permitted 0-Not permitted 1L¥es 0.5. 0ptional limited O-No |-Requited 0.5-Either Not permited ees No) 1 Yes 0 No 1 if tho sulting muro from the calelation below is greater than 0-0 otherwise [Strong 0.5 Moderae|sznifcant 0% Wea [No deferred tax 0.-Limited 20% O-Yes\ecomnize Ieee 0 Sometimes O-No [ees 05-Limited 0-No 6 1LYes 0.5-Limited 0-No Lee 0S-Limited 0.No Tudesss ave provide by Jenifer Baloch, Dats sources ave Gourers ad Lybrann (193) ad ‘Alexander and Archer (1985). "Additional accelerated depreciation refers to accelerated deprecation methods olber than oslining balanes, double declining blanc, and sum ofthe yours digits methods excluding goodwill and R&D costs their rights by voting for worldwide antidirector rectors, rights by La Porta et al. (1996) measured the ease with which shareholders exercise their right to vote, They found that countries with strong anti- director rights have larger and more liquid capital markets, which implies 48 M, Hang { Journal of Accounting and Economies 30 (2001) 401-420 Table 2 Accrual indo, aosounting cluster, antiditeotor ight index, logs system, and tx book conformity Index by country" Country Accrual index Accounting Antidreetor”_ Legal system Tax-book luster riots index conformity index Australia 082 Brish-American 4 T 0 Belgium 0.68 Continental 0 0 1 Canale 082 Biili-American 4 1 ° Denmark —U33 Continental 5 u 0 Finland 035 Continental 2 0 1 France 64 Continental — 2 0 1 Geiny att Comincatsl 1 0 1 Hong Kong 0.64 Brish-American 4 1 0 Ireland UX2 Brsh-Amenican 3 1 0 Italy 4s Continental =O 0 1 Japan ass Continental — 3 0 1 Nethertands 0.73, Bri American 2 0 ° New Zealand 0.73, Brish-American 4 1 ° Norway (82 Continental 3 4 0 Singapore 0.61 Bish Ameria 3 1 ° Souin Amen 0.88 prvsh-American 4 1 ° Spain a7 Continental = 2 “ 1 Sweden 150 Continental 2 0 1 Switzerland 0.32 Continsatal 1 0 1 UK as Brivsh-American 4 1 0 us. 086 Brish-American 5 1 0 *Defnions: Acerual index represents the dear to which the accounting system moves awa from a cash method measure of performance. A highor index value indicates igher use of 2cerual accounting. The index is constructed as reported in Table I. Accounting cluster refers tothe cluster ‘hassteation assigned according to the country’s accounting prachoes by Melle etal. (1498), -Amsidivecior rights index indicates how easy itis for shareholders to exercise thie voting rights. This inden ithe anliirector right index constructed by La Porta a al (1996), This index ranges from 0 (5. Ke aggregats the followings vpouets of Steller tig. (I) the big W Note by ml, (2) the abity to gain control of shares during the shareholders’ meeting, (3) the possibilty of ‘cumulative voting Tor directors, (4) the eae} calling an extraordmary shareholders mesting, and (5) the availability of mechanisms allowing minority shareholders to make legal clams against the director. Lega stm squals |i common law snd equals OP code la. Tax-book conformity index shows the wonvergenve between tas reporting sid finnnial aexounting, M equals 1 or counties uth high tax-book conlormuty and equals 0 lor countries with low eonfomuty. ‘The mdex 5 cconsructed as reporied in Table | that antidirector rights discourage opportunism by incumbent managers and stimulate outside investors’ willingness to participate in capital markets.” Another implication for their results is that countries with strong antdiestor sights probably have more information production (.¢., analysts, news releases, mandated disclosures, conference cals, et.) I thank the editor for providing this insight. M, Hang { Journal of Accounting and Economies 30 (2001) 401-420 0 ‘The antidirector rights index, drawn from La Porta et al. (1996). ranges from zero to five. Each country starts with an index value of zeto and reveives an additional point for each of the following: 1, The country allows shareholders to vote by mail 2. The country does not requite shareholders to deposit their shares before the shareholders’ meeting. 3. The government allows cumulative voting for directors 4. The minimum percentage of share cupital that entides a shareholder to call an extraordinary shareholder meeting is less than 5%, 5. Minority shareholders are allowed to make legal claims against the directors. The second proxy for shareholder protection is a country’s legal system, generally classified as common law or code law. I assign the legal system a value of one if it is common law and zero if code law. Common-law countries are likely to exhibit greater shareholder protection than code-law countries because their public shareholders are mote willing to provide funding to ‘companies. Common law originated in England and was established chiefly by Judges who resolved specific factual disputes. Code law (or civil law) originated in ancient Rome and was instituted as rules of conduct linked to concepts of Justice and morality. Ball et al. 2000) suggest that common laws are adapted to contracting in open, public markets, and code laws are appropriate for contracting between a small number of parties. Thus, in common-law ‘countries, such ay the U.K. and tre U.S., eumpanies rely heavily on public shareholders and croditors as. sonrres of capital In contrast, in. ondectaw countries, such as France and Germany, companies typically rely on employees, managers, hanks, and governments Table 2 presents the antidivector righty ingeres and fegal systen sample countries A high association showld evict hetwoen rights and legal system because both factory are proxies for shareholder protection. As expected, the data indicate that common-law countries have higher antidircetor rights than do the code-law countries. For example, the U.S.. a common-law country, has a score of five, the highest antidirector rights score. In contrast, Belgium and Italy, both code-law countries, have a score of zero, the lowest antiditector rights level. ‘Ihe mean (median) antidirector rights is 3.89 (4.00) for the common-law countries and 1.75 (2.00) for the code-law countries. with both differences significant at p-values Jess than 0.01 for the tidirector 3.3. Value relevance of accounting performance measures Following recent U.S. studies on value relevance, I define value relevanes a3 the ability of an accounting measure to capture or summarize information that 10 M, Hang { Journal of Accounting and Economies 30 (2001) 401-420 affects firm value.” Using this definition, researchers often measure value relevance as the association between an accounting measure andl stock returns and operationalize the value relevance in two ways: a portfolio-returns approach and a regression-vatiations approach. I use the portfolio-returns approach fo operationalize the vahie relevance of accounting measures heraiise Of ity statistical superiority over the regtession-variations approach (Kotla and Zimmerman, 1995; Francis and Schipper, 1999) The portfolio-returny approach defines the value relevance of accounting measntes as the proportion of information in security returns captured by the accounting measures (Alford et al., 1993; Chung, 1998; Francis and Schipper, 1999), This approach measures value relevance as the total return that could be earned trom a portfolio based on perfect foresight of earnings. Value relevance 15 scaled by the total return earned on a porttolo based on advance knowledge of market prices, | use the following procedure to calculate the value relevance of accounting performance measures, First, at the end of each year, I rank firms in each country-specific sample by change in net income (ANJ), change in ROE (AROL), and market-adjusted return (Audet). Next, following Alford et al (1993) and Francis and Schipper (1999), I compute 15-month cumulative market-adjusted returns ending three months after the fiscal year, for three hedge portfolios: ‘ANT portfolio refers to the equally weighted hedge portfolio formed on the basis of ANY and scaled by heginning-of-year market value. I take long positions in stocks with the highest 40% of ANY and short positions in the lowest 40% of each year. AROL portfolio refers to the equally weighted hedge portfolio formed on the basis of AROE. I take long positions in stocks with the highest 40% of AROE and short positions in the lowest 40% of each year. AdjRet portfolio refers to the equally weighted hedge portfolio formed on the basis of AujRet. I take long positions in stocky with the highest 40% of AdjKet and short positions in the lowest 40% of each year. Finally, I calculate the value relevance of earnings and ROE as the ratio of the corresponding return earned from the ANY and AROE portfolios divided by the return earned from the AdjRet portfolio. 34 Tav-hook conformity Previous studies (loos and Lang, 1994; Ali and Hwang, 2000) document that accounting information in counties with a strong liuk between tax and Francis and Schipper (1999) for discussions of altrnative definitions of valve sclovanss. "Note that the deinition of vue relevance also depends on the information production system (or Drive formation process M, Hang { Journal of Accounting and Economies 30 (2001) 401-420 au financial accounting is less value relevant. Thus, I control for this link by using a tax-book conformity index that shows the convergence between tax reporting and financial accounting. Based on Coopers and Lybrand (1993) and the 1995, European Accounting Guide, edited by Alexander and Archer (Alexander and Archer, 1995), I aggregate the average consensns estimate of the proximity af tax and financial accounting systems with Olle tax-related iudicatory shown it Panel B of Table 1. The higher the number, the stronger the link etween tax nd financial reporting. To be consistent with prior studies (Alford et al, 199%; Ali and Hwang 2000), I use a high/low coding scheme to classify the resulting numbers trot the tax-book conformity index calculation." I assign the index a one if the resulting number is greater than zero and assign a zero otherwise (Le. one designates high tax-book conformity. and zero designates low tax-book conformity). The final numbers, provided in Table 2, are similar to those in prior studies."” 4, Sample selection, va ions and descriptive statistics 4.1. Sample 1 select the sample from the intersection of the Global Vantage Industrial) Commercial and. Issue iles. | initially include countries with more than 100 total firm year observations, if they have at lcast one observation cach year. 1 restrict the sample to industrial firms (SIC codes 2001-3499 or 5000-5999), as in Alford et al. (1993). [use this restriction to inerease the homogeneity of the sample and the comparability of the results across countries. In addition, cach firm-year observation must satisfy four requirements, First, firm-year observations must have sufficient data to calculate change in net income (AND, change in ROF (AROF), and returns (Ret). Second, firm-year observations must not include the highest of lowest 1% values of each variable (VI, ANI, ROE, AROE, and Ret) within each country. Third, firms must not ‘change their fiscal year-end during the sample period. For example, if a firm ‘changes its fiscal year-end in 1994 from June to December. its 1994 net ineame might cover only June 1994 to December 1994, This would make the relation between net income and annual returns in 1994 inconsistent with the relation in "The resulting numbers fll toward extreme values, Therefore. it seems reasonable to assign the taxbook conformity index at a binary variable rather than a continuous one. The results are qualitatively the sane iegaidles of the specifiation of the taxcbook conformity indes Ge ‘continuous versus Biny) "NY have identical tax-book conformity elasifications forthe 16 countries, except Nocways in Alford etal. (1995). I repeat the analyses afler changing the classincation for Norway. The ‘ualtaive results do not change an M, Hang { Journal of Accounting and Economies 30 (2001) 401-420 Table 3 Distribution f fem year observations by sountry and fac yeu Country Toul 99192 SHH 169 ‘Australia a OUelUH 6 Belgtum sy eo oo y Canada 98 SSS 3 Denmark BR UB 36 Fada % 0 2 w 9 rance ww 98 Germany 89 TS 1 Hong Kong mo 8 ou » Inet ey ey 0 Italy ls npg 3 2B Japan 1N6s 251362 949 Netherlands 00 eee eee nea ae) oS Now Zealand 23 $ 5 6 6 ® 5 Nora wre ss boo Singapore Ww wo South Africa 9 on oR ob OR boos Spain M6 6 em 4 noo” woven en eas Switzerland Bod % 9 uk oi AR MHD aK 20 us. pom. 1278s tame Ls 16 Total 1773236 2400 2480 -2.595, ant 2m * Sample, Uist 17.742 faneycar ober vatis from dhe Glo! Fntnge feo! Cm and Jue es om 1991 to 199/- ta elecung, I use the following enter: (1) eh country needs to have more than 100 initial total itm-year observations, provided tha it has atleast one observation ‘each sour, 2) only industrial rms (SIC codes 2000-3999 o 5000-5090) are included, (3) each Bem year observation needs to have sulcient data to compute change in net income, change in ROE, {and returns (4) fms do not chang ther Hscal year-end (9) lim-year observations do not have the highest or lowest 1% values of net income. change in net income. ROE. change in ROE. and returns within och eountry, and (6) Grea year dala are prepared under domedic aevounting tandarde. prior years. Fourth, firm-year data must be prepared under domestic accounting standards, rather than other standards such as IAS or modified US. standards. The sample selection procedures yield 17,713 firm year observations from 1991 to 19V/ for the 21 countnes listed in Table 2.'° Lable 5 lists the distribution of firm year observations by country and fiseal year. The size of firm-years for these sample countries ranges from 43 (New Zealand) to 9.0/2 PT have thrse more samp: countries than Alford tal (1920): Finland, New Zcaland, and South atric 1 use a mote recent Lime period so these countries pass the requirement of intl 10 Ar sear observations M, Hang { Journal of Accounting and Economies 30 (2001) 401-420 413 (the U.S.). The number of firms grows over time mainly because of the increasing coverage of international companies in the Global Vantage Files. 4.2. Variable definitions ‘he earnings vartable .V/) 18 net income betore extraordinary items scaled by the beginning-of year market value, The ROE variable (ROE) is earnings divided by beginning-of-vear equity book values. The market value variable (MY) is price multiplied by number of shares outstanding at fiscal year-end. If firm has multiple issues, | use the oldest issue because the identification of the primary issue is not available, The return variable (Ret) is the 15-month ‘compound return (adjusted for dividends and splits) ending three months after the fiscal year-end, Market-adjusted return (AdjRer) is return minus the return on the equally weighted market portfolio in the firm's country. Table 4 shows the descriptive statisties of Ret, NI. and ROE across countries Mean returns fall between — 8.0% Japan) and 41.4% (Spain). The standard deviations of returns range from 31.7% (Japan) to 60.5% (Norway). This wide Tange shows the importance of controlling for market volatility across countries, and therefore supports my use of the portfolio-returns test instead of the regression-variations test, Returns are also positively skewed (medians ower than means) across all countries except New Zealand. The mean (median) NF fall between 1.5% (2.0%) in Japan and 146.9% (13.3%) in Sweden.'? Finally, the mean (median) ROE fall between 3.1% (3.8%) in Japan and 17.9% (17.7%) in South Africa 5. Empirical results Table 3 provides the matket-adjusted veturus for the ANZ, AROE, awl AdjRet portfolios and value relevance measures of NT and ROE for the sample countries. For example, the U.S.’s market adjusted returns are 30.6% for the ANT portfolio and 80.4% for the AdjRer portfolio. Consequently, the value relevance of NU, the returns for the ANI portfolio divided by the returns for the AdjRet portfolio, is 38.0%. This number indicates that about 40% of perfect, foresight returns are available to U.S. investors with advance knowledge TEXiy simple descriptive statistics of Ret and NP are enmparahle with Rall et al. (1998) forthe seven countrss in thelr study. Other multicounty studs (Alford st al, 1993; Ali and Hwang, 2000) do not provide doscripive stastes for comparison. 1 note that there are extrem ‘observations in N/ for Sweden, even thoush Ihave deleted observations with extreme 2% values. I randomly cherk anal reports Fo the companies with extreme vies The nbeervations apnea be data errors in Glob! Vunnige Fes. Therefore, I delete two Swish companica with NZ greater than sin and repeat the analyses, Ue revised slandard deviation of 17 Yor Sweden reduces 10 under 60% from over 800%, The qualitative results Jo not change. 414 M, Hang { Journal of Accounting and Economies 30 (2001) 401-420 Table 4 Descriptive static of return, net income, and rtura on equity (ROE) Bet N08) ROE (%) Country Mean Med St Mean Med. Sid. Mean Med. Std ev ev aes, Australia 36263 «4S 3 Sd 71 ODS 10 IT Belgium 87 273 10 -%2 KM 79 ORT 96 Canada om 216 23 69 32 61 IE S986 LT Denmark Il 169 383778 na uz 7s Finland 9 300 «28 496 162 14 97133 37 France 4 80D WR 87-69 o> m3 7 Germony 8 6 62 D2 3S 46 Gl 78 169 Mong Kong 10S-«128 «43-52-7073 We 149177 ireland 4 S17 338 432 NO 9 139 40172 Italy 9 373 236 390 4 70 St 72 124 Japan 186s 80-193 UT 1S 20 U1 ak 69 Netherhinds 309-280 BS MSM OT 19166 124 New Zealand 4311130 A380. 72 ena 132 Norway 17 340 182 6S 98 99 19158 27 Singin Ui 12 wR IR AT 7k 73 01 South Aftiea MT M4 458 107 89 m9 7779 Spain ala 48 79 1s 93 183. Sweden 354 69133, 139160 163) Switzerland ass Iss17 So 9a 130 UK. 192 G1 71 TOL 147183 189 us. 22 60 18 kU IL) aS * Sample: 1 select 17.743 fim-year observations Irom the Global Vantage Indsril/Commercad and Fase Files from 1991 to 1997. use the following ertria: (1 each country needs to have more than 100 nial total im year observations, provided that it has at east one observation each year (2) only inclatial ferns (SIC cades 2000-5999 vr 5000-5999) are include, (3) each fray observation needs to have suflicient data to calculate change in net income, change in ROE, and tennme () fms da nat change thee seal yourend (5) firmyenr abservations ds not ave the highost or lowest 1% value of ct income, change in net income, AOE, chanzein ROE; and sotuens ‘within ash country, and (6) fem year dato are propared under dometie accounting stendard. Varabie djotions: N denoues the aumber OF Ts-year observations. er denbus 13-momth fequrms ending three months after the fiscal yeatend, adjusted for dividends and stock splits. NT denotes net income before extraordinary items. scaled by heginning-f-year market value. ROF denotes rturn on equity of carnings. Is percentage 1s comparable to the findings im Altord et al. (1993). Table 6 reports the Pearson and Spearman correlations among the value relevance of NJ, value relevance of ROE, accrual index, tax book conformity index, and the proxies for shareholder protection (antidirector rights index and Tegal system). The upper (lower) triangle of Table 6 shows the Pearson (Spearman) correlation coetficients. Table 6 shows that the accrual mdex 1 M, Hang { Journal of Accounting and Economies 30 (2001) 401-420 als Table Cumulative market adjusted returns to hedge portfaice based on perfect knowledge of et income ROE, and stock price, 1991-1997 (1Smonh period ending three months afer the Hscalyeur-end ANT portolo AROE portfolio ‘AdjRer portftio Country ‘AdiRet Proportion —_AdiRet_—_—Proportion —-AdiRer e% of AdiRer——(%) of AidjRer_— (4) CH postolio (% Australia 26 468 060 Belgium 27 367 st Canada nas 07 ms Denmark 43 425 Ba Finland el m3 670 ance 226 487 on Germany M49 2 322 Hone Kone 199 81 Ircland 23 683 Ialy 94 42 Japan 83 365 Netherlands 1a Set New Zealand 266 656 Norway 46 sos Singapore 183 305 South Africa na ne Spain tos 166 sweden Ww> 286. Switzerland 27 486 390 Ux ne at ray vs. 06 380 S04 Average 184 283 24 366 652, * Refinion ANT donee change in an income scaled hy hagioning-aFywar market vale ANT portfolio refer to the squally weighted hedge portfolio that takes lone (short) positions in stocks ‘ith the highest (lowest) 40% of ANZ. AROF denotes changes in ROE. AROE portfolio rte to he eqully weighued hedge porilo dha kes tong short) postions In souks with che highest lowest) 40% of AROE, AdjRet denotes matkotadjusted return, Adj Ret postlio refers to the equally weighted hedge portfolio that takes lng (short) positions in stocks withthe highest owes!) 40% of ar. Positively associated with the antidirector rights index and legal system and negatively associated with the tax book conformity index (correlation coefficients are all significant at the U.UI level). The results suggest that countries with a higher use of accrual accounting have stronger shareholder protection and weaker alignment between their tax and financial reporting. Additionally, the association between the value relevance of NY and legal system Is signiticantly positive at the 0.01 level. 416 M, Hang { Journal of Accounting and Economies 30 (2001) 401-420 Table 6 Correlation co cnts of value relevance of eamings value relevance of ROE, accrual indo amigirector rights index, legal system, and wx-book conformity index; Pearson (Spearman) correlation eoetcients inthe upper (lower) triangle; two-tailed p-values in parentheses" Variable Val NI Val ROE Accrual index Anvitirctor Leva svstem —Tax-book Fights ide conformity inden Val NT oat 006 03 ost 028 (oar (usw) wr) (von 2 Val ROE 056 ~028 01 010 008 won ox) (098) 67) (0283) Acerut mies 0.20 — 001 0.03 037 008 (038) (098) (<00) (QOL) (=01) Aniirecor a3 0216 ome 0.78 righ index coos 036) (<0.01) (<0) (

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